Early Stage Startups Are Struggling, While VC Investment Dollars Are At All Time High.
It’s a mixed bag for startups and funding this year, according to the Q1 2018 PwC/CB Insights MoneyTree™ Report. Since the beginning of the year, the US has seen more than $21B in funding across more than 1,200 deals. Although deals were up since the end of 2017, the money was divided among fewer companies. Unfortunately for young companies, first venture rounds were on the decline. They were at their lowest rate in about a year and correlated to a pullback in VC investment at the seed and early stage.
On the plus side, money is definitely flowing in established startup community. The US saw more than 34 deals at $100M or more. In addition, five new unicorns were minted. These companies racked in $3.1B VC investments—mainly from Sequoia, Fidelity, SoftBank and Saudis—in the first quarter of this year.
Mid-sized companies with revenue and looking for $2M to $10M funding also are getting funding. They are typically covered by tier-two VCs, although big VCs occasionally provide some funding to have a foot in the door for a future round where they can write an even bigger check.
The bad new is that the seed and early stage companies are struggling and don’t get as much funding. Why do young companies have difficulty attracting the attention of major VCs? There are two main reasons, and it doesn’t necessarily have to do with the concept of the startup. The first (and perhaps most obvious) reason is that bigger deals with proven companies are less risky than investments made in early-stage companies.
The second—and maybe more important—reason is the VCs’ 2%/20% model. A typical deal provides VCs with two-percent of annual fees going to operations (rent, salaries, etc.) and 20% of the existing value of the deal or company. Structurally VCs have to write big checks to cover their operating expenses and work really hard on fewer investments to ensure they get a high return on investment. So, plainly put, most VCs just don’t have the bandwidth for small/early-stage companies.
The biggest gap in funding is for companies in the idea stage. Given the 2%/20% rule, it is very difficult for major VCs to really pay attention to this segment. It’s not that idea-stage companies never break through, but those that do usually have a relationship with the VC or come through a major recommendation through the VC network. The majority of companies at the idea stage, though, will be rejected by the most VCs even if their concept is very promising.
So, what can you do for funding if you are just getting your company off the ground? Self-funding is one option, but you should also try to get support through a well-known incubator and have your product ready for early testing. Without working product, the likelihood of getting funding is very low.
Corporate VCs (CVC) are another increasingly popular option for funding young companies. It will still take some major sweat equity to attract their attention, though. The best way to garner CVC support is to focus on the following things:
1) Build a good and diverse management team. You need to create a balance between business and technical competency.
2) Make sure you have a demonstrable product protected by IP. If you don’t have IP, reach out to your local university and partner with them to get it.
3) Get a customer that will buy your product and is willing to sign a letter of intent.
Checking all three of those boxes should help you look more attractive to potential investors.
Although the current environment is difficult for early stage investment, there are some positive developments. In addition to CVCs, local governments and incubators are ramping up their support for startups especially in places like California, New York, Boston and Toronto. If you’ve seen my recent articles about Canada, you know I believe Toronto is one of the best regions for startups right now. I think Toronto will lead early-stage investment over the next five to 10 years.
At the end of the day, building an idea into a real company is difficult, and those with great ideas, dedication, commitment and a bit of luck will get there. Those that can make it through the ideation stage to the first VC check stand the best chance of making it. Unfortunately, many startups die before they see a single VC dollar because of lack of experience, products or money—or because of an idea that just doesn’t pan out. So, manage your expectations, look for untraditional plans, and keep driving it. Also, stay tuned for my upcoming articles on building early stage companies.