The Caltech/MIT Enterprise Forum – The New Realities of Early Stage Funding

The more I go to these kinds of entrepreneurial events and seminars, the more confirmations I seem to get about the common themes that crop up when talking to startup founders. For many entrepreneurs, there’s oftentimes no greater source of worry than having the capital to continue on with their venture, so startup funding is a subject that’s near and dear to their hearts. That was what the Caltech/MIT Enterprise Forum’s latest event focused on: early stage startup funding and how much of that has changed since the dot-com bust and the credit crunch.

The business of venture capital (VC), by its nature, tends to be a very cyclical one, and that was the main point that Randy Churchill, the Director of Emerging Company Services at PricewaterhouseCoopers drove home. When he showed the audience graphs of how the scope and levels of funding have changed, he took care to point out significant economic events like the ones mentioned previously. In terms of the sectors that get attention, software and biotech continue to get the most of the funding, but cleantech has been making some headway into that arena. As for location, no surprise, Silicon Valley gets the bulk of the funding, followed by New England. The whole southern California region (which includes both the LA area and San Diego), ranks third. I thought that was a bit deceptive though, since if you only looked at just LA and Orange County, that region would rank fourth behind New York City. Still, that’s not bad at all.

The main trend that’s been taking place in VC is that the level of funding has gone down quite a bit and is only beginning to pick up. Furthermore, the critical cog in the funding cycle, seed funding, is still low compared to what we’ve seen in the past five years. The deal size for venture-backed IPOs have also gotten smaller. There has been some recovery earlier this year, but the last quarter (Q3 2011) has not been kind to many entrepreneurs.

Despite all this doom and gloom, there are positive signs. If you read my piece on Steve Blank’s talk at UCLA, you’ll know that we’re in the second decade. That is,

…goods are no longer necessarily confined to physical products and sales channels are no longer confined to physical locations. The internet has effectively changed all this and it’s going to be even more true with time.

which spells good news for entrepreneurs. Now that everything can be done online, startups require less capital. You can easily release a webapp provided that you make a time investment in getting your code up and running and shell out for an Amazon Web Services account. The costs are low and are getting lower; in 2001, the cost of of starting up was around $10 million. In 2011, you can get started up for $50 a month in web hosting services.

On top of that, launching and scaling have been much easier. There are sites like Launchrock where you can set up a landing page quickly and use that to notify customers when you actually launch the product. And because you’re operating through the web, it’s also easier to scale since you’re not constrained by geography. Even customer acquisition is easily done through online channels and screensharing services that give you an opportunity to demo your product.

When you put this all into consideration, there is a great opportunity for a group of investors called micro-VCs to really lead the way. This special group consist of smaller funds and their considerations are far different from what traditional larger VC funds offered. The next speaker would get into more of that.

That speaker, John Greathouse, General Partner at Rincon Capital Ventures, noted that just because the funding landscape has gotten smaller doesn’t mean that the current model of VC funding is broken. Rather, it’s just going back to its roots. The ridiculous levels of VC funding we’ve seen in the last few years are more of an aberration. In a sense, what we’re seeing now is more of a correction to a saner level of funding.

And micro-VCs are the ones making the charge. Depending on their focus, this new breed of VC can consist of a diverse set of companies or be composed of large, concentrated clients. By being smaller, their priorities are different and they actively work towards making sure entrepreneurs achieve that exit rather than waiting for a larger deal to come through. And because many micro-VC partners put in their own capital for investment, John Greathouse believes that micro-VCs are more aligned with the venture founder’s interests. The larger, traditional VC firms, he argues, are lazy and don’t have quite as much skin in the game because they’re not investing for themselves.

But while micro-VCs are doing well, the cheapest source of funding are still customers. When a venture reaches a point of profitability, it’s already proven that the business model works and one of the few reasons to consider outside financing at this stage is to scale even faster. However, no company should wait to receive funding. The mistake that too many entrepreneurs make is to chart out a path that is dependent on funding for them to accomplish their goals. Good entrepreneurs will forge ahead relentlessly no matter what obstacle arises.

Greathouse concluded his portion of the talk by emphasizing that for many VC-entrepreneur relationships, there’s no shortage of ideas. Only a shortage of trust. To gain that trust, he encourages entrepreneurs to build investor love through channels like twitter, blog posts, blog comments, or get an introduction from a trusted source. And for entrepreneurs, the goal should be to work with the VC who focuses on building value and will work in concert with the entrepreneur as a partner rather than an overlord who needs to be pleased.

After the speakers, they had a Q&A section with John Greathouse and 3 other investors: Jeff Stibel, who mostly invests in the life sciences, Zao Yang, the Farmville co-creator, and Alex Kazerani, the co-founder of KnowledgeBase and HostPro, a webhosting service provider.

The first question that was thrown at them is what sort of founder or venture they go for when they invest. When this question got asked, I had a vague inkling of what the answer was going to be, and sure enough, Jeff Stibel confirmed this when he dismissed all other elements like location, sector or idea, choosing to emphasize the importance of the founder. Zao Yang went a bit further by delving into more specific traits, saying that he is generally open to a Paul Graham-esque kind of founder, one who is relentlessly resourceful.

This relentlessness is key, because founders should, first and foremost, be able to execute. Founders should not be too fixated on the money. Their goal should be to build up an actual prototype because it shows that even if the odds are stacked against you, you can still execute upon your business idea; that you have the energy, motivation, and drive to see it through.

Other interesting that might be of interest to non-attendees:

  • Never forget the ecosystem in which the startup is operating out of because it is possible to have a product that’s simply not ready for people to use because the technological infrastructure just isn’t able to support it. Zao Yang’s example of this is none other than YouTube, where he notes that without the growth of broadband and flash, there was no way YouTube could have worked.
  • Starting businesses during economic downturns might not be a bad thing. When Jeff Stibel brought this point up, I had recurring flashbacks of Paul Graham’s post on the same topic. Stibel also goes on to say that entrepreneurs will start ventures no matter what the business climate is, which affirms what Paul Graham says in his essay.
  • Lastly, the post-PC era is at hand. At least, that’s what Zao Yang is observing as people begin shifting away from computers and into tablets and smartphones. It’s certainly a real possibility, at least on the consumer end. I’m having a bit of difficulty seeing these devices replace computers in the workplace though.
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