As more transparency to seed-round funding transaction details have emerged, especially with the advent of Angelist and accelerator programs (which both educate and even sometimes set terms & structure for graduating companies), I’ve noticed an increasing number of entrepreneurs signal pricing expectations much earlier in the seed fundraising process. By communicating pricing expectations with potential lead investors, I mean sharing either an “ask” or even stated floor for the pre-money valuation of the company (with a priced preferred round) or explicitly stating a valuation cap (for convertible note round). Sharing these expectations early in potential lead investor discussions fundamentally qualifies the conversations, but it also runs the risk of prematurely losing a potential financing partner or reducing options to maximize a financing process outcome.
Like any economic transaction, the pricing of a startup’s seed round ultimately depends on the equation of perceived supply (the quality of the team, product, & market) and demand (how many competitive alternatives there are to any one given funder, including non-consumption). In theory, there are three levels of pricing for an entrepreneur to potentially signal to a prospective investor:
- Lower than “market.” This approach is almost never a good idea. Although some investors will certainly recognize value in a startup which is raising at a modest valuation level, sharing this aspect as a feature to the investment (which I have seen) will likely result in the perception that the company is weak and undeserving of additional capital.
- “Market.” By overtly sharing that an entrepreneur is “looking for the best partner and will accept whatever the market dictates” -or- by stating a figure or range which falls within market, it sets the tone for the fundraising discussion about a collaborative process moving forward looking for a mutual fit.
- Above market. By definition, all entrepreneurs should think that their endeavor is truly exceptional. But, also by definition, that just can’t be the case. Directly stating a high valuation expectation up-front can, on the positive side for an entrepreneur, anchor the negotiations to a higher level (assuming that investor takes the leap of faith to invest). Setting a structure and price in advance can also expedite the negotiation process, especially when it’s with multiple parties. Yet stating a high valuation number early can risk unnecessarily disqualifying a potential investor because it can create the perception that a zone of possible agreement doesn’t exist. With finite time to spend on exploring new investments, a potential investor isn’t going to spend time on an opportunity where he doesn’t think a plausible scenario for him to participate exists.
The key to the calculus above is that an entrepreneur knows what the market range for his startup based on its current state, his ability to generate meaningful funding options, and the external funding landscape. I’ve observed frequently that situation #3 occurs not because an entrepreneur is savvy in negotiating towards a more favorable outcome, but because there was ignorance as to what the prevailing valuation rate is.
The challenge of early price signaling is further exasperated, as different seed funders are going to have varying degrees of sensitivity to pricing. Angels can be the most wildly unpredictable about how they’ll react to differing valuation levels. Probably the most price-sensitive seed investors I know are sophisticated individual angel investors. This handful of people is extremely and unabashedly cheap, as they’re fully self-aware of their role within the funding ecosystem and are accordingly systematically seeking to invest in startups at the lowest cost-basis possible. On the other end, I’ve seen the highest-priced seed rounds come from a syndicate of individual angel investors who were essentially price-insensitive (investing in a convertible note without a valuation cap). At the end of the day, this latter cohort is backing a particular entrepreneurial team and vision no matter what the financing circumstances.
Larger venture firms are probably next in line in terms of seed pricing (along decreasing variability), depending on what their stated (or implicit) seed strategy approach is. As a general rule, the more seed investments a firm of this profile makes per year, the less price sensitive they are. With an “option approach” to seed funding, larger firms worry less about ownership initially and more about just being investors in the startup to maximize pole position for later rounds of funding. Whereas, if the firm only makes a small select few seeds which it treats like a “normal investment,” the same filter for valuation typically applies for the seed rounds as it does for the firm’s later round investments.
Lastly, seed-focus venture firms are going to be least variable in valuation sensitivity. Fundamentally these firms are financially-driven with the seed round being either the or one of the few rounds of financing where they’re deploying their capital, so there is a bias to focus on pricing in the seed.
Regardless of profile and seed strategy, all investors just have differing philosophies about how to treat valuation. On side of the spectrum are those who believe that overall asymmetric returns will be derived from being an investor in the one exceptional company regardless of entry price, and on the other side are those who are especially cognizant of the exit market skewing towards moderate-sized outcomes and want to position their investments to be able to capitalize on that reality. Both profiles are valid because they’re both true; it’s a matter of how investors translate these factors into their own decision-making.
On one hand, sharing valuation expectations early can qualify an investor to ensure he is worth spending time with given their valuation philosophy. Also, if executed effectively, it can also set a positive direct tone towards all proceeding discussions. However, sharing valuation expectations too early can communicate that the search for investors is largely about price, not about finding a good partner for the business moving forward. It’s like opening a job interview by sharing salary requirements. So the communication may needlessly shy away some investors from the table who would otherwise be good partners. Over the course of a fundraising process, pricing expectations may shift (either downwards or even upwards given demand), and it’s challenging to re-open a conversation about the business when the dialog broke down early on over pricing expectations which have since changed.
Of course, as a funding conversation progresses from an initial to subsequent meetings, the topic of round structure and pricing become much more natural. A good investor relationship is born out of fundamental mutual interest in the startup itself, not the deal structure. So the foundation for that partnership begins with a discussion about the shared opportunity, not the details of the arrangement.
In the past few weeks, we’ve seen extremely positive headlines about the surge in VC fundings like “Venture Capital Hits Highest Level Since Dot-Com Bubble.” It must be the best of times for the industry with $8.1B invested in startups during the second quarter of 2012 (the highest in a decade!) along “…with seed-round venture capital hit[ing] an all-time high” [According to CB Insights].
But during this same month, there was a sobering report from Thompson Reuters & NVCA suggesting that perhaps rather it’s still the worst of times, with only $5.9B raised from LPs brought into the asset class this past quarter and the number of funds raising new capital its lowest in years. Sure, that figure is up from immediately after the Great Recession hit, but annualized it’s not nearly a full recovery, and nowhere near the height of the late nineties boom.
In fact, as the two above citied figures show, venture capital firms are actually actively deploying capital at a faster pace than they are raising it. Obviously that imbalance cannot continue in perpetuity, and some have said that “this won’t end well.” But what’s really going on here? Are VCs drunken sailors soon to spend themselves off of a cliff?
Quite the opposite – this fundraising paradox has resulted given the dynamic changes occurring within the industry. Two years ago, I wrote a blog post analogizing the beer industry to the VC industry as it has matured to create two bifurcated poles. On one side are the large VC firms resembling Budweiser-type macrobrews, competing based on scale and brand with a standardized product across multiple geographies, sectors, and stages. And much like the emergence of microbreweries specializing in craft beer, new Micro VCs (like my own firm NextView Ventures) are thriving by specializing along at least one or more of these three dimensions (geo, sector, stage) with a unique offering for a specific subset of entrepreneurs.
Included in the July 9th NVCA report where the figures above originated, Mark Heesen, President of the organization wrote: “As the number of venture capital firms continues to contract, we are beginning to see a clear bar bell forming with several large funds weighing in heavily on one side of the spectrum and a multitude of smaller funds on the other side… As the venture industry bifurcates further, successful LPs and portfolio CEOs are going to have to search for quality firms on both sides of the barbell.”
Given the size and scale of the macrobrews of the VC business, it’s increasingly the largest venture capital firms driving all of the fundraising figures quoted in the media. In fact, according to the NVCA report, “the top five funds accounted for nearly 80 percent of total fundraising.” The two largest funds this past quarter (NEA and IVP) raised over a $1B in capital each.
The imbalance between venture capital deployed and raised isn’t a collective irrational action of the industry – rather, it’s a leading indicator about the fundamental bullishness of the largest funds’ ability to raise additional capital. As there has been a flight of LPs to concentration in fewer VC names, the largest firms have been empowered to raise even larger funds as they expand their footprints. The meaningful dollars currently being deployed are not an unhealthy reflection backward, but instead an optimistic point-of-view about the capabilities to raise additional capital in the future.
This conclusion seems counter-intuitive given the anecdotal stories about the challenges that many venture capital firms have experienced in fundraising since the 2008 collapse as the industry has contracted into two distinct winning strategies of either a macrobrew or microbrew1. But again, the aggregate numbers are being driven by just a few of the largest macrobrew firms. Take just the two largest funds raised from this past quarter: both firms raised this most recent fund more quickly after their last one than the time-period of the previous fund cycle. Surely that conveys optimism.
So while the fundraising environment is more challenging than it was during the middle of the past decade, the pain has been felt unevenly across the industry. And there are many of the largest firms in the venture industry which not at all negative, but rather just plain wildly bullish. The bifurcation has by definition hit the middle the hardest while stirring the pot on the smallest end to create unique situation, the subject of my next post in this two part series on the best and worst of times in venture capital.
1Of course there are exceptions of unique firms with heritage brands, unique positional advantage, and/or exceptional historical returns which don’t fall neatly into one of these categories but are able to presently succeed by leveraging their own past success – call them the “Samuel Adams of VCs,” perhaps the subject of another post.
Personal networking is a key business skill. And as a VC, I get plenty of practice doing it. As one of my former high school coaches used to put it, “Practice doesn’t make perfect. Practice makes better.” While I guess you could develop a “strategy” to networking successfully (… with many a book written about the subject), I think becoming especially productive at networking is largely tactical. Along the way, I’ve stumbled across two tactics which I think are valuable.
First is leveraging the pretty obvious concept of giving-to-get, but being specific about it. In any two-way relationship which builds based on the trust that the exchange between the parties will be equal over time, someone needs to give first. With any potentially valuable relationship, it’s just best to do something for the other person first and not worry about reciprocity initially.
- As a tactical matter, I try to end each networking conversation with “How can I specifically help you?” Rather than just getting to know someone with the hope that you may be helpful in some way in the future, directly asking the other person how clarifies and sets expectations immediately so that a meaningful relationship can develop sooner rather than later.
The second tactic is just the reciprocal of above. When networking to ask for help, I’ve found that after a rapport is established, it’s best to be as specific as possible about what you’re looking for. Even though it narrows the scope of possibilities, an extra level of specificity jogs the thinking for things that are current, as well as plants the seed for recognition recall in the future.
- For the job seeker, instead of saying “I’m looking for new job opportunities,” rather communicate “I am looking for a VP Product role at a consumer-mobile startup.”
- In seeking new customers, instead of saying “I’m looking for people to buy my product which does XYZ,” rather communicate “My product which does XYZ most resonates most with individuals in ABC roles at companies with DEF profiles that face GHI problems.”
- For VCs (including myself), instead of saying “I’m looking for innovative early-stage startup investment opportunities,” rather these days I am saying “I’m proactively seeking seed-stage investments in both ad tech and those which leverage the trend towards ubiquitous computing through device proliferation.”
There are essentially two distinct basic strategies for startup entrepreneurs to raise a seed round of capital:
- Subscription approach – An entrepreneur sets a structure (usually a convertible note) and recruits individual angel investors who subscribe to the round, all without a term-driving lead investor.
- Term-driving investor approach – An entrepreneur finds a lead (quasi-)institutional venture investor to price and set the structure/dynamics of the round, working together to bring in additional syndicate partners (either/both other funds and individual angels).
(Sometimes the subscription approach works to include venture capital firms, but only for very “hot” company or in a competitive environment, like at a Y-combinator demo day. )
Reaching a decision between the above two options is a post for another day, but when entrepreneurs select the latter route, they are then faced with the daunting task of navigating the murky waters of the myriad of firms who at least market themselves as active seed venture capital investors. While we’ve seen an increasing amount of information and transparency about the players in this market, it can be challenging to embark on a set of meetings raising seed venture capital without a structure to think about potential funders. Every firm, whether it follows a dedicated seed venture strategy or a full life-cycle approach or somewhere in between, has a set of qualities that affect how they would fit into a seed venture round syndicate:
- Check size – Some firms have a typical seed check size which is their standard bite size (as low as five-figures as high as seven-), some are agnostic therefore very flexible because it’s just about the option on the following round, and some have different processes/decision-making for different check sizes within a seed round. Unfortunately, this figure is rarely if ever on a firm’s website, and must be asked during the first meeting.
- Willingness to lead – This leadership dynamic is important especially when talking with seed-only focused funds, as many have an explicit strategy of only participating in a round coming together with a third-party lead syndicate VC partner. I’ve seen many entrepreneurs can find themselves with numerous parties “interested to follow” but without a firm willing to catalyze the process. There is some correlation here, but not complete alignment, to check size (i.e. larger check writers have a greater tendency to lead rounds).
- Active partner involvement level of lead partner post-financing – Venture firms approach involvement after a seed round wildly differently. For larger life-cycle firms which make a myriad of seed investments, partner involvement can be little to none after a seed round. Or, it can be meaningful if the company “counts” as a full investment within their partnership dynamics. Similarly, for smaller dedicated seed firms, partner involvement can vary depending on strategy. In both cases, the amount of time spent is generally inversely proportional to the number of new seed investments the firm does a whole each year.
- Board seat requirements – Partner involvement post seed financing can, but doesn’t always, require codification with a board seat. The board seat dance at the seed stage can be challenge on either direction, with occasionally no firms wanting to designate someone’s time for the role and sometimes more than one looking for an official board role that isn’t a fit at this stage. This dimension moves in similar direction as the previous point of partner involvement (i.e. more time spent translates into more desire for board seat), but some firms are satisfied with “in-between” measures like official board observer status and defined information rights.
- Additional systematic value-add after investment – Strategic venture investors can add a unique set of benefits, firms with large portfolios have network effects where many institute systematic sharing among the companies, some larger VCs offer a range of “full-service” including PR and recruiting and other functions. There are many ways that venture firms can help their portfolio seed CEOs in lieu of or in addition to partner involvement which can be a real plus but isn’t immediately obvious.
- Geography – It’s always easiest for an investor to make an investment in her own backyard, and especially at the seed stage with partner involvement, geography becomes a more acute issue. So as a general rule, seed-stage firms have more of a tendency than larger firms to follow a strategy which limits geography to a particular city or region. Of all the firm attributes, geographic preference one is the easiest to discern from a portfolio company list on a VC’s website. But actions speak louder than words – sometimes VC firms would like to market geographic focus or agnosticism, but in practice it deviates. No matter what a VC says, the proverbial bar is higher in making an investment outside their typical geography, however that’s defined.
- Sector-focus (or lack of it) – Like geography, sector focus can be more readily gleaned from a portfolio-company list than from other marketing, with the two sometimes meaningfully differing. Where a firm has been and where it wants to go are two different things. Some funds promote themselves as completely focusing on a particular space, while others take a broader approach. It’s important for the partner and firm to have some background in the area of a new investment, but extremely heavy investor concentration in particular space can have both risks in addition to rewards for an entrepreneur.
- Follow-on capital and strategy – Many people have covered this topic in the blogosphere about the perils of venture firms’ signaling in follow-on financing subsequent to seed rounds. It’s not worth rehashing here, other than to say that signaling issue of larger life-cycle VCs is real. Period. We’ve seen it directly in our portfolio companies raising successive rounds. That being said, there are indeed clear benefits to having deep pockets at the table immediately from the seed round. I think that the most important aspect of this issue is for a venture firm to state a clear follow-on approach and be consistent in implementing it. The most trouble comes when a player’s intentions are unknown (or undefined) or inconsistently applied so that there are surprises in the subsequent follow-on process.
- Conflicts of interest in existing portfolio – Especially given that some seed-only funds follow a rapid deployment strategy in making dozens of investments annually, competitive conflicts of new investments and even existing investments with others within a portfolio can be a real factor. Some firms are lax about these conflicts (which indeed are sometimes inevitable when startups pivot), while others are very strict about not having more than one company in a general space. But I have observed VC firms intentionally invest in competitive offerings.
- Prestige – Nobody explicitly talks about it because it’s implied: prestige matters. It matters in a lot of things all the way from recruiting to especially in attracting that next round of financing. On the margin, higher-prestige seed investors attract higher quality Series A investors.
- Institutional LPs and standard VC fund structure – Why their investors’ fund structure matters to an entrepreneur isn’t immediately obvious. The more the traditional plain-vanilla the structure of the VC fund, the more consistently financially motivated the investors are going to behave. That is not to say that these VCs are not going to behave badly… just that even the bad behavior should be consistent in trying maximize return. So at least you know the driving force motivating actions. Whereas less formalized sources or non-traditional structures of capital can sometimes (yet only sometimes) risk exerting more erroneous and erratic non-financially motivated behavior. This dimension is about structural bounds and consistency in investor actors and avoiding surprises further down the road.
- Personal dynamics – Last on this list but certainly not least, as it’s about answering the extremely important question: do you want to work with both the person and partnership on the other side of the table? Are you merely holding your nose because the money is green or do you truly want to work alongside this person for the months and years to come?
Dedicated seed firms often have a fairly set and consistent answer to most of these questions, as participating in seed rounds is their bread and butter. But it’s surprising that it’s not always the case. And sometimes larger life-cycle VCs ones aren’t as consistent in their approach to the above because the exact parameters of a seed investment aren’t clearly defined internally.
Putting together a seed VC syndicate of one or more firms is like fitting together many puzzle pieces. There are different “right” attributes for a startup’s round depending on the situation, and then those characteristics can be assembled by selection one firm which most closely matches or by aggregating a series of participants which bring a couple of those attributes to the table. The key in building the optimal seed VC syndicate is to figure out what qualities should be present and then construct a scenario which includes them with one or more partners. Without doing easy homework and asking the right questions up front, entrepreneurs can miss out on including valuable investors in the round -or- add too many non-valuable or “redundant” constituents which just complicate the composition and communication going forward.
One of the things that surprised me most about venture capital when I got into the business is how much VCs seem to like to meet for breakfast. VCs usually typically reserve dinners for portfolio companies’ CEOs and board members. And “doing lunch” doesn’t happen that often because VCs don’t like going out of the office mid-day much. But breakfast for venture capitalists is an open free-for-all for all sorts of networking meetings and conversations.
Along the way, I’ve noticed that there’s a pattern to what VCs order which shows what kind of VC he is. Like my previous post about what the founder’s email address says about your startup, I thought I’d turn the tables a bit with a light-hearted look at what a VC orders at breakfast says about him or her:
- Full breakfast of eggs, bacon, hash browns, & toast – newly minted post-MBA Associate just getting into the business… (you can’t eat that big of a breakfast three or more days a week for long).
- Bowl of oatmeal – standard VC breakfast for those who schedules a morning networking meal almost every day of the week; this guy just follows the herd and isn’t going to pay attention as he eats.
- Bowl of oatmeal but he barely touches it – he eats a networking breakfast every day of the week, but the oatmeal is really just a prop as he’s really engaged with what the other person has to say.
- Eggs Benedict – VC partner who just had a monster exit and is in the mood to celebrate.
- Veggie omelet with egg beaters one yolk no onions double tomatoes – overly-detailed nit-picking VC who will pick apart an entrepreneur’s pitch and board deck without seeing the big picture; tough guy to deal with on the board.
- “Breakfast” brought into the office – overscheduled VC who doesn’t even have time to meet in a diner; on dozen+ boards and doesn’t have time for his portfolio companies.
- Yogurt fruit parfait – Venture guy who doesn’t care what others think about him; leads new off-the-beaten-path investments with conviction and without following the herd.
- Nothing – uber-networker who is already on his second breakfast meeting of the day; is a huge help to his portfolio companies with recruiting and BD intros for his portfolio companies.
- Just coffee – jittery VC who is on the fundraising trail struggling to close their next fund.
- Triple order of bacon and nothing else – signals “I am the king of my firm and I don’t give a sh*t.”
What else am I missing?