Don’t Launch A Company, Launch A Fund (Or The Series A Will Die) November 4, 2011Posted by Ian Cheng in Funding.
Founder of The Founder Institute and TheFunded.com
Every investor and entrepreneur knows there is something scary about the current startup economy. There is an enormous amount of angel capital available, while at the same time there is a small amount of Series A and a large and concentrated amount of late stage capital. Industry insiders have affectionately dubbed this situation “the Barbell”, and it has become the most serious threat to the progress that startups have made — since 2008.
At least nine out of ten high-quality angel-funded startups face an unnecessary death, because there is no Series A money to help them survive critical expansion. (See Rip’s post on the rise in late stage capital here.)
In the last boom ending in 2008, there was approximately $30 billion in angel investments and another $30 billion in venture investments done every year. By most estimates, there is now as much as $80 billion in angel versus just over $10 billion in all stages of venture. Just 1 in 100 angel deals may get funded by venture capitalists today, yet there are probably at least 10 strong startups in a 100, if not more.
As if this were not bad enough, estimates are that 70% of angel deals across the United States and a growing number of investments in other countries are structured as convertible debt. The debt needs to convert into Series A equity within a year, or the debt needs to be paid back. Investors regularly extend the debt that has come due for another year, since asking the startup to pay back the loan would bankrupt the business. With 10 or 20 angels of varying levels of sophistication in a deal, it only takes one angel to request a payback, and the company will go down. (Elad Gil has a smart post on TechMeme today that also analyzes this series A crunch.)
The solution to this structural problem in the startup economy is simple: we need more venture funds. Unfortunately, thousands of funds around the world have been killed off since 2007. Just in the last three months, 1 of 4 of the top-rated venture capitalists on TheFunded have left their firm or the field altogether, so further declines in Series A investments are on the horizon. At this pace, the venture industry won’t hit bottom until 2014, after which turnover cycles in limited partners and growing returns from secondary markets should support new interest in the asset class. In the end, more funds will save the good companies and balance out the infamous barbell.
All of this means that it is precisely the right moment to launch a fund. First, you have a large number of high-quality companies that need capital, while the competition to provide capital is decreasing. Second, you have a pool of frustrated limited partners looking for new managers. Finally, there are new forms of liquidity that are starting to drive returns, most notably the active secondary markets. It probably won’t get much easier to launch a new fund than it is right now, and the startup economy needs the help.
A great source of these new fund leaders may be the hundreds of people setting up Y Combinator clones around the world. These seed-fund/ incubators require two to three million dollars per year to run, producing between 10 and 20 angel funded companies. Many of these will fail due to the high cost of annual operations without a functioning Series A market. The people that set these incubators up have already raised capital, so they are in a good position to set-up a fund. If you are really bold, like Dave McClure, you can run both an incubator and a fund, though there are some obvious conflicts of interest.
Running a fund is not for everyone, but, if you think you have it in you, go for it. Now is the time.
Another important note: There is the upcoming Founder Showcase on November 8th, where TC’s founder Mike Arrington will be the keynote speaker, and I am sure he will talk about the issue on stage at the event.