Broken VC: Downward Spiral

I know it can feel a bit depressing to continually harp on the dearth of angel and venture capital, but I will take that risk to highlight what I think is an issue of importance. There is a virtuous cycle among entrepreneurs, investors and markets. That cycle is broken, and not just in Ottawa.

Entrepreneurs bring the ideas, enthusiasm and hard work. Investors provide the money to keep entrepreneurs working at turning all of that into a business. That business is then marketed to acquirers or the public market. The cycle depends on a profitable return at this final stage, since this puts the wherewithal for investors to renew the cycle even more strongly than before. At its best the cycle is an upward spiral.

This is regrettably no longer true, and it was brought home to me again this morning as I read this article in the New York Times (registration may be required). I extracted a couple of paragraphs to highlight what I believe is an important point.

During normal economic times, several years after a start-up raises angel financing, it seeks larger amounts of money from venture capitalists to grow. But as venture capitalists also cut back on investments, many angels are wary of investing in a start-up without the assurance that the company will be able to raise more money to keep growing.

The start-up cycle is more complex than my diagram shows in that there are usually multiple stages of investment, and valuation of the company. Even in Ottawa it is not hard to find people who are willing to invest small amounts of capital in a basement-level start-up, but they won't because they don't believe there will be investors coming forward for the next round. Experience shows they are quite right to be concerned.

The real impact will hit Silicon Valley two or three years down the road, said Mark Heesen, president of the National Venture Capital Association. That is when start-ups that receive angel financing today would typically turn to venture capitalists for their first round of institutional investments, known as a Series A.

“If we don’t have angels, that hurts us. Where are we going to be getting our next Series A deals if those entrepreneurs aren’t out there with the ability to move their idea forward?”

And there is your downward spiral completed. There is diminishing capital availability at every stage. It isn't just the investors getting spooked, it is also the entrepreneurs who are increasingly feeling that it just isn't worth the pain. As in the broader market there is a lack of confidence, and that perception creates the reality. Some investors, as the article points out, are still investing. I'll bet many of them are not sleeping well at night. It's difficult to feel comfortable when everyone else is abandoning ship.

Regrettably, Ottawa's tech scene is in the midst of this downward spiral. I know that I have rejigged my own thoughts towards a very low-capital intensive path to building a company. Speed is perhaps less important now in this suppressed business environment so the juice delivered by large capital infusions is less necessary. That doesn't make it easy, just necessary.