Forget the data: VCs brace for the Instagram aftereffect

Venture capitalists greeted the new year with fewer overall deals and dollars invested during the first quarter, but in the rapid-fire world of investing in web startups this first-quarter data is about as relevant as a day-old newspaper. There are two things to know as an entrepreneur looking at the latest MoneyTree Report from PricewaterhouseCoopers LLP and the National Venture Capital Association. The idea that the VC business is contracting as the NVCA and news reports imply is laughable in a post-Instagram world and it’s still a hard time to raise a Series B unless you’re a firm like Pinterest.

During the first quarter of the year VCs invested $5.8 billion in 758 deals, a 19 percent decrease in dollars from the previous quarter and a 15 percent decrease in deals. This isn’t unexpected as the industry has also seen its ability to raise funding from its investors drop after the financial crisis in 2008 and 2009, and because the first quarter is historically the weakest one for VCs. The VC industry moves in five-to-seven-year cycles, so anticipated trends from even a few years back can take a while to be felt, and then they can change on a dime. Or a deal.

But this trend won’t be felt for long, and there’s one huge reason why: Instagram. The sale of that photo-sharing site to Facebook for $1 billion in funny money and cash caused every single venture firm to sit up and take notice. And behind Instagram are several successful exits with LinkedIn, Yelp, Zynga and Splunk going public.

Facebook has filed to raise capital on the public markets and that should lead to more interest in the asset class, plus it will also have the stock to do crazy inflated deals such as Instagram. Zynga’s assertion this week that it planned to make more acquisitions is only the start of an all-out race to the top to be the king of the consumer web. So entrepreneurs can expect more opportunities to raise capital and the anticipated shrinking of the industry won’t last long.

On the funding side, the dollars flowing into seed and Series A deals also dropped to 45 percent of total deal volume, while the average size of such deals increased to $2.7 million. Again, this doesn’t reflect the change in the market post-Instagram and as VCs start doing deals again in the second quarter. In fact, it’s getting frothy out there with some startups commanding crazy post-round valuations of up to $7 million after taking on a Series A/seed round of $1.5 or $2 million.

In January I pointed out that the trends in early stage funding indicated that the Series B rounds were when entrepreneurs were feeling squeezed. VCs were willing to toss money at any deal in the early stages as a way of claiming their territory. However, if those investments didn’t show significant traction, revenue or product development, they weren’t getting their Series B dollars. Venture firms want a Pinterest by the second round, so entrepreneurs should use their Series A rounds prudently.

The hunt for whales at the Series B level concerns Chris Dixon, a co-founder of Hunch who wrote last week:

The problem with this model of Series A and B investing is that, in reality, many of the companies with big hits weren’t overnight successes. Pinterest, OMGPOP, Twitter, and Tumblr were around for years before taking off and all benefited greatly from having patient investors. In the current financing environment, a lot of good companies won’t live to get Series As and Bs and big VCs will pay valuations on hits that are priced to perfection.

The question that remains to be seen is if the Internet has crossed over so totally into a consumer-market story that venture success and returns drop to reflect the crazy competition that’s endemic in the consumer marketplace. A home run is only a home run if your returns are high, and paying too much to get into the round can give a venture firm a publicity win, but less of a monetary one.

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