The State of Software Startup Funding: Should We Believe the Hype? - 11/25/2008

It has been a month since my last post.  I have written this article three times over the past three weeks, changing my view and perspective as a picture finally came together… So here is an update, finally. And look for a new series of posts starting soon that will evaluate the growing role of business accelerator seed funds in jump starting software companies.

Over the past month, the blogosphere has been awash in posts describing a number of negative developments in the venture capital industry. Even USA Today ran a short piece last month talking about the venture capital downturn. For companies seeking funding, it is safe to assume things have become more difficult now at both the angel and venture capital level. But the available data does not show a significant downturn, at least not yet. So how much should an early stage software entrepreneur be concerned about these developments? How big is the issue, and is the funding window closing? This post will take a look at some of the reports, the latest data points, and what they may mean to early stage software companies.

VC partners I have spoken to directly in the past couple weeks are very concerned, and describe the current environment as one in which “capital is becoming scarce.” Much of this is driven from a need to conserve capital to weather a downturn, but also unknowns regarding their ability to raise new funds or get currently committed funds in a timely manner. Several posts ago I mentioned the developing risk of Limited Partners (LPs) in venture funds not being able to meet their capital call requirements, or in some cases, VCs requesting dollars earlier than needed to try to get their money. Recent reports from PE News, Silicon Alley Insider, and lalaNews indicate that the risk is playing out. The bottom line is that many VCs need to make their current capital last longer, which means they will be more selective in doing new deals while preserving more capital for existing portfolio companies.

Looking historically at venture fundraising, the past 3 years have seen the largest amount of venture capital raised in any historical period outside of the 1998-2000 bubble. This chart shows fundraising data since 1995:

VC Fundraising since 1995

So the one bright spot is that there is still an historically high level of capital out there, even if firms are being much more conservative in spending it. And, even with this downtrend, total investment in the first 3 quarters of this year (at all stages) has already exceeded TOTAL 2005 levels, and the full year is likely to exceed 2006 levels, maybe even 2007 levels. Despite the claims of Adeo Ressi, venture capital is not quite dead yet and we are coming off a high level to begin with.  But this data captures deals that are already done. What about new deals?

In the past 2 weeks, I have seen several examples of established companies failing to raise money. Ambric, a company out of Portland (OR) in which I am an investor through a fund, shut down last week and is being sold because they could not raise more money. This is a company with top-tier backers and a strong technology and patent portfolio. I know the CEO of a Massachusetts-based venture funded company who cannot or will not seek another round, due to market conditions, and is going to sell. Another local investor I know has a portfolio company that failed to secure a Series D round, and will go bankrupt or be sold. This is just in the past 2 weeks and represents a noticeable uptick in failed financing.

However, deals are still being done. Each day VentureWire, Tech Wire, and other services report new financings. VCs are still out there scouting for good deals. One firm that is not slowing down seems to be Advanced Equities, a late stage venture capital firm that draws capital from hundreds or thousands of individual investors and pools it to make sizable investments in primarily later stage companies. My contact at the firm stated that opportunities remain strong and some clients are increasing their allocations to take advantage of valuations that are up to 50% off where they were at this time last year.

Fortunately software, as a category, needs venture capital much less than it ever did before. You may have heard the phrase “500k is the new 5 million.” Software companies can be launched much more cheaply than in the past. If bypassing or delaying venture capital is an option for you, I seriously urge you to consider it, as it keeps your exit options much more flexible and will save a lot of time, especially now, which could be better spent on product development or taking care of your customers. For some motivation I suggest reading this post at Dogster.

Pullbacks, even good size ones, are a normal part of the venture cycle and do not necessarily mean a reduction in market effectiveness or even the lowering of overall technology innovation. Instead, they can lead to higher efficiency in the market – less copycat deals, squeezing out of some weaker VC players, less funding of bad ideas, etc. The industry overall has historically had boom and bust cycles like every other sector, and VC funds are particularly bad at self-adjusting to market cycles. For a perspective on this, I refer you a very worthwhile article from 2002 by Josh Lerner from Harvard discussing the natural boom/bust of venture capital and its impact on innovation. Although written following the burst of the Internet bubble, it seems just as applicable today.

When it comes to angel investors, I also see some real weakness. Some individual investors are less able to do deals, and others will certainly be more selective. “I will only invest in companies with solid revenue,” or “I am going to wait for valuations to come down” are comments I have heard. Individual investors face the same challenges as the LPs, with portfolios devastated by the market and potential challenges in liquidity. But despite this, I can assure you there are individual investors that still want to make investments.

I have watched carefully the activity following the Speed Venture Summit, which was held here in New Hampshire about a month ago. The event was a huge success – being oversubscribed by both investors and presenting companies. In fact, 50% of the companies which applied could not get accepted due to space limitations, among other reasons. The event was intense, full of energy, and very worthwhile for everyone I have spoken with who participated. Looking at deal follow-up, interest remains high with many investor/company matches. There are definitely deals to be done for the right businesses with strong market opportunities. Be prepared to compromise on valuation, however. One consistent theme I heard from all the investors at the summit was “All the valuations were far too high…”

So my conclusion is that we do need to believe most of the hype. Every sector of the economy has been hit harder than initially expected, why would venture be different? Fundraising is difficult, but not impossible. A lot of pain will be felt by companies trying to raise B, C, or even D rounds who took money on a higher valuation 9-12 months ago. It may be hard to get initial attention for an A round, but a strong idea will get looked at - especially if it can help companies in this environment. There are opportunities available right now for companies that can seize them.

Some of the best strategies I see for early stage software companies right now are:

  • Put together a board of advisors. Good people are out there and may be more willing to spend time on an exciting idea.
  • Go heads down and build product. Now is an excellent time to put the blinders on and write lots of code, ideally working with a small number of clients to solve real problems that will help keep them afloat.
  • Start a company if you have a strong idea and access to a small pool of funds or can self-fund for a while. Everything can be had on the cheap from space to help to equipment and services. Even great Microsoft development tools can be secured cheaply now through the new BizSpark Program (NOTE: First Ascent Ventures is a Microsoft program partner). Build modestly to put yourself in a strong position 12-24 months from now. Part-time is always an option too, while keeping the day job.
  • Seek strong talent on the cheap, if you can land new projects or grow. People are more willing to work for less and take upside on equity. Recruiters are reporting candidates typically choosing more stock over money in negotiations right now.
  • Seek opportunities for viral marketing, word of mouth, partnerships, and maximizing the leverage of the Internet.
  • If you need to raise money, bring to the table a low-budget plan that demonstrates sensitivity to the current market conditions and minimizes your dilution due to a low valuation.

So with this post, enough about the market! It is time to get back to building companies and doing deals. Coming soon is a look at the emerging category of seed funds/business accelerators and the increasingly important role they are playing in launching software and Internet companies.

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