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Innovation Economy

After feast of seed funding, famine may be near

When most people in Boston talk about the fiscal cliff, they’re talking about the deadline-driven negotiations in Washington over taxes, spending, and the federal debt. But Boston entrepreneurs and investors are obsessed with hurtling over a different cliff right now.

They worry that the feast of initial “seed” funding available to young companies over the past few years is going to lead to a major famine in 2013, as the crop of start-ups that raised their first $1 million discover that there isn’t enough follow-on money to support all of them.

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How’d we wind up here? I’d point to six key events:

2006: Amazon launches AWS, Amazon Web Services, which makes it easy for start-ups to buy data storage and processing capability as they need it. That made it much less expensive to get a website off the ground, since entrepreneurs didn’t have to buy and set up their own equipment.

2007: The social network Facebook launches an open development platform, enabling game companies and others to create apps that connect to users’ Facebook ­accounts. This quickly turns into a viral way to acquire users.

2008: Apple starts distributing mobile apps through its iTunes Store, making it possible for software developers to reach a large audience of smartphone users, and potentially generate revenue from selling apps or advertising within the apps.

2009: “Shark Tank” airs on ABC, featuring entrepreneurs pitching a panel of investors for money. That, along with the release of “The Social Network” in 2010, helps glamorize (or at least legitimize) the start-up life.

2011: More than 1,000 tech start-ups around the country attract an initial seed round of funding, according to research firm CB Insights. That number is up from 770 in 2010. This year, it has already surpassed 1,700.

2012: Three new accelerator programs, focused on helping entrepreneurs turn ideas into businesses, get started in Boston. The dominant accelerator program, TechStars Boston, is cranking out about 25 companies a year, double its pace in previous years.

Basically, over the last six years, it became sexy to be an entrepreneur, and relatively cheap to set up a site or create a mobile app. Many Boston venture capital firms that traditionally backed companies at later stages — say, after they’d landed a few customers and needed $10 million to build a sales and marketing department — started plunking down a few hundred grand into companies that were basically experiments. Could the stuff in this little test tube start bubbling, and grow into the next Angry Birds, Instagram, or Facebook?

But it’s starting to become clear that beneath all the app store and social media hype, it turns out to be just as hard as ever to build a real business. As 2013 nears, making money is starting to become more important than simply chasing a cool opportunity. Essentially, many of these seed-funded companies are about to be kicked out of mom and dad’s house.

“You are going to have this natural selection that takes place,” says Doug Brenhouse, founder of Quick Technologies, an eight-person Boston start-up that built a mobile app for people to sell used goods on marketplaces like eBay and Craigslist. “You have all these seed-funded companies with very little revenue. We’re all competing for the same capital.”

Brenhouse has raised about $2 million so far, and the company’s app has been downloaded by 250,000 users. One of Quick’s West Coast rivals, EggDrop, raised $1 million and hit 500,000 user downloads, but it shut down in October after failing to raise further financing.

Matt Cutler is no newbie to the start-up scene; in 1994, he was part of one of the first Massachusetts companies to create software for websites, net.Genesis. He’s now chief executive of Kibits, a Boston start-up that makes a mobile app to help teams of employees collaborate more efficiently. The company has raised more than $1 million from investors. Last month, a year after its app was launched, it started charging a $20 monthly subscription fee to team leaders. Cutler says: “We’re serious about building a real business. But to do that, we’re going to need additional financing. That requires real results.”

Several investors tell me that they are already slowing the pace of seed investing. One reason, says Elon Boms of Cambridge-based Launch Capital, is that as more firms started making very early investments, the valuation of the companies started to climb. And as company valuations increase, investors are paying more for each share they get — which makes it harder to eventually produce a meaningful return.

Fred Destin of Atlas Venture in Cambridge says his firm made 20 seed investments last year, but “we’re slightly adjusting our pace to more like a seed a month.” Angel investor Roy Rodenstein says he has also slowed his investing pace, even as he raised money for his own digital marketing start-up, TrueLens. Rodenstein says he can sense an increasing emphasis on revenue growth: “There might be 10 companies out pitching investors that can say they’re bringing in $1 million a year in revenue, but VCs will pick the top two.” TrueLens raised $1.2 million last week.

We’ve already seen some local seed-funded companies hit the wall. Two Cambridge companies that tried to capitalize off the popularity of Twitter, Oneforty, and Play140, were sold at fire-sale prices in 2011 and 2012. Other start-ups will meet similar fates in 2013.

Thankfully, for those of us who like progress, the most driven entrepreneurs tend to tune out the wild oscillations of investor sentiment. Ziad Sultan raised $1.7 million for his start-up, Marginize, but the first iteration of the product, which displayed comments in the margin next to Web pages, didn’t take off. So he’s “pivoting,” and launching a new idea soon.

“If you’re worrying about whether the odds of success are going to get better or worse in the next week or the next month,” he says, “maybe you got into this for the wrong reasons. The odds are always against entrepreneurs.”

Scott Kirsner can be reached at kirsner@pobox.com. Follow him on Twitter @ScottKirsner.

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