Too Many Startups Chase Too Little Dough

(Reuters) – Venture capitalist Bill Gurley has noticed something new this autumn: a big jump in the number of what he calls “legitimate introductions” that he receives each day to entrepreneurs who hope he might invest in their start-up companies.

The money-seekers are companies that have benefited from a tidal wave of early-stage investing in start-ups and who now need funding from mainline VC firm’s such as Gurley’s Benchmark Capital to take them to the next level. But many companies, even some that have done fairly well in their initial phase, are finding it increasingly difficult to raise the next round of cash.

So far this year, some 859 companies have raised an initial round totaling $3.9 billion, according to data from the National Venture Capital Association and Thomson Reuters. That compares with 777 companies raising $3.5 billion this time last year and 523 companies raising $2.3 billion in the first nine months of 2009.

The plethora of early stage companies is a result of the comparatively low cost of bringing new technology products in the age of dirt-cheap software and data storage and massive social-marketing engines such as Facebook. A growing legion of wealthy “angel investors,” many of whom made their money in the last boom, has contributed to the start-up boom too.

But it can still cost a lot of money to get a company from proof-of-concept to maturity and that’s exactly where start-ups are running into trouble.

Every year sees some start-ups that don’t make it to that next round. But this year, the situation is particularly bad, entrepreneurs and their potential backers say, simply because there are so many more young companies. And next year they expect it to get worse.

Of course, the hottest companies are having no trouble winning new rounds of funding. Cloud-based storage company Dropbox raised $250 million earlier this month in its third round of capital from companies including Benchmark.

Instead, the crunch is hitting the hundreds of fledgling companies that most people have never heard of.

“This is more about the long tail,” meaning companies that aren’t dominating, said Gurley, whose counts companies such as real-estate service Zillow Inc and restaurant-reservation service OpenTable Inc among his investment picks.

Exacerbating the problem: there is less cash to go around. Except for a handful of marquee names such as Benchmark, Accel Partners and Sequoia Capital, venture-capital firms are having trouble raising funds themselves. Last quarter, fund-raising reached an eight-year low, with VC firms raising just $1.72 billion, compared with $3.5 billion a year ago, according to the NVCA.

All of this means that many start-ups will have to look for alternatives to raising new funds.

One such route is what’s known in the trade as a “face-saving acquisition.” That means selling the business, sometimes for a song, before it has had a chance to grow, with the acquiring company often interested mainly in the start-up’s staffers.

That talent, particularly engineers, usually ends up deployed in the acquiring company’s core business, while the acquired start-up’s business quietly closes. Facebook is famous for this type of move, as with its purchase last year of Internet-services company Chai Labs.

Another potential outcome for a cash-strapped start-up is to simply muddle along, never achieving the scale that might have been possible with more money.

And some, of course, will fail outright.
That’s what happened to MyNines, a sample-sales aggregator site that raised around $350,000 in seed money last year, according to Thomson Reuters data. It would have taken another couple million to ramp up the business, founder and former CEO Apar Kothari told Reuters, which she didn’t think she could raise when she ran out of cash earlier this year.

Now, Kothari is head of new business at online retailer Rue La La and MyNines is no more. She blamed its shuttering partly on missteps and partly on the fund-raising climate.

“I still believe in the concept,” she said.

For venture capitalists, having more companies to choose among means, in theory, that they can select the most promising and deserving start-ups and perhaps get better deals than previously.

That is, if they have time to sort through them. Gurley said he is receiving some 5-10 introductions a day, up from 1-5 a year ago.

“There’s no way to process that,” he told Reuters.

By Sarah McBride