Even before Sequoia Capital made $3.5 billion on a $60 million investment in WhatsApp, the seed- and early-stage funding landscape had already changed significantly. Most major VC firms have significantly scaled back their seed-stage investment programs.
Furthermore, many Series A funds will openly admit that the traction needed to raise a Series A today as opposed to 18 months ago is comparable to Series B.
At the same time, seed funds are raising more and more money for their new funds. Five years ago, the average seed fund was about $35 million; today, that number is closer to $100 million. The need to deploy more capital and the reality that traditional Series A firms have moved upmarket from the traction perspective for Series B-like companies has translated into seed funds happily deploying capital in companies that no longer look like “seedlings.”
Even accelerators have changed their tunes. During the latest Y Combinator demo day, a significant majority of the portfolio companies already had significant traction before starting the YC program, and many have been around for more than two years.
Every investor in the ecosystem has, in effect, gone up “one-stage” for supply and demand reasons. Of course, the fact that Sequoia can invest in a startup at $100M+ pre and still make more than $3 billion just validated this strategy — invest late, look for gobs of traction, pay up, and hope to god it turns out to be a unicorn. Except there is only one Sequoia.
VCs can go “up and down” the stage cycle as they please. However, for entrepreneurs, it’s the worst possible outcome. Entrepreneurs still have to put one foot in front of another to get from point A to point B. In the last 18 months, it hasn’t gotten any easier to close a big partnership, acquire users, or get an LOI from a customer. The startup laws of conservation of mass still apply. Based on the deal flow we are seeing, and from talking to other seed VCs, the average time needed from “founding” a company to getting an institutional VC to invest has gone from zero to at least one year — and, in some cases, two years.
The distance between that “eureka” moment when an entrepreneur has an idea to getting funded by a seed-stage institutional VC has become the valley of death — littered with companies that just simply could not get off the ground with little fanfare, attention, or data.
Not all is lost. The entrepreneurs who can survive the long death march usually have access to bootstrap capital or are able to survive with little to no burn. Some are able to raise money from friends and family for the capital they need to bootstrap the business. Others have fully-formed founding teams that can survive with almost no capital — usually “younger” founders needing very little to live. Some entrepreneurs have been planning this road for a while, and have actively been saving up for this 12-18 month path. Rarer, especially outside of the Valley, are entrepreneurs with either a track record or relationships that allow them to raise venture capital even before achieving any type of product-market fit. Regardless, the room for errors, for pivots, for experimentation has narrowed considerably.
In the Valley, this phenomenon is cushioned somewhat by a very active angel-investing ecosystem. There are still millionaires being minted from Twitter, WhatsApp, etc., where up to $100,000 can be invested purely based on trust of a friend of an ex-colleague. But nonprofessional investors do not provide the consistency of capital and operational help that a professional firm can provide. And even angel investing activity in the Valley has decreased to some degree because of the Series A crunch.
Outside of the Valley, the lack of true seed-stage capital is much more acute. In Los Angeles, where I’m based, many angels have either finished allocating the money they have set aside for angel investing, started waiting for cash returns of their investments and stopped investing, or gotten caught flat-footed by the lack of Series A capital for their seed investments. First-time angels rarely internalize that the usual lifecycle of a venture-funded startup is about seven years, and thus any pool of capital should be diversified across at least five years of cohorts.
There is a silver lining to all of this. The reduction in number of startups is certainly welcomed from the signal/noise-ratio perspective. That being an entrepreneur is not a fad, but reserved for those with the means and the stomach for the job, will ultimately increase the success rate of these startups. Furthermore, it also creates opportunities for angel and new seed funds that are willing to invest and nurture companies in the ironically named “pre-seed” stage.
Reputations and franchises are not made by investing in companies already on their way to success — they are made by taking bets, bending the growth curve, making a contrarian bet on an entrepreneur whom no one else will. This has already happened once before in the aftermath of a dot-com crash. Seed-stage funds founded in 2006-2008, like Baseline, First Round Capital, Floodgate and Harrison Metal became household names, at least in entrepreneur circles, because they filled a need in the venture ecosystem effectively.
Entrepreneurs will need to be more resourceful and scrappy to survive this “valley of death” to achieve product market fit. But at some point, maybe in about two years, new capital and new operating entities will appear to invest in these entrepreneurs, as well as help take these companies under their wings to help them navigate probably the trickiest and most deadly part of the startup life system. The storied venture capital firms of the Valley can afford to — and should continue to — look to turn their $60 million into $3.5 billion. The rest of us should learn from entrepreneurs that being a contrarian, being the crazy ones, is how we can change the world.
William Hsu is co-founder and managing partner of Mucker Capital, a pioneering Los Angeles-based venture capital fund that invests in seed- and “pre-seed”-stage companies building defensible and scalable businesses in Internet, software, services and media. Reach him @muckerlab.