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12/16/2009

The Great Abdication: Consumer Internet, Venture Capital, and Angels

(My day job is investing in the public markets, but I have a small personal portfolio of private investments, mostly angel investments in internet and software related startups. In the past six months I have spent some time helping a few of these companies raise venture capital and thought I would share some of the insights I have learned through that process over the course a of a few posts.)

Anyone who has recently spent anytime fundraising for a consumer internet start-up in Silicon Valley quickly comes to an inescapable conclusion: there is effectively no Venture Capital available to Consumer Internet startups.

“How could that be?” you say. After all didn’t Twitter just raise 100 large @ $1BN post? Didn’t Facebook raise $200M @ $10BN pre? Yes indeed they did, but rather than confirming the health of Consumer Internet Venture Capital, these deals merely provide prime examples of how screwed up the space is.

Too Many Deals Needing Too Little Money
To be sure, there is plenty of investment capital available for Consumer Internet companies that have demonstrated significant market traction in terms of traffic or revenues, but there’s almost none available for what, up until recently, would be considered the sweet spot of true VCs: Seed or Series A startups. Alas, the days of a bright entrepreneur thinking up a great idea, putting together a business plan, and then having a Sand Hill VC take a leap of faith to fund the business are effectively over, probably for good.

Why is this happening? Well there are really three main trends driving VCs out the venture capital business in the consumer Internet space:

  1. Start-ups costs for consumer internet companies have plummeted. A few years ago my former partner Ryan McEntyre wrote what I consider to be a classic post on the decline of technology of technology costs for startups. Since that time, technology costs have continued to plummet to the point where a start-up can now host their entire consumer internet service in the cloud for a few hundred dollars a month with effectively zero upfront capital costs. The combination of low start-up costs with RAD-like web development environments such as Ruby-on-Rails, has in turn led to an explosion of web sites and services in almost every conceivable niche.
  2. VC Fund sizes have increased. The average VC fund size grew almost 250% between 1990 and 2002 and has grown more since. The reason is simple: the more funds under management, the more fees, the more “risk free” money for partners to split up. Unfortunately bigger fund sizes present VCs with a conundrum: if they increase the size of their fund to make more “risk free” money, they necessarily have to increase the average investment size because if they don’t increase the average size of their investments they have to add more partners to do more deals and adding partners effectively cancels out the financials benefit of increasing the fund size. Needless to say, most VCs have resolved this dilemma by increasing the size of their investments.
  3. VCs increasingly perceive the market success of Consumer Startups to be almost a Random Walk. A few years ago, if you told VCs that Twitter would do a financing at $1BN pre, almost all of them would have laughed heartily at the thought. Same thing if you had told them that Friendster, a Kleiner & Benchmark deal with an A-list management team would be schooled by an east coast (East Coast!) knock-off run by a 23 year old. Yet here we are. Despite all the bravado about investment themes, deal flow, and thesis driven investing, in moments of candor many VCs will tell you they have been surprised as much as anyone else by which deals have worked and which deals have not.

The Great Abdication
So thanks to these three trends what we currently have in the consumer Internet space is the following situation: We have a ton of start-ups that need a increasingly small amount of capital to actually get off the ground. We have a ton of VC funds that need to invest in deals that take up more capital, not less. And we have a bunch of individual VCs who have determined picking early stage consumer internet winners is at best a crap shoot.

Confronted with a profusion of random walk startups that don’t actually need a sufficiently large amount of investment, VCs have made a very rational decision: they’ve simply abandoned the early stage Consumer Internet business and resigned themselves to only providing what is traditionally known as expansion or even late stage capital. An added bonus of refocusing on expansion or late stage deals is that these investment rounds tend to be a lot larger which means more money can be put to work. Sure that money goes in at much higher valuations and thus returns should theoretically be lower, but for many VCs, thanks to size of the their funds, returns are not as important to them as they used to be.

Implications of the Great Abdication
There is nothing inherently wrong with what the VCs are doing. They are arguably acting very rationally given the market trends they are faced with and more than a few will probably generate good returns with this strategy. However, their behavior does have several long term implications for the Consumer Internet space including:

  1. Angel investors are becoming the dominate force in Consumer Internet Venture capital. The vacuum created by the withdrawal of VCs from traditional Seed and Series A opportunities in the Consumer Internet space has been filled by a motley collection of angel investors. It is angel investors, not VCs, that are writing checks based on good ideas, business plans, and “alpha sites”; not VCs. The importance of angel investors is such that it is not unusual these days to see an internet startup publicly announce its round of angel funding, when in the past such events did merit a public mention. Yes, angel investors have always provided seed money, but they today they typically provide 100% of what was once considered Series A money as well.
  2. VCs are boxing themselves into a pretty tight investment window. VCs retreating to the expansion stage makes a lot of sense in theory, the only problem is that if all of them retreat at the same time, it can make for some screwy market dynamics. I can count on two hands the number of VCs in the last 3 months who have told me something along the lines of “this market is crazy, anything with traction is getting multiple bids at huge valuations without even putting together a powerpoint presentation, while everything else is just roadkill.” The reason this is happening is that you have a ton of VCs sitting on a ton of capital (which they have to deploy) and they all are holding out hope that they will be the one person to realize that a company has started taking off before anyone else does. The reality is that the traction is obvious to everyone (quantcast anyone?) and they all swoop in at the same time. What’s more, because of the dynamics in the consumer internet market, most “hot” companies entering the expansion stage will end up spending very little time there. It seems as though if you blink, a company can go from interesting alpha site to 50 million uniques and at 50 million uniques the companies are demanding what would traditionally be considered late stage valuations. Thus there is a very short window of opportunity to fund “hot” internet startups and way to many VCs with way too much money chasing just a few “hot” deals within this window.
  3. Only “small ball” ideas are getting funded. Because VCs generally won’t back Seed or Series A startups, these startups must rely on angels for financing. Now putting together $100K or even $250K in angel financing is doable for most entrepreneurs, but much more than that can be difficult to accomplish. This is leading to kind of natural selection in that only internet companies that require $250K or less to get off the ground are even being started. If you have a really big idea that requires $5M before it can launch, you might as well not bother because your chances of getting funded are close to zero. Now big ideas aren’t necessarily better, just look at WebVan, but the current state of consumer Internet VC is so biased against big ideas that one has to wonder: are there big ideas that are being left on the table simply because VC’s aren’t willing to stomach the upfront risk?

Truth be told, I am admittedly painting this story with a pretty broad brush. There are still some VCs doing Seed/Series a deals, some of whom I know well, but even they would admit that on the whole on the average, the trends and implications that I describe above have some validity. Still I can’t help thinking that while The Great Abdication may make logical and financial sense for VCs, it is creating an incentive structure and reward system that not only marginalizes traditional venture capital firms in the long term but one that theoretically leaves a lot of potential growth and innovation “on the table” not just from startups that require more than $250K to get started but from the thousands of low cost Internet startups that haven’t yet caught lightening in a bottle and just need a little financial push to get to the next level.

December 16, 2009 in Internet, Venture Capital | Permalink

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