Jim Andelman, my Partner at Rincon Venture Partners, aptly describes the genesis of the Series A crunch, stating: “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 one or two investments per partner per year.”
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 100 investments per year, each in the $25,000 to $200,000 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
There is a 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.
Darwin aside, savvy entrepreneurs are increasing their chances of survival by proactively anticipating the Series A shortfall. Here are some tactics to consider:
- 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 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 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.
- Focus on sales. 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.
John Greathouse is a general partner at Rincon Venture Partners and has held a number of senior executive positions with startups, including Computer Motion, Citrix Online and CallWave. Follow him on Twitter @johngreathouse and read his blog here.
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