When I first entered the venture capital business 10 years ago after being an entrepereneur, my partners warned me that "my bar" for new investments would get higher over time. In other words, the criteria to make a new investment – clearing "the bar" – would get more strict with time as I developed more experience and saw more things. I found this to be very true, and the notion that investors get wiser and more selective over time has become common wisdom in the industry.
But there's something very new going on in the last few years – something very striking. Simply put, the collective bar of the investment community to fund young companies has recently gotten higher – much higher.
The entrepreneurs I speak to are feeling it every day. When they pitch their new idea to investors, they are told to build a prototype first. When they build the prototype, they go get customers. When they get customers, they are told to show engagement metrics. When they show engagement metrics, they are told to run some monetization experiments. When they run monetization experiments, they are challenged to prove scalability. Maybe I have Passover on the brain this week, but it's like investors are putting entrepreneurs through a nightmarish version of Dayeinu, where no matter what they achieve, it's never enough (speaking of Passover, if you haven't seen this Jon Stewart clip of Passover vs. Easter, it's a must. I'll wait.).
Why is the new investment bar so high today? Isn't there plenty of euphoria and "animal spirits" to go around with the IPO market returning, marquee acquisitions (e.g., Instagram at $1 billion) and the impending, earth-shattering Facebook IPO?
I believe this new phenomenon of an extraordinarily high bar is an outgrowth of three related forces: (1) the Lean Start Up movement, which has trained entrepreneurs on capital-efficient start-up techniques; (2) the plummeting cost of experimentation and the cloud, which allows entrepreneurs to rent infrastructure that allows them to develop prototypes and pilots much cheaply than ever before; and (3) the proliferation of social media, which allows entrepreneurs to read innumerable books and blogs to educate them on building start-ups and effective fundraising.
These three forces have led to a major increase in the collective "Start-Up IQ" of both entrepereneurs and VCs, while at the same time putting in their hands inexpensive tools to progress with their ideas. Thus, if you are an entrepreneur, your competitors – not necessarily market-based competitors but simply other entrepreneurs who are pursuing capital – are that much more sophisticated and advanced than ever before.
A great example of this is Crashlytics, a compay we led a $1 million seed round along with Baseline last year and then a $5 million Series A, which was announced this week. At the seed round, the two entrepreneurs (who are in their mid-20s and, like many young entrepereneurs today, wise beyond their years) had already both been successful serial entrepreneurs, had completed a customer discovery and development process with 20 application vendors and had built an alpha product. In other words, before they had raised a nickel, they had made as much progress as a $10 million funded Series A start-up circa 1999 or even 2004. They had achieved initial customer validation and identified a precise experiment they were going to run with the first $1 million – whether they could get broad adoption for their crash reporting tool. Indeed, they crushed their milestones. By the time they had spent half the $1 million and were ready for a Series A round, they had over 500 organizations using the product across tens of millions of devices.
Crashlytics is a special company run by special entrepreneurs, but their story isn't unique – it is playing out across the world as more start-ups are more sophisticated in their approaches and achieving more with less. That's generally a good thing for everyone. But it does mean the bar has gotten higher, much higher comparatively speaking, to raise money.
And in the spirit of sharing more information to help entrepreneurs raise their game, below is a presentation I gave as part of a Skillshare class I delivered at Harvard's i-Lab with a few tips on raising capital:
How To Raise Your First Round of Capital
SEEING BOTH SIDES 
I just sent this post to a bunch of my friends as I agree with most of what you’re saying here and the way you’ve presented it is awesome.
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Not sure I’d say VCs aren’t taking risk, Tom. Look at every major success (including Groupon, whose market capitalization is still a pretty juicy $8.6 billion) and you’ll see VC backing at a very, very early stage – often pre-revenue and even pre-product.
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Hi Jeff,
Looking at it from an entrepreneur’s viewpoint (trying to raise seed funding from a concept), it seems to me that it’s because VC are naturally risk-adverse (which is understandable when you’ve got to spend money!) that entrepreneurs have had to get smarter. But isn’t it the case that VC only do business with people they know, ignoring anything else that’s not within their circle of connections/recommendations? So it may be the case for VC that the bar looks higher , but isn’t it more because VC are ducking a little bit too much?
I know the figures get bigger year-on-year and they might indicate I’m wrong, but you can’t really trust the figures. I mean $100bn for Facebook? Groupon has cost $4bn so far and it looks like a dying giant! The VC world looks to me as if it’s getting a little too excited by big figures and might be blinded by the spotlights. Isn’t it time to go back to basics?
My $0.02
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There are essentially no barriers to starting something these days. So, that means that absent a personal track record, the startup must have some market validation. At the very least we need to know the team can build a good product. Even better if that product is out in the wild.
We are a seed fund, theoretically set up to fund even at the idea stage. But pretty much everyone who comes through the door has at least a prototype.
While all your points above are correct, I actually believe the bar has lowered. Too many people are getting funded with little to no diligence at valuations that make no sense.
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Mark – You are right that raising < $500k does feel easier and is getting more democratized, yet even here the bar is pretty high. Raising a $5m series A is definitely a higher bar, I would argue.
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Whoops – thanks! Usually my mother catches those sorts of slip ups – you beat her to it!
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Hey Steve – Good point. Maybe that the returns numbers, and VC investment confidence, will change as the IPO market opens up, but that caution will take years to shake. By the way, another spin on the dayeinu routine is the rock fetch game. Ever played it with your board of directors? They ask you to fetch a rock. You come back with it. They examine the rock and declare that wasn’t the rock they had in mind and send you out to fetch another one. Great fun for the whole family. 😉
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Hi Jeff. I think you may have left out reason #4 — venture returns have been negligible to negative for a decade. so venture investors are more cautious, and more focused (desperate?) to try to find super-mega-grand-slams, because whatever method for selection and funding etc that they have been doing for the past ten years has been a failure, and one, just one, super-mega-grand-slam can make up for an entire fund portfolio of failure.
Imagine if venture had been generating great returns (and ergo, lots of carried interest) for the last decade. funds would be bigger and there would be more of them. and GPs would have the faith of their convictions have=ing been proven so they would not indulge in the “Dayeinu” manuever (which, for those not in the tribe, I sometimes describe as the Wicked Witch of the West maneuver — if you recall the Witch sent Dorothy and friends out for her sister’s broom, but whe they got the broom, the Witch reneged and sent them back our for the ruby slippers.
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You probably meant “innumerable books”. “innumerate” means ignorance of math.
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I believe the bar is actually lower and the process becoming more democratized. There is access to greater and wider networks outside of cloistered angel groups and VC’s. There is more and more money pouring into the venture class as investor seek better return on capital. There are numerous startup contests and accelerators and incubators and collaborative working spaces.
I understand your point about the bar for proof-points. Certainly the success of programs like YC and TechStars has created almost a template for what investors should look for in startups. But the amount of seed funding that is out there sloshing around is pretty large and very much accessible even for the earliest of startups. If there is a barrier, it would be the seed to series A path, and that is where I personally have seen a lot of startups stall.
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