Entrepreneurs are forming startups and early-stage funding at record levels, but there's a lack of later-stage--Series A--funding from institutional venture capital investors. It's called a "Series A crunch," and although it's not confined to just music startups, being involved in music presents an additional set of problems. Simply put, music is doubly difficult.

During the past decade there has been tremendous growth in the number of early-stage investors putting money into startups. Numerous startup accelerators like Y Combinator, TechStars and Bain Capital's StartUp Academy provide seed money, advice and networking opportunities to young companies. Such celebrity investors as Justin Bieber, Ellen DeGeneres and Ashton Kutcher have put money into technology startups. Cities from obvious (New York) to not so obvious (Bloomington, Ill.) have their own startup incubators.

Things took shape in the early 2000s. Seed funding grew from 74 deals worth $130 million in 2004 to 814 deals worth $793 million in 2012, according to Pitchbook. But startups have gotten crunched through the years. In 2008, 118 startups out of 225 (52%) that received angel funding were able to find additional Series A or B funding. In 2012, just 244 startups of 814 (30%) that had received angel funding were able to do so.

Media startups have had it bad. The percent of media startups with angel funding that were able to land Series A or B funding dropped from 29% in 2008 to 23% in 2012. (Pitchbook couldn't break out data for music startups.)

The entire music category has a bad reputation due to the experience that some investors have had with music copyright, says Larry Marcus of Walden Venture Capital, an early investor in Pandora. Where VC firms invest their money comes down to perceived opportunity. If one category is deemed too risky, complicated or unprofitable, money will be put into others. Firms "want to paint with a broad brush" even though many music companies don't actually license music from labels, Marcus says.

The music-startup landscape does indeed show some signs of VC neglect. There aren't many consumer-facing music startups getting funding given the mainstream potential of music. The music startups that receive funding tend to have service-oriented or business-to-business models-for example, direct-to-fan service providers (Moontoast, Topspin), cloud storage and file transfer services (SoundCloud, Gobbler) and music analytics services (Next Big Sound, Musicmetric).

A winning formula becomes more difficult when a startup licenses music from rights-holders. A subscription service can expect to pay 70% of its revenue to rights-holders in a good year and even more in its formative years. This is the major knock against services like Spotify: It's such a low-margin business that only one large company can survive. Internet radio has only slightly better economics. Venrock partner David Pakman told a congressional hearing in November that his firm is "skeptical, under the current licensing regime, that profitable stand-alone digital music companies can be built."

There isn't a broad bias against music startups in the portfolio of Index Ventures. The VC firm has put money into two Internet radio startups: Last.fm, which CBS acquired in 2007 for $280 million, and more recently 8tracks, a service that lets users upload and stream playlists. It has also backed Songkick and SoundCloud. But the firm has yet to invest in an on-demand subscription and download store.

"I wouldn't say investors have soured on music," Index Ventures' Mike Volpi says. "I'd say straight-up licensed music doesn't make money."

A "Series A evolution" could come next. The markets are maturing and the companies have customers, but "from an investor perspective, you get real picky," says Mark Montgomery, founder of FLO {thinkery} and an early-stage investor. Startups will become deprived of cash and drop in value. They will have to merge with competitors or be acquired to survive. To the victor go the spoils.

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