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The end or the beginning? Thoughts on the current startup environment

Just as an additional disclosure, these are my thoughts, not that of First Round Capital, my employer.

The other day, Adeo Ressi wrote in TechCrunch about how we need more venture funds, because

"Every investor and entrepreneur knows there is something scary about the current startup economy.  There is an enormous amount of angel capital available, while at the same time there is a small amount of Series A and a large and concentrated amount of late stage capital... At least nine out of ten high-quality angel-funded startups face an unnecessary death, because there is no Series A money to help them survive critical expansion. In the end, more funds will save the good companies..."

To me, there's some seriously flawed thinking here.  Just because there's a lot more angel money available (by Adeo's own estimates, $80 billion vs $30 billion just three years ago), doesn't mean the system needs to provide additional follow on capital.  If anything, this kind of situation actually makes things *better* for the environment.  More entrepreneurs get to try out their ideas with smaller amounts of capital, but the bar remains the same to get to the bigger rounds.  More ideas, more companies, but the system vets the ideas earlier before they require tons of additional capital--and better ideas make it.

Just because an angel investor that made tens of millions of dollars gives $50k to a startup, and got 9 of her friends to do the same thing, doesn't mean that company deserves to get a $5 million check.  Companies that find product/market fit deserve to grow--and if there are enough of those, there will be enough capital to follow them.  The entrepreneurs that don't make it, they join other, more successful startups showing more traction and take their learnings with them--or go back and try another idea.   It's actually a great situation for the ecosystem.  So, yes, the end is near for many, but it's a healthy end--and one that will probably teach a lot of lessons to some new angel investors as well.

At the same time, we're seeing new sources of capital come online and some firms getting a refresh.  Chamath has a new Series A fund, the NYT just profiled Reid Hoffman, who is part of a generational shift at Greylock, along with John Lilly.   AH is out raising a huge new fund.  So, while we might feel like its a "crunch" because a lower percentage of all these seeded deals are going to make it, trust that you're not going to have some kind of Armageddon where great companies can't get funded because there are always new venture players being formed and reconstituted.

In addition, the public offerings of LinkedIn, Groupon, Zynga, and eventually Facebook are going to create a lot of new angel investors--so whatever the VCs don't pickup, I'm sure you'll see individuals continue to fund.

This brings to mind a bigger question of where we're going from here.  Are we in a bubble?  Is 2012 going to be 2000 all over again?  There are a few reasons to be concerned and some other reasons why perhaps we're not so close to the edge.

Valuations...  There are a ton of companies being funded at $500+ million valuations--seriously limiting exit opportunities.  There aren't very many companies that can swallow up another company for this kind of money, so it's going to either be going public or nothing.  The difference between many of these companies and what we saw back in 1999 is that there are real revenues and revenue growth at many of these companies--and their costs are largely in people, which can always be trimmed down.  Facebook is doing billions in revenues.  LinkedIn has great revenue growth.  Many of the private companies like AirBnb, Dropbox, and Square and that have been rumored to have big valuations are real, growing businesses.  Are their valuations justified?  Who knows, but it's pretty clear these companies are not going anywhere.  The have actual revenues that are growing.  Worse comes to worse, they'll just stay private longer and grow into their valuations, focusing on generating cash if they need to.  As for companies like Twitter, Tumblr, Pinterest, Instagram and Foursquare--the jury remains out on whether or not they'll create business models that justify their valuations, but they're well funded and will have the runway to figure it out.  As for Groupon, is it the next Amazon, where the numbers won't look good for a long time before they turn it around, or is it a ponzi scheme?  I don't know that either, but here's something I do know...

Public market holdings aren't dominated by internet companies with questionable business models the way they were in the late 90's.  When the bubble burst in 2000, many of us felt it in our pockets.  The public had largely participated in the funding of these tech companies.  Our 401ks aren't going to take a huge hit if Twitter doesn't make it. On March 20, 2000, Barron's wrote, "America's 371 publicly traded Internet companies have grown to the point that they are collectively valued at $1.3 trillion, which amounts to about 8% of the entire U.S. stock market."  These were mostly companies that didn't have revenue, or whose revenues were from other tech companies.  That's problematic and we're nowhere near those levels now.

There are a number of major trends that give me long term hope for the innovation ecosystem.  First off, if nothing else, the sheer number of broadband subscribers and smartphone users has created a market that is several times greater than the one that was supposed to consume all these web services in the late 90's--and that's just in the US.

I met with a major institutional limited partner the other day--the kind of money that funds VC's.  He said they were putting 10-15% of their new deployments in China and some in India--and already seeing some solid early results.  These huge global markets with improving infrastructures and growing middle classes represent significant growth opportunities.  While so far American companies haven't necessarily fared very well here, I have no doubt that there will be global online services brands built that originate here.

I'm also fairly optimistic about the potential for innovation as more and more devices go online--when my car gets connected to the internet, my TV (in a more elegant way), my fridge, home lighting, etc.  Even my phone, with as many apps as it has on it, could stand to become a lot more useful as a payment tool and key to the rest of my life.  We haven't really even scratched the surface when it comes to connected devices.

We're also just seeing the beginnings of how online and mobile services can create opportunities for the labor supply--how services like Uber and Taskrabbit can help create more liquid markets for services where previously people had limited options for monetizing their time.  These types of services will help put people back to work by matching talent and services to opportunities in a more liquid, efficient market.

So will we have a market correction?  A bubble burst?  I'm fairly optimistic that it will take longer for some of these companies to exit, a few big ones might go away, and many many seeded companies will disappear, but that the pain of all this won't be so severe and we'll continue to find new opportunities for innovation over the long term.

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