A version of this article previously appeared on Forbes.
Jim Andelman, my Partner at Rincon Venture Partners, aptly describes the genesis of the Series A crunch, stating that: "Over the next 12-to-18 months,
a lot of good companies that have been Seed financed are going to have a tough time raising a Series
A from a new outside lead. This is due to a fundamental disconnect between the increased activity of high-volume seed investors (that fill out lots of Seed rounds) and the relatively small number of Series A investors, who only make 1 or 2 investments, per partner, per year."
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Turtle Eggs And Startups
I was in a board meeting recently at Connexity when Dave Gross, the company's Co-Founder and CEO, made an insightful observation regarding the shortage of Series A funds. He joked that it is akin to turtles hatching on a beach and running in mass toward the ocean. Thousands of turtles are hatched, but only a fraction evades the grasp of predatory birds and reach the safety of the water.
Once in the water, another significant percentage of the baby turtles is quickly devoured by hungry sea creatures. The nasty and brutish deaths of the unfortunate turtles are disquieting , but the process ensures that the survivors are (on average) strong, healthy and able to capitalize on the ecosystem's resources.
There is a similar Darwinian aspect to venture capital investing. Companies that exhibit the greatest prospects are those that attract the necessary capital to survive. Non-performing companies (unless they are artificially propped up by a Washington bureaucrat with tax dollars) are usually unable to garner adequate financing. Their demise, albeit painful in the short term, frees the employees (and in some cases the underlying technology) to pursue more productive opportunities.
There are no villains in the current Series A drama. The rapid growth of seed investments is the natural result of a number of industry trends, which continue to drive down the cost of launching and operating a web-based business. Some seed investors execute over one hundred investments per year, each in the $25k to $200k range. Paul Singh, a partner at the seed stage firm 500-Startups, effectively articulates the market forces driving this investment strategy in his Money Ball presentation.
The other primary factor contributing to the Series A shortfall is the concentration of venture capital funds in the hands of a shrinking number of large firms. This has been driven by venture partners' desire for larger and larger fees (which are a function of the amount of capital they manage) and institutional investors' allocation of funds to a handful of VC firms with long (but not necessarily stellar) legacies. This is the "no one ever got fired for buying IBM" approach to investing.
Due to their size, these legacy funds must invest relatively large amounts of capital in each of their deployments, which ill-equips them for participation in most Series A rounds. This flow of funds to large, mediocre VC firms has been widely discussed, usually under the heading, "Is Venture Capital Broken?"
According to Jim Andelman, "These market dynamics combine to leave good companies unfunded, even when they do not need 'much' more capital to achieve a good exit. If a venture does not have a reasonably high-perceived chance of a $250 million exit, most Series A investors are passing. The crunch is especially acute outside of Silicon Valley, as the Bay Area VCs focus on their home market, and the relatively fewer Series A investors in other markets can thus afford to be especially picky."
Avoiding The Series A Crunch
Many of the unlucky baby turtles are healthy and speedy but still fail to reach the relative safety of the ocean. Similarly, companies with a viable value prop and promising future are finding it challenging to raise adequate capital. Fortunately, there is a key difference between startups and baby turtles: entrepreneurs can make their own luck.
To this end, some of the tactics entrepreneurs can execute to avoid becoming a victim of the Series A crunch, include:
Take more money at the Seed stage - Although the incremental dilution will be painful, it is prudent to accept 30% - 50% more capital in your Seed round than you would historically, as it will give you a longer runway in which to create value in advance of seeking Series A funds.
Court Seed Investors with a demonstrated history of participating in a post-Seed rounds - As noted in Extracting More Than Cash From Your Angel Investors, there are a variety of parameters you should use to identify and target potential seed investors. Given the current paucity of Series A funds, the depth of an investor's pockets should be given special prioritization.
Be realistic about your Series A valuation - Although it may seem counterintuitive, the lack of equilibrium between Seed and Series A investors is causing valuation inflation. Per Mr. Andelman, "The Series A investors are now paying more for businesses they think will have outlier exits." These high-profile deals, which are covered extensively in the tech press and pursued by numerous investors, contribute to unrealistic expectations among rank and file entrepreneurs regarding a reasonable Series A market-rate.
If your company is not perceived to have the potential of a huge exit, do not expect a major uptick from your Seed valuation. If you are forced to accept a lower value, consider reducing the dilutive impact by raising a mix of equity and debt, as described more fully below.
Consider venture debt - If your business has a predictable, reliable cash stream and you have a high degree of confidence that you can reach sustaining profitability, it might be prudent to supplement a smaller Series A raise with debt. With current interest rates in the low-single digits, the cost of such capital has never been cheaper. Expect such debt to include a modest equity kicker component, in the form of warrant coverage. In addition, be on alert for camouflaged fees.
Customer dollars - Sophisticated entrepreneurs understand that the ideal source of capital is from customers’ wallets. Not only does revenue validate a startup’s value proposition, it results in zero dilution. The sooner you generate customer revenue and internalize paying customers' feedback, the shorter your path to self-sustainability.
If you follow these tips, you are not guaranteed to avoid the Series A crunch, but you will undoubtedly increase your odds of adequately funding your startup, through its Series A round and beyond.
Follow my startup-oriented Twitter feed here: @johngreathouse. I promise I will never tweet about double rainbows or that killer burrito I just ate.