Startups Must Get Creative as Early-Stage Investors Shift to Larger Deals

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The swashbuckling masters of the universe of who fueled the early days of Silicon Valley have aged and it shows in their investment choices.

It wasn’t so long ago — 10 or 15 years — that many venture capitalists were willing to make bets on early and even seed-stage startups. After hitting the jackpot on companies like Google, Facebook and Yahoo, the early generation of tech investors now have more money to spend — but they’re less likely to put it into young startups that require time and handholding to grow.

That shift into later-stage investments has created a more challenging landscape for entrepreneurs looking for someone to invest in their startups. But don’t despair. You can still find seed money if you know where to look.

Investment in early-stage companies has entered a cooling-off period. While the vast pools of venture capital money continue to grow, seed-stage funding had fallen from 10 percent of the overall funding pool in 2017 to just 5 percent last year, according to Upfront Ventures. VC firms are less likely to take on early-stage companies, opting instead to invest larger sums in fewer and more established enterprises.

The reason is simple: A decade and a half ago, many were in their 30s and early 40s, eager to cash in on the budding tech revolution and happy to invest $250,000 in a deal that might eventually yield a significant return on investment — when it didn’t end up being a total loss. That first generation of tech investors has matured — in age, in investment capital and in appetite for risk — but those early successes have swelled investment coffers, giving VCs the latitude to invest $100 million or more in a single promising venture. But as they move through their 50s and toward retirement, these investors have a diminished appetite for risk as their desire for faster and more certain returns has grown. That’s good news for companies like Uber and Airbnb that show success with private investment before going public, but young companies are forced to look harder for the funding they need to begin.

The money is there, though, for startups that connect with angel investors, accelerators and incubators. There are also emerging opportunities with VC firms that are slowly returning to the early-stage arena instead of focusing exclusively on lower-risk, late-stage deals.

Growing up and moving on.

Seed funding deals began to accelerate in the early 2000s, when an array of new tech companies burst onto the scene with great energy and promise. Many of these startups capitalized on advances in open source and cloud computing, which made it cheaper and easier than it had ever been to get a business off and soaring.

Nearly two decades later, the people who invested early in Google, Facebook, Yahoo and the like have matured into seasoned investors. They’ve moved upstream onto bigger, more lucrative deals.

As they grow older, though, this group of investors has shorter time horizons in which to register an acceptable return on investment. They also have less time to oversee and get actively involved in multiple deals. It makes more sense to manage five deals at $100 million each than 50 deals at $10 million. Smaller deals that can’t noticeably move the needle are no longer worth their time.

Disproportionate funding.

The data from CB Insights indicates that, although early-stage funding deals are down, the amount of available capital has reached an all-time high — with a significant portion of it concentrated in deals that can reach $100 million or more. Jeff Grabow, the venture capital leader at Ernst & Young, warned in October of 2018 that we are in a “cash bubble,” with “too much money chasing too few deals.”

Instead of taking a gamble on an early-stage company which is statistically likely to dissolve within the first year, seasoned investors are increasingly taking a wait-and-see approach, banking on companies that emerge as top contenders within a specific niche or sector.

Airbnb and Uber, which were founded in 2008 and 2009, respectively, created buzz by announcing plans to go public in 2019 (although excitement about those debuts dimmed after Lyft’s IPO produced initially disappointing results). Investing in well-established companies can come with lower risk, but these deals also have larger capital requirements, drawing more funds away from early-stage startups.

Alternative sources for new companies.

Bucking the recent trend, some investment firms are returning their focus to early-stage funding. For example, in January, 2019, top Silicon Valley VC firm Kleiner Perkins announced that it was establishing a new $600 million fund for seed, Series A and Series B financing.

Entrepreneurs are also getting a boost from the vastly expanded ecosystem of startup accelerators, which provides another path for early-stage ventures. Although acceptance rates are often in the single digits, programs like Y Combinator and Tech Stars help young startups grow by providing funding, training, mentorship and space to develop their prototypes.

The last decade has also seen significant growth in organized angel investing groups, many of which focus specifically on seed and Series A deals. A significant handful of elite colleges have even formed alumni investing groups, facilitated by Alumni Ventures Group, a firm dedicated to “Venture Capital Investing Made Easy.”

Seed funding is far from dead; the cycle will continue as big wins from today’s early-stage companies reinvigorate the market. Niche tech fields like data security and software testing are exploding, with numerous startups emerging as strong players. For example, Headspin, a four-year-old company that allows developers to test and debug their apps in real-time, is already valued at $500 million.

The question, though, is how startups can best position themselves to win the race for funding. Early in a company’s life, it’s survival of the fittest — and few will survive without investors taking chances on seed or pre-seed deals. Though many have bemoaned the decline of early-stage funding, the good news is that there are still many angel investors, accelerator programs and forward-thinking venture capitalists available to help promising upstarts survive and, after the first years, thrive.

The startup ecosystem certainly looks different today than it did a decade ago, but opportunities still abound for entrepreneurs who are willing to learn from experts, weather uncertainty, and pursue creative funding alternatives. Entrepreneurs who don’t let themselves get down have nowhere to go but up.

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