David Beisel’s Perspective on Digital Change
Seed Round Signaling Revisited: Myths, Truths, & Half-Lies
It’s been five years now since large VC ‘signaling’ entered the seed stage entrepreneur’s lexicon. Yet even today, whether or not to take a (relatively) small check in a seed round syndicate from a multi-hundred million or even billion dollar fund is still a decision which takes quite a bit of consideration and sometimes consternation. It seems as though it’s been talked about ad nauseum in the blogosphere, but we see first-hand as entrepreneurs we’re investing in at NextView Ventures work through building their seed round syndicates, it really is a tough issue.
And although the new conventional wisdom became that it’s best to avoid a larger firm’s seed investment dollars as it depresses the ability to raise a Series A, entrepreneurs (often wisely) did so anyway. Moreover, research firms like CBInsights have recently debunked this rule of thumb with rigorous analysis. Looking at a smaller dataset of our NextView portfolio companies, we too see a higher “graduation-rate” of Seed to A when there is a larger VC which participates in the seed round.
In my own anecdotal observation, the reasons that startups which include larger VCs in a seed round syndicate are successful raising a Series A are twofold:
- There isn’t such a thing as being half-pregnant; you either are or you aren’t. It’s human nature for it to be more difficult for a VC firm (as disciplined as they may be) to completely cut off an investment after one round of funding. Or, to flip it around, a VC firm is more likely to invest more dollars if they’re already investors in the company than if they weren’t. There’s a reason that they wanted to become investors in the first place.
- There is a high correlation between the best (i.e. more likely to succeed) entrepreneurs having the opportunity to take a larger VC’s capital at the seed round. The best entrepreneurs can attract the widest options for their initial round of funding, including larger VCs. So there is an element of (positive) selection bias in the larger VC syndicate cohort companies.
Does that mean that entrepreneurs should ignore signaling risk and seek to include larger VCs in their initial rounds of capital if they can? Follow the larger VCs argument that it’s best to have accesses to capital with “deeper pockets” than exclusively seed-stage VCs? Not necessarily:
- Not all large VC seed round checks are the same. Many in the blogosphere including my partner Rob have drawn the distinction between large VCs making low-velocity high-conviction investments and large VCs writing machine-gun velocity option bets. So prevalent is this understanding that this large VC spray approach has waned (though not disappeared) in the past couple years.
- Not all startups are the same. “Seed stage” startups raising $1M-$2M rounds of pre-Series A capital come in very different flavors. Some are pre-product, while all the way on the other side of the spectrum, some have meaningful revenue and clear up-and-to-the-right metrics. The risk associated with raising a subsequent round of capital are different for different profile startups.
“Ability” to raise a subsequent Series A is only half the story. The other is valuation of the next round of Series A financing.
A larger VC in a seed round will naturally depress the price of the next round of capital because it inhibits (but not prohibits) the ability for an entrepreneur to run a truly competitive process. As soon as the “insider” VC realizes that the company has crossed the threshold for a Series A financing, s/he’ll understandably push for the round to happen sooner rather than later and lead it. External VCs realize this fact and want to avoid becoming a stalking horse for an inside deal. That’s not to say that an entrepreneur isn’t able to successfully able to bring in an outsider firm and allow them to get to their proverbial 20% ownership requirement while still holding the insider firm at bay… but it’s just that much more challenging … especially when trying to maximize valuation in the process. Again, we’ve seen all of these multiple scenarios play out within our own NextView portfolio.
So while there are clear benefits of diminished financing risk to including a larger VC in a seed round syndicate, it comes at a direct trade-off in later upside valuation.
What, then, are the takeaways for seed-stage entrepreneurs considering taking a larger VC in their round:
- Heavily bias towards a situation where the large VC partner has high conviction and only does a small number of this type of seed investment per year because it takes up a partner time slot.
- Determine given the context whether the goal is to optimize around success-rate of Series A financing -or- valuation price of Series A financing. Often, the more “raw” the startup when Seed funding occurs, the more risk there is in product-market fit, the better it is to take a larger firm’s capital. Better to be safe than sorry. Conversely, if the company already has established some early success metrics and is on a trajectory to look Series A-ready within 18 months, then eschewing a larger firm for now so that a competitive-run process then is likely a better route.
Of course, both of the recommendations aren’t to be taken blindly. Other factors include the value-add involvement of a larger VC taking a Board seat or active role, unique “value-add” portfolio services of the larger “platform” shops, valued prior working relationships, etc.
In another post, I’ll re-examine the benefits of including an exclusively-focused seed fund in a seed round even when there is already a larger VC firm involved.