Early Stage Startups Face Funding Block

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Early Stage Startups Face Funding Block
January 24, 2002
By Katherine Goncharoff

When Advanced Reality Inc., a one-year-old collaborative software startup, went hunting for first-round private financing last year, it didn't waste much time with traditional venture capitalists.

"Many VC firms were distracted and not that interested in early stage investing," said Advanced Reality financial consultant Dan Watkins.

The Houston company quickly changed tack, and in three months, raised nearly twice what it expected — $2 million — from angel investors.

It's an oft-repeated story these days, and one given added pathos with new statistics from Venture Economics showing that early-stage fundings by traditional VC firms have nose dived. In the fourth quarter of 2001, early- stage startups received just 9% of overall investments compared to 25% on average over the past five years, the research firm said.

"We've seen pretty dramatic declines in terms of the ability of early and seed-stage companies to whet the appetites of venture capital investors," said John Fitzgerald, president of Katalyst llc, which acts as adviser, agent and investor in early-stage companies.

Added Ronald Weissman, a VC with Apax Partners in Palo Alto, Calif., "There was certainly a wild exuberance two years ago for early stage companies but that time has come and gone,"

Several factors contribute to the decline, notably an overall drop in venture investing, the difficulty large funds have in devoting time to manage needy startups and the closure of several funds.

Further, VC firms are forced to devote more time to their portfolio companies to keep them alive, grow their customer bases and achieve revenue until they can exit them through an initial public offering or acquisition.

"We're seeing a lot of portfolio drag in the VC community at large where investors are spending a great deal of time working out problems and as a result, they don't have a whole lot of time to look at new opportunities," said Daniel Ahn, a managing director at the Woodside Fund, a Woodside, Calif.-based lead sponsor of the Early Stage Venture Capital Association, a national networking group.

Doug Chertok, a venture capitalist with Hudson Ventures in New York, noted that many venture investors are concerned about providing enough capital to their investment targets to ride out the recession. "Almost by definition, it is difficult to give a lot of money to an early stage company these days because while you want them to have enough money, you also have to allow the founders to retain enough equity to have the incentive to build a successful company," Chertok said. "In this environment, that's not easy."

Moreover, the economics of early- stage investing is no longer viable for the 30 or so venture funds that have each raised $1 billion or more in the past few years. Many of these funds are inclined to make larger investments in later-stage companies that do not require the time and effort to nurture and manage early-stage companies.

Exacerbating the early-stage retreat is that most venture firms have simply cut back on overall investing.

David Barry, a vice president at Asset Alternatives, noted that big early-stage funds made very few investments last year overall. Palo Alto, Calif.'s Accel Partners made only four new investments, compared to 24 in 2000, according to its Web site, while Barry said Waltham, Mass.-based multi-stage fund Battery Ventures made nine new investments last year against 29 in 2000.

Investors also cite the recent shuttering of early stage and accelerator funds. Earlier this month, The Barksdale Group opted not to raise a second fund and wind itself down, and Mohr Davidow Ventures said it would cut limited partners' contributions to an $850 million fund back to 80%s.

"We are in the early stages of a shake-out in the industry and a lot of early stage funds have or are in the process of closing down," Ahn said.

Despite the dire statistics, some venture capitalists are optimistic.

"I think early-stage investing will be on the rise in 2002," said Ravi Mohan, a Battery Ventures partner. "A great many good companies that already had product and revenue and were priced as though they were early stage deals got funding last year. But the good ones have already been funded and so, I think that more VCs will now turn to early stage funding," Mohan said.

Apax's Weissman agreed, "For us, this is a great time to be an early stage investor because the valuations are great and there are wonderful management teams available for hire."