There was a lot of chatter last week about the “Series A Crunch”. It started with this post and has stirred a bunch of commentary. The gist of the story is that there has been a significant increase in seed stage investments activity over the last 2 years, and many companies are now coming back into to the market for their next round of financing.  The problem is that the availability of series A dollars has not expanded – in fact, it has contracted.  As a result, there is going to be a bloodbath of dead companies in the next 6-12 months.

Like most things in the tech blogosphere, reports of this crunch are somewhat exaggerated.  I think it is indeed true that there have been more seed stage companies funded in the last couple years, and that will lead to a relatively more crowded series A fundraising market right now.  But the repercussions of this are not as dramatic as some people are reporting, and for most investors, it’s going to be business as usual.  Here are a couple sub-points to hopefully bring a bit of sense to this discussion.

First: This is nothing extraordinary and comes to no surprise. Investors who have been in the early-stage investing game for some time know that markets come and go.  Sectors get hot one day, and less interesting the next.  Smart investors don’t try to time the market.  Instead, they try to maintain a steady investment pace, and create diversity across time (a form of diversity which is often overlooked).  Although the next few quarters may be somewhat more challenging for seed stage companies to raise their next round, it probably means that it’s a great time to be making new seed investments as other investors are distracted tending to their portfolios.

Active seed investors have also known that this was going to be coming.  We’ve seen valuations creep up as more capital has entered the seed stage (although this have varied quite a bit by geography).  I’ve been telling our portfolio company founders about this for half a year, and if you watch carefully, many of the most successful institutional seed investors like Floodgate or Harrison Metal have actually slowed their pace a bit the last few quarters because of all the new capital that has entered the scene. Instead, we have picked our spots, been valuation disciplined, and tried to put our portfolio companies in the best position to stand out when they do go out for more money.  Balance will be restored, and it happens surprisingly quickly.  The investors that have a strategy and stick with it will be rewarded over time.

Second: repurcussions of this series A crunch is overblown and net-net will probably be good for the startup ecosystem.  I really don’t think it’s going to be bloodbath some people think it will be.  The main reason is that many of these companies that have been funded were never really candidates for investment from large VC’s anyway. Broadly, I think there are two kinds of companies that fit the bill.

1. Companies that are capital efficient and can get to viability and a very interesting returns without VC funding.  Taking VC money is not the ideal path for every company, and the capital efficiency of internet businesses means that more and more companies can actually yield a successful outcome without taking large amounts of capital from very large funds.  So these companies aren’t really effected by the crunch since they weren’t part of the VC funding chain anyway.
2. Companies that want to raise VC money, but probably never had a chance to begin with because they weren’t going after big enough opportunities.  VC’s have very strict incentives when they invest in companies. Because of their fund size and the return profile of VC portfolios, VC’s only invest in companies that have the potential to be very very big.  That’s why the #2 reason why VC’s pass is because an opportunity is not “big enough”.  Investors that work with VC’s often understand this, and it will usually factor into how they think of their portfolio composition.  Angels that have just been dabbling in internet investing will be hurt here because they may have invested in companies going after opportunities that likely would never be perceived as big enough to get large VC’s excited.  Institutional seed investors may have a handful of these too, but it usually is a minority of their portfolios and they have mentally expected to push these companies to get to CFBE quickly or find other non-traditional funding sources to keep these companies going.

I think a lot of the surge in new companies can be attributed to these two categories.  I do think that there are also companies going after VC-scale opportunities and are performing “ok, not great” and are going to have a disproportionately harder time raising their next round.  That is probably true, but there will likely still be some name-brand companies that come out of this crop.  It will just take a bit more time for these companies to stand out.

Onwards!