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September 24, 2010 / Danny Robinson

Tsunami Continues to Rip Through VC Industry. First Wave Complete, Second Wave is Approaching

Wave 1 – The rise of the Seed Accelerator and Super Angel

Within the past 5 years, the cost of starting an internet company hit a floor. There is no cyclical effect here. It will not go back up.  Today, all founders need to get a company off the ground is a roof over their head, food, internet access, a laptop and a whole lot of passion. That massive drop in costs has caused a tsunami, which has been ripping its way through the VC industry ever since.  In it’s wake, Seed Accelerators, Super-Angels, and a new crop of Series A VCs, operated by former entrepreneurs, have emerged as the benefactors. Seed Accelerators like YCombinator, TechStars, and us at Bootup Labs are investing between $10k-$100k per startup. Super Angels invest between $10k-$250k, and reinvented Series A VCs invest as low as $250k-$2M per startup. Most are making healthy returns with more frequent exits in the range of $10M-100M in less than 5 years.

From my observations, regions with a higher concentration of super angels and/or seed accelerators, such as Boulder, New York and San Francisco have completed this transformation, While other areas including Boston, Seattle, LA and Austin are next, and Vancouver will get there in about 9 more months.

This wave took about 5 years to subside, and has changed some of the definitions of the words we use to communicate. So, before we talk about the next wave, we have to reconcile our nomenclature. For the sake of this post, let’s assume that $250k-$2m is no longer called a “Seed” round, and is the new “Series A.”

Wave 2 – Take it to the Bank!

The ripple effects are continuing to run it’s way through the VC eco-system, and are now challenging the economics of series Series B VCs.  If Seed money is used to test if the market wants something, and Series A is to identify and mature user acquisition channels, then all we need Series B investment for is to grow an already proven business, right?

Take this for example: If I prove that google adwords produces 1,000,000 clicks of a certain keyword, and those clicks convert at 2% at a cost of $1.25 per click, and the lifetime value of those conversions is $113 each, with a churn rate of 5% per month, then the company should net about $2.2M over 20 months, and you can take that to the bank — quite literally. (here’s the model) It’s conceivable that banks (yes, banks) will get confortable that acquiring users has the same level of risk as collecting receivables.  These banks will loan money (or factor) against individual acquisition channels, which have shown statistical significance.  If you’ve been in the Internet industry as long as I have, you know that acquiring users becomes as predictable in terms of revenue generation as a signed PO from an enterprise customer.

What does this mean for the Series B/C/D investors?  A lot.  There is already a lot of competition for Series B investments, which makes sense; Risks are low, quality deals are scarce, and great upside potential.  On top of that, when the first wave hit, the risk tolerance and economics for the incumbent Sereis A VCs forced them to higher ground, aka Series B.  Over the next few years, I predict that specialty lenders or venture debt, and some progressive banks will provide some interesting options for founders of Internet companies.  I’m just glad I’m not managing a VC fund over $50M.  If I’m right, life is going to get tougher than it already is, and, as far as Internet investing is concerned, it’s never coming back.  In fact, if I was in that position, I’d stick to biotech, cleantech, or any other capital intensive tech industry.

Wave 3 – Lights, Laptops, Launch

I don’t believe anyone can predict the future more than 3 years out but it doesn’t stop me from thinking about it.  I’ll describe my admittedly “out-there” vision for what will happen when the 3rd, and final wave hits in another post.

I would be grateful for any comments and of course, criticism and counter-arguments are welcome.

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  1. Basil Peters / Sep 30 2010 5:36 am

    Outstanding post, Danny. I've added a link on my list on the broken VC model here:

    You bring up an important point on new investment models. Earlier this week, in Washington State, I had a fascinating discussion on this with Rob Wiltbank from Willamette University. He is one of the world's top researchers in the area of entrepreneurship, angel and VC investment. Yesterday, Gary Yurkovich from Espresso Capital and I discussed the same thing.

    We all agree completely with your prediction that new sources of financing will soon be available to fund the scenario you describe above. But we don't think it will come from traditional banks, but instead from new types of funds that will designed specifically to service this new need in the market. Both Rob and Gary are thinking about building a fund to do that.

    • Danny Robinson / Sep 30 2010 10:46 pm

      I thought you'd get a kick out of this post…. Agree, Banks wont be first to try this out. But I've been speaking to one very progressive bank about this and I can assure you that they're looking at it very seriously.

      In the mean time, I fully expect that some of the companies I work with will put some of Gary's money to good use.

  2. @derekball / Sep 30 2010 5:15 pm

    Danny, I would have to agree with @chrisalbinson. It is easy to get started, and the cost is low, but the game now is to change the world. If you want to create a Twitter or Four Square that scales to a massive level, usually that next significant round of capital is a necessity. You are correct though that the number of funds who want to place a large piece of equity (i.e. $20 million or more) into one of these deals is much greater than the number of deals that can absorb and deploy that capital effectively, so amongst this group of funds, the competition can become intense. Definitely there is a complex dynamic at play. There is an interesting WSJ article on this – but damned if I can find the link right now.

  3. Danny Robinson / Sep 30 2010 10:34 pm

    Yes, I agree that I was thinking about the consumer space first. But, just to make sure you understand the argument I'm making, companies may only raise 2M from sales of equity, but could easily borrow another $5-$10-$20M in growth debt. This type of financing for growth only will provide the revenue/income the company needs to reinvest in innovating the product, developing new markets, and acquiring small startups.

    Both Four-Square and Twitter are not "freemium" type internet companies. They're shareholder value is based on the number users they have, so in that case, I agree with you. But, regarding Zynga and GroupOn, they had to raise $40M in equity because they had no choice. The concept I'm talking about in my post isn't available today, let alone in the past. If GroupOn was raising that $40M a year or two from now, my bet is they wouldn't raise $40M by selling equity.

    thanks for the comment!

  4. @IanHand / Sep 30 2010 10:59 pm

    Good post, Danny. This idea, lets call it "next generation factoring" has some legs for emerging consumer and other internet companies. The magic will be for the companies (borrowers) to reduce uncertainty (or lender risk) using reliable market tests to provide a sound basis for lenders to place significant loans. Rates may need to be higher than shown. An equity kicker or warrant may do the trick. The ROI math should also incorporate TVM.
    Keep these ideas rolling!

  5. Sam Znaimer / Oct 1 2010 12:16 am

    What an incredibly sweet & optimistic vision – banks & venture debt funds lending to startups with weak balance sheets underpinned by their sweat, smarts, and some spreadsheet magic. But can you give us some examples of this happening? I sure haven’t run into it. The banks, mezz debt firms, & venture lenders were always tight, and they’ve become twitchier. They lent against real receivables & hard assets, and almost always maintained covenants that allowed them to pull out their cash if the business went sideways. A very few lenders, like the Comerica of yesteryear, put a thin layer of debt frosting atop a cake composed of several deep layers of venture investment. They bet that venture investors who’d committed tens of millions wouldn’t walk from their investments without a fight, and that they could always be made whole even if the investment proved to have only a modest salvage value. Now you expect these bankers to write cheques against a short history and some wishful extrapolation?

    • Basil Peters / Oct 1 2010 5:59 am

      Sam, I don't think it's wishful at all. As I say in my first comment, this is happening. If I run into two fund managers working on this in one week, I wonder how many others are. The world has changed. The optimum entrepreneurial models have changed. This creates new, lucrative funding opportunities. Its not about balance sheets anymore. Its about customers and revenues – especially recurring revenues. If I brought you a business that could prove their cost of customer acquisition was $100 and the lifetime value of that customer was $500 – wouldn't you be interested in providing them $100,000 to acquire another 1,000 customers (worth $500,000)? Sure, that's a very simple model, but that's what this new funding opportunity looks like. I think it's exciting.

      • @kevin_swan / Oct 1 2010 10:48 am

        For early movers, this can definitely be achieved. However, as more capital flows to these businesses more competition will result, leading to lower revenues per customer. This will result in the risk of margins significantly decreasing as companies try to scale. These risks would definitely scare away lenders like banks. Whether or not it will continue to be a space for VCs to operate in is hard to say.

    • @IanHand / Oct 1 2010 10:45 am

      This idea is by no means a panacea for financing all early stage internet companies, but it is already happening, albeit in small deal sizes. I recall a couple of years ago received $5 Million in venture debt specifically for customer acquisition and a number of venture debt firms use this model; Horizon Technology and Leader Ventures are two such firms.

      Also, aside from tax considerations, a rational investor should be notionally indifferent about an equity or debt investment in given growth company providing the return is sufficient for the anticipated risk. There will need to be enough execution, sales growth and conversion data for investors (debt or equity) to assess the risk. Given its additional security features, debt may be more attractive under conditions of high uncertainty, and funds can be advanced in tranches based on outcomes to limit downside risk.

    • Danny Robinson / Oct 1 2010 11:41 am

      Sam, Very much appreciate your view point. That why I asked you for your thoughts. Calibrating theories is what trying to predict the future is all about. Perhaps it is an optimistic vision, but hey, I'm an entrepreneur and we're plagued with eternal optimism. That said, it is a vision of the future, and I never meant to suggest that this model is in existence today. So I can't point to any early examples, even though @IanHand mentioned some in a later comment. Although, this is not something that I see happening now, from my vantage point, I am suggesting that this could very well happen in the near future.

      To believe, it takes a deep understanding of how systematized it has become to build Internet companies.

  6. @kevin_swan / Oct 1 2010 10:41 am

    Great thoughts, Danny. I have come across a couple of people lately that were looking at running a fund that would offer debt financing based on recurring revenue models – mainly SaaS plays.

    I see this model working for companies focusing on a niche or specialized market where smaller market caps are achievable, but not for market leading companies that have a large share. Those will still require VC backing to get to that position. This doesn't mean that entrepreneurs can't build great companies that make them a lot of money or have a really nice exit one day ($10-50M).

    The other distinction that has helped me look at the web space is whether or not an entrepreneur is building a feature, a product or a platform. I believe that only the latter will fall into VC category in the near future. Currently, we are seeing many one product based companies (and even one feature – i.e. raising VC. I don't think that future returns will warrant these kind of investments when they are realized. Although there will, of course, be a couple of "outlier" companies.

    All in all, these developments are exciting as a new form of venture (debt) financing results in opportunities for more entrepreneurs and more innovation!

  7. Florian Feder / Oct 1 2010 3:04 pm

    An interesting comparison is the world of micro-credits. As it turns out, there are more factors that control the likelihood that a debtor will repay her creditors than just past success or the ability to provide a down payment. High among these factors is a sense of community and responsibility. Banks in developing countries are usually amazed be the number of debtors that repay their loans once accepted principals of micro-credit are applied.

    Wall Street has, for good reason, gotten a terrible reputation recently. But once it finds back to its roots – giving loans for people who deserve them – it will realize that entrepreneurs are their ideal clientele. The start-up community is tightly knit and twitter & co. only foster this. Entrepreneurs, who often pay very high opportunity costs for working on their start-up (instead of simply “getting a job”), have every incentive to work hard to make their venture a success. Financing those start-ups with simple debt is therefore, in my view (and I work on Wall Street), within the risk profile that banks can live with.

  8. @touraj / Oct 1 2010 4:28 pm

    Great post Danny! As an entrepreneur, I certainly hope your vision of the future is the correct one, but my more cautious side whispers otherwise. The immediate consequences of lower cost to start an Internet startup have been the following: (a) Over-inflated valuations and (b) over-abundance of competitive offerings / copycats. The longer-term consequences of those is that cost of customer acquisition is rapidly increasing, while exit opportunities are shrinking. Therefore, to succeed, entrepreneurs are forced to raise a lot more cash upfront and do a "land grab" at a faster pace than they had done previously. So, in my prediction, we will see a lot faster, compressed progression from angel to Series B/C rounds, but the players will still be the same.

    • Danny Robinson / Oct 1 2010 5:32 pm

      Touraj, I think you've been in the valley too long. 🙂 The world is a big place, and the magnitude of valuation swings is much more pronounced there.

      But, I'm really only talking about debt financing specific user acquisition channels that have proven to be lucrative.

      Put it this way. If a user acquisition channels is not predictable enough to be trusted with borrowed money then selling equity to finance them might not be the answer either. It might be that the business just doesn't work, or at least that you should stop buying customers via that channel.

      • Touraj Parang / Oct 2 2010 8:03 am

        Hey now, this isn't the Super Angel panel 🙂 But seriously, my point is that VC's have a higher risk tolerance than lenders, as you know, and given the increased competition in the market fostered by the ease of starting a company and raising angel money for it, a customer acquisition funnel that may look solid on paper based on historical data, would still have very high market risk, which would turn off most lenders!

    • Danny Robinson / Oct 27 2010 5:17 pm

      Touraj, I think you've been in the valley too long. 🙂 The world is a big place, and the magnitude of valuation swings is much more pronounced there.I'm talking about only debt financing specific user acquisition channels that have proven to be lucrative.Put it this way. If a user acquisition channels is not predictable enough to be trusted with borrowed money then selling equity might not be the answer either. It might be that the business just doesn't work, or at least that you should stop buying customers via that channel.

  9. Danny Robinson / Oct 1 2010 4:40 pm

    Thanks Gary. Espresso is exactly who I was thinking about when I mentioned "specialty lenders" in my post, and I agree that banks won't be the first to do this. Maybe they'll never do it. But I am aware of others too.

    The added benefits to this model for the lenders, equity investors and founders are quite material. Lenders don't have to wait for the elusive "Exit" in order to generate a return. The previous Seed & Series A investors will not get diluted by relentless rounds of later stage equity financing. And the founders will, in most cases, retain control of the company.

  10. @bwertz / Oct 3 2010 3:39 pm

    Interesting idea, Danny, but it might take some time to see this happen on a large scale. Banks have been notoriously shied away from lending against anything than "hard assets" despite numerous opportunities that have presented themselves in the marketplace. What I think might happen is the emergence of niche funds that go after this opportunity but these funds would still be backed by LP's with a specific risk / return profile in the same way traditional VC's operate.

  11. @bholly / Oct 8 2010 9:05 am

    Dan, I am probably way too late with this feedback as you are on your way home from Toronto and Montreal…
    I mostly agree with the fact that it is cheaper and easier to start a company today. And that the tsunami is real…. in a certain sector which is Internet related content, software and services. So put aside the argument that it is still no cheaper today to start a company in hardware, semiconductor, consumer electronics, biotech and clean technology… which still require venture capital. Permit my tangent for a moment: the venture industry was born in the 70’s because these new “electronics” companies were being started that required significant capital before cash flow… and the banks, yes the banks, had no idea how to lend against a promise of untold riches. A new model was born. Dare I say that, if there were blogs in 1976, Steve Jobs and Steve Wozniak would be talking about a tsunami of change in how start-up technology companies were being funded. (splitting post due to length)

  12. @bholly / Oct 8 2010 9:06 am

    Here’s the deal: VCs will always be required and necessary for the formation of strong intellectual property based companies. In the sector that you live and work in every day… not so much. Which brings me back to my point, that I mostly agree. Here’s what I disagree with and Boris has already mentioned it. The classic banks will TAKE FOREVER to get their minds around new business models. It took 20 years for the banks to figure out they could lend against distribution agreements in the video game sector. You still can’t borrow money from a bank for three year signed contracts for monthly delivery of software (SaaS) from absolutely prime, A1 business customers. It took a local clean technology company with $20 m in revenue from huge companies like Ingersoll Rand (and profitable for three years), eleven (that comes after 10) months to get an asset backed line of credit from a Canadian bank. In your world, Dan, companies are formed and sold in that time frame.

  13. @bholly / Oct 8 2010 9:06 am

    So Wave 2 is not about the banks, despite what these lenders may be saying. The history of risk capital tells us that banks will only lend when the risk is so minimal that your grandmother would lend you the money first anyway. There will be derivatives of the venture model or the venture lenders (which are not banks and secure your IP ask for personal guarantees and make life generally miserable for you if you stumble even slightly) that may make up part of your second wave… but it will not be banks.

    Hope you had a productive week!

  14. @kradage / Oct 9 2010 9:35 pm

    I agree with the overall premise that new funding options will be created for specific types of startups. But, I'm not sure banks will lead this way. These new options probably won't work for big plays either. I believe some creative funding options could work in a market I'm bullish on – ecommerce. Transactions/Revenue can start quickly allowing funding options based on cashflow, revenue sharing, etc. However, one potential side impact is that this thinking could drive the focus to financial engineering rather than on how to change the world. Having that "change the world" passion at the early stages in a startups life is critical. Thanks for sharing your thoughts. -Kalle

  15. Sharron Clemons / Dec 21 2010 12:15 pm

    Interesting idea, Danny, but it might take some time to see this happen on a large scale. Banks have been notoriously shied away from lending against anything than “hard assets” despite numerous opportunities that have presented themselves in the marketplace. What I think might happen is the emergence of niche funds that go after this opportunity but these funds would still be backed by LP’s with a specific risk / return profile in the same way traditional VC’s operate.

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  17. Evelyne / Jun 15 2011 6:17 am

    It’s a great pleasure to visit your website and to enjoy your excellent work! You have fine ideas. Really looking forward to read more! 🙂


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