After Rocky Year for Start-Ups, Investors Are Pickier

Chris Ratcliffe | Bloomberg | Getty Images

Call it the Facebook effect. Until recently, investors had been all too eager to pour millions into any Web start-up with rapid growth, regardless of whether it made money or even had plans to do so down the road. But after Facebook's rocky initial public offering and flameouts at Zynga and Groupon, venture capitalists are entering a picky phase.

Investors predict that Zulily, a flash deal site for mothers, will have a hard time justifying its recent $1 billion valuation.

"Earlier, entrepreneurs didn't need a real monetization strategy," said Brian O'Malley, an early investor at Battery Ventures. "They could punt on revenue indefinitely because their investment dollars were their revenue. They could fund their start-ups with funding versus customers."

No longer favored are e-commerce start-ups, which face logistical hurdles and require a lot of money. The celebrated shift to smartphones, once welcomed with an outpouring of investments, is now making some investors nervous as monetization proves harder for mobile devices than it did for the Web.

Investors have also grown weary of start-ups and applications that rely entirely on Facebook, Twitter and LinkedIn for customers, now that those companies are focused on their own bottom lines. And Silicon Valley is discovering that while it may be easier than ever to start a company, it is harder than ever to build an enduring business.

Younger start-ups are beginning to feel the pinch. CB Insights, a research firm, analyzed 4,056 initial, or seed, investments made in tech start-ups in the United States since 2009. It found that more than 1,000 start-ups that attracted seed financing from angel investors — wealthy investors who put in money from their own pockets — will find themselves orphaned this year when venture capitalists reject their requests for more money. As a result, $1 billion in angel investments will evaporate.

(Read More: Too Many Start-ups to Survive?)

That carnage hardly compares to the bursting of the dot-com bubble in 2000, when $3 trillion evaporated on the Nasdaq, but it is enough to give Internet investors and entrepreneurs pause.

CB Insights predicts that Internet start-ups will be the hardest hit, because they have attracted more seed money than enterprise and hardware companies but will most likely have a harder time securing follow-up investments.

Part of the problem is simple math. Angel investors seed businesses with small sums, often less than $1.5 million. But to grow a business, entrepreneurs eventually have to solicit financing from the venture capitalists who invest on behalf of endowments, pension funds, foundations and the like. And while the number of angels eager to write checks has increased, the number of active venture capitalists has decreased.

But investors say it is not just the bottleneck that is to blame. The realities of building an enduring business are starting to sink in. "It has never been easier to start a company, and never harder to build one," said David Lee, a venture capitalist at SV Angel, an early-stage investment firm.

David O. Sacks, a Silicon Valley executive who sold Yammer to Microsoft for $1.2 billion last year, summed up the challenges in a bearish note on Facebook last August.

"I think Silicon Valley as we know it may be coming to an end," Mr. Sacks wrote. "To create a successful new company," he said, entrepreneurs have to find an idea that "has escaped the attention of the major Internet companies, which are better run than before." To attract follow-up money, new companies now have to prove themselves for less than $5 million.

On top of that, they must be "protectable from the onslaught of those big companies once they figure out what you're on to," Mr. Sacks said. "How many ideas like that are left?"

Mr. Sacks's comments were widely debated within Silicon Valley. One of his most vocal critics was Marc Andreessen, the co-founder of Netscape and of Andreessen-Horowitz, a venture capital firm, who said on Facebook that the opportunities for start-ups were "unending."

But start-ups are finding that their supply of capital is not. "The valuations got ahead of themselves," said Rich Wong, a venture investor at Accel Partners. "Where people only paid attention to multiple quarters, now they are looking more than a year ahead for projected results."

Mr. Wong said e-commerce companies in particular were drawing closer scrutiny. Investors who took note of Amazon's $1.2 billion acquisition of Zappos and its $540 million purchase of Quidsi, the owner of, poured millions into e-commerce sites, only to discover that they are difficult to run.

Gilt Groupe, a flash deal site for fashion, raised some $220 million in capital but is still not profitable. Last year, the company was forced to cut staff. It is scaling back on smaller brands like Gilt Taste and Park & Bond, and it has put Jetsetter, its popular online travel site, up for sale., a daily deal site for design, raised money at a lower valuation than it had planned because of Facebook's troubled I.P.O. Investors also predict that Zulily, a flash deal site for mothers, will have a hard time justifying its recent $1 billion valuation.

ShoeDazzle, Kim Kardashian's shoe site, raised $66 million and Lot18, a flash deal site for wine, raised $45 million from investors impressed with their user growth. Both companies were forced to make staff cuts last year.

"I am skeptical of 'Commerce 2.0,' which has come to mean daily deals and discounts," said Peter Fenton, a venture partner at Benchmark Capital. Mr. Fenton said flash sites like Zulily and Gilt "are capital-intensive, face structural challenges to their margins, and if they do go public, they trade at low multiples. Plus, I seriously question their ability to compete with a juggernaut like Amazon."

Likewise, investors are becoming skeptical of social games and applications that build on social networks like Facebook, Twitter and LinkedIn. These social networks are a shaky foundation for a business because they themselves are feeling pressure to monetize.

For example, Facebook made tweaks to its newsfeed algorithm last fall that reduced the number of users who can view Facebook status updates. The company said it made the tweaks to serve its users more relevant content, but advertisers complained that the changes cut the audience for their posts in half.

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The real impetus for the change, advertisers say, was to force companies to use Facebook's new promotion feature, which gives users the option to pay to ensure their updates reach a wider audience.

(Read More: Zuckerberg: Facebook Will Make More Money on Mobile Than Desktop)

BranchOut, a professional network that culled data from LinkedIn and Facebook, raised $85 million from venture investors but had to change its business model in 2011 after LinkedIn cut off access to its data. More recently, Tweetro, a Twitter application for Windows 8, was removed from the market in November after it outgrew Twitter's new third-party user limits.

"Investors are getting smarter about the sources of traffic," said Mr. O'Malley of Battery Ventures. "Companies that rely heavily on Twitter and Facebook, or mobile, are having a tougher time."

Venture capital investments in mobile companies were up 75 percent in the first nine months of 2012 compared with the same period in 2011, according to CB Insights, but developers face different challenges on smartphones than they did on the Web.

(Read More: Venture Capital Firms Pressured as Internet Shares Suffer)

"There was so much hype around the transition to mobile, but people are realizing that mobile is challenging," Mr. O'Malley said. Among the obstacles is the fact that developers are subject toApple's whims. Also, they must persuade people to download their apps, and advertising is more complicated on a smaller screen.

So which consumer start-ups are likely to survive the chopping block?

"People are looking more seriously at engagement metrics," Mr. O'Malley said. "What percent of your users are coming back? How engaged are they? Are they a 'sticky' user?"

That dose of reality may be healthy. Mr. Lee of SV Angel said that 18 months ago, every other business pitch he heard was social, local or mobile. Today, he sees more diverse company ideas and more durable, predictable business models.

"Now companies that have a predictable business model, or a way of getting engaged users, and global, addressable markets are the companies getting the lofty valuations," Mr. Lee said. But, he added, "that's making me more cheap."