Editor’s note: Contributor Ryan Spoon is a Principal at Polaris Venture Partners and focuses on investments in internet, technology and digital media.
Thanks in part to the Wall Street Journal’s “Web Startups Face Cash Crunch“, much has been made about the state of early stage investments and investing. While there is debate as to whether the article is accurate and/or overstated, let’s look at how we arrived here:
1. Pace of innovation. It is unlike anything we’ve seen before. This is happening because today is a better time to launch a company than ever before: technology, speed, cost, and capital all support the trend. The continued maturation of the internet, the cloud and the emergence of mobile platforms have changed everything involved in building product, targeting users and engaging customers. It has changed the fundamental operating and time constructs behind building compelling businesses.
As a result “entrepreneurship is in vogue”, using Fred Wilson’s words.
2. Capital. Over the past few years, it has flowed quickly into early stage technology – and it’s come from all directions:
3. Cascades. As more money flows into the seed stage, it affects the investments.
Most obviously: more financings get done.
Less obviously: the financings look different.
There are more early stage investors and those investors want to put more money to work…and invariably the deal economics shift. Entrepreneurs have a desired dilution amount and investors have a desired ownership amount —those move in relative concert. For instance, those rates are the same for a $500,000 round on a $2.5m pre-money valuation as they are for a $1m raise on a $5m pre.
Furthermore, it affects the deal structure. The majority of today’s seed deals are done on convertible notes—in part because it is often a more efficient way to raise a round and in part because the investor makeup looks different: a slew of great investors perhaps, but no true lead(s). These ‘headless seed’ rounds—without a lead investor to help support and shepherd the raise process alongside the founding team—can make downstream Series A fundraising challenging for those other than the rocket ship startups.
4. Cash Crunch. The “cash crunch” for a company comes when it is time to raise the subsequent round.
There has been a surge of seed-funded companies, many financed at strong valuations and by a wide network of investors; consequently, the burden is on the company to differentiate itself, show meaningful progress and grow into a subsequent funding in-part influenced by the initial round (capital and valuation).
Great companies won’t struggle here, but the reality is that there is a limited number of firms who can write these size checks and a limited number of companies that can support those valuations. Hence the “crunch”.
So what does this mean? Some simple advice I’d offer early stage founders:
Two questions I always ask seed companies:
“What will success look like at the end of the seed phase?”
“When do you know it’s time to raise your A round?”
If you have a great handle on those questions, the rest will fall into place.
Image credit: Shutterstock/ Lasse Kristensen
Ryan is a Principal at Polaris Venture Partners and leads Dogpatch Labs California. Either as lead investor or board observer, he works closely with Automattic, Formspring, Frid.ge (acquired by Google), KISSmetrics, LOLapps, Movity (acquired by Trulia), Offline Labs, Recurly, and ShoeDazzle. Previously, Ryan founded beRecruited.com (acquired in 2007), spent 2003-2007 at eBay (internet marketing, social media & leading Kijiji.com) and launched InGameNow as part of sfEntrepreneurs, LLC. Most recently, Ryan ran marketing at Flite (formerly Widgetbox).