The Wall Street Journal recently reported that funding of consumer web companies is down 42% in the first nine months of 2012 (as compared to the same period in 2011).  This is not due to a shortage of seed rounds, but rather a shortage of adequate follow-on financing.  Fred Wilson attributes this shift to three factors: (1) The consumer web has matured, and the dominant platforms make it harder for new companies to accumulate a large audience; (2) the transition from web to mobile presents distribution challenges that also stifle the ability to build a strong user-base; and (3) consumer IPO failures have sent late stage VCs running for shelter in enterprise deals, so that’s what the early stage investors will feed them.

Fred observed that these factors are making it harder for young companies to generate the breakout traction that traditional follow-on VCs have become accustomed to seeing, and it’s important to expand on that thought.  For nearly a decade, growth-VCs have been spoiled by a flow of consumer deals showing massive and rapidly growing user-bases, and they now hold certain arbitrary benchmarks as prerequisites for investment.  This has paralyzed some large cap venture investors, since it is becoming increasingly difficult for them to identify winning deals in the new flood of lean, seed-funded companies.

Despite the high-risk / high-reward aura surrounding the venture capital business, many (if not most) venture investors are indecisive and wait for social proof from the herd before making decisions.  While that strategy may be successful in bull markets, it’s bound to fail when the crunch comes.  In difficult financing environments, the emergent winners will be the investors with the domain expertise to recognize disruptive companies on early evidence of traction, without having to wait and see social proof or the inflated growth of the early consumer web days.  This is true regardless of whether the company is a consumer deal, an enterprise deal, or anything else, as long as the investors are adequately prepared to help CEOs navigate the market prejudices they might encounter from later stage VCs.

At firms like Bullpen, Floodgate, First Round Capital, etc., we carefully selected our positioning in the venture ecosystem to thrive in good times and bad.  With an increase in angel investing and a decrease in founding capital requirements, it is only natural that we’re seeing a flood of seed-funded companies.  But while it’s easier than ever to start a company, it is perhaps more difficult than ever to build (and spot) a great company.  With Series A financings remaining flat, it’s only natural for us to expect many seed-funded companies to face fundraising difficulties over the next year.

No need to fear – at Bullpen we designed our fund to bridge the gap between the top seed funds and traditional “big check” VCs.  At a time when Series A investors will go hoarse telling companies “come back when you have more traction,” we extend the lean investment strategy into the later innings so that companies can go hit those key milestones.  We help CEOs arbitrage their valuation by staying leaner longer and either (1) taking an early acquisition with minimal dilution, or (2) proving the traction necessary to raise their growth capital at a significantly higher valuation than they would have otherwise.  Large cap VCs that are hungry for deals with traction will pay a premium to gain access to substantially de-risked opportunities, creating a win for the founders, for Bullpen, and for the late stage investors as well.

So for VCs, the correct strategy when the crunch arrives is as follows: (1) maintain a small fund, so you can deploy capital efficiently; (2) stack your team with domain experts to stay ahead of the herd; (3) invest small amounts in the early stages; (4) maintain oversized reserves to support your winners; and (5) remain disciplined and don’t throw good money after bad.  For entrepreneurs, your best bet will often be to seek smaller follow-on rounds or seed extensions in the $1m – $2m range.  This will allow you to survive the flood of seed deals and prime your valuation during the struggle to cross the gap between the seed and Series A.

Follow James on Twitter: @jamesconlonvc