Ash Rust had good reason to think his start-up would take off. He's a co-founder of SendHub, a start-up that lets companies set up corporate phone systems using their employees' smartphones. In 2012, Rust and co-founder Garrett Johnson raised $2 million in seed funding in two weeks. Their service worked well, and more than 5,000 businesses signed up. So when it came time last spring to hit up VCs for the several million dollars in Series A funding SendHub needed to keep growing, Rust expected smooth sailing.

The results caught him by surprise. "We were told we weren't far enough along," he says, "that the market was too competitive, that we just weren't the right company." By his count, he and Johnson sent thousands of emails to potential funders and went to about 100 meetings, all over the course of three months. But they came up empty-handed. In June, with only three months of funding left to stay afloat, SendHub laid off two of its 12 employees and cut expenses in half. "It was easily the most stressful period of my life," says Rust.

Rust's experience fits the template of the "Series A crunch," a story that's been roiling the start-up community for the past couple of years. It goes like this: After slogging through six months to a year of frenzied product development and user testing, seed-funded tech start-ups are fatally hitting a wall--the million to several million dollars in VC funding they need to scale up their cool new services is nowhere to be found. The result is the cruel and needless throttling of a vast stream of promising fledgling companies down to a mere trickle of survivors.

Share of seed-funded companies that won't be able to get follow-on funding: 61%Source: CB Insights

That's the story, anyway, and it has the start-up community vibrating with angst and debate. But that's not the whole picture. The Series A crunch is really just shorthand for a broader, longer-range shift in the start-up ecosystem, one that has unleashed an explosion of new companies and a revolution in the system that funds them. Yes, it's true that the situation has created far more demand for venture capital than there is supply of it, and many new companies will perish in infancy as a result.

What many entrepreneurs don't realize--or, more likely, would prefer not to admit--is that this is not a bad thing. For all the hand wringing, the Series A crunch is not a sign that the system for funding start-ups is broken. On the contrary. This is how it's supposed to work.

The Crunch Is Real--But it's Misunderstood

It's true, the odds of a seed-funded start-up getting Series A funding have dropped substantially over the past few years. The exact numbers are much debated--and also depend on how seed and Series A funding are defined. (Seed is typically a few hundred thousand to a couple million from angels and early-stage VC firms. Series A typically ranges from a few million to $15 million from VC firms.) But almost everyone agrees that a much lower percentage of very-early-stage companies is getting follow-on funding, with a typical estimate suggesting there has been a drop from perhaps 1 in 3 being funded in the past to 1 in 6 today. According to a report from research firm CB Insights, the crunch will probably strand more than 1,000 start-ups this year.

But it's not because there are fewer seed-stage companies that go on to get funded at the $5 million or so level. It's because the number of seed-stage companies has ballooned--to more than 1,700 in 2012, up 64 percent since 2011, according to CB Insights. "It's become much easier to start a company and raise seed capital," says Keith Rabois, a partner at VC firm Khosla Ventures. Rabois held key roles in the early growth of PayPal, LinkedIn, and Square and has supplied angel funding to some 70 companies. "It just hasn't become any easier to raise a Series A. The funnel is wider at the bottom and the same at the top, so there's more of a narrowing, and that's creating more disappointed entrepreneurs."

One of those disappointed entrepreneurs is Benjamin Zises, who founded RetailMLS, an online real estate listing service for retail spaces. His company raised $1.9 million in seed funding in 2011 and 2012. When those funds began to run low and Zises started contacting VCs earlier this year, he collected what would ultimately prove a long, unbroken string of rejections. "We've really had a lot of trouble," he says, adding that he has kept going by offering employees stock in place of much of their salaries.

Still, the narrowing of the funnel isn't necessarily bad news for entrepreneurs. The key to understanding why lies with looking at why so many more companies are getting seed funding and what's going on with those that don't make it to a Series A.

Average amount raised per angel or seed deal in 2012: $880,000Source: PitchBook

Seed Funding Is Easier to Get...

One reason so many more companies are getting seed funding is that there are so many more investors to provide it. Until recently, seed funding was mainly the territory of angel investors, traditionally wealthy former entrepreneurs who hit it big and who can write checks for a hundred thousand dollars in exchange for a small percentage of a company. But now a variety of other players are getting into the angel game.

In particular, Silicon Valley is seeing the rise of angel syndicates and crowdfunding collectives that let smaller investors, who wouldn't otherwise have enough money to be angels, pool their resources. One of those is FundersClub, which, as of August, has pumped more than $100 million into 31 start-ups, with its numbers growing fast. Alex Mittal, the CEO of FundersClub, co-founded the organization in 2012 to "democratize" funding, after living through the time-sucking strain and hassle of raising money for his three start-ups.

Another organization, AngelList, founded in 2010, has helped reduce friction in angel rounds by matching founders and angels online. To boost its impact and free up even more angel money, AngelList founder and CEO Naval Ravikant recently unveiled a new service that allows a single angel to act as a lead investor in an angel group that invests in a single company, with that lead serving as sole signing authority in order to simplify the process. "The lead angel takes 20 percent or so of the profits, providing a huge incentive to keep working with the company," says Ravikant. "And the entrepreneur only has to deal with the person they trust in the first place." Ravikant led the first bundled investment himself, putting in $25,000 and raising $350,000 from other angels online.

Another growing source of seed-stage funding is VC firms, which have essentially been forced to become active very-early-stage investors. That's because angel funding has become so prominent in the company-building process that by the time founders start meeting VCs, they've already established close relationships with one or more angels, stealing from the influence VCs have long enjoyed in Silicon Valley and making it harder to get in with the hottest start-ups when they're ready for larger funding amounts. In the race to beat out other investors, VCs now act as angels--and they tend to be somewhat less discriminating than angels have traditionally been because they can afford to be, given that a $100,000 check is coming out of a massive fund rather than their personal savings.

...And You Need Less of It

Even as seed money has gotten looser, start-ups need less of it to get off the ground. Development tools for building a high-functioning website and the services behind it have become cheap, high powered, and easy to use. The cost of servers and other hardware has continued to drop. "Three years ago, companies could for the first time get all the way through a prototype of a service before they even raised seed money," says Ravikant. "Two years ago, they could make it through launch before raising money. Now, they can start to get traction with a user base by the time they come looking for seed money."

Average amount raised per Series A round in 2012: $5.3 million Source: PitchBook

Even some of the technologically ambitious start-ups are finding they can get by with a fraction of what it used to cost to get off the ground. Patrick Riley, co-founder of Ark, which is creating a search engine for finding people, notes that several years ago, his company would have had to build its own servers to meet its needs. But now, they're inexpensive commodities. "It's been cheaper to build this company than it was to do my Ph.D. project," says Riley.

The result is that instead of needing as much as $1 million or more to get going, start-ups are often able to run with $100,000 or so for six months, which can be plenty long enough to get to a fairly polished product and a loyal user base. With companies needing less money and more cash than ever available for seed funding, it's obvious why there has been an explosion in the number of start-ups vying for Series A funding--to more than a thousand a year.

The Hurdles Forgetting Series A Funding Haven't Changed

The basic requirement for getting Series A funding is simple and hasn't changed in a decade: Have a better chance of getting to be a billion-dollar company than most of the other start-ups competing for funding. Getting a chunk of a single Facebook, Twitter, or Instagram is so phenomenally lucrative that it greatly outweighs whatever a VC firm has lost or won in all its other dozens or hundreds of bets on start-ups.

"It has nothing to do with how likely it is you'll be profitable or whether you're going to have 10 million users," says Jason Freedman, founder and CEO of commercial real estate site 42Floors, his third company. "There's no room at VCs for companies that are going to merely be very good. If you can't prove you have a chance of building a truly great company in eight years, no one will want to fund you for the next two."

That's one of the reasons VCs gave for turning down funding for RetailMLS, explains Zises. "They said we could be a $200 million business, and that wasn't enough for them to want to invest in," he says. "They have nonrealistic goals." On the other hand, search company Ark, which is gunning for a chunk of Google's market, is being wooed by VCs. "Anyone can make a Groupon for dogs and get it up quickly," says Riley. "Only a small number of people in the world can design a search engine and roll it out at scale."

Another factor in the Series A crunch equation is the fact that the amount of money available for Series A funding has barely budged in recent years, mostly because that money is determined by how much pension funds pump into VC funds--and pension fund investing tends to change little year to year. More start-ups competing for that money, and those start-ups doing more with less money, means that on paper, at least, the numbers that a start-up has to present to a VC to make the grade have all gone up--way up. "The bar is at least twice as high on what VCs expect," says Brian Pokorny, a longtime prominent angel investor, most recently as a partner at angel investment firm SV Angel, who ran a start-up called DailyBooth. "If whatever market traction you used to have to demonstrate to get funding was X, it's now at least 2X."

That's a major reason SendHub was turned down by VCs, even though it already has tens of thousands of dollars in monthly revenue and sales are growing 25 percent a month. "Showing revenues can actually be a drawback, because it gives the VCs a clear measurement that they can find less than overwhelming compared to some other start-up," says Rust. "But if you're prerevenue, you can sell the company on dreams for its multibillion-dollar potential."

Revenue isn't the only metric VCs look at. Growth in user numbers is another big yardstick, but even low user numbers can be overlooked if there's a surge in growth or an unusually high level of engagement among users. Or if the service is starting to capture a previously untapped and potentially large bucket of users. AnyPerk, a start-up that hooks up employers with discounts for their employees, took off last year. It quickly signed up a string of top-tier customers and is clocking 40 percent monthly revenue growth. Now, the VCs are very interested. "They don't care about our pitch or who we are, the way they did in our seed round," says co-founder Taro Fukuyama. "They just want to see that we have good numbers."

All in all, most observers agree, the entrepreneurs who are making it through to Series A these days don't need to be significantly sharper--nor do their ideas need to be substantially more brilliant--than those who did it four years ago. They just need to be able to keep up with the technology and the market in order to push their start-ups further along the path toward demonstrable potential greatness than was the case four years ago.

There were 1,749 seed deals in 2012 and 692 Series A deals in 2012.  Seed-funding deals increased 64% from 2011 to 2012 and Series A deals decreased 2% over that same period.Sources: CB Insights; Pitchbook

Who, then, are the expanded hordes of entrepreneurs who aren't making the grade? It's largely newbies and people who haven't yet figured out they just aren't that great at creating a business. These entrepreneurs wouldn't have made it four years ago, and they're not going to make it today--there are just more people today ready to give it a go and who are getting a chance to fail because of the increased availability of seed funding. "The Series A crunch is the great culling of lesser entrepreneurs and ideas," says Freedman.

In fact, almost everyone interviewed for this article agreed that, for all the difficulties it creates, the Series A crunch isn't causing any truly promising companies to bite the dust. The founders being turned down probably shouldn't be trying to raise a Series A round, many argue. They got a shot and ended up proving that their idea doesn't make for a great business. When they get a no from the VCs, they're getting the right answer.

The Series A Crunch Is Good for Entrepreneurs

Many insist that this culling of start-ups is in the end good for all entrepreneurs and for several reasons. For starters, those entrepreneurs whose companies are destined to fail are much better off being shut down eight months into the journey rather than years later, after they've sweated a lot more blood and have dozens of employees who are dependent on them. "The crunch is only going to stop those who wouldn't have succeeded anyway," says Jessica Mah, co-founder and CEO of inDinero, maker of a money-management tool of the same name. Mah raised $1.2 million in seed funding for inDinero, and at 23, she is on her second company. "If you're actually good at this, then you'll learn from the experience and be much better the next time around," says Mah. "If you're not good at this, you want to find out as soon as possible."

That's not to say there isn't a dark side to the crunch. There is, and it can be measured in the pain and disappointment most entrepreneurs experience when they can't keep their companies afloat after a year of frenetic activity, high hopes, and, toward the end, increasing desperation. "It's the equivalent of throwing someone into the pool to teach them to swim," says Khosla's Rabois. "Some people do really well with that sort of struggle--it makes them grow faster and become stronger because of it. Others sink and feel thrashed and destroyed, and end up becoming emotionally fragile in a way that's hard to recover from." The result is that some people who might have made successful entrepreneurs if they had gone through a gentler, more supportive system are driven out of the field by the race-into-the-brick-wall trauma of the crunch.

Rabois's advice for dodging this trauma: Don't bank on getting VC funding unless you're obsessed. "The only people who end up making successful founders are those who just can't stop themselves from pursuing their idea," he says. "They can't sleep because they're thinking about it all night, they can't stop talking about it, they can't focus on their relationships. Those people have no choice but to take that leap of faith, and they might actually have a good shot at it if they have the right skill set. Everyone else isn't cut out to start a company in this environment. They should join someone else's company."

Indeed, adds Rabois, the funneling of failed entrepreneurs into employment is another of the great benefits of the crunch. The fact that so many people want to start companies has created a serious dearth of affordable talent for great start-ups that find themselves competing for software engineers with the likes of Google. If it weren't for the crunch kicking so many gifted technology and marketing people out of the company-founding game and into employment, even some of the best start-ups would be foundering for lack of people to hire. "The limiting resource on tech start-ups is not funding; it's talented people," says Rabois. "If the talent pool gets too fragmented among too many start-ups, most of them won't be able to reach the critical mass of talent needed to succeed." Of course, that's easy for him to say.

But even if your company runs out of funding and fails, that doesn't make you a failure, argues Matt Brezina, an angel investor who is co-founder and CEO of Sincerely, a company that produces a number of gift-giving apps; his first company, Xobni, sold to Yahoo in June. Brezina contends that starting a business--even one that eventually flops--is one of the most effective management education and training programs in the world. As far as investors are concerned, there's no stigma attached to launching a company that fails to take off. In fact, you will have a much better chance of attracting funding the next time around. "Going through that process is the best training experience ever," says Brezina. "When you've gone through it, investors know you can hire, you can raise money, you can execute on a business idea. Investors want to see that experience behind you."

There's A Way to Beat The Series A Crunch

Entrepreneurs can do an end run around the Series A crunch. For starters, groups such as AngelList and Funders-Club, which have mostly aimed at seed funding, are moving aggressively into bigger rounds. Outbox, a start-up that digitizes postal mail, was turned down by a number of VCs, but it pulled together a $5 million Series A in June largely based on bundled funding from some 70 investors put together via AngelList. That option won't be available to every company that can't impress the VCs, but it can help some.

And there's another way to beat the crunch: Focus on building profits early. That strategy tends to be a poor one for scoring big rounds of VC funding, because early profitability usually requires focusing on small niche markets and then reducing the customer base even further by charging handsomely for your service. Most VCs want little to do with start-ups willing to settle for a tiny and less-than-fast-growing market, even if they're making good money at it. That's why VC-funded companies tend to ignore profits and concentrate on churning big user numbers any way they can. But as long as you're making money, you can keep going and growing and thumb your noses at the VCs--as well as at all your funding-starved fellow entrepreneurs--while you're doing it.

One start-up that's going this route is PlanGrid, whose iPad app provides an elegant way of handling design blueprints. After a $1.5 million seed round last year, the company has already hit profitability, and it has no immediate intention of raising any more money. "My bigger problem is convincing our seed investors that we don't need a Series A," says co-founder Ryan Sutton-Gee. Eduardo deCastro also decided against raising money. He's a co-founder of HashFast, a start-up that sells specialized hardware for the computing-intensive tasks that support the bitcoin virtual-currency market. DeCastro didn't like the terms VCs were offering-;and ended up not needing the cash after customers forked over a combined $6 million in orders for the company'sfirst product.

Brezina's company, Sincerely, looks as if it may turn out to be a slow-growing, profitable, VC-less company, and he says he's fine with that. "We're not taking off in the market," he says, "but this might be exactly the right way to build the company." The Series A crunch, as painful as it may be for founders who get far enough to feel its squeeze, clearly isn't preventing the good companies from moving ahead. That's what SendHub's Rust ultimately decided. He finally raised $2.8 million in Series A funding, after all the initial rejections led him to focus on groups such as FundersClub and AngelList. "This has been a serious test for me and the team," he says. "But what it's made me realize more than anything else is that I love doing this and wouldn't want to be doing anything else."