There were a number of interesting articles published over the last week in response to Mattermark and CB Insight’s data around early stage financing activity. In particular, a number of people commented on what looks like a dramatic rise and fall in seed deal volume over the past four years coupled with an increase in seed investment dollars.
As a team, we’ve been thinking about what has been going on in the seed market in recent years. Are we in the midst of major transition? Have things settled to the point that there is a new normal? Should alarm bells be sounding, or is it business as usual?
Answer first: we think that the seed market has settled somewhat, so charts like these don’t really cause much alarm but are generally consistent with what we’ve been seeing. Couple thoughts.
First: It’s impossible to accurately chart the level of angel and seed activity over time. The data sources are not at all robust, so while the trend may be directionally accurate, the levels are not. And I’m not saying they are off by 20%, I think it’s close to an order of magnitude off. Here’s an obvious gut-check. Almost all series A’s have some prior funding round, so that would be either seed or angel (usually both). I also would argue that as an overall market, at least 2/3 of seed funded companies fail to get to series A. Based on this, you would expect that the steady-state level of seed + series A deals for any period of time would be at least 3x the number of series A’s. As you can see in the data, this isn’t anywhere close to the case.
Furthermore, I generally find that almost all the companies I consider for an institutional seed round has raised some angel capital in the past. So the number of angel rounds should be some multiple of the number of seed rounds. Again, this is far from what you see in the data, where there are actually fewer angel rounds than seed rounds. The bottom line is that I would completely ignore the absolute level of investment activity reported, but I think the trends can be illustrative.
Second: So what does the trend show? It shows that there was a rise in seed funding activity followed by a decline several years ago. This was caused by the so-called “series A crunch” where many seeds failed to raise series A’s, causing seed investors to buckle down and invest more carefully. That’s kind of old news – the number of seed deals simply lagged the performance of seed investments made in 2012 and 2013. On absolute terms, I think we still have a fairly healthy level of seed investing activity. Based on the Mattermark data (which might be inaccurate but hopefully is internally consistent), it looks like we are currently in an environment of similar investment activity as late 2010 and 2011, which I would characterize as bullish but not frenzied.
Third: The definition and dynamics of seed rounds have changed. In our view, seed rounds are the new normal for most early stage software based companies. What’s also the new normal is that the majority of seed funded companies raise some money before their seed round from angels. But because of the capital efficiency of building and launching software products, what these companies are able to achieve prior to a seed round is pretty broad. Internally, we talk about he “broadening definition of seed”. Seed rounds can look like a company that is pre-product or has an early product prototype. But in some cases, companies are able to launch a product that grows to tens of thousands of dollars in monthly revenue or more through modest initial investment. This means that “seed rounds” should end up looking pretty different, and can become confused with A rounds pretty easily.
So, what does this mean for founders? Here’s what I’d take away:
- The size and purpose of financing rounds have been shifting. For a really good summary of this, just read Jason Calcanis’ recent post here: http://calacanis.com/2015/01/18/the-official-definitions-of-seed-series-a-and-series-b-rounds/#more-33974
- The market for raising seed money today is pretty solid, so there isn’t really a reason to be worried or concerned by the shape of these graphs. Sentiment among seed investors isn’t excessively optimistic, but they aren’t overly bearish either. There is plenty of appetite for good seed-stage investment opportunities. Also, remember that in good or bad times, promising companies get financed and can have a terrific start.
- The parameters of seed rounds have broadened. Overall, I’d say that most companies should plan on a financing path where they raise <$500K from angels first, followed by $1-$3M in funding from an institutional seed investor. But although I think these are reasonable guidelines, there will be many many outliers. Just like some series A’s are $4M and some at $15M, there will also be a broad range of seed rounds. Don’t sweat this. The goal for any financing round is simply to get your company to the next major value-accretive milestone. You should raise enough to accomplish this for your own company, and know that others will probably do things pretty differently.
As an early stage investor, should you pay up for team or traction?
I posed this question on Twitter in Dec and got a bunch of different opinions. It’s something I’ve been thinking a lot about recently. Prices in the startup world are relatively high. And as a firm, we generally believe that there isn’t a “sub-prime” market for VC. This means that while it may be possible to find the odd “cheap” deal here and there, the goal is to invest in the best opportunities, which often come at market prices.
This question isn’t just relevant to investors either. When you are thinking about joining an early stage company, how should you be evaluating the risk of the overall company? How should you be weighing the presence of a great founding team vs. early signs of traction? It’s not totally intuitive.
The Case For Team
The case for overpaying for team goes something like this. Great teams find traction. Great teams also know what to do with traction and can work from there to build a company of value. Great founding teams also attract other great team members, so the advantage compounds.
Teams are durable, traction less so. Traction is fleeting for a bunch of reasons.
1. You may only get traction with a small set of early adopters that will never translate to mainstream users
2. Your product may have gotten traction due to some distribution hack or novelty factor, both of which may not lead to sustained usage and growth
3. You may not be able to control the operational complexity and economics of your business even though there is a lot of demand
4. Barriers to entry are so low in software that new entrants can always steal your thunder, and sometimes draft off your early learnings
5. It is hard to translate rapid end user adoption with actual business success (eg: monetizing a large audience, or moving from end-user SAAS to enterprise sales).
So, if you are going to pay up, pay up for team. If there is “conventional wisdom” here, I think this is it.
But a counter-argument can also be made.
The Case for Traction
The case for traction is some version of this. Going from 0 to 1 is really really really hard. Great teams fail to build a product and get early distribution successfully all the time. But when something is working, it doesn’t matter why or how it happens, it’s such a rare occurrence that you need to pay extra special attention. Also, great teams are much harder to identify for a bunch of reasons.
1. Teams that seem great on paper or by reputation may actually not be great. They may have just been lucky. We tend to overly-ascribe value to individuals sometimes, when luck or circumstances had more to do with one’s track record than their actual capabilities.
2. Greatness doesn’t always carry over in different contexts. For example, different type of products, different go-to-market challenges, different market context, different stage in one’s life, etc.
3. Great companies are often founded by first time founders who don’t seem obviously special. For every David Sachs, you have a David Karp. Karp turned out to be pretty extraordinary, but it wasn’t obviously so when Tumblr got started.
On top of this, there are probably a lot more people in the world who are capable of taking something from 1 to N, vs. 0 to 1. So if you have a company that has traction, attracting talent to augment what’s already working is quite doable.
Traction for Consumer, Team for B2B
A more sophisticated answer to this question is that broadly speaking, you want to pay up for traction over team in consumer, and overpay for team with less traction in B2B. The observation is that founders of great B2B companies more often then not have some demonstrable track record as operators or entrepreneurs. This is less often the case for consumer. Generally speaking, this is because of what it takes to get early distribution in these markets. In B2B, more of the distribution challenges for certain types of products are in the team’s control. Someone with experience and relationships are better at landing early customers, negotiating more favorable deals, building out and managing a sales team, raising more money earlier to build a more robust product, etc. In companies that require more viral distribution, a great team still has an advantage, but perhaps less of one. Often, consumer companies that gain early traction do so on completely new, emerging distribution channels that an experienced operator who is used to working at greater scale is completely unfamiliar with.
In my view though, it’s less about a consumer vs. B2B dichotomy and more about what distribution channels a company is going to take advantage of and how early growth and monetization are likely to happen.
The Founders Perspective
This post is mostly from the early stage investors perspective, but what does this mean for founders?
In a world of constrained resources, founders are in a way “paying up” with each hiring decision or dollar they spend. So they are similarly making the judgement of where to be allocating resources. A very common mistake I see some companies make is hiring a very seasoned marketing executive way too early, and then realizing that it was a mistake to pay-up for team at that moment in time. The converse is that I’ve also seem companies choose not to stretch to bring on more senior or more expensive talent when the time was right, and then lament “I wish we had hired her 6 months ago”.
Not “paying up” when the time is right is a challenge for founders broadly. It is true that it pays to be conservative with cash early on and that being lean or being CFBE gives you a lot of leverage. But in a world of asymmetric outcomes, it’s important to make big bets and pay up even if it feels uncomfortable. But as both investors and operators know, choosing the right things to pay up for, and doing it at the right time is easier said than done.
I did a fair bit of speaking at Universities in the last few months of 2013. In Nov and Dec, I think I gave guest lectures or spoken at events at HBS, MIT, BC, Harvard College and attended a capstone event for an entrepreneurial program for Duke undergrads. These frequent interactions with students has gotten me thinking about the topic of starting companies in college.
Startups and entrepreneurship are in vogue in universities these days. More and more schools are introducing new courses and programs geared towards supporting entrepreneurial endeavors. While business plan competitions and accelerator programs used to target business school or grad school teams, more and more colleges are creating their own programs to enable undergrads to build businesses during their time at school. Venture capital firms are supporting this in various ways as well, through funds and programs specifically targeting campus founders (Rough Draft VC and the Dorm Room Fund are a couple examples, but there are others).
Some of these programs have given rise to some promising companies, and here at NextView, we’ve funded a handful of companies founded in college (Plastiq, Whoop, and Bridj). But overall, I have mixed feelings about all of this activity around entrepreneurship at the college level. On one hand, any endeavors to promote more risk taking and entrepreneurial aptitude are great for the startup ecosystem broadly. But in some ways, I think these efforts actually do some harm. “Starting a company” or “working on a startup” is becoming something to do for its own sake. One can adopt all the lingo and mannerisms and “play house” without really having the great raw ingredients for building something that solves important problems. Even worse, I often find that companies founded in college are the result of an academic investigation of ideas rather than an authentic one. I happened to be listening to Paul Graham’s lecture at Stanford a few weeks back, and I noticed that he touched on this topic as well. In his subsequent essay, he wrote:
“Given this dichotomy, which of the two paths should you take? Be a real student and not start a startup, or start a real startup and not be a student? I can answer that one for you. Do not start a startup in college. How to start a startup is just a subset of a bigger problem you’re trying to solve: how to have a good life. And though starting a startup can be part of a good life for a lot of ambitious people, age 20 is not the optimal time to do it. Starting a startup is like a brutally fast depth-first search. Most people should still be searching breadth-first at 20.”
So, my advice to 99% of students is not to start a startup in college. I have two reasons for this.
1. The best startups are born out of authentic experiences. And when you are 20, it’s hard to have enough authentic experiences to form unique and exciting companies. This isn’t true for everyone, but I think that starting great companies require both unique insight into a problem and unique dedication to solving that problem. These insights don’t necessarily come out of insanely unusual experiences, just ones that are different enough and meaningful enough to set a founder on the right path. I think the vast majority of people have neither when they are in college. But, these same people may have a decent shot of developing both over the next 10 years of their lives (and certainly much later in their life as well). If you are passionate about a problem but don’t have a unique insight into it, find a way to work on that problem during and after school in the context of a business, non-profit, or someone else’s startup. If you lack both a unique insight and unique dedication to a problem, searching for a problem to solve wont’ really help. You need to live life – search “breadth first” as Paul Graham suggests. It’s hard to lay out the steps to develop this, but like Steve Jobs talked about during his Stanford Commencement Speech in 2005 ,“You can’t connect the dots looking forward; you can only connect them looking backwards. So you have to trust that the dots will somehow connect in your future.” And so my companion advice to this is: draw bold, interesting dots.
2. Great founders must be able to assemble significant resources much earlier than their company deserves. This includes, people, capital, partnerships, customers, etc. But probably most important is people. Attracting extraordinary people to a company and having them working like crazy at low wages requires A) that you know these extraordinary people and B) that they would want to work for/with you. Out of college, one’s network of extraordinary people may be pretty strong, but it is likely to expand exponentially after college when you are able to naturally interact with a broader set of talented people in a different context. Not that there isn’t amazing raw intellectual horsepower among one’s classmates in college, but sometimes, industry or functional specialists can really move the needle for a company and are very important to get on board sooner vs.later. Some people may be in a position to bring on board their first three A+ engineers while in college, but many others will find themselves better positioned to do this at a different point in their journey.
So, if you are going to start a company in college, I’d suggest thinking about where you fall relative to these two factors. Remember that most startups fail, most are more difficult and more painful than you can imagine, and many of these failed companies are led by pretty remarkable individuals. I think it’s wonderful that an individual in college has the gumption to go down this path, but I’d urge him or her to do so for the right reasons and with the right appreciation for what it will take to be successful. Do not start a company for the sake of starting a company. Your friends may be impressed, and it might make great fodder for interviews or grad school applications one day. And you probably will learn a lot in the process. But there may be other and better ways of making progress towards this goal, and there may be different better experiences in store for you if you if you challenge yourself to seek them out.
This week, we helped organize an Angel Bootcamp where some of Boston’s most successful angel investors shared their experiences and lessons learned to a crowd of aspiring angels and entrepreneurs. It was a terrific event with some really unique content and stories. If I were to give a talk at this event, I would have spoken on the following topic:
WHY BEING AN ANGEL IS BETTER THAN BEING A VC
In the informal conversations during and leading up to the event, I noticed a bit of a sentiment that angel investing was somehow less appealing or less interesting than being an institutional VC. While I can’t speak to the specific motivations around this, I found this somewhat puzzling. I suppose there may be a sense of prestige or credibility garnered by managing a fund of capital, but there are some major advantages to being independent. I think if one has the means to pursue angel investing in a relatively aggressive way, investing as an angel can be way better than being a VC. There are a lot of reasons, but it really boils down to two. Fist, the difficulty/ease of getting into a deal and second, flexibility across multiple dimensions.
#1: Difficulty/Ease of Getting Into a Deal:
The dynamics of a round differ case by case. But for angels that are writing relatively small checks (sub $200K, or perhaps much less), it’s relatively easier to get into an interesting deal than if one were a VC.
The reason is that most seed syndicates have room for 5-10 angels or more, but only room for 1-3 funds. If an angel is value-added and low-maintenance, it’s a relative no-brainer decision to allow that person to invest $50K into a company. In probably every investment we’ve made, if the founder asked us to make room for a high-quality angel, we would have done so without hesitation.
This dynamic is very different for VC funds, where there is often a struggle for allocation. We’ve faced situations where we’ve been unable to get our allocation in competitive rounds, but would have been able to participate fairly meaningfully as angels (which was decline as a firm policy). It’s a very different ball game.
Because of this, there is a lot of pressure for VC’s to get to an investment early, differentiate themselves meaningfully, and move with a huge amount of conviction. Great angels do this as well, but can be a little more relaxed about it and still get great results. As an angel, it’s possible to get to an investment a bit late, or follow the signal of a strong syndicate and still do pretty well. Even if an angel gets to an investment very early, one is able to hedge their commitment a bit by saying that they are “in for $X pending market terms and a strong lead.” This may seem like a bit of an annoying caveat, but I think it’s totally fair game for an angel that isn’t making investments for a living but wants to show early support (as long as you don’t go back on your word).
Finally, angels can also pro-actively go after rounds that are pretty close to closing. Because you are making decisions unilaterally, the ability to commit on the spot allows you to be very aggressive. Why not cold-email a founder and say “my name is X, I can help in these ways, if you’ll take me, I’m willing to commit $Z to this round right now. Your choice whether you want to do a call to check me out or not.” The best angels hunt for investments, but it’s much easier for them to squeeze into rounds than VC’s.
The last example above also highlights the second benefit of being an angel – flexibility. Most institutional VC’s present a coherent strategy to their LPs about how they will focus their efforts, what kinds of companies and rounds they will invest in, and how they will construct their portfolios. Most VC’s have target ownerships, target stages, target sectors, target geographies, target returns, target time frames, etc. They also should be doing due diligence of some sort. Angels can do whatever they want. Angels also aren’t investing a fund with a finite amount and time horizon, so he or she could think about each investment as an independent, money-making endeavor.
Some examples of stuff an angel could do:
- Invest $10K into an incubator (many VC’s have a policy against investing in any entity that charges an additional layer of fees)
- Invest in a bunch of angelist syndicates (most VC’s don’t want to follow other VC’s or angels blindly)
- Invest internationally (many VC’s are geographically constrained)
- Blindly follow other investors without even meeting the founder or doing any due diligence (most VC’s would get killed by their LPs for doing this)
- Invest in a company or entity that has great ecosystem benefit, but probably won’t yield a huge financial return (VC’s have a fiduciary responsibility to invest in a way that maximizes the return for their investors)
- Invest in companies or sectors “as marketing”, or “to learn”, or “to build relationships with syndicate members”
- Invest in a company to establish brand credibility to expand their network, even if the price or terms or other factors are crazy
- Invest any amount they want into any company (most VC’s care quite a bit about internal consistency and coherency of their strategy)
- Invest in companies that may never have a liquidity event (VC’s need to get their money out within 10 years)
- Invest in a company that is a very solid 4X, but has absolutely no chance of being a 10X+ (VC’s need to invest in outlier companies to move the needs on their funds)
- Invest in a hardware company, followed by a biotech, followed by a consumer product, followed by a consumer internet company (again, most VC’s care about consistency and coherency of strategy)
- Stop investing for any period of time for any reason without any accountability to anyone
As a VC, I do believe that having a very focused strategy is the best way to drive fund level returns and to fulfill our commitment to our LPs. But angels can manage multiple incentives, and the flexibility and independence of being an angel is a wonderful thing. There isn’t one obviously right answer for any person, but there are some major benefits of being an angel that should not be underestimated.
We held an awesome Angel Bootcamp yesterday at MIT. It was an amazing collection of speakers sharing their experience and wisdom around angel investing. It including folks like David Tisch, David Cohen, Paul English, Diane Hessan, Katie Rae, Andy Palmer, and many others. The full speaker group was here: http://seedboston.com/angelbootcamp/
Even though we are a seed-focused VC fund, we were very excited to help organize this event because of our belief that increased angel activity is critical to keep propelling the Boston startup ecosystem (and the local economy) further. More and better informed angels allow more founders to pursue ambitious companies, not just by providing dollars, but by doing so in a way that is as helpful as supportive as possible.
The content presented during the day was unique and amazing, and I’m still processing everything. But I took some notes along the way of my top takeaways from the talks. Here they were below:
1. Focus on founders that just won’t give up. This is something I’ve seen in my own investing experience. Of all of our investments, a large percentage will not work out. The founders that we are most likely to back again are the ones who just wouldn’t give up, and keep fighting. I remember personally a friend of mine giving a reference for a founder he had worked with, and his response was “he will fight to the death like a cornered badger”. That’s a good trait to look for.
2. You don’t necessarily need to like a founder to want to invest in their company. This is somewhat controversial, but a number of speakers talked about how some founders were amazing, even though they weren’t necessarily the people they’d want to have dinner with. Founders tend to be extraordinary people, which often makes them quirky, unusually aggressive, or awkward in other ways. If the founder is committed, effective, honest, and capable, does it matter whether or not you particularly “like” the person vs. just being confident you can work together?
3. SAFE docs are on the rise. These are financing docs that were pioneered by YC and is apparently starting to see some level of acceptance in Silicon Valley. There was fairly heated debate about these during the afternoon, with some very experienced angels (who spend more of their time in SV) saying that there was “no F*cking way” they would invest in one of those. The benefit of a SAFE is that it isn’t actually a convertible note. Which means no maturity (and thus, no ticking clock for a payback), no accrued interest (since it’s not actually debt), and preferences that are equivalent to the dollars invested vs. some multiple of that (for a discussion around this, see this from Mark Suster). Personally, I’m not a fan of notes and very much prefer equity financing. I think there is probably innovation to be found in simple equity financing documents that:
- simplifies the documentation required and keeps cost in line with that of a convertible note
- allows founders to close on cash quickly and sequentially
- establishes clean, fair terms for future financing rounds
Some of these docs exist, but for whatever reason hasn’t been adopted in a way that allow for low friction similar to notes or SAFE documents. But in my mind, if a founder and investor can agree on a valuation cap, agreeing on the simple terms for a plain vanilla equity financing shouldn’t be that hard, and aligns interest much better. That said, I’ve never been that dogmatic about this topic – I have a preference, but I think some of our objectives can be achieved through different instruments. It just ends up being more trouble that it’s really worth, typically.
4. Back founders who like talking about the hard parts of their business. This was suggested as a major lesson learned from my friend Eric Paley at Founder Collective. The idea is that you want to back founders that engage honestly, and with great depth on the biggest challenges of theirbe business. This is good because it shows that the founder has an appreciation for what is hard, embraces the challenge because they see it as a long-term competitive advantage, and is intellectually honest about the difficulties they are likely to encounter later. More specifically, founders that are able to do this well are a) able to have specific hypothesis that they are testing to address these challenges b) able to distinguishes between challenges that they feel can be overcome by sheer will or because it plays to their strengths vs. those that are more uncertain, and c) able to show vulnerability and uncertainty to investors while still earning their confidence. I think this is a great lens through which to think about founders.
5. Platforms on the rise. Two of our speakers were Jeff Fagnan and Alex Mittal. Jeff is a seed investor and founding board member of Angelist, and Alex Mittal is the co-founder of FundersClub. Both spoke a bit about the development of these respective platforms, how they have performed, and how one could get involved on them. What struck me overall was the scale of these platforms, and how successful they have been. Both platforms boast really extraordinary companies coming through their platforms and really impressive performance. In the early days of these platforms, there were major questions about adverse selection, essentially that “only the crappy companies would resort to a platform for their fundraising needs”. Given the progress so far and the direction these platforms are headed, I think those concerned are pretty far in the past.
6. Pro rata rights – much ado about something (and nothing). There were a number of heated discussion about pro-rata rights and what to do with them. Some investors are religious about insisting on them and capitalizing on them, others were much less dogmatic. At Nextview, we like to have pro-rata rights, because we want to be heavily invested in founders we believe in and companies that are outperforming. In our opinion, it’s reasonable for founders to make sure that the investors that believed in them early and were supportive from the beginning can continue to invest. On the flip side, the reality is that these right end up being somewhat helpful, but only partially so because allocations end up being negotiated at the next financing round pretty much independent of these rights. But again, I think it’s reasonable for seed investors to be put in a position where their ability to capitalize on pro-rata will be driven by their ability get a founder to fight for their rights, which usually means that they were supportive, responsive, and added a lot of value along the way. So in short, I think this is much ado about nothing. I think it’s right to offer these rights to your earliest investors and to put it into financing docs so that there is mutually agreement about expectations post financing. I also think it’s right for investors to have to show that they deserve their pro-rata based on how they behave post financing.
7. The best angel investors hunt. There is a misconception that as an angel, your job is to evaluate opportunities based on the companies that come across your table. But the best angel investors hunt. David Tisch mentioned that something like 80% of the investments he makes comes from some sort of proactive activity, and he’s an angel that gets a huge amount of inbound deal flow! Other angels talked about “not dabbling” and being “committed” to angel investing, which I think are some other versions of this. Being an angel can be very rewarding, but it’s more rewarding if you are involved in more interesting companies and more impressive founders. That doesn’t happen by accident.
There were many other nuggets of wisdom, but there were the first ones that came to mind when I got home tonight. It was a great even overall, and I learned a ton. Thanks again for our terrific Sponsors, Wilmer Hale, Jones Lang Lasalle, and Silicon Valley Bank for their financial support, and for Jon Pierce (the godfather of this event) and Jay Acunzo for their help organizing. And again, huge thanks to all the amazing speakers for donating their time and efforts to the day. It was really rewarding to help put it together, and hopefully we’ll see some great fruit for our labor in the years to come.