Industries change and evolve over time; why should venture investing be different from other industries?

Recent declines in venture fundraising…

Shouldn’t we be worried about the recent decline in venture fundraising?

Venture capital funds raised only $3.4 billion in the last three months of 2008, according to new data from Thomson Reuters and the National Venture Capital Association. Unsurprisingly, this is a big drop (about 70.9 percent) from the same period in 2007, when venture firms raised $11.7 billion, and also a substantial decline from the $8.4 billion raised in Q3 of 2008.

Was the amount of capital raised in Q4 2007 or Q3 2008 a meaningful base for comparison? Is a measure of venture fundraising over a short period of time meaningful? Is this a signal or just noise?

Wouldn’t we expect some venture capital funds to fail, struggle and close up shop in an economic downturn? Isn’t that part of a healthy cycle of creative destruction?

In any case, less venture capital isn’t necessarily a bad thing; more money doesn’t necessarily lead to better startups and innovation.

David Hornik, Innovation doesn’t take a vacation in an economic downturn:

So why am I optimistic about investing in 2009? Because entrepreneurship is an addiction, it isn’t a choice. Great entrepreneurs aren’t driven to create companies because it is easy, or because capital is plentiful, or because the public markets are swallowing anything the venture community will throw at them. Great entrepreneurs start companies because they can’t help themselves. They see a problem or a solution or white space or an opportunity and they have to do something about it.

Innovation doesn’t take a vacation during an economic downturn. Innovation is a constant. While the resources an entrepreneur may be able to bring to bear on a problem may vary with the economic climate, the desire — the need — to innovate never goes away. And Venture Capital is the fuel of that innovation.

… combined with a shift in investment strategy…

A more meaningful trend, however, may be the increasing deployment of “risk capital” to fund follow-on investments, even as seed-stage valuations are decreasing.

Based on everything I’ve heard, venture investors are using funds to keep their current bets alive rather than making new bets. It’s a reasonable strategy given the structural math behind venture investing, the Darwinian nature of startups and the resulting need to give possible successes the chance to be “moonshots”.

… is helping create a gap between funding for “testing ideas” and “building businesses”.

A wide range of business, cultural and technological trends created the need for new models to support early-stage ventures, and the resulting rise of seed-stage and venture-launch funds investing in the $5K – $25K range have created many new opportunities and paths for entrepreneurs to test ideas.

But what comes after the ideas have been tested and “proven”? From what I have heard, entrepreneurs are finding it difficult to raise funding in the next level of investment, the more traditional seed-stage $100K to $500K range. If I’m wrong, please correct me.

Why?

Is this funding gap a sign of economic conditions or a deeper structural problem in venture investing?

As usual, the answer is not either / or but both. In the last decade (especially the last five years) the M&A market has been a popular exit strategy for startups looking for funds in this range, but current economic conditions have forced many strategic investors to the sidelines. Traditional Series A institutional capital will find it difficult to make the math “work” for deploying smaller amounts of capital. And even though the recent shift has been towards focusing on follow-on investments, the new early seed-stage funds really do not have the capital or the investment focus to make the follow-on investments to take their “proven ideas” into businesses.

Which leads me to ask: what is a bigger problem for the venture community: not being able to find funding to test an idea, or not being able to find funding to take a promising idea forward?

Bemoaning the structural gap between venture capital math and the new operational and economic realities behind new ventures is pointless.

What’s the path forward?

If it’s a structural problem, venture investors will figure out an operational and investment model that works. The recent rise of the early seed / test / launch phase investors is one of the newer evolutions in venture investing but hardly the last. I would be surprised if investors do not figure out how to bridge this seed-stage gap. Perhaps we’ll see tighter angel networks, strategic shifts from institutional Series A-stage investors, follow-on funds run by the early-seed funds or even new entrants with new investment models.

If it’s part of the broader economic downturn, then we’ll see good investors succeed and less-successful investors fail until the next run-up in venture fundraising and investment creates new opportunities. It’s not the death of the industry.

And on the other side of the coin, entrepreneurs will figure out how to build new businesses regardless of the funding climate. All new ventures have to have a business model “built-in” from the start; it’s the entrepreneur’s choice when to turn it on. [1] Right now is the time for entrepreneurs to focus less on raising nonexistent capital and focus more on turning on their “built-in” business models.

Need help figuring it out?

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[1] I think I read that line somewhere, but I can’t seem to remember where…