Xconomist of the Week: Michael Greeley Dissects the VC Data

4/26/12Follow @wroush

Michael Greeley is no pessimist. Eeyores don’t get picked to run the New England Venture Capital Association, as Greeley did from 2005 to 2008, and they don’t win gubernatorial appointments to state entrepreneurship boards. But he’s more willing than most VCs to talk about troubling trends in the innovation economy. So we paid attention earlier this week when Greeley, an Xconomist and a general partner at Boston-based Flybridge Capital Partners, offered a bleak interpretation of the latest quarterly venture investing data from the National Venture Capital Association

The NVCA data, compiled with help from PricewaterhouseCoopers and Thomson Reuters and released April 21, showed that investors put $141 million into 53 seed-stage deals across the U.S. in the first quarter of 2012. That was a small decline relative to the $155 million invested in 90 deals in the fourth quarter of 2011, but it was way below the year-ago level of $211 million put into 86 companies, and it was the worst quarterly showing since 2005.

Michael Greeley

In a blog post, Greeley speculated that the decline signals the “End of the Great Seed Experiment” and the beginning of a correction that will see the disappearance of many angel-funded “me too” companies. With venture firms apparently shifting their money toward later-stage investments that are more likely to bring their limited partners some liquidity, there’s unlikely to be much succor in the coming year for the hundreds of startups that will, sooner or later, exhaust their seed money and go out in search of real Series A investments, Greeley worries. “With less capital to invest across the board, many seed entrepreneurs will be deeply saddened when they come back to market for their early round,” he wrote.

I caught up with Greeley at the NVCA annual meeting in Santa Clara, CA, yesterday and pressed him for more of his thoughts about the numbers and what they might mean for entrepreneurs, including those going through startup accelerator programs like Y Combinator, TechStars, or their equivalents in sectors like cleantech and health IT. If there are more entrepreneurs starting tech companies these days (and there definitely are—my bloated inbox proves it), it’s partly because there are many more accelerator programs to help them. But once these carefully incubated startups exhaust their angel funding, what then? If venture interest in early stage deals continues to decline, there won’t be any place for the young companies to turn, and many could be forced to shut down. That, in turn, could take a lot of the sheen off the accelerators they graduated from. Y Combinator probably wouldn’t be hurt, but accelerators with less celebrated brands—and those outside the largest tech hubs—would be.

It might all turn out okay, Greeley says, if the surviving companies can find a way to absorb all the entrepreneurs who will be affected when the seed bubble bursts. But no matter what, he cautions, there’s some “pain and disruption” on the horizon.

Xconomy: As you pointed out in your blog post this week, both the number of seed-stage deals and the dollar amount that went into these deals were down dramatically in the first quarter. What do you think is going on?

Michael Greeley: My sense is what we see is a little bit like an accordion. When things are going well, a lot of new investors come into the market. New angels, new seed funds. And they make one or two investments and then they pause. And when things start to turn down, they are very quick to leave the market. There is this cohort of angels who are incredibly prolific and they will keep powering through it. But if you’re sort of dabbling, you’re the first to leave. As soon as there is bad news I think you see a lot of people flee.

Also, a seed round probably lasts 12 to 15 months, so a lot of those companies are coming back and they first go to their existing investors and they say, “I raised $500,000 from you, and I now need to raise $3 million.” I think the inexperienced angels are now realizing, “Oh my god, I actually have to set aside a meaningful amount of money to support these companies.” I think you are seeing a sort of boomerang effect.

X: You also observed that the number of late-stage deals was up. It was like all the money was shifting from the early to the later stages.

MG: That, I think, is real for all of the funds that are out trying to raise money. What I have heard from our LPs is, “We need distributions. We need to see that we’re getting capital back.” What can be a little bit misleading is that in the later stage deals, the dollars can move very quickly with a couple of big investments. But they clearly went to later stage, to get closer to distributions.

X: In the big picture, is it a bad thing to have more investors in the market? If all of that blew up, would it slow down innovation?

MG: It’s great that we have all these active angels. Do I think [the early stage shakeout] is going to fundamentally impair innovation? I don’t think so, because I think we have wildly overfunded the number of early stage companies. We have just created too many look-alike companies. I feel quite strongly about that. There is a very prominent guy here in San Francisco who is affiliated with an East Coast firm who moved out here a couple of years ago. He has made 17 seed investments! There was this realization three or four years ago that entrepreneurs don’t actually want $5 million, they want $500,000. So there was this land grab. And a lot of people got very aggressive and they’re now in this phase of digesting.

In the process we have created far too many companies that are undifferentiated. Ad-tech, algorithms, e-commerce optimization—all of these very narrow, vertically focused seed companies. Now they are coming back, a wave of them, saying “If you squint, I kind of hit my milestones, and now I need $5 million.” And the funds just don’t have that collective capacity to support all of them.

X: But at the very same time, you have the first-generation accelerators scaling up—you have 130 companies a year coming out of Y Combinator alone, not to mention TechStars and 500 Startups. And you’ve got new incubators popping up in verticals like cleantech and media and healthcare. So there are even more startups in the pipeline. Is it a reality for these companies that not all of them will make it past the seed stage?

MG: Absolutely. The way we think about our portfolio construction is that we expect half of them not to graduate. Our orientation around a seed is, it’s an experiment. Experiments can be successful or they can fail. You should be perfectly willing to walk away. Our Series A’s and B’s are real investments. We are building a company.

You started by talking about the proliferation of all these incubators. Groups like Y Combinator have become such a beacon for the better seed talent that they will probably have better success rates for their graduates. In New York now, somebody told me this week that there are 25 incubators in Manhattan alone. Three years ago there were none. There is a little bit of adverse selection. My sense is that those guys are seeing lower quality commercial opportunities. Y Combinator has a three- or four-year head start, has a record of success, has incredible sponsorship. Those cohorts that graduate there will be on average, much stronger companies.

X: Now you’re even seeing some specialized, vertical accelerators like Rock Health and Greenstart and Turner MediaCamp.

MG: And Blueprint Health in New York. I have met with all of their companies, and they are all smart people, but even in that small group they start to look like derivatives of one another. And what’s hard, I think, for any of us in our position, is when you look at those and ask “Can that be a $100 million business?” More often than, you conclude that it’s just not going after a massive market opportunity.

X: There are only a certain number of $100 million markets out there.

MG: Right. Some of these are very compelling—you can see that they could quite comfortably build a $10 million or $20 million business and be marginally profitable. But that’s probably worth $20 million. If it doesn’t have the explosive, uncapped market opportunity you just never make a [venture] return on it.

X: Do you think there will be some kind of correction in the number of accelerators?

MG: Oh, absolutely. New York can’t sustain 25 accelerators. The truism is that every year a couple of dozen great companies get created. If you explode the top of the funnel you still have your couple dozen at the bottom. So maybe it’s a more vibrant process, but it just means greater failure to get that same couple of dozen companies.

X: That’s a sad way to look at it. There are so many talented people pouring their hearts into these startups.

MG: There will be pain and disruption. But it’s really temporary. Getting people into the system and giving them a taste of that is incredibly powerful for society. They will go off and do it again or join others that are consolidating, and at least that way we have retained the best minds in the innovation economy.

The only thing that may mitigate against some of the dramatic contraction of some of these incubators is if they are state-sponsored. You have states trying to build these ecosystems and put in uneconomic dollars to sustain it. For example, Bloomberg has made a huge push in Manhattan. If it becomes clear in the next two years that many of these companies are not going to be viable, I don’t think he turns that off. It’s part of a larger agenda for what he’s trying to do in Manhattan. So you may see them sustained a little bit longer than their useful lives because of the state support. But any of them that are sponsored by business or private sector, I think they will back off pretty quickly like they did in 2000-2001. Think of all the incubators that burst on the scene and disappeared very quickly.

X: It was a different style of incubator then.

MG: Yeah, you brought legal and accounting—you brought in services that were, frankly, less value-add. We fixed that model. Having free legal advice didn’t make a company. You needed great product vision and technical skills. Incubators now are much more focused on those elements. You don’t even see a general counsel or an accounting firm in these places.

X: So there’s a place for incubators—just not as many.

MG: Yeah. I think the other observation is that as the tide goes out—and the tide is clearly going out—the secondary and tertiary markets suffer disproportionately. So incubator in…these cities with great intellectual bases but not great venture bases, I think those get washed out very quickly. So it may be more sustained in the Valley or Boston or New York because there is a history there. But other cities that put up their obligatory incubator space, that could wash out pretty quickly.

Wade Roush is a contributing editor at Xconomy. Follow @wroush

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