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.
Raising venture capital is not an end to itself. Capital is an enabler. Not every great company needs to raise outside capital to be successful, but some do, and that’s the world that we participate in as venture capitalists.
I find that capital gets talked about a lot in blogs in terms of things like runway, getting to profitability, solving the VC math equation, etc. But primarily, I think capital for early stage companies should be discussed in an offensive manner. As my partner David likes to say “capital is a weapon”. It’s true that sometimes too much capital creates tons of issues, but if wielded appropriately, capital is very much a part of a company’s offensive arsenal.
We think about this quite a bit with our portfolio companies as they scale. As seed stage investors, we find that we tend to prefer modest sized rounds early on to focus a team and establish discipline around being excellent at one thing and proving things out efficiently. But beyond the seed stage, capital is primarily about winning and winning big. We look to invest in GOLAZO companies with capital efficient beginnings, and usually, those types of companies do take in a fair bit of capital and use that capital as a weapon. Typically, this happens in some combination of five ways.
1. Solidify Network Effects. This is pretty obvious. If you are building a marketplace and things are working at small scale, you would want to invest big $$’s behind growing the market quickly. Each incremental node in the network increases the value of the entire network, so capital can be useful to accelerate this growth either directly by acquiring buyers/sellers or indirectly by allowing the company to maintain low fees and burn money in the short term while the network is being built.
2. Geographic Expansion. Some businesses don’t have great network effects, or if they do, those effects really only exist at localized scale. Groupon, Uber, Taskrabbit, GrubHub and the myriad of other local-services oriented companies are examples of this, at least early on. If you have hit on something that is working in an isolated geography, it’s relatively easy for another competitor to get some scale in another market unless you get there first. So capital is a weapon to scale geographically much more quickly than the cash flows of the business would allow.
3. Data Scale. This is an internet version of economies of scale. For many businesses, the more data that you have, the better or more cheaply you are able to deliver your goods or services almost by definition. Companies that exhibit this include advertising technology companies (eg: more unique data leads to better performance), financial services companies (eg: more data leads to better risk models leads to lower costs), and many many others to varying degrees.
4. Buying Credibility. Credibility matters for many companies. If you are selling software to enterprises, those companies will want to believe that you will actally be around in 5 years and can meet the levels of service they require. If you are playing in a regulated space, capital and credibility helps you get difficult deals done, or avoid getting taken advantage of by incumbents, or allows you to invest in the things that are required to help you avoid getting sued.
5. Boxing Out Competition. Some companies are able to raise a huge amount of capital relatively early on, making things much more difficult for competitors. These companies drive up the cost of customer acquisition for everyone, drive up the cost of acquiring talent, soak up the attention of the media and BD partners, drop prices, scare off other VC’s who don’t want to short fund the #2 player, etc. An old colleague of mine used to call this “sucking the oxygen out of the room”.
Each of these are reasonable and potentially effective tactics. Pretty much all companies that scale quickly with venture capital employ some combination of these. But they aren’t foolproof, and things can often go wrong too (that’s the subject of another blog post). Raising capital has never been an indicator of success, but if used appropriately can be a critical weapon in becoming more successful faster.
I’ve seen many founders make this mistake over the past 7 years, so I thought it was worth a post.
Surprisingly, one of the hardest types of VC pitches (and one that a lot of founders struggle with) is the pitch to existing investors.
This is the “update meeting” to the broader investment team of an existing VC. Often, this might happen relatively early in the fundraising process, but sometimes, it happens later. Sometimes, the fundraising process hasn’t really started yet (in the eyes of the entrepreneur). So, they are surprised when they walk into an “informal update” and realize that the entire partnership has assembled to critique their business.
Entrepreneurs struggle with this for a couple reasons:
1. Too casual. These meetings are almost always couched more casually then they really are. That’s because as the VC, bringing in a portfolio company to update your team does seem casual. But to the founders, this is a very high stakes pitch. It’s the job of the other members of a partnership to press on a company and keep their partner honest and offer fresh perspective, so although the environment will be friendly, the folks in the room are likely to take a more critical eye on the business than one would think.
2. Assuming too much. It’s easy to see friendly faces in a partnership pitch and think that everyone in the room is up to speed.
As a result, these pitches often dive quickly into the details, and fail to present an emotionally enticing story-arc. Big mistake. Even though other members of a VC team have some context, you can’t assume that they are fully informed and have seen the narrative unfold. In fact, these pitches are tough because you have to cater to both folks who are pretty unfamiliar with the business, and others who are intimately involved. On top of that, VCs are always asking themselves, “how would other investors evaluate this opportunity.” So even if they are aware of the details, failing to cast an exciting vision can lead existing investors to think “maybe there will be future financing risk for this company.”
3. No practice. Often, by the time you get to partner meetings during an external fundraise, you have honed your story through repetition and practice. In this case, you probably haven’t had much practice, and practice would seem contrived anyway since it’s just an “internal update”.
4. No sense of competition or external validation. All fundraising conversations are easier when there is a sense of competition that
creates both external validation and/or FOMO. With internal pitches, it’s harder to create this. Usually, these meetings happen at the beginning of a fundraising process, so it’s hard to create external validation. Also, as an existing investor, there is an assumption that even in a pretty competitive round there will be the ability to do one’s pro-rata and maintain ownership. The investors have a very strong sense of security, which makes it tougher for founders to get investors hot and bothered.
So, what should a founder do? Couple thoughts,
1. Practice. Find some insiders who are relatively small investors that do have experience with this but aren’t likely to influence the round dynamics significantly. Practice the real pitch with them, and do so in a realistic setting so it really does feel like a pitch.
2. Create some external demand. Even if it’s new angels or strategics, it’s helpful all around to show some external demand for the company’s equity. I wouldn’t front run a ton of VC conversations, but some outside validation helps a ton.
3. Own it and deliver. Realize that this is going to be one of your harder pitches and treat it as such. You have to captivate with your story, but show complete mastery of the details, for an audience that doesn’t feel like they are at risk of missing out. It’s tough. Don’t take it lightly, and be prepared.
Everyone knows that nobody gets consumer in Boston. If you want to invest in the next great consumer company, you better be in Silicon Valley or New York. It’s just a given.
It turns out that claim is total BS. Boston has amazing consumer companies, but the region gets no love for some reason.
Case is point are three really interesting companies that have come to prominence over the last year or so. Care.com, Wayfair, and Simplisafe.
When I ask consumer internet investors about their areas of interest, I hear three things these days.
1. Network effect businesses.
3. Connected Devices.
Funny enough, all three are represented here. Care.com is a classic network effects business. The more and better the caregivers in the network, but more valuable it is for consumers. The more consumers, the more attractive it is for caregivers. Care just went public, is an $80M+ revenue business, and has a multi-hundred million dollar market cap (not a vapor private valuation).
Wayfair is a great ecommerce company going after one of the largest and underserved categories – furniture and home goods. The company is no longer really a secret, and is doing over $1B in revenue. They compete against current (or former) darlings like Fab and One Kings Lane that celebrate great taste and design. Sorry, those companies aren’t in the same league.
And just this week, it was announced that Simplisafe raised $57M from Sequoia. What a beautiful business – nice hardware revenue + recurring subscription in a big category. Oh and they have over 100K customers. Pretty darn impressive and totally disruptive. Connected devices is a pretty new meme, and Simplisafe is probably the most interesting company in this category next to Nest.
So, why doesn’t Boston get more love on the consumer internet side? Couple thoughts.
1. Main Street Stories. I could say that Boston is just far away from the major media centers, and thus doesnt’ get enough attention, which is true. But deeper than that, I think there tends to be a practicality to Boston companies that is a little less media friendly. The three businesses above don’t market themselves in flashy or audacious ways. They tend to market in a main street way, and talk to everyday consumers about their problems and value proposition. One of my friends in Boston admitted that he had never heard of Simplisafe until “one of my friends in Indiana bought it and installed it (and loved it)”. What are other companies that built huge businesses focused on regular people as customers? Ebay, Amazon, and Netflix come to mind. If you are going to be huge, main street is the way to go. But the stories aren’t necessarily that sexy.
2. Too early? This is counter-intuitive, but Boston startups I find are often too early. Simplisafe started before connected devices were cool. Wayfair started before the resurgence of ecommerce. Zipcar was way before Uber and Lyft (and I’d argue still a more disruptive model). Taskrabbit, which started in Boston, is the poster-child of the outsourced service economy. Runkeeper predates most companies in the quantified health space. The list is long. But sometimes, the earliest companies just don’t get the same attention.
3. Not enough “mediocre” companies. I can’t quite explain why, but I notice that Boston tends to have quite a few really great, sustainable consumer companies. But relative to the great ones, much fewer “ok companies” or flame-outs. That seems like a good thing, but it really isn’t. For an ecosystem as a whole, it’s really great to have a large number of people who have been involved in companies early that had some promise, had some success with their product and marketing, but didn’t end up making it. The skills around going from zero to 20MPH are really valuable and needed. But in a market where there are fewer of these, you tend to have a lot of people with experience getting from 30-60MPH and beyond, but fewer who are adept at doing what it takes to get things off the ground. You need flameouts and ok companies to produce great ones.
But overall, I think there is one major issue at work, and it does come down to the culture and high-brow intellectualism of this market. No one wants to look stupid. And because of that, when someone does look stupid, people are quick to pile-on and be nasty and snarky.
Journalists don’t want to look stupid by talking about a crazy consumer company as the next great thing.
Founders don’t want to look stupid by beating their chest and shining the spotlight on themselves in case the spotlight shines on them when things go wrong
Angels don’t want to look stupid by having the large number of losses required to catch winners, or get crammed down by VCs investing big dollars ahead of them
VC’s don’t want to look stupid by investing in things too early, or trying to use capital as a weapon only to go down in flames
And when a town is NOT the center of the tech sphere OR the center of the media universe, the bar is higher to get noticed, so the risk is magnified.
Don’t be afraid to look stupid.
The dynamics of a series A round have changed in recent years. As seed rounds have become much more common, it’s been said that the “seed is the new series A”. This is sort of true – it used to be that Series A’s would often happen pre-product, and certainly before product-market fit. With capital efficiency, companies in certain sectors have been able to do more with less and show some market traction even after a pretty modest seed round.
The end result though is that the dynamics around series A rounds has started to seem pretty murky for entrepreneurs. But for investors who see a lot of these deals, it’s not as unpredictable as it seems. Below are some broad guidelines on the major topics around series A’s that I hear entrepreneurs thinking about.
VC Ownership: Institutional VC’s that lead series A rounds still target ownership in the 20%+ range. Historically, VC’s wanted a bit more, 25% or so, but 20% is a threshold that has been around for a long time. This hasn’t really changed. As a result, questions around valuation are less about “what is the value of this company” and more “how much capital is a VC willing to part with to buy 20%?” This is why larger funds are on average are able to be a bit more aggressive on price than smaller funds because they can stretch to invest a bit more to get the ownership they are looking for in a competitive situation.
This leads to some interesting sub-dynamics, especially when a larger VC is in your seed round. In theory, if that VC is really excited about the opportunity, they should be willing to pay a higher price for the series A than anyone else because they are already partial owners of the company. It’s a lot easier to get an investor from 7% ownership to 20% vs. getting a new investor from 0% to 20%. In practice however, this doesn’t happen as often as you think, because large VCs that bore the seed risk will often feel like they ought to get higher than 20% ownership because they put in the hard work early in the company’s life.
I find that it’s also pretty typical for an existing VC investor to be willing to syndicate the deal with another outside investor. This enables the large VC to have another deep pocket around the table post Series A to be able to add capital into the company with less friction in both a good and bad scenario. In that case however, the founders might end up taking a lot of dilution. The existing investor will need to buy up to get to 20%+, and the new investor will want to buy 20%. This potentially makes it all worthwhile if the round is pretty large, and this is how some series A rounds end up being $10 – $20M of new capital, rather than the more standard range of mid single-digits.
Speed and Timing: Insitutional seed rounds typically provide companies with enough cash to take a company around 14-18 months. This assumes some increase in burn over time, but the capital could also be stretched to go longer. As an entrepreneur, one could always make the argument that it’s best to keep operating longer and show more progress before raising to get the best valuation possible. In practice however, many companies that have the most successful series A fundraises raise their rounds much sooner, often <12 months from the seed. This happens for three reasons.
First, time is of the essence. Waiting 6 months longer to raise may improve valuation in the short term. But having the capital in the bank to make the most of an attractive opportunity sooner usually is the better move overall and will enhance valuation in the long term. Second, when things are working, founders will usually lean into the opportunity with the capital they have, which will reduce runway but make their growth curve steeper. Third, it’s more advantageous to raise capital when you don’t need it, and having a nice buffer gives you more boldness to negotiate a better deal.
This certainly is not to say that companies that take longer than 12 months or raise their A are not successful. In fact, there are a quite a few examples of companies that needed to raise extensions of their seed to get to a place where a successful series A could happen. But for companies that have something that is working, I find that being more aggressive and raising sooner tends to be better at the series A stage.
Who To Choose?: Series A investors are almost always going to want a board seat, and it’s very hard to get rid of a board member that you don’t like. Therefore, who invests is much more important than valuation. 10/10 times, I will recommend that a founder go for the series A investor that they have good rapport with, trust, have aligned vision with, and they believe will most impact the long term performance of the company. Investors that will pay a higher price but have misaligned styles and goals just aren’t worth it.
Valuation: Taking my own advice, I propose thinking about valuation in terms of round sizes. There are broadly three buckets of series A’s, and therefore, three valuation buckets.
- Solid Series A: New VC investor invests $3 – $4M and owns 20-25%. This suggests a post-money valuation range of $12M – $20M. Remember, usually the round is bigger than just the capital that the new investor puts in because of pro-rata rights or other smaller angels that may want to participate. That’s why I’m focused on post-money here and solving for the ownership ranges of the new VC.
- Great Series A: New VC investor invests $5 – $6M and owns 20-25%. This suggests a post-money range of $20M – $30M. These are terrific series A outcomes.
- Outlier Series A’s: Outliers exist with extreme traction and/or extreme competition for the deal. In these cases, a new VC investor invests $7M+ for 15% – 20% ownership. In these cases, the new investor may break their rule to own less than 20%, and is writing a large check for series A standards. This does not happen that often. Sometimes, you see rounds like look like huge series A’s and it’s discouraging to entrepreneurs. The reality though is in those rounds very rarely happen and/or something else is going on. Something else might mean that the total dilution is a lot higher than one would think because an existing investor is also buying up. It might mean that the “seed” was actually quite a bit bigger than the typical institutional seed, so the company has already taken in a fair bit of capital.
Founder Liquidity: It used to be that founder liquidity would almost never happen until very late into the life of a company. Today, it’s become a tool that is used earlier to better align incentives between founders and investors. Usually, it’s not a huge amount of liquidity – often a few hundred thousand dollars to a million max. It’s enough so that the founders will feel emboldened to step on the gas and go for a big swing rather than play it conservatively to preserve value, but not enough that they won’t work maniacally hard to win. I personally think this is a reasonable thing, especially when founders have gone a long time with limited pay and/or are struggling with the dilution of a big round. It’s not uncommon these days to see some founder liquidity in the series B and C rounds of companies. It’s still very unusual to see them at the series A stage as usually, an investor wants every dollar to go into the business they are investing in. But it’s not entirely out of the question, and can (in very rare instances) be orchestrated in large series A rounds when there is a huge amount of competition and investors are scrambling for ways to get as close as possible to their 20% threshold. But overall, I’d recommend not even considering this until later in the fundraising path of your company.