More on seed level funding – a response to Paul Graham

As many of you will know Paul Graham has been at the forefront of innovation in small company financing for a couple of years now.  He is the founder of Y-Combinator, a startup accelerator that developed a new model for financing and helping companies at the very earliest stages and which has now been widely copied, and he writes and speaks extensively on the trends and developments in this space.

Two years ago he wrote that there was a big gap between the $20k financings Y-Combinator and others provide and the $2m+ that VCs like to invest.  Angels exist in that space, but in Paul’s opinion there weren’t enough of them, particularly given the increasing number of companies that can do great things with that amount of money.  And he was talking about the US.  The dearth of angel funding is more acute in Europe.

Since then in the US the number of VCs investing at that level has increased and a cadre of specialist funds targeting seed level investments has emerged – e.g. my friend and former colleague Jeff Clavier’s SoftTech VC, Dave McClure’s new fund, and Founders Fund.  Here in Europe the number of funds active at this level is also increasing – Fred Destin’s post from yesterday gives a good breakdown.

Earlier this week Paul Graham wrote another piece on the future of startup funding, describing where he sees things going next.  The main thrust of his argument is that founders are getting more powerful relative to investors, and therefore the funding environment (terms, the way deals work etc.) will shift in their favour. Paul says that this is a meta-trend, and that Y-Combinator was based on it from the beginning.

Let’s explore that for a moment – if you think about investing as a market place for money then if the balance of power is shifting in favour of founders it must mean that the demand for money is falling relative to supply.  I think that Paul is right in calling this trend due to movement on the demand side.  The demand for investment equals the number of startups seeking cash multiplied by the average cash requirement, and whilst the former is increasing slowly the latter is declining rapidly and may have fallen by as much as an order of magnitude over the last decade.

It is important to note that declining demand for investment doesn’t mean the end of big VC rounds and the venture capital model as we know it.  The average cash requirement that I’m talking about here is for an internet startup to get going and prove itself – either by getting significant traction or getting to profitability.  For many there will still be large capital requirements after demonstrating the ability to cost effectively acquire customers – just look at the money raised by Twitter, Facebook and Spotify, and tradtional VC funds will be happy to operate in that space.

In Europe, of course, the supply of capital is less than in the US, so any shift in favour of the entrepreneur will likely be less marked.

This post is long enough already, but before I finish I want to note a couple of other interesting points that Paul makes:

  • Despite the increase in the number of funds targeting seed investments he thinks there is space for more.  After all the trends in favour of capital efficiency are only getting stronger.  (Note – if this is true in the US, it is doubly true in Europe).
  • VCs could do more smaller deals if they adapted their model – e.g. by taking less board seats;
  • But not many will, and the new super angel funds will come to dominate the seed space leaving VCs to focus on later rounds
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