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Is the startup crunch coming?

Is the startup crunch coming?


A funding drought could mean fewer frivolous startups, but less creativity

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bravo silicon valley
bravo silicon valley

A scene from the Bravo reality show "Start-Ups."

Over the weekend, widely-respected startup investor Fred Wilson posted a lengthy blog post musing over the implications of some uncomfortable data: startups in the trendy consumer internet space are having more and more trouble raising money once the first lumps of cash run out. "The wind that has been at our back for seven to eight years in consumer internet is no longer there," he wrote.

Consumer internet startups include Facebook, Twitter, Groupon, and their descendants. These are the startups people tell their friends about, the hip new toys that get people excited, and the best ones — like Kickstarter or Etsy — have had profound effects on society.

So, is the consumer internet boom over?

These are the kinds of companies that populist investors like Wilson love to fund. There was an explosion of them over the last five years as investors started shoveling money into the consumer internet, seeding record numbers of startups every quarter.

After a heady spell, however, the total number of dollars invested in these companies is trending back down. Funding for consumer internet companies is down 42 percent so far in 2012 according to Dow Jones VentureSource. The so-called Instagram effect, which was supposed to supercharge the market after that company sold for a whopping $1 billion, has not materialized. The stock market’s ambivalence toward Facebook continues. Ventures that target businesses instead of users are suddenly getting hot. So, is the consumer internet boom over?

Well, no. There are still record numbers of consumer internet startups being funded at the early stages — 372 last quarter compared to 308 in the same quarter a year before, and 233 for the same period a year before that, according to market research firm CB Insights. Consumer internet startups are still getting more than twice as much money as they did in 2009.

At the same time, early stage investors like Wilson and Howard Lindzon are saying that it’s getting tougher and tougher to raise more money after a startup has raised its first and second rounds. "We are seeing fundraising challenges everywhere, even in our very best portfolio companies," Wilson wrote.

What's happening?

As the social web has evolved, no valuation seems too high. A parade of ostensibly genius companies from Groupon to Instagram to GroupMe to Pinterest have cast a rosy glow over the sector. Later stage investors see opportunities in potential public offerings and generous acquisitions. Meanwhile, early stage investors have been under pressure to get more deals done than ever before: meet more entrepreneurs, vet more companies, draw up more term sheets.

The cost of launching a startup has been going down, and that means it's cheaper for investors to buy in. Many investors have adopted a "spray and pray" strategy, sinking smaller investments into lots of companies. The hope is that one will be a huge hit, or at least do well enough to raise more money.

In some cases, investors have gotten a little sloppy. The temptation to pick up a company on little more than a good first impression or a colleague’s recommendation was strong. One entrepreneur who raised over half a million dollars for his startup last year told me that he fudged the presentation to investors — the technology didn’t work yet, so he used a video and pretended it was live.

There's also the boom in "accelerators": business incubators that provide young startups with mentorship and support and help them raise funding. At one point, a new startup school was launching just about every day, and these startup factories generated dozens of new companies of varying quality every quarter. Less experienced angel investors, who were more likely to invest with their hearts, also boosted the fortunes of companies that wouldn’t have passed muster in more conservative times.

Entrepreneurs have been forming very narrow companies that can feel more like features

Entrepreneurs have been forming very narrow companies that can often feel more like features than full products. In 2010, Daniel Gross became the youngest entrepreneur to graduate from the prestigious startup school Y Combinator. His startup, Greplin, made it possible to search your email, Twitter, Facebook posts, and other accounts at the same time. It raised a $700,000 seed round from eminent investors including Facebook’s CTO, Thrive Capital, and SV Angel, then scored a $4 million round in February of 2011 from similar big names.

After all that grooming, Greplin sputtered, realizing that its service was too narrow to build a userbase. The company recently changed its name to Cue and pivoted to aggregating personal information to "give a snapshot of your day," a tool that was more well-rounded but much harder to explain. TechCrunch threw it under the bus, pimping a shiny new company: "KiteDesk Goes Where Greplin Failed."

The crunch

All these extra early stage companies were competing for money from later stage investors. Meanwhile, Groupon, Facebook, and Zynga have gone public and seen their stocks thrashed in the open market. In the private market, Color blew up despite its impressive investor slate and $41 million in funding. It was now clear that there is no magic new business model. Later stage investors have turned away from riskier consumer-targeted plays toward safer enterprise-first strategies.

Wilson offered a few more explanations for why it’s gotten tougher to raise follow-on funding. People’s online behaviors have "ossified," he hypothesized. Mobile is increasingly important, and mobile is hard. Also, "opportunistic, momentum driven, and thesis agnostic" investors are skewing the market away from risky consumer internet startups.

A healthy startup ecosystem is full of people who are unafraid to try things

Whatever the reasons, companies that got early funding are getting a shock when they come under the stricter scrutiny of later stage investors. But that’s how things are supposed to work. Venture capital is a pyramid, with the best companies climbing to the top while weaker companies are left behind.

That’s not to knock on these companies — a healthy startup ecosystem is full of people who are unafraid to try things, and it’s nice because it means startups make things that are cool even when the path to profit is unclear. The contraction we’re seeing now with later stage funding means we're likely to see less crap, but also less experimentation. Whether that’s good or bad is still up for debate.

Early stage investors like Wilson and Dave McClure are sticking with the consumer internet. It’s still arguably the most fun and exciting kind of startup you could be, one that touches people's daily lives and could potentially get written about by The New York Times. But ultimately companies that last are those that figure out how to make a profit. Even Twitter and Tumblr are still struggling with how to build sustainable businesses. The startup industry is learning a collective lesson: building a consumer internet business is really hard.