Venture Trends - 2001 and beyond   - by Alan Fisher

The new economics of venture funding
As you have probably read in the news media, valuations of private companies have fallen, and we’ve seen a marked compression in the seed and early stage deals we target.  To give you some perspective, here are typical pre-money valuation ranges (prior to our investment) that we’re seeing:

• $2M to $3M concept stage
• $3M to $5M product development stage
• $5M to $7M early revenue stage

 
Because valuations are lower, we think that the best time to be investing in seed and early stage companies is now.  Unfortunately, entrepreneurs haven’t yet fully adjusted their expectations relative to market valuations.  In some cases they’re taking investments from foreign VCs who are willing to pay higher prices than Silicon Valley VC’s.  In other cases, they’re doing nothing, electing to build their businesses without benefit of venture financing and hands-on assistance, or they’re doing deals with corporate investors.  However, we expect entrepreneur’s expectations to quickly change over the next few months.
 
There is a “floor” below which venture financing doesn’t make sense for most entrepreneurs.  Even the scrappiest of startups have to pay salaries, rent offices, and fly to customer sites.  This imposes a certain base cost on a startup that is funded by venture capital.  In our experience, it takes about $2M to $3M to get a product to market with an initial handful of customers.  Often this is done with a combination of angel money followed by venture money.  An entrepreneur’s ownership percentage is diluted when this money is raised, and there is a valuation floor below which it doesn’t make sense for the entrepreneur, usually 50% dilution.  For example, it’s hard for an entrepreneur to raise $3M at less than a $3M pre-money ($6M post-money) valuation without suffering dilution that leaves them very little ownership in their own company.

Deal flow has changed dramatically
The “scrappy” entrepreneur has returned!  Since January, we’ve seen an increasing number of deals started by entrepreneurs literally in their spare bedrooms and garages.  These entrepreneurs are not taking any salary, and their initial seed funding comes from their own bank accounts with maybe some “friends and family” money.  These are true entrepreneurs.
 
Prior to January, most of the deals we saw were companies with inflated headcount -- 20-35 people – which had excessive infrastructure and cost relative to their stage of growth and maturity.  Accordingly, these companies needed to raise larger amounts of money to fund this infrastructure, raising the overall price of the deal.  We “passed” on these opportunities, preferring to wait for companies with leaner teams, more customer-focused businesses, and more reasonable valuations.  The days when a group of MBA’s with no experience and just a business plan getting can get funding have gone.
 
There has been a resurgence in startups focusing on enterprise software.  Traditionally, enterprise software companies take less money to start and are less complex – they build a product, sell it to large companies, and support the product.  Customers are acquired by a direct sales force calling on individual companies one at a time, allowing the company to grow organically with its sales.  Enterprise software companies don’t require big marketing and advertising budgets (unlike B2C) and don’t require a lot of customers to make the business viable (unlike B2B).  We like enterprise software because capital requirements are modest, enterprise software companies have a strong history of going public or getting acquired at attractive valuations, and because there are a lot of entrepreneurs in Silicon Valley who know how to build enterprise software companies.
 
We have also seen a resurgence in infrastructure companies, especially in the network provisioning and security services areas.  Large networks need specialized software to manage them, reducing the burden of individually configuring each device as it is added to the network.  Similarly, security is an ever-present concern for Internet-connected machines, and a wide variety of solutions are being developed to secure networks and content at a variety of different levels.