I think we can all agree that early stage investing has changed significantly over the past 10 years and I don’t see it reversing any time soon. And by “changed significantly” I mean it is increasingly difficult to raise the $100K – $2M necessary to move from the pre-seed stage (where you likely raised $10-$100K from friends and family or your 401(k)) to raising institutional venture capital (~$2M +). This gap straddles two stages of financing - seed stage and early stage. For purposes of this post, I’ll refer to this gap as the “early stage gap”. The companies looking to raise money in this early stage gap are generally past the proof of concept stage, are not yet ready to blow it out with institutional venture financing or growth capital, and are looking for additional capital to continue building out their product or service and gain the elusive “traction” (see my earlier thoughts here on the “traction” concept) necessary for raising larger sums of money at a decent valuation.
This early stage gap is a problem that desperately needs a solution. According to Bloomsberg Businessweek, in the 1st Quarter ’09, venture investments plummeted to $3B (down 61%), and only $169M of that total number went to companies raising seed stage financing. The longer this early stage gap continues without a workable solution, the greater chance the institutional venture funds and growth capital players will see a widening gap in the number of companies that reach their respective stage of investment.
The reasons for this widening gap are numerous and varied. It’s complex, to say the least. Here are some of the contributing factors, in my opinion:
- Angels groups, and some individual angels, are now co-investing in larger deals or later stage companies – a portion of the early stage gap (i.e., $100k – $500K) used to be purely the realm of angels (for a description of angels, see my earlier post). In th0se early days, you’d fill in an angel round like with 1-10 individual angel investors. Recently, however, angels have begun to form groups or networks in order to better source and diligence deals – this made finding angels a lot easier. The law of unintended consequences though has intervened. These groups are now easier to find, but they are also now banding together with venture funds, and in some cases individual angels, and doing syndicated rounds. Syndicated rounds used to be the realm of just institutional funds or large private equity houses. According to the Angel Capital Association, in 2008 the greater majority of angel groups or networks looked to invest between $250K – $500K, with $0 – $250K running a close second. Now, two years later, rather than have one angel group put $250K in an early stage company and run the risk that such company couldn’t raise any more money down the road, angel groups are now co-investing with other angel groups or venture funds so that the total round is more like $1m or $2m or more. With that much money, and the fact that most of these syndicated deals are occurring with expansion stage companies rather than in the early stage gap, the angel groups are able to significantly reduce at least one of the risks inherent in these deals – the company running out of money and not being able to raise more. As I mentioned, this method of co-investing has trickled down to individual angels also. A perfect, recent example is Swipely, a company still at the invitation-only beta stage. Swipely recently raised $7.5M from both venture funds (First Round Capital, Greylock Partners and Index Ventures) as well as several well-known angel investors (Ron Conway, Chris Sacca and others). What does all of this mean? Well, the angels (both individuals and groups) that used to be putting $100K or more into a company in the early stage gap are no longer doing so. Couple that with the fact that there is no one to step in and fill that role, and you have a significant reduction in companies being funded at the early stage gap phase. Having angels invest at such an early stage was crucial. Even Harvard reports that they’ve gathered evidence that angel-funded firms are less likely to kick the bucket and that improvements of 30-50% can be seen within businesses funded by sophisticated angels. Talent like this is really needed in that early stage gap.
- It is hard to raise true early stage funds in today’s economy - it’s not the mid-90′s any more when, historically, the most venture money was being raised by old and new funds. A lot of that money was put to use in ways that produced zero results. In the early to mid-2000′s, many venture funds got hosed and, in turn, their limited partners got hosed too. Limited partners, like pension funds, endowments, insurance companies, started to realize that the late 90′s bubble produced some very heady exits, but for the most part also produced a large number of duds. It also took 8-10 years to figure out which were duds and which weren’t if you had invested at an early stage. Nowadays, limited partners are hesitant to back true early stage funds because they don’t want to wait 8-10 years to find out where the investment is going. Later stage funds that may only have to wait 2-3 years for an exit aren’t having those same money-raising problems. Without limited partners supporting early stage funds, those funds are disappearing at a fast clip and with them goes what were, historically, core investors in the early stage gap.
- There is a lot of competition right now trying to raise money in that early stage space – given the fact that this early stage gap exists, and given the fact that the creation of start-ups hasn’t seemed to wane, the competition for raising money in the early stage gap is increasing at an alarming rate. There are lots of deals chasing very little money in that early stage gap right now.
So – how do we fix this? I don’t believe that a silver bullet exists (it never does), but here are some of the self-executing solutions popping up in the marketplace:
- Capital efficiency – capital efficiency is all about doing more with less. Don’t confuse this though with bootstrapping mentioned below. Whereas bootstrapping generally implies that no outside money has been raised, in a capital efficient business model companies still raise outside money, but they deploy the money in a model that uses that capital efficiently. By that, I don’t mean that the officers of that company sit around pontificating the best use of their dollars but, rather, I mean that the company uses technology to reduce their operating costs. Recent improvements in open source software, the outsourcing of development and reduced customer acquisition costs have allowed capital efficiency to thrive in certain sectors. It is these advancements in technology that allow companies to achieve the same level of performance but for less money. Not everyone is a fan of capital efficiency, however. In this article, the author does a good job critiquing capital efficiency and arguing that it does not deliver. Eric Wiesen, a partner at RRE Ventures, argues in his article that capital efficiency leads to building incremental products with no real innovation.
- Super-angel funds- Paul Graham, co-founder of Y Combinator, says it well on his blog when he writes “instead of making one $2M investment, [venture funds should] make five $400K investments.” In essence, he is describing the super-angel model employed by First Round Capital, Founders Collective and Mike Maples’ new fund Floodgate. First Round Capital’s current fund is approximately $125M (which is much smaller than some of its competitors which have $500M funds). Nevertheless, First Round did 41 deals in 2009 which made it the 4th most active investor. Typically, First Round’s initial investment is only $500K – $600K. These funds are referred to as super-angels because they invest amounts reminiscent of angel investing but they are doing this out of funds that clearly exceed any angel fund in terms of overall size (e.g., First Round’s $125M fund). Super-angel funds attempt to spread the money around in a large number of start-ups. But super-angels also provide more than just a check. As this article makes clear, super-angels offer at least one of three values: (i) a networking mastermind, (ii) geniuses ability-usually in the technology arena, and (iii) deep expertise in certain fields that would simply take years to replicate. In my opinion, super-angel funds are really trying to take seed and early stage investing back to its roots.
- Incubators – incubators can be a very effective way to bridge the funding gap because they provide free resources that can help reduce an early stage company’s overhead. Examples of well-known incubators include TechStars, Y Combinator, and DreamIt Ventures. States also frequently create incubators to deploy state money and resources with the main focus being the creation and retention of jobs. The best known, and most successful, in Pennsylvania is Ben Franklin Technology Partners. However, incubators generally deal with companies in their earliest stages, as that is the time that incubators can deliver the most value. Some incubators provide money (either in the form of a stipend or in the form of a loan with warrant coverage), whereas others provide free access to office or lab space, office supplies and advisory resources like legal and accounting (which can be just as good as money). Some provide both. However, the later stage you are, the more “real” money you’ll need - it becomes less about free office space and more about being able to hire competent workers and pay them a salary. So the incubator model certainly helps, but it only goes so far.
- Bootstrap – as mentioned above, bootstrapping a company means not raising any outside money and essentially growing the company at a pace set by retained earnings. Bootstrapping is all about getting a lot done on very little cash. For instance, the software industry has come up with bootstrapping methods such as minimum viable product and microtesting. For a good article on bootstrapping see this one by the Kauffman Foundation. Or see Guy Kawasaki’s tips on bootstrapping. Taken to the extreme, however, bootstrapping can seriously restrict a company at a time when that company could be hitting it out of the park. Bootstrapping can be very effective if the timing is right and if it is used early in the company’s history to overcome the initial financing hurdles. If the company really needs to grow at a later stage then outside financing will most likely be needed. If you are still bootstrapping a company after 5 or 10 years, it’s more likely you are running a lifestyle business that cannot even support a revolving line of credit from a bank. For companies entering that early stage gap, bootstrapping can be an effective way to bridge that gap and reach a level where serious expansion money can be raised. It just might take you longer to get there.
In my humble opinion, super-angel funds and incubators currently have the best opportunities to solve the early stage gap, with capital efficiencies and bootstrapping helping out in other limited area. Questions and comments welcomed. Thanks.
Chris McDemus is founder of VC Deal Lawyer, a blog devoted to providing insights on start-ups and emerging growth companies. Chris is also founder and owner of MCD Law Partners, LLC, a boutique corporate law firm serving start-ups, early-stage and emerging growth and middle market companies.