How to Get More Capital to Flow into Early-Stage Startups

Those who can identify trends may be able to avoid potential pitfalls as well as profit from predicting them. However, the problem with trends is they are always much easier to spot when you look back over time. For example, after the fact I have accurately called: Dutch tulip-mania (get out before 1637), the first dot-com rally (buy Amazon) and the US Housing market up until 2009 (avoid Nevada). Additionally, you really should have purchased Apple stock in 1996 before Jobs came back and the stock took off.

I recognize I’ve now set the bar pretty high for the rest of this article.

With the release of Q2 results for the VC industry and the flood of articles about firms raising mega funds to invest in late-stage startups, it appears that early-stage companies may be losing out on funding opportunities when compared to their late-stage counterparts. Additionally, there have been announcements about VCs exiting early-stage funding such as Kleiner Perkin’s Edge as well as other firms who have exited or are considering doing so in the near future.

One can argue that this makes sense because the failure rate of early-stage startups is so high and investing late-stage has a greater probability of a positive return. An investor has far more data to analyze with a late-stage company. Such a company has financial history, years of management decisions, and clear market results from launching their solution. You may get a few of these data points — or none — with an early-stage startup.

This is at a time when there are many accelerators helping very early-stage startups with the basic tools of starting a company, more cities encouraging startups by making resources available to them, and the simplification of starting a company such as online legal services, KISS documents, and web services. It’s difficult to say if this helps bad ideas get further along in the process or it helps people focus more resources on developing their ideas. I think it does both.

Early-stage funding is far from suffering. The entire industry saw a decrease in funding and deals at the end of last year. However, if you look at how the two segments have bounced back, early-stage investment growth is lagging. The following charts are from the CrunchBase Global Q2 2017 Venture Capital Report and clearly show the differences.

Both early and late-stage deals and funding fell at nearly the same rate (-12% & -11%), but since the bottom of 2016 Q4, late-stage has bounced back faster. Looking year-over-year, early-stage deals have increased by 6% but overall volume is still down 16%, while late-stage deals have increased 11% with volume down only 4%.

The next few quarters will confirm if a longer-term trend is emerging, but with mega-funds eager to invest combined with headlines proclaiming late-stage investing is the new IPO, I think this trend may continue.

So how can early-stage investment increase faster? Does it need to? In general, investment flows toward what provides, or is believed to provide, the best returns based on the investor’s criteria of risk, industry, time horizon, etc. If we assume that there are still a large number of startups looking for investment and previous investment rates were not abnormally high, I think the question is how can early-stage investing generate better returns.

Early-stage has a longer horizon and a higher likelihood of failure. Additionally, early exits tend to generate lower returns on deployed capital which also weigh down VC fund performance. In a previous article, I talked about many investors being very good at covering the three M’s: Management, Market, and Model. Instead, I look at product analysis as an area where VCs could significantly improve the likelihood of startup success and therefore overall fund performance. If returns increase, more capital should flow toward this segment.

Product analysis is critical during early-stage investing because initial product decisions increase in importance as the company grows. A company with excellent management in a hot market and a strong business model will fail if the product doesn’t ultimately deliver. Additionally, a poor product can be a bellwether for problems within the three M’s. The CEO or key management may be limiting or negatively influencing development or the market needs are out of sync with business requirements. Finally, the product economics may run counter to the assumptions made in the model. If these issues are identified early enough they can often be corrected before it’s too late. Otherwise, it won’t take long for competitors to exploit your company’s flaws or to see your burn rate jump as you add more sales, developers, marketing and/or 3rd party resources to try and push a poor product into market.

At the start of this article, I stated that those who can identify trends may be able to avoid potential pitfalls as well as profit from predicting them. If the trend of capital flowing into late-stage funds is because there is a real or perceived benefit vs early-stage investments, a focus on product analysis with an actionable plan could reduce product failures, gain market acceptance, improve economics and ultimately enhance early-stage portfolio performance.

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William Reid leads Bantry Group (www.bantry.group), a product consulting firm supporting the VC community and early-stage startups.