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June 8, 2014

Raising capital is really difficult, no matter what people say about the influx of seed and early-stage dollars into the startup eco-system. I know very strong entrepreneurs that need to grind really hard to get seed rounds done, so I definitely don’t want to take away from the challenge of doing that.

But in some cases, I find that exceptional entrepreneurs have the opportunity to “jump straight to A”.  That is, by-pass a traditional seed round of $750K – $2M from angels and seed funds and raise $3M+ primarily from one large venture capital investor. The rationale for doing this is obvious. You get a large capital partner involved early who is fully committed to your company.  You also get more money earlier that you can use as a weapon. After all, if only a minority of seed rounds (on average) result in a series A investment, why not take that risk out of the equation early and jump straight to A?

There are a few reasons NOT to do this. Jumping straight to an A may seem like a good idea, but you are giving up a few things that I think are pretty valuable, and are offered by raising a typical seed round.  Keep in mind that I’m a biased observer here since we are exclusively a seed-focused fund and I think that is usually the best “product” for most entrepreneurs.  But having said that, here are the four main reasons to raise a seed, even if you have the option of jumping straight to your series A.

1. Getting a variety of great people involved. Seed rounds tend to be composed of a larger number of participants, including both angel investors and institutional seed funds.  Getting access to a breadth of network and resources is pretty helpful in the early stages of a company when you are under-resourced and have no scale. When jumping straight to A, the ownership requirements of large funds will dictate that there is less room for other participants for the round to happen, and that fistfight for allocation will result in fewer helpful investors around the table.  The first round is usually the last time one can get some really terrific folks involved, whereas most larger VC funds happily invest in the series A or B rounds of companies.  Just check out the list of great people involved in Uber’s seed round.

2. Maximing your series A firm.  Great people are always stretching.  Entrepreneurs are stretching to get the best investors in the world involved they possibly can. VC’s are stretching to back entrepreneurs that are a little outside of their network, or are more “premium” than the brand of their own firm. Often, I see that when founders jump straight to A, it’s because a VC was stretching and the founder got one of their top choices, but not the absolutely best capital partner for their business.  Seed rounds allow you to put some wins on the board for your company, and then run a process to really maximize your series A round and the firm and person that you would want to work with.

3. Maintain flexibility.  Raising a smaller amount of capital not only forces more focused experimentation and opportunity validation, it allows founders to be more flexible in the path they want to take for their business.  Sometimes, founders will find that the company they thought was going to be great was going to be a lot harder to build, or take a lot longer, or is actually not as big of an opportunity as they thought.  If she has raised a lot of capital out of the gates, there is greater pressure to do unnatural things to try to morph the business into something of greater scale, even at much greater risk.  A seed round allows you to be more measured about your progression, and respond more flexibly to your learnings.  This isn’t primarily about maintaining optionality of a smaller exit.  I think it’s primarily about time.  Does a founder want to take 7-10 years of his life to grind out a company towards an unnatural outcome, or would it be better to sell a company sooner, make money for investors and employees, and then give it another shot again after a few years?  The small or mid-sized exit may mean a lot less for experienced founders, but getting years of their productive life back is pretty valuable for almost everyone.

4. Lower possible net dilution.   It’s hard to predict total dilution over time for two different financing paths.  But what I do see is that when jumping “straight to A”, entrepreneurs usually do need to sell a large chunk of their company to make it worth the while of a large VC to write a big check.  Usually, the dilution is in the 25% range, and certainly at least 20%. On top of that, this capital will essentially need to take a founder through the next 2 value accretive inflection point to be able to raise their next round at a big step up.: 1) getting to product market fit and 2) build a scaleable marketing machine.  That’s a pretty tall order most of the time, and if you can’t achieve both, you are going to raise your next round at flat terms or at a very small step-up to the last round.

In raising a seed round, you can minimize dilution up front due to the smaller round size, and then take these 2 inflection points one at a time.  At each juncture, you are able to use competition to your advantage and optimize for the best terms.  You will still be selling 20% of your company in most cases to your series A investor, but you may be able to raise more capital than you would have if you jumped straight to the series A.  That then gives you a better chance of knocking it out of the park in developing a great marketing machine.  So in a big upside scenario, you may achieve less total dilution after the series B, or acheive the same dilution for much more capital.  And although capital is never an end in and of itself, it is a weapon that you can use to turn your company into a monster.

  • http://www.mikevolpe.com/ Mike Volpe

    Good argument for raising the capital you need, when you need it, to get to the next step in the startup lifecycle.

    Do you worry that in Boston the series A investors have become overly conservative and make this path of seed to A round harder than it should be? For example, I can think of a couple companies that in my opinion have taken their seed money and proven product market fit and now need an A round to build a marketing and sales machine. However, a lot of the typical A round investors are saying things to them like “we like to see $50K-100k of MRR for an A-round”. To me, that much MRR indicates you have figured out a lot of the funnel and just need to scale it. Do you think that on a ~$1m seed round a company can both prove product market fit and build enough marketing to get to $100k of MRR? I don’t, but maybe I have expensive taste in desks and coffee. :)

    • robchogo

      I’ve seen cases where companies have been able to get there with $1M or less. But what you are seeing is consistent with my observations overall. I think it comes down to 2 things. First, many ideas are rational, but not obviously huge. IN those cases, VC’s like to see a little more traction, since they really need to believe that the founder is off to a great start to counter-balance the potential small-ness of the opportunity. And by small-ness, I mean opportunities that are still big: $500M – $1B. But not mega huge $5B+ opportunities.

      The second is that the series A has become much more like a series B, which was historically the hardest round to raise. As a result, seed rounds are getting bigger – often $1.5-$2M for great founders because they just need that much capital to achieve what you describe above. Before long, the seeds will really be smaller series A’s, and the prices will go up to the point that angel rounds (or Genesis rounds as we call it) become more attractive again.

      • http://www.mikevolpe.com/ Mike Volpe

        Very interesting. Sounds a lot like b2b software and other markets, where companies tend to drift upmarket (selling to larger customers) over time and then new companies start selling to the smaller customers trying to disrupt.

        My sense right now is that there is a real gap between seed and A – which I know everyone has talked about – but the reasons are less about there being a lot of seed money and not much A money, and more about what you said. The A round folks are behaving like B round folks (no guts) and expecting way more progress than is reasonable off of a seed round.

        I should look up how much MRR we had at HubSpot when we raised our A round, but my (poor) memory tells me it was something like $15k of MRR from about 75 customers. We’d never be able to raise an A round in today’s market.

  • reggiedog

    What are the typical differences in terms for a Series A vs. a seed. I assume that the option pool is quite different between the two, for example, as well as preferences and security types. I have been scouring the web for such info and no one discusses that aspect. Surely a seed has a much different set of terms than an A round, simply by force of the perceived leverage (and value?) that a VC firm has, no?

    • robchogo

      Good question.

      Seed rounds tend to be either lightweight preferred equity rounds or convertible notes with a valuation cap. Seed preferred terms are usually very straightforward, because aggressive terms would only set a tough precedent in later rounds that would hurt the seed investors who have less deep pockets. Option pool is always a negotiation, but at the seed, it’s usually fairly low, sub 10%. For series A, it can be larger.

      Were there other specific terms you are curious about?

      • reggiedog

        This is the problem with analyses like this. No offense, but without the terms the analysis is not useful. The difference between an option pool and not an option pool can be twice the dilution, hence 1/2 the valuation. In fact “selling 20% to an investor” is actually selling 30-40% if you add on the option pool (which you might discount as a VC because it doesn’t effect your investment, but it comes out of the entrepreneur’s hide.) Say what you want about the reasons and future value, but this analysis, from one side of the table, is lacking. Terms of all sorts are quite meaningful in valuation and strategy. It is a disservice, honestly, to ignore them. (but every write up like this does!)

        At the same time, I feel that you are touching (in 3 & 4) the real issue: what progress you can make with the/any funding. Having “people involved” isn’t usually operationally valuable, because they aren’t involved, nor would most successful entrepreneurs be able to find anyone with the domain expertise that the founder has. (signalling, yes that is valuable, but on a financial sense, which shouldn’t be a priority until PMF.

        A seed round should enable some measure of progress to PMF, right? “A” is for scaling? So what is the business progress calculation in terms of terms and expenses and what are the trade offs? If most startups fail, then what is the risk:reward/cost:benefit expected from the seed round from a founder’s POV? Should they fund their future employee’s option pool before PMF? Should they expect to pivot in some way before “A” such that they need dry powder (either cash or equity)?

        Again, I have looked high and low for some analysis like this, and even those “database” and metrics folks who try to quantify rounds across the board completely ignore them. I guess they are just too hard to account for in an article (other than B. Feld’s work, and a little from F. Wilson). But it is a real shame that founders don’t see more analysis that really values other people rounds correctly.

        • robchogo

          Thanks for the comments. I’m not really sure what level of detail would be acceptable to you. I leave out option pool and terms here so that there is an apples to apples comparison. In our portfolio, 90% or more of our rounds and subsequent rounds are preferred equity with no bells and whistles. On option pool, it depends on the team and type of company, so for the purposes of this post, I take them out to simplify, but maybe I could just assume some standard %. Maybe in a future post, it would make sense to look at how option pool sizes have changed over time for the rounds we’ve seen. That could be interesting.

          • reggiedog

            The point is that it is not an apples-to-apples comparison from the founder’s point of view if you leave out the option pool if it doesn’t come out of your investment and only comes out of the founder’s share.

            As noted there can be a 100% difference in effective “valuation”. I’m not saying that it is possible to get apples-to-apples, but it sure is not helpful (to be kind) to omit the option pool effect on the valuation, because the option pool is a cost to the founder.

            What is helpful is to measure what a founder gives up to get ahead, not just the cash he takes in.

            The calculation should be an economic one based on total dilution (what the founder “pays”) and what he attempts to get in return for what outcome.

            Instead of saying, “I’m selling 25% in a seed round for $1MM” the founder should look at it as,

            “I need $1MM for these 3 things to achieve PMF, at which point the enterprise should be worth $8MM. So I will dilute (“pay”) now 25% to the seed investors and “pay” another 20% of my company for the option pool to get PMF, with the goal of arriving at the A round owning T-45% and what ever additional terms I have agreed to.”

            Again, I know that is really hard to make comparisons in articles like this, but a founder runs a real risk of missing the forest for the trees if he doesn’t account for the whole picture.

            Thanks for your writing.

          • robchogo

            In future rounds, the option pool does come our of my ownership as well, so I am sensitive to it. But you are right, talking in terms of percentages understates things meaningfully by ignoring the option pool. I’ll consider that in future posts. Thanks!

    • robchogo

      what is your name? I’d like to mention you in my next post where I’ll provide a bit more info on this topic.

      • reggiedog

        Chris Woods. Again, thank you for your efforts.

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