The Pig Passing Through The Python

Last Friday I received an email from a good friend at a high profile startup. He asked a question I’ve been thinking about a bit lately. From the email:

tons of startups have been writing in recently (i think there was one for every day this week) digging around to see if we might want to buy them. what’s really incredible is the timing…something we don’t know?

This is a trend we’re seeing accelerate as well. Companies running out of cash, unable to attract new outside money, and looking to find a home- preferably a home with a little upside for their investors.

Another growing trend for those not finding homes at acquiring companies is to raise a seed+ round of a couple hundred thousand up to a million or two more dollars from angels and seed investors- as opposed to traditional early stage VCs. I’ve had the sense that this trend has been accelerating too and today we get a little more data to fill in pieces of the story.

First, angel investing has become very popular. PEHub notes it has seen a nearly 5% increase of activity in the first half of 2011 over the prior year. In the first 6 months of 2011 over 26,000 new companies received an average of roughly $340,000 in angel funding each. That’s a lot of new companies!

So far so good.

Second, and this is where the trouble begins, the venture capital landscape on which many of these angel investments depend for follow on investment is shifting dramatically. Many early stage funds are struggling to raise new capital and remain active investors. In fact, the recent NVCA numbers highlight that investment in early stage venture funds dropped nearly 53% in the third quarter marking it the worst fundraising quarter for early stage funds since 2003.

But that’s not the whole story.

As Scott Austin, from Dow Jones Venture Source, reports there’s another dynamic at play here. It’s not just that investors aren’t backing funds, it’s that they’re only backing a handful of them

As limited partners continue to show a strong preference for investing with only the most prominent firms, the number of funds and the amount of capital committed have shrunk. If this trend continues, entrepreneurs will face greater competition for capital and other investors.

This steep increase in number of companies angel/seed funded, paired with fewer and fewer active investors up stream is creating a scenario akin to a pig passing through a python. As the time, attention and capital becomes more scarce upstream the number of companies who will attract follow on capital will continue to decrease.

Which isn’t necessarily a bad thing.

Somewhere in this rush to seed 10s of thousands of companies, it seems the purpose of a seed round has gotten lost. The intent of seeding something isn’t simply to get it going- most of the companies we see seeking seed funding have something demonstrable. Nor is seed funding simply done because it’s the cool thing to do these days- the cool factor wears off quickly once the sleeves get rolled up.

No, seed funding is a different kind of animal.

Seed funding is for validating and de-risking, not scaling. As Josh Kopelman wrote:

The goal of seed funding is to validate (or disprove) an entrepreneur’s hypothesis, and thereby “de-risk” the opportunity. Early stage companies should raise enough money to allow them to iterate - as long as their initial hypothesis is still valid and they are making demonstrable progress towards lowering risk…In the new funding model a startup is able experiment/iterate over an extended period of time for very little capital. Only once some of the venture’s risk has been eliminated through accelerating adoption does the company raise more money to further refine the model and expand. Overall the time and cost between the founding of the company and knowing whether both the entrepreneurs and investors should continue to pursue the opportunity is greatly decreased.

My purpose in pointing this out is not to play chicken little or create artificial fear, it’s simply to highlight the phase of the cycle we’re in. The pig is passing through the python- the pig is growing by the day and the python is shrinking. Follow on capital will become less and less available over the coming quarters so validate, derisk and plan accordingly.