Are you seeing any trend of investments getting smaller? E.g. would your firm invest $200k into a promising company, or is that still out of the question even in these "tough times"?
My firm would do and always has done pre-Series A stage, with a view to building a relationship and following-on in due course. However that is and has always been a less common strategy: most 'bulge bracket' firms (active fund of $300-600m) don't invest such small amounts.
More generally, no, I do not see any trend in rounds getting significantly smaller. I do see a trend in pre-money valuations coming down, of course, but that's entirely different.
The economics of bulge-bracket VC work when you invest say ~5% of your fund in each portfolio company, in the hope that 1/10 or 1/20 of your companies will hit it out of the park. Total fund size equilibriates when drivers for scale (partners' remuneration, principally, less relatively invariable overheads) balances with diseconomies from political inference effects which kick in when too many partners try to reach consensus and cut the cake. That's why top tier firms with a 'plain vanilla' strategy have roughly comparable fund sizes.
FUD aside, nothing I'm seeing at the moment that gives me any reason to believe that underlying model is 'broken' or failing (though of course '07 and '08 vintages will be shot). Almost all successful start-ups need a lot of money to scale beyond a certain point. Free software doesn't really change the cost of airtime, or a VP bus dev. I'm writing anonymously so I have no real axe to grind in saying that.
What is certainly happening in the industry is a shake-out. Good firms with strong reputations are raising quickly and comfortably (if quietly because it's not a time to be above the parapet), and will continue to invest without interruption. That is because there are well-priced deals to do in this environment, and innovation doesn't stop in a recession.
A number of 2nd tier firms, on the other hand, are finding fundraising very difficult. Many will not survive.
Firms that are thriving seem to be investing more slowly just at the moment. This is because there is a lot of noise in the market, and visibility is currently low. Analogy: when it's foggy you drive slower. (Economically: transaction costs rise as expectations less aligned, so liquidity declines.)
What is tough is the squeeze at the bottom end for start-ups. I get the impression (though have less direct evidence of this) that there is a bit less easy money on offer from HNWs sub $500k as many are licking wounds, etc.
I'm sure there has been a discussion of this article before. But I get the feeling that you disagree with it's predictions. I'm interested to know which points you think are off & why.
The conclusion was that VCs are in a worse position. Investment needs to get smaller & to maintain their investment sizes VCs will need to buy shares from founders.
1 - Software Startups need/want less capital because of (a) lower technology costs (b) lower promotional costs (c) smaller teams.
2 - IPOs are less likely. This results in (a)the lower risk/reward goal of acquisition being set as a target. (b) less capital needed for the IPO process. I've added in point b
3 - Sellers' Market. (a)VCs' structure dictates investment size & fund size (as mentioned above) creating a surplus. (b)VCs are competing with acquirors offering a lower risk option. I imagine the current climate dampens these
I suppose the last point is most debatable. It may be temporary. The VC industry may contract or move away from Software. But if 1 & 2 are correct, this should result in smaller investments, founders cashing out or some combination of these. Do you see these points as being incorrect? Am I missing something else?
PG's argument as I read it is that there's a shift in comparative market power towards entrepreneurs qua producers because the barriers to innovation have fallen so their funding needs are less.
I agree that companies pursuing small opportunities (web 2.0 features, iPhone/Facebook apps, etc.) will face little competition from funded competitors. That's because there's little money to be made out of those innovations. In the short term, that may even apply to situations where the prize is large (Skype, Google, Facebook, etc.).
But in the longer term, economic systems operate in equilibrium, so you have to think about marginal not absolute factors. In equilibrium, competition will increase, and in turn cost of supply (of developers, airtime, etc.) will scale, in proportion to the size of the prize. Only proprietary cost advantages offer sustainable competitive advantage, whereas free software tools, cloud hosting, and cheap airtime benefit all contestants equally. When credible signalling costs are high and transparency is low, relative early advantage tends to be self-reinforcing. So when the pie is big enough, unfunded start-ups will find their marginal rate of growth just as constrained by a lack of capital as it's ever been, and will lose the initiative to better-funded rivals accordingly. Which means VCs will be just as essential in supporting high-value product development as ever.
Of course, you might say that the rate at which the marginal utility of wealth declines is high enough that few rational entrepreneurs will be motivated to pursue big new product innovations given the higher likelihood of failure compared to developing iPhone apps. In practice I tend to think that success for most entrepeneurially-minded individuals is as much about recognition (a positional good), as it is about absolute wealth. And again, in equilibrium, position goods are definitively scarce, meaning the arms race for status will continue ad infinitum.
There's an old adage about how to make money: sell bullets in the war without end. That's what VCs do. And the invention of the taser doesn't put gun makers out of business. On the contrary, it increases their utility.
I think the only fallacy I'd point to in that argument is the idea that "more money helps" when building software.
In practice, I've found that adding more developers to a team actually makes it less likely to succeed. Imho, the ideal team size for a software start-up is three - three excellent, top-notch hackers, but just three. More than that and the communication overheads start to hurt your early progress and flexibility.
That's not to say that the three hackers won't want additional help later, which is where you could come in. But that's only the case until the tools get good enough that the three can continue as three pretty much forever.
The increased productivity of tools like Rails means that larger teams are actually at a disadvantage. This to me is the greater threat on your industry. In my start-up, I don't want us to grow to a mega-team of hundreds of people. In fact, we've already had numerous discussions about having it as part of our business model to keep the company as small as possible and outsource any work that's not core to the business - so that we can ensure that the only people we employ are top notch.
Otherwise, your analysis is good - but imho this factor could be the chink in your armour.
Even were that uncontroversial, the cost of developers' time generally accounts for only a small proportion of the costs of bringing product to market.
At some point, isn't it in the best interest of the VC firms to pioneer innovative methods for screening, analyzing and funding large amounts of quality smaller deals?
1) In addition to building relationships, funding a significant portion of smaller businesses would increase the number of available quality deals at later stages.
2) Lowering the transaction cost of attracting, analyzing and screening deals to the point where smaller deals could be profitably funded, would likely have efficiency impacts throughout the funding process of any VC firm. In fact, you could make the argument that if a VC firm really masters this process, it could obsolete the need for the 'bulge bracket' model entirely.
YC did something innovative - they figured out how to invest <$20k in early stage companies in order to help those companies get to the level where they can bring a product to market. If the VC community really brought their perspective and resources to targeting this opportunity, it seems they would only stand to benefit in the long-term.
I know virtually nothing about YC so it seems off for me to be jumping in on this. But is YC really pioneering methods of investing.
Aren't the other components: motivation, introductions, community, promotion, etc. more substantial the the "investment" element. I guess you could call those things investment too, but not capital investment. Basically, is YC in the same industry as VCs at all?
