I’m not a venture capitalist, but because I do some investing and work with several VCs finding and evaluating deals, I get to see a lot of  plans and have the chance to meet many people working on new ventures. In the last year, the volume of plans that I’ve seen and entrepreneurs I’ve met has grown at an astounding rate. This could be because of changes in my little piece of the entrepreneurial universe or a trend resulting from good people and ideas coming out of hiding after the bubble burst earlier in the decade. I think the latter is more likely.

The problem is, that while the number of ventures seeking money has expanded rapidly, the money available to fund more deals has not. This leaves some great ideas and entrepreneurs out in the cold without funding or, for the luckier few, with crappy deals which require that the entrepreneur give up too much of the equity in his/her company for too little capital.

So here are my thoughts on this problem interspersed with some real data from Ernst & Young and Dow Jones VentureSource to make me sound like I know what I’m talking about. If you’re an experienced entrepreneur with a few successes under your belt, this stuff won’t apply to you.  If you’re a first-timer or you’re moving to a completely new market, though, here is the situation.

The number of venture capital firms today (~1,500) is roughly half the number that were doing business in 2000.  In 2000, a little over half of the then existing venture capital firms did four or more deals.  In 2005, the deal activity dropped to only about a third of the firms in business doing four or more during the year.  Keep in mind that this is also on a smaller base of venture capitalists, too.  At the same time, the percentage of funds with over $100M in investment grew from less than 30% in 2002 to over 60% in 2005.  That’s right; fewer funds but, on average, more money per fund. 

Additionally, most of the remaining venture capital firms are those that still have money available to invest from previous funds, although this money has a fairly short lifespan to it, it has to return a gain to the fund’s limited partners in a short period of time.  The only way for a VC to effectively use this money is by making follow-on investments into companies already in their portfolio or by making very late stage investments that could become liquid in short order.

The bottom line is that there are fewer, bigger funds doing a smaller number of deals, each deal requiring an investment of more money to best utilize the funds’ cash and maintain the dynamics of VC partnerships with a limited number of partners to watch over the investments. 

Of course, the problem isn’t only about fund size and number of deals; the path to liquidity for investments has gotten incredibly muddy.  Classically, venture-backed companies had two paths to exit – an IPO and a merger or acquisition.  The situation in the public markets has caused the first option to virtually disappear for most companies.  In 2005, there were less than 50 IPOs of venture backed companies.  During that year, 87% of all liquidity events of venture backed companies were through M&A activity.  Because of this, VCs are more cautious about their investments, having to limit the companies and markets they invest in to ones where M&A activity is likely.

This all creates a huge dilemma for the entrepreneur seeking any early round investment, especially seed money to get going.  What little money is available is substantially harder to get.  A considerably smaller number of venture capitalists want to make big investments into fewer companies and only into markets that have a lot of projected M&A activity.  The result of this is that in 2005, only about 2% of venture capital was invested in seed deals – a percentage that is not likely to increase.  This is down from a high in 2000 of 7%.  Of course, that was 7% of a substantially larger pie.   

Angel investors have always been a potential source of capital for startups.  The difficulty in taking angel investment is that, generally, the entrepreneur has to get many angel investors involved to have enough money to fund the company.  Often, this can take 6-10 separate investors.  Not only is it difficult to find that many qualified individual investors, but it is very difficult and time consuming to manage the group after the investment is made.

In order to fill this gap, Recognizing this problem and in an attempt to optimize deal flow and investment returns, angel investors have banded together to form angel funds.  Getting funding from an angel fund is quite a bit easier than getting money from many individual angel investors.  The entrepreneur can avoid the hassle of having to find and manage many individual investors by taking this route, the angel funds generally invest as a group. 

The rub here is that these groups have moved into a position where they are filling the void left by VCs who are no longer doing early-stage investing.  It used to be that an entrepreneur could get a good deal from angel investors.  That is, some reasonable working capital without having to turn over too much ownership in the company.  This is not true any longer as these angel funds think of themselves as similar to professional venture capital investors and are asking for, and getting, similar deal structures.  In my experience, these funds are making $500k-$1M investments with $500K to $1M pre-money valuations so they own up to 50% of the company with a relatively small investment.  Of course, some entrepreneurs take these deals because it’s their only way to fund their ideas.

Yup, the situation mostly sucks.  There is some good news, though.  Trends are getting better. 

The market for venture capital has caused startups to become much more efficient.  From 1998-2000, the median equity raised by a venture-backed company was $27M and the median value of an M&A transaction was $40M.  This represents a growth multiple of 1.3X.  From 2001-2004, the median amount raised was $10M with a median exit of $50M, resulting in a 4.3X growth multiple.  This increase in return on capital with a lower initial investment should work its way through the system to justify more early investment.

The M&A market is also improving.  In 2005, the median amount paid for the acquisition of a venture-backed company was about $60M, well above the $18M of 2002 and $23M of 2003.  Although still below the $100M median acquisition price of a company in 2000, the growth in this number should drive a trend toward more early investment. 

Finally, even the IPO market is doing better.  There were 13 IPOs of venture-backed companies in Q1, 2006, up from 8 in Q1, 2005.  These 13 IPOs also raised 61% more money than the 8 deals in the same quarter last year.

These positive trends will not likely create any immediate respite from the current problems for entrepreneurs looking to fund the startup of new companies.  There are some ways to optimize your chances for funding your baby, though.  Here are a few:

• Don’t knock on doors before the idea is fully-cooked – for the most part, you get one shot at an investor.  There are plenty of good ideas to invest in.  If you present a half-baked idea and can’t answer rudimentary questions about your customer, product or market, you’ll have blown your chance.  The investor will just move on only remembering how you wasted his/her time.  Spend the time and energy to get it right before you start making calls and shaking hands.
• In general, don’t think of potential investors as part of your team before they invest – I’m sure some VCs will say I’m wrong about this, but I have seen many deals die as entrepreneurs use an investor to help refine an idea.  See the first suggestion, above.  Post-investment, investors are obviously an integral part of your team.
• Consider funding the development of the product (subsystems of the product for complex stuff) or refinement of the service prior to seeking funding – I see fewer and fewer people willing to do this these days.  Going to an investor with a beta product or completed service offering is huge.  It’s much easier to invest in something that feels real.  Less risk attracts more money.
• Find a customer – Even better than creating the product; find someone who’s willing to pay for it.  Nothing like a customer to validate a need and the solution.
• Recruit your team – More experience = greater chance of getting funding.  Period.
• Don’t let the difficulty of getting money dampen your enthusiasm for your idea – The bar is pretty high these days.  Expect it and expect that you’re going to have to work harder and longer than you ever even considered.  If you truly believe in what you’re doing and it’s a good and unique idea in a strong market, it will get funded.  Follow some of the guidelines here and it may even get funded a bit faster or without having to hand over all the equity in the company to get the working capital you need.

We aren’t in the 90s anymore, Toto.  Finding money is a lot more difficult.  If you get too caught up in the stories of how venture capital flowed a decade ago, you’ll be ill-prepared for what it takes to get it today.  Over the next few years, access to money should get a bit easier.  In the mean time, money is definitely available today, you just have to be smarter about it and work harder for it.