Where startups really get (cash) crunched

Oct 13, 2011

If startups are facing a cash crunch, it isn't when they start up.

Venture capitalists today are buzzing about a Wall Street Journal story about how Internet startups are facing a "cash crunch."

It's mostly based on AngelList data (or not, see update below), plus venture fund-raising statistics from Dow Jones. I don't dispute either of them, but believe they need to be viewed in a broader context. More importantly, I think the real story they tell was overlooked.

First, overall venture capital activity is not decreasing. Official Q3 data won't be released until later this week, but a preliminary look shows that U.S.-based companies raised less money than in Q2 but more than in Q1. And since third quarters are traditionally slow due to the vacation months of July and August, there doesn't seem to be much news in the top-line numbers.

Moreover, around 49% of completed U.S. venture deals in the past three months were for seed-stage or early-stage companies. For the past 12 months, the figure stands at 47%. The difference in dollars invested as a percentage of the whole was negligible (from 30.4% for past 3 months to 30.6% for past 12 months).

AngelList data is an important metric, but it also reflects the biases of a relatively small -- and arguably skewed -- subset of venture investors. For example, the recent market volatility has likely knocked out a lot of angel tourists who had been allocating 10 or 15% of their assets to venture investing (denominators don't only affect public pension funds). Institutional VCs, however, have not been similarly affected (and I include super-angels in this category).

It certainly is true that fewer and fewer VC firms are raising money, but that trend has been in place for years and there is still plenty of dry powder. After all, the rise of super-angels is barely one year old. Moreover, many larger firms have launched seed-stage investing programs within the past 18 months -- thus increasing the overall capital pool for nascent startups. Examples include New Enterprise Associates, Greylock and Menlo Ventures. Some folks discount these programs as cynical window-dressing, but money is money within this particular argument (and I happen to think most of the programs are legit).

To me, the larger issue is capital availability beyond the seed-stage. I'm not talking about massive Series F rounds for Facebook or Groupon, but rather Series A or B deals in the $5 million to $25 million range. This is where I see a bit of capital gap. How many venture firms out there market themselves as Series B investors, first and foremost? Not many (it's no surprise that First Round Capital hasn't been copied by a Second Round Capital or Third Round Capital).

For example, expansion-stage deals made up 28% of all U.S. venture deals completed in the past 12 months, and around 35% of the total invested capital. Five years ago those figures were 36% and 42%, respectively.

How come? Because post-seed A or B rounds often carry the same risks as seed with less potential reward. It's one thing for an existing seed investor to participate pro rata, but quite another for an outsider to join the party (unless success seems obvious, at which point the valuation will be sky-high). In fact, that's a pretty good case for entrepreneurs to sign on with larger institutional VCs at the seed-stage, rather than trying to rely on angels who are one 400-point Dow loss away from being tapped out.

I know some entrepreneurs don't want to get "lost" in a larger firm, and appreciate the personal attention and networks of angels. And there certainly can be a happy mix of both. But, if you have to choose, the institution is far more valuable. If Web startups are hitting a cash crunch, it's likely because they chose the wrong seed-stage investors (assuming they had a "choice") and there aren't enough mid-round institutions to help them out.

Update: AngelList's Naval Ravikant just tweeted the following:

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