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Seed Stage Startups Are Now Graded on a Curve
Over the past five years, we’ve witnessed an Atomization of the Seed Stage. Early fundraising is no longer a one-and-done fundraise of a single round of Seed capital subsequently followed by a Series A 12–18 months later.
Rather, it has been broken into bits of a series of capital raises to reach meaningful milestones… “pre-seed,” “post-seed,” and rounds in between have become the norm. A seed extension has ceased to be the equivalent of scarlet letter, and instead has become commonplace.
Whether or not this situation is good or bad for entrepreneurs and the ecosystem, it is indeed reality.
One of the results of this change is that Founders now approach Series A funds with increasingly varied histories.
The bar for Series A has moved
The flood of seed-funded companies coupled with proliferation of seed funds willing to underwrite incremental capital into new and existing portfolio companies, has yielded a broad backlog set of “seed startups” with wild variations across the following three dimensions:
1. How much time has elapsed since company founding.
2. How much total capital has been put into the company since founding.
3. (Effective) post-money valuation.
Then, that bar started to drift upwards, and more traction was required for a Series A, since the increased volume of seed funded startups yielded a more stringent requirement for what was considered the top of the class.
However, now with increased heterogeneity in funding history, startups are now only being evaluated on the absolute progress and scale which they’ve reached, but also the relative progress and scale. Seed stage startups are now graded on a curve.
A company with $250K monthly recurring revenue which took 4 years and $5.5M to build sitting at a $17M post-money is going to look fundamentally different than that exactly comparable startup which took only two years and $2M total capital at a $10M post- to get there.
Even though the traction milestone is the same, the history is not, and that context will meaningfully alter the ability to successfully raise a solid Series A financing.
Fair or not, investors look at the time it took to accomplish that traction as a proxy for the success trajectory following a multimillion dollar Series A. And they’re looking for that success to happen measured in months and not years.
Similarly, the capital-efficiency to date is taken as reflective of inherent in the business itself and operating mindset of the team, rather than as the amount of capital used for discovery of product-market fit that is decoupled from the efficiency post-traction.
Lastly, the post-money valuation is a strong signal for the expectations for the next round of financing, which may not be congruent with the sentiment once evaluating the company in the context of the time and money was utilized so far.
A startup’s history increasingly drives future expectations… which is directly considered when Series A firms are selecting companies to back.
What can seed stage entrepreneurs do to position themselves effectively for future capital?
1. Proactively stage capital during the seed phase.
It’s easier said than done, of course, but the ideal path is to strategically plan when and how much capital to take during the seed stage. “Easy” items include avoiding a messy string of notes/SAFEs with varied valuations over time, reducing valuation overhang, and even rounding down total capital raised for optics (ie. raise $1.8M not $2M as it “feels” like less) etc.
More difficult choices include running extremely capital efficiently until truly feeling product-market fit, saying “no” to early additional capital when it won’t buy new milestones or prematurely ramp burn, and choosing investors which will help instill discipline.
2. Crisply define when the “real” business started.
If there has been a long and expensive journey to product-market fit, then in crafting the fundraising story, articulate a clear starting point for the “real” business as it stands today.
A narrative like: “Yes, the four-year journey to get here took longer than we expected, but since June 2017 when we pivoted to launch new product X and discovered product-market fit, we’ve been extremely successful and capital efficient since.”
Rather than conveying a multi-year wandering in the woods, a series of incremental changes in strategy, it’s helpful admit what was tried and failed to contrast with a distinct change when to of the working strategy commenced. But it has to be actually true, otherwise, it’ll just seem like hand-waving.
It’s more painful to do, but in addition to positioning the business, a lot can be gained by proactively and preemptively changing the structure of the capital in (converting the notes to preferred and/or lowering the post) to remove the “hair” on the company to position it for a new outside lead to easily lead a new clean round.
(Re-)starting the business with a new starting line is helpful, and there’s no more powerful way to do so than change the capital structure (as tough as it may be).
No longer is the optimal Series A fundraising strategy to run the playbook of a concurrent competitive process only when the company is “ready to fundraise.”
Rather, it’s productive to engage with partners at Series A firms who are genuinely interested in what a Founder is building all throughout the seed stage. It’s difficult to predict when a new investor will recognize the venture-scale opportunity given the traction and history curve, so it’s best to be in communication with a small set of sincerely interested parties as a startup develops.
A decade ago, a seed stage company “graduated” to Series A or quickly died, which left the markers for what constituted a Series A company fairly clear. But in an extended seed phase, those old rules of thumb became less relevant. In raising a classic Series A round, how and why a startup got where it is today matters just as much as where it is.
If you have any topics you’d like to see covered, or any questions you want answered, please reach out to us. You can comment below or tweet any of us (@robgo, @davidbeisel, @leehower, @melodykoh, @nextviewvc).