The Funding Drought

Don't believe the hype.  Yes, it's a nice environment to be starting the winners of tomorrow and seed funding has not dried up.  And yes, Wellington and friends feel Spotify is the [Google][Apple] of media and pay (supposedly) €200m pre for the privilege of working with the excellent Messieurs Ek and Lorentzon.

But do not let these facts distract you, for most companies are facing a period of extended drought.

The focus should not only be on current activity but also on forward looking indicators such as this one: 75% of funds surveyed by Ernst and Young in Q1 indicate they are increasing reserves.

A number of effects are at work here:

• LPs closed for new business: Many funds are either failing to raise or are deciding to postpone their fundraising.  Hence they have to live for longer with the cash at hand.  That means reduced investment pace and a generally defensive stance.
• Companies in need: Companies are needing more cash.  Even late stage "safe" businesses suddenly revert to spending hundreds of thousands a month as they grapple with a tough economy and expansion plans gone wrong.  Exit are few and far between and the alternative sources of finance have dried up (venture debt, public markets etc).
• Optimistic funds chastened: Most funds were under-reserved for this crisis.  In other words, the ratio of reserves held back versus capital invested was too low.  Now, as you decide to hold back say $2 per $1 invested, all of a sudden cash planning shows a massive gap.  The result is ruthless portfolio triage and weakened syndicates.
• Uncertain future: most of all, lack of visibility on when this crisis ends and when liquidity returns block decision making and risk taking
• Existential crisis:  the industry must shrink, the GP's often need to reinvent what is they do, the legitimacy of the sector as a whole is in question.  Behind the short-term angst are some good questions about the abundance of fairly undifferentiated venture capital out there chasing fairly undifferentiated deals in shrinking niches.  But more on that some other day.

Net-net, the result is a two speed market where

• Atlas / Accel / Balderton/ Index / Wellington / Greylock / fill the blank are fighting hard for the "must-do" deals (wonga, just-eat, spotify etc)
• 75% of companies receive a firm but polite "no thanks, unless this is a recap" and are having to rely on their existing syndicates

Welcome to "pay-to-play" country where weakened investors who cannot follow their cash get washed out and often entrepreneurs along with them.  I have an aboslute sense of deja-vu from Q2-Q3 2003 here that is hard to shake.  Sure, this may the coming of age of VC-less bootstrapping and low capital intensity, no question.  But this exicting view of the world is oflittle solace to all the existing businesses out there who are VC backed and will have to rely on their existing investors for survival. 

We seem to be turning a corner and the worst may well be behind us, with some new fund initiatives such as Birch/Hoberman's ProFounders or the Boyz at Atomico.  But this will not solve the funding crunch fast.  For most companies out there in the "grey zone" (worthy but not obviously hot), it's tough and it's going to remain that way.

Comments

[rapidrollout.wordpress.com]

From the perspective of an entrepreneur who is committed to VC-less bootstrapping, the bigger problem may not be foregoing funding because of the funding drought, but losing access to the advice, referrals, and best practice knowledge of smart VCs. I wrote about this recently here: What To Do When There’s No Venture Capital.

[twitter.com/sferguson]

Thanks for the temperature check on the current climate. Just wondering if you have any advice for startups w/out VC funding other than continued angel rounds and VC-less boostrapping? Very interested to know what you think on the examples of Myngle (taking out a loan) and Trampoline (crowdfunding) ???

[Fred Destin]

Loan have a payback profile (with amortization) that usually does not fit the financial profile of early stage companies.

Crowdfunding is amusing and not a bad idea if you have a fervent following, but managing shareholders and keeping complexity down must be considerations too.

[Charles Armstrong]

fred, your point about "keeping complexity down" made me smile. going down the crowdfunding path enabled trampoline to return to a capital structure with only one class of shares and a set of articles 80% shorter than our vc investor imposed on us. overall trampoline's governance has been dramatically simplified by choosing crowdfunding compared to the conventional vc route.

[Fred Destin]

hey charles thanks for the comment. you are making a great point and i had not thought of it that way. my comment was motivated by experiences where you end up with 50+ angels who you have to hound down every time you need to get them to sign documents and who all call you at different times to get updates on the business. So from an ongoing governance standpoint it's simpler to have few people around the table. But you are absolutely correct that our documentation is much heavier (much of it geared towards downside protection and never used) and that we impose reporting requirements etc.

I woulod be interest in understanding better how easy it is to deal with your investors on an ongoing basis e.g. can a group block voting on key matters such as an acquisition or an exit ? Is it generally a good ongoing experience.

In any event you are making a very good point about the upfront "complexity cost" of dealing with a VC; thanks for sharing.

Fred