It it obvious to any of us entrepreneurs out there that the entrepreneurial market is growing not shrinking. Yet we have venture capitalists talking about their problems and the overall shrinking venture market.

This article several weeks ago from my friend Jon Callaghan, founder of True Ventures, got me motivated to share my observations on the startup market. It’s based on some conversations we had in the SiliconANGLE /SAbackchan as well as on the YCombinator Hacker News forums several weeks ago, but with all the talk of funding and new startup creation at Techcrunch50 yesterday and today, it’s still pretty timely.

This article “Case for IPO Optimism” tries to dodge the biggest issue – the startup community is stuck because problems in the venture model not due to those other factors. The venture model is broken across the board even at the early stage level.

From the story:

“The overall number of offerings in the past 7 to 8 years has been paltry. Notable individual exceptions are Google (2004), SynchronOSS Technologies (2006) and, more recently, Open Table and SolarWinds (both 2009). But let’s face it: if yours is a venture-backed company, you have had higher odds of being struck by lightening than going public in this first decade of the 21st century.”

Bigger Issues Going On Underneath Venture

There is a counter culture going on among startups that pit the venture capitalists against the entrepreneurs. There are just to many companies to fund and the operating capacity of the venture model just cannot handle the volume. This isn’t due to the lack of money, but to the fact that the market is growing and venture doesn’t have the capacity or business model to handle it.

So to summarize: the entrepreneurial startup market is growing yet venture is shrinking – the equation doesn’t balance.

Here is a glimpse of why the startup market is growing – a story from Wired hits it home with the title “The Good Enough Revolution” by Robert Capps.

What we are seeing is a massive changing in what I call the “inbound logistics” of the venture capital value chain -vetting deals or simply put which deals are worth investing in.

Within the past 3 years I’ve seen a huge tsunami of innovation that has nothing to do with technology advantage (a cornerstone of the venture capital market) but instead business model or market demand oriented solutions – technology is become less of a core driver. This is turning the venture playbook upside down.

The article mentioned above talks about what I call “market factors” from a venture perspective- the liquidity market (and regulation mainly liquidity). Because of the breakdown in liquidity there are just to many company that is causing a “backup” in the system. The venture capitalists depend on liquidity to exit out the companies in their portfolio. So if the venture capitalists don’t change their model the trickle-down effect hurts entrepreneurship.

The Big Disconnect

The big disconnect is the lack of understanding in the venture market between their problems and the general entrepreneurial market. Personally I would rather see solutions not a description of the problem. Benchmark’s Bill Gurley recently talked about about venture shrinking (and that might be good from his perspective), but the fact is the entrepreneurial market is growing. There are more developers and entrepreneurs working on startups then ever before (Facebook apps, iPhone aps, cloud, etc).

Until the venture capitalists figure out how to deploy “people” resources to fund a volume of deals then the market of entrepreneurship will continue to go sideways at the funding level. This will only accelerate the counter culture that is looking like how young people in the 60s viewed the government.

Here’s a suggestion to venture capitalists: fund companies that will create value or be durable over time (profits) not just to flip them or match some outdated liquidity timetable. The problem is I don’t think they can. Many of the venture capitalists have the “heart” but seemed locked into the “old way” of doing things.

It’s time to change the expectations and time horizons of what “wealth creation” means and it’s not liquidity. Why not reward entrepreneurs who create durable companies. Companies with values like profitability, citizenship, and lasting employment.

Who knows the two guys you fund for $250k might just build the next Hewlett-Packard or Apple Computer.

The Interesting Thing about that $200k Funding Level

In our original version of this post, it ended just above this section.  We threw it out to the community at the YCombinator Hacker News boards as a draft and solicited their feedback. The thing we found was that the very last sentence of the post resonated with the comunity just about as much as anything else I said.

For technical folks bootstrapping something like a iPhone or Facebook app requires very little money and 25-150k could be used for market validation – another very important part of the startup cycle. If the entrepreneur is a business person who can’t code anymore then a prototype cost will be roughly 25k or so just to get an initial build this still isn’t enough to launch. Getting a customer immediately is very important as is the working capital to service and grow.

There are only two ways to get money for a startup: 1) top line revenue from a product or service or 2) sell equity or do a debt note. That’s it.

I’ve estimated that the required amount for a "real" seed round in today’s open source environment for tech ventures is about 200-300k – that is unless you are young and can do the coding yourself.

Technology, however, isn’t the driver any more for startups. The scarce talent is business model engineering and product marketing – building for scale isn’t the problem anymore. I can build a hack protytype that works well into the "validation" stage to establish a funding event or customer revenue stream then use the new capital to rebuild, hire and grow.

This comment by Carlos Bueno (who works on Yahoo’s Xoopit) seemed to summarize the sentiments of many of the folks who chimed in on the discussion:

I would have loved $200K-ish for a seed round. For a startup today the feasible options are $20K from friends & fam or $1M after somehow making a prototype with "traction" over a couple of years. That step function kills a lot of good companies. Once that gets solved the current level of startup activity will seem quaint.

The problem is where the money comes from upstream. The LPs in a fund want huge returns in 5 to 10 years. The work of raising money is so great that VCs do it all at once (hah, that sounds familiar). Then they are locked in.

The YC model is trying very hard to form a conduit of startups up to larger but sub-$1M rounds, but so far no one’s figured how to get that tier established. You probably don’t want money from podiatrists and i-bankers, but neither does there seem enough talented geek millionaires who want to join in.

Many entrepreneurs need more than 25k to build their prototype yet fail to do it do to the clutter in the funding market hence two guys building in a garage for a customer project might not get funded in today’s climate. The possibility of creating a huge "home run" which is the desired VC outcome (eg like an Apple or HP) is difficult when VCs "pass" on what looks like a few guys making an iphone app or something.

If an entrepreneur can create a product get it to market and get profitable they are a success and possibly could be a big "home run". If the investment thesis is to get the home run then it most likely will overlook two guys in a garage.