Happy New Year and welcome to 2013. According to all of the blogosphere chatter over the past month, seed-funded internet startups are entering this year gearing up for the now-near-infamous Series A Crunch. The CB Insights report specifically which came out just before the holidays put a bright light on the supply-demand imbalance of the seed-stage companies searching for Series A capital. The figures are indeed the facts, and this report is probably the most accurate reflection of what has actually happened in the rise of the number of seed investments completed over the past couple years. However, I would take issue with the near-consensus conclusion of what is to follow.
There is an incorrect implicit assumption in the Series A Crunch talk that all of the seeded companies are in the funnel to raise a Series A. Look back to the reasons why there was a Cambrian explosion of seed funding in the first place – a dramatic reduction in the initial capital requirements to launch a new company because of cloud hosting infrastructure, social graph distribution platforms, open source and low-cost development tools/methods, etc. It is for those same reasons that it is capital efficient to start a software bits-based company that it is also now just as capital efficient to operate a software bits-based company. What isn’t as efficient is aggressively scaling a business ahead of cash flows, which is the reason why companies of any sort raise capital (equity and debt) in the first place. Given the ability to plug into (often self-service) monetization platforms and/or employ freemium models which weren’t available or de rigueur five years ago, seed stage companies are able to transform into seed stage businesses (with real revenue!) to become not just ramen-profitable, but sustainably profitable.
The nuance which isn’t being recognized is that most of the companies of this latter profile, while viable businesses, aren’t venture-scale businesses. Businesses which should and do attract venture capital are ones which have the potential to be both high-growth and extremely large. Many startups which have been seeded in the past couple years just don’t fit this profile, but that doesn’t mean they’re not viable businesses which are going to hit a brick wall and Crunch, as has been prophesied. Instead, startups are now empowered to create focused services which benefit a small niche audience.
To use an analogy, think of starting newspaper/magazine in the previous century. At the beginning of the 1900’s, the only way to do so was make a capital investment in a large printing press, so the only audience justified was an entire metropolitan city. But as the printing technology improved dramatically, the ability for publications which served smaller and smaller niches became increasingly viable. Then not every newspaper needed to be as large as the New York Times or required the capital to do so. We’ve seen an accelerated & compressed version of this phenomenon over the past decade in bits-based startups, which has led to a proliferation of niche services. Just as a small community newspaper or a special-interest magazine didn’t need significant amounts of capital to become sustainable, so too today with many of the recently seeded startups which have focused services for a specific target audience or customer-set.
Not to say that there aren’t plenty in the category of photo-sharing apps or mobile games which required mass audience which never materialized. Or that entrepreneurs or their investors sincerely believed that they had a venture-scale opportunity in front of them, but it turns out that they didn’t. But a ramification of the Lean Startup movement which has been espoused and adopted is that you directly serve customer’s needs, even though the opportunity to do so might not in the end be large or high-growth.
So it doesn’t surprise me at all that in the CB Insights report cites that “seed deals in which VCs participate have a historically higher rate of getting follow-on financing as compared to seed deals in which VCs are not participating.” Despite the signaling issues present, VCs getting involved at the seed-stage have the lens to and propensity to recognize those sets of companies which truly do have the potential to become venture-scale businesses.
In the end, just as always: startups are risky and a majority of them do not survive. But good businesses are inherently that – good businesses, and the exceptional ones which can be both high-growth and extremely large will attract additional venture capital regardless of any Crunch. Others in this recent cohort of seed fundings will find alternative capital sources or will accelerate their path towards cash-flow sustainability. However, sensationalist headlines about thousands of companies “evaporating”, “dropping like flies”, or being “kill[ed]” will surely generate pageviews, but isn’t an accurate picture of what 2013 will actually bring. So the good news is that I don’t think startups should be entering 2013 with a Crunch-mode mindset, but rather, they should be entering in a business-building-mode mindset… which is a good mindset to have been in all along.