BLOG STARTUPS, VENTURE AND THE TECH BUSINESS

November 20 2014
by Todd Hixon

It’s A Tough Market For Both Entrepreneurs And Early-Stage VCs

[This post first appeared at blogs.forbes.com/toddhixon on November 14, 2014.]

The price of equity in early-stage companies has popped up more than ever before in my ~30 years as a venture capital investor. The chart below shows that the valuation of Series A financings — the price investors pay per dollar of ownership in an early stage company — has about doubled in the last two years, and the price rise appears to be accelerating. These market changes are most visible in Silicon Valley and to a lesser extent in New York.

What is happening here? I think two things have changed. First, demand for seed stage equity is strong. Big recent successes (Facebook, Twitter) have created many new angels and much enthusiasm for investment. Plus, over 100 “institutional seed” or “micro VC” funds have  raised substantial dollars. The flow of money into the seed stage has accelerated. Entrepreneurs are in a strong position, so they are able to push the price up and make the terms lite.

Data from Cooley via Tomasz Tungaz of Redpoint Ventures. Reproduced with permission.

Data from Cooley; chart from Tomasz Tunguz of Redpoint Ventures. Reproduced with permission.

And the cost to get a company off the ground has dropped precipitously. This is the familiar story of improved software development platforms, cheap cloud-based infrastructure, and easy-to-access distribution channels, like Facebook ads and the Apple App Store. Start-ups have much more traction before they go out for Series A. So in many ways Series A is the new Series B: companies raise Series A with the degree of maturity and traction that formerly we saw at the Series B level, and they raise larger Series A rounds, similar to the Series B rounds of the past. And then Series B is the new Series C.

So, what is the new Series A? It’s “institutional seed” financings: a couple of Seed venture funds and/or super-angels investing ~$2 million in a company that is pre- or very early-revenue with a prototype product and the kernel of a great team. But, a lot of the institutional seed rounds are done on terms that offer investors little reward for taking the early risk. It’s common to see convertible notes that convert into Series A equity at a 20% discount with a conversion value cap near $10 million. And the seed investors typically have few rights. So the opportunity for appreciation from the seed round to the A round is limited, and the seed investors place themselves in the hands of the later investors for governance. Those are not great terms, and they are far less good than Series A terms were until a few years ago.

So, it’s a tough market for early-stage VCs: prices are high.

It’s not easy for entrepreneurs, either. They face a Darwinian cull of companies between seed stage and later stage. While seed financings have boomed, the total number of venture financings has remained between 3,500 and 4,500 per year (1). 2014 is on pace for 4,200 financings.

The structure of capital flows into venture funds amplifies this problem (see graph below). Capital in-flow dipped sharply after 2008. It has since recovered, but most of the capital has flowed to later-stage or growth funds. These funds invest mostly in the few winners that have crossed the chasm, established momentum and leadership, and need big dollars to scale. Exits for successful companies often come later now. As a result they need more private capital to fuel growth. The later stage and growth funds are serving this need.
Note that the capital allocated to mid-size funds, the classic early-stage investors, has not recovered from post financial crisis levels. This means that entrepreneurs with seed financing that now need early stage investors to help them across the chasm are competing for scarce dollars. It’s a tough market for entrepreneurs, too.

Data via Shai Goldman, Pitchbook, Atelier Assoc., and NVCA

Data via NVCA.org (total capital), Shai Goldman (seed funds), and Mark Suster (mid-size funds).

As with any Darwinian situation, the strategy for survival is to be the best [or at least to be seen as the best]. For entrepreneurs this means team quality, great strategy, brilliant product execution, and above all tangible traction. This explains the especially frenetic quality of entrepreneurial work and company promotion in Silicon Valley now. It’s a sprint up a greasy pole.

Early-stage investors need to pick investments that will perform much better to offset the higher price paid. They have a lot of options from which to pick but limited capital to deploy. This puts a premium on quality of deal flow and investment judgment. At NAV, we are taking specific steps to tighten the criteria for investments and focus our lead gathering in areas where we have advantages from networks, knowledge, and reputation.

And, limited partners should consider that the bottleneck in the venture industry is now in the middle. As my old boss liked to say, “When everyone runs to one side of the boat, the other side is likely to be drier.”

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Notes:

  1. Data for 2006 to 2014 from NVCA.org.  The number of financings in 2009, the nadir of the financial crisis, was slightly lower at 3,162.

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