Ego Capital and the “Series A Crunch”

The problem isn’t too little smart money, it’s too many dumb deals

The meme of the month is “The Series A Crunch.” According to Crunch Theory, many worthy seed-funded startups lack follow-on capital because VCs now have smaller funds or have moved later stage. CB Insights estimates $1 billion in seed financing will be “incinerated” and at least 1,000 companies will be orphaned. Other data suggest that the number of orphans could be much larger.

Those who say the problem lies with VCs (CB Insights isn’t one of them) must argue that the number of Series A deals has fallen sharply. This is not true and the problem lies elsewhere. Whatever the cause, there is, certainly, a capital crunch for seed-funded startups and it is likely to get worse, as the backlog of seed-stage companies needing Series A funding continues to grow.

Angel investors are panicked that it is hard to move from seed to institutional funding. As Adeo Ressi (founder of The Funded.com), urged well-heeled angels in late 2011, “don’t launch a company, launch a fund” or startups will die. The pain is growing; a search for “Series A Crunch,” now returns more than four million hits.

So, are VCs funding significantly fewer Series A deals? According to CB Insights’ venture and angel investing data, not at all. VC Series A deals in the U.S. have actually increased over the past two years, (until Q4 2012, when both angel and VC funding decreased). The average quarterly number of Series A deals for the past two years has been higher than the overall average (145) number of deals per quarter for the past four years and the trend line is positive. (See Chart 1: Weissman Crunch Series A)

So, where’s the VC-caused crunch?

Take a look at Chart 2: Seed Vs. Series A Funding. The problem is clear when one compares the number of VC Series A (green) to the number of angel-funded seed deals (red). Series A financings have been stable, but there has been a dramatic increase, since late 2010, in the number of seed-funded startups.

Pitchbook noted that the ratio of seed to Series A was 1.9:1 in 2008 but is 3.3:1 today. And analysts may be understating the problem. CB Insights estimates that 4,000 new U.S. companies were funded by angels, from 2010 to 2012. The University of New Hampshire’s Center for Venture Research (CVR) estimates that nearly 58,000 startups received initial angel funding between 2010 and June 30, 2012. According to CVR, angels invested $20.1 billion in 61,900 deals in 2010 (31 per cent were startups); $22.5 billion in 66,200 deals in 2011 (42 per cent were startups); and $9.2 billion in 27,200 deals in the first half of 2012, (40 per cent were startups).

If CVR is even half right, there are far more companies at risk of becoming orphans than CB Insights estimates. CVR’s data, for example, suggests that the 11,000 software startups founded and funded during the past two-and-a-half years is, by itself, more than double CB Insights’ total of all seed-stage deals in all sectors.

Angels everywhere

In the last full year studied by CVR (2011), 66,000 startups were funded by 318,500 individual angels. Where did all of these angels come from?

It seems like everyone is an angel. Major groups like Sand Hill Angels, Golden Seeds, Tech Coast Angels, Launchpad, The Angels’ Forum, Investors’ Circle, New York Angels, the Band of Angels and 300 other institutional angel groups account for approximately 12,000 to 15,000 of these investors.

Beyond institutional angels, there’s been an explosion of new models: seed stage funds, so-called “super angels,” and initiatives like Startups Across America to launch incubators and accelerators in every major metro. And almost every university has its incubator, too. Angels have gone online via Gust, Angelsoft and Angel List, websites that enable speed dating between investors and entrepreneurs. The recent US Jobs Act will broaden the base and lower the qualifications for angel investing even further. Today, virtually anyone, the proverbial “dentist with dollars,” can be an angel. I fear that the New Jersey boiler room hucksters are salivating at the chance to sell Florida retirees the latest “hot” Internet property.

As an active angel (the Band of Angels and the Berkeley Angel Network) I am strongly in favour of a healthy U.S. angel capital sector. Smart angel financing, together with the mentoring that experienced angels provide, is a tremendous force for social, political and economic good. I’d much rather see creative, private sector approaches to the problems that aging Western societies face than government “investments” and mandates.

But viewed in the aggregate, it seems like a year 2000-style investment bubble all over again, with angels this time, instead of VCs. We’ve new angel groups, incubators and seed funds appearing weekly. Xconomy identified 20 startup incubators in 2009, 64 in 2011 and 121 in 2012. Each of these nurtures dozens and in some cases hundreds of startups annually.

Why the surge in angel investing?

1.  Lean startups. Capital requirements for software and Internet businesses are at record lows thanks to open source, cheap hardware, and offshore and outsourced engineering and customer support. A little capital–$50,000 to $200,000 – can go a long way. This has tempted a new generation of lean entrepreneurs to seek funding from a new generation of investors, many too new to remember the last bubble in 2000, or the PC-fueled storage bubble of the 1980s.

2.  More exits = more newly minted angels. Since 2009, we’ve seen a sharp recovery in exit valuations, which soared in 2010 and 2011. Facebook, LinkedIn and many other public and private exits have created a new group of angels.

3.  High public valuations attract investors and are a self-fulfilling prophecy. Angel and VC investing trends react to public markets. Pre-money valuations of deals in so called “hot” sectors, like social gaming and social commerce, reached stratospheric levels for a while after celebrated IPOs. High valuations are, to some, a sign that good times are back and investor confidence has increased. During the Internet Bubble, just like during the Dutch Tulip Mania, high valuations gave investors the psychological confidence to keep investing in public and private companies. For someone like me, high valuations are signs of trouble.

4.  The rise of Ego Capital. The sexy career path for some successful entrepreneurs is to become angel investors or seed fund managers. Having had one startup success, many newbies seek to apply their success formula to a new crop of startups. We’re seeing new seed and even “dorm funds” managed by recent college grads who have no experience in venture or fiduciary fund management. It’s so cool to run a fund that even bloggers are doing it. And a new class of angels, “super” angels, are writing bigger cheques. One super angel, Ron Conway, famously warned in 2010 that angel investing shouldn’t focus on the personality of the investor; it is, he argued, about helping entrepreneurs succeed. Sadly, we’re now at the stage where angel investors are becoming brands. This is bad for angels and for the companies we fund.

Rather than look for unique deals, the Ego Capitalists all too often look in the mirror to invest in a familiar, narrow range of deals from their entrepreneurial past or in herd deals – mostly catalyzed by the last over-hyped social commerce or digital media exit. The Ego Capitalists need to ask, “how many social coupon or video sharing sites does the world really need?”

So, what’s wrong with this state of affairs?

We’re drowning in me-too companies. The number of self-funded or angel funded me-too deals screams that the supply of people and capital has far outpaced the supply of good ideas. Adding “social” to a few gaming, e-commerce or media sites is interesting. Doing it hundreds of times is self-defeating.

Let’s look at a few tech sectors where Crunchbase’s partial but helpful directory of startups hints at the depth of the me-too problem:

• 450 businesses with tags indicating a focus on coupons
• 257 “daily deal” deals
• 408 sites tagged as focused on dating
• 80 video sharing sites
• 146 photo sharing sites
• 330 job recruiting boards
• 151 places to go shopping socially
• 142 online sites to help charities raise funds
• 64 places to go to find bars
• 75 companies managing or monitoring social media
• 60 gifting sites
• 108 sites to find an online tutor

Investors advise a first time founder to start a company based on “what you already know.” So Crunchbase suggests that today’s software entrepreneur knows how to find a bargain, search for a date in bars and online, share photos and videos of his date online, give dates gifts and, when he’s run out of dates, or, more likely, run out of cash, he knows where to go online to look for a job.

Even staid categories have a serious oversupply of companies. A year ago, the Gartner Group listed more than 60 mobile device management firms. How many does corporate America need? A handful is likely to do well; the rest will die or become zombies. Most tech sectors are winner-take-all, where only the top two or three firms IPO, M&A profitably, or partner with market makers. In a 50-company market, you’ve a six per cent chance of being in first, second or third place.

We’ve been starting and funding far too many Me-Toos that compete for limited market share. With many firms exactly like all the others, dozens of startups compete for the same customer. Cisco, Blue Cross, Pfizer and even your college roommate can’t buy from all of them. And Google, IBM, Salesforce and Facebook can’t partner with every startup, either.

At a recent pitching event, I was unenthusiastic about a CEO’s undifferentiated advertising deal. He asked (and you can’t make this stuff up), “Would you like the deal more if we added a shopping cart to our ad network?”

We’ve started thousands of copycat, paint-by-numbers companies. As a result, many seed-stage startups who are competing for small slivers of market share will never gain enough traction to raise follow-on capital – and many don’t deserve to. Overfunded sectors are bad for everyone.

Following the 2000 dot-com implosion, one third of all angels disappeared, as did most incubators and accelerators and many corporate VCs. Startups suffered down rounds, a capital crunch and plenty of low-value IP asset sales. Many investors and incubators lacked the capital to defend their positions in the inevitable pay-to-play rounds that followed the crash and took crushing valuation hits, and eventually disappeared.

Sound familiar? The Ego Capital bubble is starting to burst. And this is one mania that we angels and our entrepreneur friends can’t blame on Wall Street or the institutional venture community. Want to know whom to blame? Just look in the mirror.