Finding funds for early stage companies has always been a great challenge. In past venture financing cycles, it's been the gap between the first venture financing (Series A) and the growth capital or mezzanine financing that many emerging companies were unable to bridge. This gap, called the "valley of death," was attributed to a number of factors, but that valley of death has shifted in important ways in the recent past.
Historically, the valley of death happened when:
Companies ran out of money before the next value inflection point – too soon for institutional investors looking for lower risk.
Classic venture capitalists moved up the food chain – looking for larger and less risky investments, leaving early stage companies in the lurch.
Companies underestimated their capital requirements for early stage growth and ran out of money.
The venture markets shifted, and once "hot" investment categories (which had no problem attracting funding during their "hot" phase) became saturated or unpopular.
Today, that valley of death occurs earlier – between seed funding and the conventional Series A financing. In other words, companies have a relatively easy time raising their first $200,000 – $1,000,000 from friends and family and angel sources, but then are faced with the absence of follow-on investment opportunities at the Series A level.
Why the change? To a large extent, it's attributable to the supply side: more early stage money is available from more sources. To begin with, the cost of creating a viable business has plummeted, thanks to capital efficiencies brought about by cloud servers, virtual companies and highly competitive and efficient outsourcing. As a result, early stage investors are willing to "sprinkle" small amount of funds among many new companies to see which one proves to be a viable business – with the use of minimal cash.
Second, the emergence of a new crop of incubators and accelerators has provided additional sources of early stage funding for start-ups.
Third, angel funding has become more popular and accepted and, consequently, a large number of additional angels have entered the market.
At the same time, many less successful venture funds of the traditional kind – those investing in the $3,000,000 – $10,000,000 range – have folded. The more successful funds could therefore become more picky and risk-averse. This leaves a gap where a large volume of early stage companies created through more plentiful friends, family, and angel support are unable to raise their next round of financing. The valley of death is littered by these companies, some of which should deserve to be financed, or at least consolidated with other businesses in the same industry.
This may be a great opportunity for new seed funds seeking low valuations for promising businesses. Out of the valley of death may grow tiny flowers of success.
This post originally was published in the Emerging Company Exchange blog: www.emergingcompanyexchange.com.
Gabor Garai, Partner, GGARAI@FOLEY.COM
Gabor Garai is a partner and business lawyer at Foley & Lardner LLP. He is chair of the firm’s Private Equity & Venture Capital Practice and co-chair of the Life Sciences Team.
Mr. Garai’s private equity and venture capital practice encompasses all legal and business aspects of structuring, financing and managing various types of investment funds; negotiating mergers, acquisitions and dispositions of portfolio companies; structuring investments in emerging companies; and participating in strategic decisions of funds and fund-owned companies.
Mr. Garai also counsels emerging life science companies, including biotech, medical device, pharmaceutical and medical service businesses. Mr. Garai addresses the strategic issues facing his clients through a combination of practical, business-oriented solutions and highly sophisticated financing techniques. He builds coherent, interdisciplinary teams to apply Foley’s nationwide "best-of-breed" talents to his clients’ diverse needs.
Mr. Garai lectures and writes frequently to business-people and professionals on venture capital, private equity and mergers and acquisitions. In 2013 and 2014, Mr. Garai was selected to sit on the Law360 Private Equity Editorial Advisory Board. He recently co-edited "Buying and Selling a Privately Owned Business in Massachusetts" and "Middle Market Mergers and Acquisitions," both published by MCLE.
Full Bio (www.foley.com/gabor-garai/)
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