Fretting about the Series B crunch

businessman in boxing gloves isolated on black

Last year was a good one for venture capital. The IPO market caught fire, distributions rose and innovation steamed along at a brisk pace. What’s more, the Series A crunch that was to be the year’s dark chapter turned out to be little more than a footnote.

The A round shortfall could of course worsen in 2014. But many VCs worry more about a Series B crunch that gathered intensity last fall and threatens not just early-stage returns, but perhaps the pace of innovation itself.

The concern is that a bumper crop of angel-funded startups that returned for A rounds in 2012 and last year are ripening for Bs. Many could face a capital squeeze when demand exceeds supply, as it is likely to do, and the fallout could hit seed and A round investors, along with the current generation of entrepreneurs.

“I do think that it is real,” said Rami Elkhatib, a general partner at Acero Capital. “I hear companies talking about it. I hear investors talking about it. I believe it has begun.”

What’s most unsettling is that there is more at stake this time. Instead of the $500,000 to $1 million a seed investor has on the line when a company goes in for an A round, early investors could have $3 million to $6 million riding when they begin to pull together a syndicate for a B round. Not getting the funding has greater consequences. Adding to the danger is the recent decline in B round deals and investors.

Over the past seven years, B round deal volume has fallen almost 30% and the number of participating investors slumped 28%, according to data from Thomson Reuters (publisher of VCJ). In 2006, 938 investors funded 877 U.S.-based companies with rounds of $5 million to $10 million, the typical range of a B round, the data show. By 2013 the numbers had fallen to 677 investors and 619 companies, a substantial fall-off.

The impact of the crunch could be difficult round pricing, more bridge deals and companies that simply can’t raise new money. Entrepreneurs who took $4 million a couple of years ago on pre-money valuations of $25 million – many with Web-based startups – may find a dose of cold reality when they test their expectations for an increase.

“There is going to be a fallout for all but the best of these companies,” said Joshua Goldman, a general partner at Norwest Venture Partners. “There will be fewer companies that get funding. Those that do will get a lower valuation than they want or they may have to raise money at a lower valuation than their previous round.”

This story first appeared in Reuters Venture Capital Journal. Subscribers can read the entire original story here. To subscribe to VCJ, please email Greg.Winterton@ThomsonReuters.com.

Photo illustration by Janet Yuen.

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