A looming apocalypse

By Ilya Lichtenstein on September 5th, 2012

The past few years have been very kind to start-ups, especially those in Silicon Valley. The cost of building software keeps falling, and new distribution models through app stores has made rapid user acquisition easier than ever. More companies without a business model are getting acquired, and more unprofitable companies are going public.

And the recent explosion of acqui-hires, or talent acquisitions, has significantly reduced the downside risk for investors: even if the company fails, its team may still get snapped up by Facebook for enough money to pay back the investors.

But there’s a flip-side. Falling infrastructure costs, open source, lean start-ups, mobile and app stores have led investors to a strange and horrifying new reality: it’s really hard to tell if an early stage start-up is going to be successful later.

Revenues won’t tell you if a start-up is going to exit for millions in a few years. In any case, few start-ups seeking seed funding have any. Users? Easy come, easy go. Traffic? Can be bought at rock bottom prices. And who knows: today’s dud might become a viral rockstar with explosive growth tomorrow.

Facing the grim reality of their incompetence at picking winners, Silicon Valley investors have been doing the only thing they know how to do well: throwing money at the problem. Thus, for the past few years, venture capitalists, so-called “super-angels”, seed funds and incubators in Silicon Valley and New York have been funding anyone with a pulse.

Most people incorrectly assume investors are motivated by greed. But it’s fear that drives investors to write cheques: the fear of missing out. It’s alright to invest in a company with a big dream and no business model. Most VC investments are going to fail anyway; that’s built into the model.

But if word gets out that you’re the guy who passed on Instagram, best pack your bags, because you’ll never work in this town again.

To a $400 million venture fund, a few $100,000 cheques are a small price to pay to (maybe) have a foot in the door at The Next Big Thing. And since it’s impossible to tell when something that seems dead will take off, it’s best to play it safe and throw a little money at everything.

Alas, the age of the mobile web 2.0 has no room for quaint vestiges of the Industrial Revolution like business plans, due diligence or reading investment terms before signing them. Every day, investors with no understanding of the industry or product being pitched to them are “taking a flyer” and writing a cheque – just in case.

And so, in Silicon Valley, we founders have become spoiled, lazy and careless. We praise the virtues of running lean and scrappy, but we act as gluttons, binging on convertible notes and double-digit valuations.

We’re told that we have to compete with Google for talent, so we shower engineers with free organic lunches and rent subsidies.

We’re told to raise just enough for 18-24 months of runway, and, if your runway is longer than that, well, that just means you’re not spending money fast enough.

Something is wrong in the state of California when it’s possible to scrawl an idea for a viral app on a napkin and pick up a million dollars six weeks later .When “We’re not focusing on revenue right now” has become the watchword of our time. When the top super-angels are making an investment every three days.

Something’s got to give.

Early-stage seed funding fueled by convertible notes and indiscriminate seed stage investing by VCs started growing rapidly in 2009, but it reached its roaring apex in 2010, with thousands of seed rounds announced that year. Too many companies – businesses that should never have been funded – raised massive rounds.

The consumer, social, local and mobile start-ups funded during the 2010 frenzy are approaching the end of their 24-month runway right about now. The overwhelming majority don’t have nearly enough traction, not to mention customers or revenue, to justify raising a second.

They’re about to start failing, abruptly and en masse. Facebook, its stock collapsing, won’t be able to fund acquisitions to save even a fraction of them.

Just like it did in 2008, the pendulum is about to swing back. Funding is going to dry up – fast. Like a poker player who just lost a big hand, investors will pull back, adopt a triage strategy, and focus on supporting those portfolio companies that have a hope of achieving revenue and survival.

In other words, the great seed funding experiment of the last few years is about to end, and everything will go back to normal – that is, everything will get harder for fledgling businesses trying to raise capital.

Here’s the good news for European start-ups, who have hitherto watched jealously from the sidelines as their undeserving American counterparts raised ever larger rounds: you might have missed out on the party, but you’re also going to skip the hangover.

European investors have always been more cautious, so the weakest start-ups on the Continent never got funded in the first place. European VCs are not used to vacillating between caution and exuberance like their American counterparts. There aren’t thousands of seed funded start-ups in Europe burning money like there’s no tomorrow, all competing for the same Series A cheque.

While many American start-ups have never really known hard times, they are now as lambs walking blithely to the slaughter. European start-ups – at least, the ones that survive – are better placed to forge ahead as battle-hardened veterans.

They’ve never expected a sugar daddy to appear at the critical moment with the next bridge round, so they won’t miss him when he’s gone.

As the inevitable and massive cascade of start-up failures rocks Silicon Valley, the European entrepreneurial ecosystem’s curse – not enough money, too much due diligence, slow decision-making – might just be its salvation.

Ilya Lichtenstein is cofounder of MixRank