Seed Stage Slaughter

Startup Winter Is Coming: Beware Funding Cliffs and Falling Valuations in the Consumer Web

Summer's children may not survive.

 Startup Winter Is Coming: Beware Funding Cliffs and Falling Valuations in the Consumer Web“It’s harder to act in a disciplined way in summer. All around you, you see excess and nonsense, companies being bought or funded for zillions of dollars without traction.” Eric Ries, the pioneer behind the Lean Startup movement, wrote those words back in August, 2011, warning that in the cyclical startup business, “what goes up will eventually come down.”

Startupland, he explained, can only stay insulated from broader economic forces–like, say, today’s warning about a new global recession--so for long: “The LP’s that fund booms are, after all, pension, municipal, and sovereign wealth funds. Consumers need disposable income to invest in the latest products,  as do the companies who serve them and advertisers who reach them.”

The latest venture capital numbers and tales from the boardroom seem to indicate that some of Mr. Ries’ predictions are coming to pass.

In a trenchant blog post over the weekend, Union Square Ventures’ Fred Wilson said, “it is a tougher time for early stage consumer internet companies than I have seen since the 2001-2004 time frame. And I think we are still in the early innings of this more challenging environment,” noting reports of a 42 percent drop in VC funding for consumer web and mobile companies for the first nine months of 2012 (year-over-year).

Looking at same report from Dow Jones VentureSource, the Wall Street Journal noted that:

“Just under half of the 165 companies in the consumer information services sector that raised first rounds in 2010 have raised a subsequent equity round and fewer than one-quarter of those who raised a first round last year have done so.”

Those numbers spurred fears of what Ed Zimmerman called a “Series A Funding Cliff,” where the emergence of seed funds and so-called micro VCs has not been matched by an increasing number of funds in the next stage. That results in the kind of bottleneck that’s bound to create carnage, though at the the moment, the impact has been softened by “the seemingly inextinguishable thirst by larger companies” like Google, Facebook, Twitter, and Groupon to “acqui-hire” talent, he explained.

Meanwhile, between heady times and inexperienced entrants, “investors have gotten a little sloppy,” says The Verge:

The temptation to pick up a company on little more than a good first impression or a colleague’s recommendation was strong. One entrepreneur who raised over half a million dollars for his startup last year told me that he fudged the presentation to investors — the technology didn’t work yet, so he used a video and pretended it was live.

But the constriction is not just at the seed stage. Last week, Bloomberg noted that investors were wary of sky-high valuations in ecommerce companies like Fab, Gilt Groupe, and celebrity-infused BeachMint and ShoeDazzle.

After pouring more money into retail startups in the third quarter than in any period since the dot-com bust in 2000, venture capitalists concerned over the formation of an e- commerce bubble are balking at deals they consider overpriced. The valuations in recent funding rounds and executive exits suggest investors are no longer willing to sink cash into online stores that don’t have proven growth prospects.

Concern over growth prospects–and profitability!–are also hurting Foursquare’s attempts to raise a $50 million round, the Wall Street Journal reported last week.

Foursquare is expected to bring in about $2 million in revenue this year, people familiar with the matter said, by selling targeted coupons. That is well behind the pace set by Facebook, which generated $153 million in revenue selling ads in its fourth year, and Twitter, which sold $45 million in ads at the same point in its history, according to research firm eMarketer.

Foursquare also faces “a backdrop of growing skepticism about young technology companies in the wake of deep stock-market declines for their publicly traded peers,” i.e. Zynga, Groupon, and Facebook.

Mr. Wilson’s astutely analyzes some of the underlying causes of this capital crunch, including competition for consumers’ attention as large platforms like Google, Facebook, Instagram, Twitter, and LinkedIn “suck up a lot of the oxygen” of time spent online in the English-speaking world.

there are still occasional new entrants into this list and departures too. tumblr and pinterest have risen a lot in the past couple years while myspace has declined. but consumer behaviors are starting to ossify on the web and it is harder than ever to build a large audience from a standing start.

What’s more, he argues, the turn towards mobile means has led to difficulties in getting that coveted homescreen spot. Careful observers of the startup scene have no doubt witnessed startups get “stuck in the transition” from having a good-looking product that does what it promises fail to get a large user base. As Mr. Wilson says:

you need to master the “download app, use app, keep using app, put it on your home screen” flow and that is a hard one to master.

For some evidence of that, look at a mobile-first companies like Foursquare. As the Journal noted, only 8 million of the company’s 25 million registered members use the app at least once a month.

Perhaps because of those challenges in adoption and engagement, Mr. Wilson notes that momentum for late stage investors is moving away from consumer towards enterprise. Dave McClure of 500Startups vehemently objected to that shift in interest, calling it a “huge error,” and seeing an upside even in the flailing trajectories of Groupon and Zynga, especially as nearly “every possible internet distribution channel has MORE users than ever before – whether it be search, social, mobile, video, local, SMS, email, chat, etc.”:

The number of recent internet services that have grown from nothing to hundreds of millions of users is frankly rather astonishing – Pinterest, Instagram, Groupon, Zynga – all of these took less than a few years to get to hundreds of millions of users and in some cases billions of revenue. While Groupon & Zynga have certainly fallen Icarus-like from higher heights, it’s still the case that both are amazing for how fast they grew and acquired users via search, social, and other channels.

Despite their respective reading of the tea leaves, neither Mr. Wilson nor Mr. McClure is backing off consumer Internet investments. And the decreasing cost of building scaleable software-based companies means one can live lean to survive harsh startup cycles. But especially in New York’s app-happy tech scene, entrepreneurs might want to look down at their home screens and keep Mr. Wilson’s litmus test in mind.

Follow Nitasha Tiku on Twitter or via RSS. ntiku@observer.com