Tuesday, September 18, 2012

The Eye of the Needle

It's fundraising season once again in Startupland and early-stage founders are feeling the pinch.

The starting gun went off on Labor Day -- when VC partners returned from their summer holidays, put their kids back in school and started showing up for partner meetings again.

The fundraising circuit will run white hot from now until around Thanksgiving, when the year-end holidays fragment VCs attention and make it next-to-impossible to get on their calendars until after the New Year.

My interest in this Fall fundraising window is more than academic -- here at Founders Co-op we have half a dozen portfolio companies preparing for or actively seeking a venture raise, and the entire TechStars Seattle class is in full sprint toward their November 1 Demo Day.

But the hard truth is that the vast majority of Series A+ fundraising efforts this Fall -- including some teams and companies I care a lot about -- will not win VC support.

This is not a new idea. About a year ago there was a brief but intense online squabble over the idea that a "Series A crunch" was fast approaching -- the idea was introduced by Elad Gil, echoed by Rob Go (and others), and angrily denounced by Dave McClure before fading (temporarily) from view.

It's that time of year again, so in this week's Washington Post, NAV's John Backus brought it up again, this time under another name: the "Angel Bubble" (his Post article is a condensed version of a longer and more detailed post he published in late August, just before the season kicked off).

Call it what you like, the math is the same: the exploding seed/angel tier of software finance now funds one or two orders of magnitude more companies each year than the Series A market has the capacity or appetite to fund.

It's ridiculous to argue that this math problem doesn't exist. What's more, as a "professional" seed investor I see the Series A Crunch / Angel Bubble as (mostly) a good thing for the startup ecosystem.

Here's why:

It's great for the future of innovation and job creation in the U.S.:
  • By giving the early-stage market more shots on goal, the growing seed / angel / "micro VC" tier has significantly increased the odds that an actual breakthrough innovation will emerge from among the clutter of mobile-photo-music-sharing-private-social-network-peer-to-peer-consumption ideas currently making the rounds.

It's great for the long-term health of the Venture Capital business:
  • The seed funding bulge has created a target-rich environment for the capital markets players that sit a level or two above angel/seed, offering a much richer pool of willing prospects from which to choose, and increasing the odds that the few bets they make will actually pay off. I suspect John Backus says what many VCs are thinking when he says: "I am... the biggest fan of the angels and incubators. They make my job easier. So thank you – and keep it up!"

It may not feel like it at the time, but it's also good for the founders -- especially those in white-hot talent markets like Silicon Valley -- whose ideas don't make the Series A cut:
  • There are too many talented teams pursuing incrementally different versions of the hot ideas of six months ago (meaning the ones that attracted big funding or saw big exits). I speak from my own experience when I say it's a gift to have your bad idea shot down early, before you've poured years of your life and millions of your investors money down the hole. The founders who learn from their early failure and take another swing will come back smarter and stronger the next time.

So is the Series A Crunch all puppies and rainbows for the innovation community? Not exactly.

The one glaring downside to the (re)concentration of power in the hands of the Venture Capital business is the chilling effect it could have on globally distributed innovation:
  • The near-total collapse of the innovation cost curve -- thanks to the perfect storm of open source tooling, pay-as-you-go cloud infrastructure and "free" global distribution via search + app stores -- has unlocked a truly global explosion of digital creativity. This democratization of software innovation lies at the heart of the Angel Bubble: when innovation is cheap and can happen anywhere, there are exponentially more potential funders of innovation, and they also can be anywhere.

  • But when power tilts back to the geographically concentrated gatekeepers of venture finance, the long-term future of distributed innovation starts to look less certain. And when those gatekeepers are inundated with high-quality dealflow right in their own backyard, their appetite to reach beyond their comfortable offices on Sand Hill Road -- never strong to begin with -- goes to zero. This shift is well underway.

So how can we hold on to the welcome market discipline of institutional finance without killing the equally powerful engine of cheap and massively distributed global innovation? The answer is already emerging, if you know where to look:

  • Two of the most well-respected new VC firms in the business -- Brad Feld's Foundry Group and Fred Wilson's Union Square Ventures -- don't even have a Bay Area office. A third -- First Round Capital -- has Bay Area partners but is headquartered in Philadelphia. Philadelphia! America's "second cities" (and "third cities, for that matter) are beginning to build world-class VC capacity that doesn't look to Silicon Valley for guidance but plays by its own rules.

  • This same trend is playing out in global innovation hubs like India, China and Brazil. Yes, the big Valley firms are plunking down offices and creating joint ventures, but there are also strong and fiercely independent local firms who see the potential for home-grown innovation cultures and are building platforms to invest in their national economies over the long haul.

The Bay Area is -- and probably always will be -- the world's #1 geographic concentration of both talent and capital for digital innovation. But the Valley's lock on both talent and capital is weakening -- not because Valley VCs are losing their touch (far from it) but because the genie of distributed innovation is out of the bottle and the capital markets have begun to follow suit.

Capital will always flow to genuine innovation, and investment-worthy innovation is now happening in lots of area codes besides 415 and 650. It will take time for the capital markets to catch up with the maker community -- and a lot of good companies that just don't happen to be based in the Valley will die a needless death before they do.

But change is coming: I know of several smart Valley firms who spotted this pattern early and are quietly reaching beyond their traditional geographic comfort zone to test the waters before their peers catch on. I'm also thrilled by the rise of strong firms in Boulder, New York, Philadelphia and elsewhere that are putting this theme at the heart of their investment thesis.

Makers gonna make. Money will always find them. It's still Day One.