Series A Crunch...just Darwin at work

As December and 2012 draws to a close, I've decided to weigh in with my thoughts on the impending (or not depending on which blogs you read) Series A Crunch.  It seems that The Series A Crunch has been discussed almost as much as the Mayan calendar this month and I've mostly sat on the sidelines figuring that if the world were really going to end, I had better things to do than write a blog post.  Alas, we survived 12/21 and looks like we will have to get back to work in 2013.

For those readers not already familiar with this concept, it refers to the bottleneck for Series A financing created by the increasing number of seed financings and constant number of Series A financings.  While this has been discussed ad nauseum on twitter and the blogosphere, I have relevant perspective given my three different roles in the new venture ecosystem - investing in seed deals as an angel, raising seed investment as a start-up CFO and teaching entrepreneurial finance as a Professor. 

I'll summarize some of the varied opinions and data before weighing in with my own thoughts. A good place to start for data is CBInsights' Seed Investing Report- Startup Orphans and the Series A Crunch.  According to their research, 2,283 companies received seed funding over a 5-quarter period beginning Q3 2011.  Out of these companies, 102 have received follow-on funding and 212 have been acquired (or more likely acqui-hired).  Out of the remaining 2,200, they estimate that 1,200 will not be able to raise follow-on financing (see visual explanation below) and $1 billion in angel investment will likely evaporate.

Is this a high success rate?  Is this a low success rate?  Is this Armageddon?  Depends on who you read.  Sarah Lacy started this round of debate a few weeks ago with The Series A Crunch is hitting now.  Jason Calacanis responded and argues in There is No Series A Crunch that this is a non-issue and up to the seed financed start-ups to prove they are worthy.  If there are more companies that have met Series A milestones and metrics, VCs will increase the number of Series A financings.  If you are entrepreneur that isn't in a position for Series A, find other financing sources and/or figure out how to bootstrap to cash flow breakeven or in Jason's words "put on your big boy undies". Sarah, of course, responded with Jason is Wrong. Have we reached the "Jane, you ignorant slut" point?

For those who haven't already left this post to catch the latest YouTube cat video, let me see if I can bring these divergent opinions together.  I did finally chime in on the twitter discussion yesterday:

I first blogged about this topic almost two years ago when I called out the large number of convertible debt seed financings that weren't going to have any conversion event.  It turns out the financing instrument probably isn't as material as I had thought, although it doesn make the mechanics different.  From an investor standpoint, I've discovered there actually can be greater leverage with convertible debt if the appropriate protections have been included.  I've had a couple of deals where investors were paid out a multiple on exit and in a better position than if holding preferred stock, where the payout would have been subject to escrow and over multiple years.

Is it a good thing that so many entrepreneurs are able to get $250K - $1.5M in seed financing? HELL YES!!! Investors know (or damn well should) the risk they are taking in making seed investments.  The accelerators clearly know the game and the ground rules.  If as CBInsights posits, $1B is going to be lost by angels in seed financings, one Instagram makes most of that back and presumably there will be positive returns on a material percentage of the remaining companies.

Giving more entrepreneurs the ability to step up to the plate is a good thing.  I love the accelerators and am a regular on Demo Days for 500 Startups, YC, AngelPad and others.  However, many of the graduates of the accelerators aren't even companies, let alone businesses.  They are projects and experiments.  These are part of the entrepreneurs' education.  Learn how to build a product, pitch investors, raise a small amount of angel funding, hire the early team, acquire users, sell, iterate.  If it works, great.  If not, move on and join another team or come up with another idea with the same or different co-founders.  With my academic hat on, this is wonderful.  I specialize in experiential education and there is no better way to learn entrepreneurship than doing it.

My recommendation used to be that it was best to do this learning on someone else's dime and would advise students to spend a few years working in a start-up or potentially large tech company before doing own start-up.  However, they now can still do this on someone else's dime, but it is the angel investor and not an employer.  As an angel, do I take this kind of gamble?  Sometimes, if I feel the opportunity is big and the team is fully committed.  But generally, I'm also looking for those proof points that go beyond what most entrepreneurs coming out of an accelerator have.  Domain expertise is critical and many of these entrepreneurs don't have enough.

So, what are the key takeaways for entrepreneurs besides pulling up their big boy (or girl) undies:

1. Keep your options open.  Don't raise seed financing with only one path to raise Series A.  I'm not a fan of "Go Big or Go Home".  That works great for big venture funds with a broad portfolio, but not so good for an entrepreneur committed to a market opportunity.  Have a plan for Series A, but also have a plan for slower growth, intermediate funding, and a route to cash flow breakeven.
2. Seek appropriate financing.  Most businesses don't fit the venture model and if that is your only path, the most likely outcome is hitting the wall.  I always hate when folks disparage an entrepreneur who is building a "lifestyle business".  If you can build a business that provides a good income, doing something you love, living where you want, and pursuing passions outside of the business, more power to you.  I'm guessing that's how Richard Branson started and he seems to have a nice lifestyle.
3. Nothing wrong with a cash flow business.  Follow around a middle market private equity investor for a few months and you will likely discover some businesses that have great cash flow potential. Unless yoru only end game is being acquired (and if so read point 1 above again), the experiments need to yield a business model that can create a sustainable business that isn't dependent on continued funding to remain off life support.

That advice should work in good times, bad times and all those in between.