The Funding Gap

There’s a curious thing happening in the world of VC and angel funding these days. Namely, that for a lot of software companies, it’s almost impossible to get a first round of funding without already having a product nearly finished. The reason for this is actually an accident based on the size of venture funds.

How Much Money Do You Need?

Of course, the funding you can get is based on the quality of the idea, the team, and the market. But the amount of money you need is a function of your business plan, and time. I remember as a child, my dad used to say that a good idea had a 2 or 3 year lifespan before someone else would be doing it. When I first entered the world of high-tech start-ups in the late 90’s, the consensus in the VC community (and the truth in practice) was that you might have 18 months. Now a days, everyone says you have 6 months.

That six months plays a key factor in how much money you need. Let’s say you already have an alpha version of your software that you’re using as a prototype for fundraising. You need to finish the product and go to market aggressively. In the last year, I’ve seen dozens of companies in this position — and they’re all looking for a couple of million dollars. Of course, if you’re not quite there yet, you probably can get buy with a few hundred thousand to build a prototype. Or if you’re looking for a follow on series, or are not in the software business, your needs may be much higher. But that’s a very common figure for first route software companies. The problem is, that amount of money is almost impossible to raise.

Angels and VC Funding Levels

A typical angel will invest $50k in a deal. That’s why even for seed rounds you normally build a consortium of angels. But at an average of $50k, getting to $2 million would require banding 40 typical angels together. That’s an impossible task; and even if you could accomplish it, managing 40 investors would be an impossible task.

VCs have a problem from the other end. Let’s say an individual VC is managing a $100 million worth of fund dollars. That’s actually a pretty small number. But still, if he were to invest $2 million per company, he’d have to be able to actively manage 50 investments. In reality, eight is about the practical maximum number of investments that a VC can manage — which means that his average investment needs to be about $12.5 million. Of course, some of that $100 million is put aside for follow-on investments, which will tend to be larger. Nevertheless, it becomes very difficult for a VC to invest less than something in the $6–$8 million range.

This leaves a serious gap. And unfortunately, many software ventures fall into it. There’s a lot of space between $500 thousand and $6 million.

Recently, there have been some investors stepping up to fill this gap. “Small cap VCs” are coming around looking to invest exactly in this range (after all, if there’s a market demand, it will be filled). However, if you look at a lot of these small cap funds, they’re only investing in certain kinds of companies. For example, a few months ago, Greycroft raised $131 million in a small-cap fund. Their intent is to invest $1.5 to $1.75 in at least 40 companies over the next four years. But they’ve primarily been investing in “capital efficient digital media enterprises”. That does not describe most start-ups.

Conclusion

Over time, I imagine this problem will be solved. More micro-VCs will enter the space; more private equity will lean towards larger angel investments. But, in the short term, if you’re planning on needing a Series A in the low, single-digit millions, you have your work cut out for you.

Still, prosperity to you!
Chris

Posted in Entrepreneurship and tagged , , , , , , .

Chris Richardson has strong opinions on just about everything. Just ask.