We hear lots of discussion these days about the fiscal cliff. This, of course, is about taxes and federal spending.
But startups face their own fiscal cliff.
Over the last few years, there's been a surge in startup activity. This has been driven by several trends. First, It's never been easier or cheaper to start a tech and/or web company. And the the maturation and growth of the Internet and other technologies and industries (genomics, clean tech, robotics, Big Data, etc.) has created vast new business opportunities.
Adding to this, startup captial has been relatively easy to come by. The rise of angel investors has made it relatively easy to attract seed rounds - small, early stage funding usually in the $200k to $500k range. This continues to be the case.
But the road past those early startup rounds is getting harder to navigate, and startups may soon face their own financial funding cliffs. Startups traditionally have turned to VC's for later stage funding, but funding from VCs is down and the industry itself is both struggling and shrinking. According to the National Venture Capital Association (NVCA), the number of venture firms has declined from more than 1,000 a decade ago to 462 today.
NVCA also reported that the level of 2012 venture funding will likely substantially fall relative to 2011. Especially hit hard are B and later stage rounds - larger deals in the $5 to $10 million range or more that go to firms trying to scale. According to the NVCA, the number of these rounds has fallen by almost one-third in 2012 versus 2011.
The reason is quite simple. VC returns have been lousy for the last decade. According to a quite negative report from the Kauffman Foundation, the majority of VC firms have underperformed public markets. This is not good, especially since VC investments are riskier and lack the liquidity of public markets.
Because the returns have been bad, limited partners - institutional investors such as pension funds and foundations that invest in venture capital - are cutting the amount of money they are allocating to the sector. For example, the California Public Employees Retirement System, traditionally one of the largest VC investors, is substantially reducing their investments in venture capital.
So we have a situation where it's easy and cheap to start companies, and it's relatively easy to raise early stage investment capital.
But at the same time, it's becoming much harder to raise 2nd and 3rd rounds of funding.
Because of this, a growing number of startups are running into a fiscal cliff where they need funding to continue, but cannot get it. Business Insider has a good article on this startup cash crunch.
This cash crunch was one of our Top 10 Small Business Trends for 2012. Key quote:
But 2012 will also be a year of reckoning for many startups. The last couple of years have produced almost a frenzy of new tech companies. Many of these firms will need additional funding in 2012, and those not able to show strong customer traction will not be able to find it.
This is one forecast I wish we'd gotten wrong. Expect this problem to continue in 2013 and get worse before it gets better.