In a previous post, I discussed the paradoxical issue where VCs were generally doing fewer but larger deals despite the costs of creating a successful business being much lower.
Venture capitalists have started pumping their remaining capital into hundreds of seed and early stage deals, looking for the next big thing. Dollars invested in these opportunities have already jumped from $893 MM to $1.49 billion between Q1 and Q2 of 2009, and there will be more increases in both Q3 and Q4.
Early stage companies have strong prospects of raising significant capital in a “make it or break it” round. Venture capitalists are offering more cash up-front with fewer chances for follow-on investments. The average early stage deal size jumped from $4.1 million to $5.6 million in the first two quarters of 2009, and this number should increase to around $6 million for the remainder of the year.
If a funded company needs more money without achieving significant market traction, the remainder of 2009 will be difficult. More than 50 percent of venture capital portfolio companies will be left with insufficient capital to operate. Many of these companies will be gutted and put into “life support” mode or sold off to competitors for stock, allowing venture capital firms to maintain inflated portfolio valuations. Any acquisitions that generate precious cash will get pushed through at historically low returns of less than 2x, like the recent story of Mochi Media.
Well, sort of. Early stage is, of course, relative. The fact that these “early stage” deals are 35% larger on average only means the gap between seed and institutional money is widening.
Still, for the viability of the venture capital business, this is probably a good approach. Given the high rate of failure even among well-funded companies, it seems like a better strategy to have $30m deployed over 6-12 companies as opposed to just a handful.
Ultimately, it will be interesting to see how this trend affects VC expectations. On one hand, more money and higher valuations usually come with higher standards for the state of the business. On the other, it’s possible that it may become easier to raise money if the VC firm is committing less money over the life of the deal, even if they are putting more upfront. If a company can truly “make it” without follow-on rounds, this will also mean less dilution for the founders and employees.