Why is seed funding down when VC funding is way up?

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As a mentor, I work exclusively with early stage companies. When these companies go out for funding they are looking at friends and family, angels and angel groups or VCs that fund seed rounds.

Unfortunately as the Wired article ‘Blitzscaling’ Is Choking Innovation—and Wasting Money, sub-titledVCs are making bigger bets on fewer startups. It’s this unconsidered, money-slinging strategy that led to Uber’s and Lyft’s dud IPOs seed funding is down even while total VC funding is way up.

VC investments last year set an all-time record in the US of $132 billion. This sounds like great news for founders. But deal size has been steadily growing. Do the math, bigger deal sizes equates to fewer deals. As the author, Leonard Sherman asks: why has the number of seed funding rounds—the entry point for most entrepreneurial journeys—declined so sharply over the past five years, despite the fact that the cost of launching new ventures has never been lower?

In 2000 Leonard Sherman’s company needed only one institutional funding round of $15 million to launch his company. But here’s the difference between almost 20 years ago and today. Then virtually all that capital was consumed by the need to buy and maintain servers and storage devices, to write highly customized code for every business process, and to build market awareness through expensive, inefficient mass marketing channels.  Launching that same venture today would probably cost 90 percent less, thanks to modern enabling technologies: open source computing, rapid wireframe and product prototyping tools, contract manufacturing, fulfillment-as-a-service, web-store design, cost-effective social media customer targeting, and cloud-based services like Amazon’s AWS, Google’s Cloud Platform and Microsoft’s Azure.

So that sounds like great news for founders, and it was for the 15 years of the new millennium, as the number of angel and seed deal rose steadily. But:

over the past five years, entry-round investments have declined by more than 40 percent, while average deal sizes have risen. The primary reason is that early-stage VC funds generally have found it more lucrative to place fewer, bigger bets, rather than spreading investments more thinly. This practice delivers a big win when the bets pay off—particularly for seed VCs with higher ownership stakes. But now, more than ever, entrepreneurs find themselves folding for lack of seed funding.

This is the driving reason behind the decline in seed stage deals. That, as well as new sources of capital making huge bets, like Softbank’s Vision Fund’s $300 million investment in dog walking service Wag. But that’s peanuts compared to Softbank’s $10 billion funding for co-working office-space startup WeWork.  (However, WeWork’s losses are accelerating even faster than its revenue growth.)

This flood of late stage capital into relatively few companies leaves less money for riskier bets on startups. But having vast sums of capital does not guarantee business success. Today’s VCs would do well to look back to the successes of companies based on the strength of their technology and business models, not venture capital: the total VC capital raised by Amazon ($108 million), Google ($36 million), and Salesforce ($64 million) prior to their IPOs and subsequent value creation would barely register as a single supergiant round in today’s blitzscale funding environment.

The poor IPO performance of companies like Uber and Lyft, which both raised billions of dollars in VC financing, might help turn the tide against late stage mega-financing and perhaps more VCs will look to spreading their risk by investing in more seed stage companies, which can ultimately provide enormous returns as have Amazon, Google and Salesforce. Until then founders would do well to look at various alternatives to VC funding such as angels, angel groups, crowdfunding, convertible debt, SAFEs, strategic investors, grants like SBIR, incubators, royalty-based funding, and such novel, nascent funding sources as digital tokens and the JOBs act.

For a bit more detail on alternatives to VC funding take a look at the attached presentation I gave last night to a sub-group of the MIT Post-Doctoral Association on different ways to raise capital: Financing a Startup

Dilution: a 4-letter word for founders

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Like it or not, virtually all tech startup founders will face dilution, the erosion of the percentage ownership in the venture they founded due to having to sell off their equity to finance the venture.

The article Dilution: The good, the bad and the ugly by Bernard Moon is a recommended tutorial for founders before you begin the process of raising capital. Keep in mind the source, Bernard is a VC at SparkLabs Group. If you want the VC perspective on dilution for founders their experience of investing in more than 230 companies is well worth reviewing.

For those of you not needing Bernard’s math through possible seed rounds to how future rounds dilute your ownership, I’m going to just highlight some words of wisdom to keep in mind regarding valuation, perhaps the most contentious issue both for founders   and investors (it’s a zero-sum game). While Bernard does a good job of defining a Good Series B (excellent execution) versus a Bad Series B (poor execution or mismanagement; product too early or too late; longer than projected sales cycles or market forces outside the founders’ control) he avoids the nightmare scenario I’ve posted about previously: asKryptonite for founders – the down round. 

As noted previously, trying to predict revenues for a startup is exceedingly difficult. But you should know your operating costs and be able to predict them with a reasonable degree of certainty, especially fixed versus variable costs. Typically founders are too optimistic and underestimate both the time and funding to ship their first product and to generate customer revenues. No matter how much contingency you build into your numbers things will just cost more and take longer – that’s just the way it is.

But there are two things you need to focus on in your projections:

  1. How much capital do you need to last 12 – 18 months?
  2. Will this amount enable you to hit the milestones needed to raise your next round?

Fund raising is extremely resource-intensive for the CEO pitching innumerable investors, so I’d err on the side of raising enough capital for 18 months, even if that results in somewhat more dilution. If you fall short of your projections, be prepared to answer these investor questions:

  1. Did you overestimate your sales’ ability?
  2. Was your capital efficiency significantly lower than projected?
  3. Is there really a large (and growing) market for your product?
  4. What mistakes did you make? What should you have done differently?

Investors are looking for founders who learn from their mistakes and use that learning to course correct. Humility is in store if your falling short is due to mismanagement or failure to execute.

There are two ways to gain a reasonable valuation and avoid undue dilution:

  1. Execute on your plan – hitting major milestones
  2. Competition generates value – have at least two term sheets

Here’s a great quote from Bernard:

Your goal is to create investor interest from multiple firms while generating the least amount of friction to quickly close your round. It might be a difficult balance between knowing your value but respecting what investors are looking for, but don’t kill your fundraising efforts by not being flexible on valuation. Remember, it’s not all about the money and your ownership percentage. If one of our portfolio companies had a term sheet for a $10 million pre-money valuation from an unknown family office or an $8 million pre-money valuation from a top-tier venture capital firm, we would tell them to take the lesser valuation, even if it’s a smaller gain on our books.

Having raised multiple rounds for VC-backed companies, I can attest the wisdom of Bernard’s words. But there are a few things I would add. First of all, know whether your first investor has deep pockets and is prepared to participate on future rounds if you hit your milestones. Angels and strategic investors may not. It’s not a good signal for new investors if institutional investors don’t participate in future rounds – you better have a very good reason. There are other ways to raise money, such as venture lending and warrants, that may work for you depending on if you have a capital intensive business with hard assets. Even if you don’t hire a full-time CFO I highly recommend you have the help of an experienced CFO to help you prepare your financials (and determine concomitant dilution!) for various scenarios. The return on investment in paying a savvy CFO can be 1,000X or more. When playing with VCs you want to try to level the playing field as much as possible. Your Board of Directors should have experience raising venture capital and be able to provide not just contacts, but valuable perspective and insight on the fund-raising process.

Finally, be careful to manage the expectations of the senior team and anyone else with options or restricted stock. They are all going to expect a step-up in your next round of financing – in fact they are counting on it to get them on the road to building their personal wealth. Much  better to under-promise and over-deliver.

What’s the difference between SAFE and a convertible note?

SafeFor the past 20 years or more I’ve seen convertible notes as the best instrument for founders taking on a seed investment. Selling equity when you are a very early stage startup is very difficult for one simple reason: it’s impossible to set a valuation that is fair for both the entrepreneur and the investor. It’s a zero sum game: investors want more equity for their dollars and founders want more dollars for their equity. And there is only 100% equity to incentivize not only founders but future executives and staff. Trying to predict the future value of an early stage company can become an exercise in frustration.

So you might say, why not just get a loan? But banks and any other financial institutions want one important thing for a loan: collateral. Collateral is something of value – your house, your car – that they can repossess if you default on your loan. But banks aren’t about to repossess your code or your prototype – neither has value to them. Thus comes the convertible note, which is a type of debt that makes sense for both the early stage investor. i.e. angels, and the founder, and it has been the standard for years.

There are two key features to a convertible note, the discount and the valuation cap. The discount rewards early investors for taking on larger risks than later investors by offering them the right to obtain shares at a cheaper price than that paid by Series A investors once the Series A round closes. So if Series A investors pay $1.00 per share,  holders of convertible notes – and a startup may have several – get to convert their loan amount at typically a 20% discount, thus enabling them to buy shares for not $1.00 per share but 80 cents. The market tends to set the typical discount rate, thus eliminating a lot of negotiation and frustration between founder and investor.

The valuation cap sets the maximum value of a company when the Series A closes. Again that provides a benefit to the holders of the convertible note as the know in advance the minimum number of shares their loan will convert to. In other words they know the worst case scenario in advance. Setting the cap, however, can be more contentious than the discount rate. Just like ordinary loans, convertible debt contain an issuance date, an interest rate, and a maturity date. But repayment is made with equity – or not made at all if the company goes belly up before raising a Series A.  The investor has the option of choosing between the lower of either the discount or the cap conversion. The conversion price that’s the lower of the two methods results in more shares issued to the early investor upon conversion.

So what the heck is SAFE and why was it invented? SAFE is an acronym that stands for “simple agreement for future equity” and was created by the Silicon Valley
accelerator Y Combinator as a new financial instrument to simplify seed investment. Here are the key variables and how SAFE differs from convertible notes which I have taken from Melissa Hollis’s article Seed Investment: Comparing SAFE and Convertible Notes with changes and annotations based on my experience dealing with convertible notes. 

1. SAFE Offers Simplicity by Minimizing Terms

One problem with convertible notes is that they have a lot of moving parts. And every lawyer likes to write his own version – similar to NDAs – there is no industry standard convertible note. SAFE simplifies things by eliminating two moving parts: the interest rate and the maturity date (these are hangover variables from typical bank loans).

2. Different Points of Conversion to Equity

There are two different points when it comes to triggering conversion of the loan to equity.  A convertible note can allow for the conversion into the current round of stock or a future financing event, a SAFE only allows for a conversion into the next round of financing. So again, SAFE is simpler.

SAFE converts only when you raise any amount of equity investment unlike convertible notes which trigger only when a “qualifying transaction takes place” (more than a minimum amount dictated on the agreement) or when both parties agree on the conversion.

Finally raising common stock doesn’t trigger a conversion for a SAFE investor (keep in mind that VCs always invest in preferred stock, with its preferences over common stock).

3. The Valuation Cap

Typically convertible notes come with a valuation cap and SAFE may not. But as above, this is the sticky negotiating term with either convertible notes or SAFE. However, by foregoing a valuation cap  you could be diluting your shares and your future investors’ shares when you go to raise your Series A.

4. Early exits

What happens if the company is sold before raising a Series A? Both convertible note and SAFE investors give the investor a return. SAFE gives the investor the choice of a 1x payout or conversion into equity at the cap amount to participate in the buyout. Obviously who the acquiring company is and the state of their stock will decide which route the investor takes. Convertible notes typically have a 2x payout.  Here’s a case where the convertible note is actually simpler than a SAFE, but may make it less attractive to the investor.

5. SAFEs have no interest rate

SAFES are not debt, they are defined as a warrant. A warrant gives the investor the right, but not the obligation, to buy shares at a certain price before expiration. Convertible notes are loans, and as such carry an interest rate, which in my experience generally runs about 8%. Again SAFE has fewer moving parts, meaning fewer elements have to be negotiated, providing a simpler instrument with an advantage for the founder.

6. Maturity date

If you have been paying attention to this point you know that SAFE is not a debt instrument so it doesn’t have a maturity date. Convertible notes do. So what happens when you reach the maturity date of a convertible note? You either have to pay back the principle plus interest – just like a normal loan or you convert the debt into equity. If you are running out of money you certainly can’t afford to pay back your note! So SAFE is a lot safer in this regard. I’ve yet to hear of a company that paid back its convertible note!

7. Administration Fees and Services

Typically neither a SAFE nor a convertible note comes with any admin fees or need for professional services, e.g. legal or accounting, although theoretically a SAFE could trigger the need for a fair (409a) valuation to formalize your company’s common stock value.

The bottomline is that SAFE is simpler, with fewer moving parts and thus less chance of getting into a fractious negotiation with your investor. The best way to determine which instrument is best for you, however, is to work through the decision trees for both options and create cap tables on a Series A for both options. Like any decision, scenario planning is usually the most effective means of decision making. That means translating legalese into practical business consequences. Get used to it, that skill will often be needed by any startup that grows successfully.

Being neither a lawyer nor an accountant I can’t give you a qualified opinion on which is best for the founder. Offhand one would think that an instrument created by an investing company, i.e. Y-Combinator would favor the investor. But I believe the reason that Y-Combinator created the SAFE is that at the extraordinarily high volume of startups it invests in the efficiencies of simplicity of SAFE outweigh the small advantages to the founder.

Pitch tips from a leading VC

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A recent megatrend that has greatly benefited founders has been the willingness of leading venture capitalists to share their knowledge with founders. Brad Feld of Foundry Group, Fred Wilson of Union Square Ventures, and Guy Kawasaki, Garage Ventures have lead the way. (What do they have in common? They’ve all met me!). Now they are joined by Scott Kupor, the managing partner of Andreessen Horowitz (a16z), whose portfolio includes multi-billion unicorns like Lyft, Slack, Pinterest and Airbnb.

I became aware of Scott Kupor’s book via Carmine Gallo’s Inc. article Five Essential Pitch Tips According To A Legendary Investor Behind Lyft, Slack, And Airbnb. Carmine is the best writer on how to do a presentation that I know of. You can search my blog for mentions of his books, which are all highly recommended. Start with The Presentation Secrets of Steve Jobs, a classic. Carmine has been writing for Inc. for some time and I make sure to never miss an article of his.

Despite all the books and articles I’ve read about how to do a VC pitch I learned a lot from Carmine’s interview with Scott Kupor. You can watch the video, which is embedded in Carmine Gallo’s article. Here are the five tips from Scott Kupor with my annotations.

1. Market Size

It’s interesting that Scott puts market size first. Of the three main determinants of a VC investment, team is usually put first, followed by either market opportunity or product/secret sauce. But I find that founders have the most trouble with market size. Either they make the beginner’s mistake of taking some arbitrary, and far too large, percentage of a large market (“If we just get 15% of the entire $92 billion shoe market …”), or they muddle through some proxies for their market. Read my post Sizing your market opportunity for a more sophisticated approach.  But Scott has a unique approach:

It’s an entrepreneur’s job to be a “patient and inspiring teacher.” In other words, don’t assume that your audience—even one made of up VCs—understands your market or its potential size.

This goes back to the need to tell a story rather than just recite dry statistics or show complex graphs.

2. Team

As I tell founders, there are two questions a VC has to answer in the positive to fund you: Is this a billion dollar idea? and Is this the right team to execute it? Too often I find entrepreneurs, especially students and recent grads, focus on their academic credentials – their list of degrees from prestigious universities – rather than one thing: what expertise and experience does their team possess that in Kupor’s words “… make this team – hands down – the best team to approach this idea?”

3. Product

Here’s an interesting point from Scott Kupor: “investors love to learn and are fascinated by how something works.” He uses the term “idea maze” for the twisting, turning process that turns an idea into a real world product. But that’s understanding your idea maze is not enough! Investors want to know why your product is 10X better than the existing alternatives along the typical dimensions: faster, better, cheaper, easier to use. Peter Drucker is responsible for this, as he stated that a new product must be 10x better to displace an incumbent product. And note, VCs will tell you they need to make 10X their investment to have a successful fund. Show them enough 10Xs and you may just get funded! 10X would make a great name for a company if it weren’t already taken.

4. Go-to-Market

Like market opportunity this part of the pitch tends to be a weak spot for the founders I mentor, perhaps because virtually all of them are first timers. Those who have previously founded a startup or worked an an early stage company realize how important the customer acquisition part of their pitch is. Kupor says this is often the most underdeveloped section of the pitch, especially for early-stage companies. You need to present a combination of your business model and marketing plan that demonstrates you know how you will acquire customers at a cost that is just a small fraction of their lifetime value. In other words, profitably. You don’t need complex spreadsheet models forecasting 5 years of financials. What you do need are sound assumptions derived from a lot of first hand interaction with customers.

5. Planning

Planning boils down to one thing:  what milestones will you reach with the money you are raising in this round? A corollary of this is, how long with this round last? A range of 12 to 18 months is typical. Fund raising is resource intensive for founders, so you don’t want to have to raise another round too soon. On the other hand, if you are going to grow at the dizzying rate that VCs expect, you are going to need more funding in less than two years.

I teach founders that the job of their product is to make its users successful and satisfied. And when selling to the enterprise find a product champion who will see that by driving adoption of your product for their firm they will be rewarded. If you can make your customers successful, your venture will be successful.

Scott Kupor makes a similar point about VCs. They want to look like heroes to their customers: their limited partners whose money they are investing.  So, consider VCs as your customers and thus it’s your mandate to help them succeed by making your company a success.

Why shouldn’t you raise money now?

NowLater-compressed

I’ve outlined numerous reasons to raise money now – the pros, as it were. But raising capital is a two-sided coin, usually many of them, so here are the cons.

Distraction

The name of the game in startups is focus. Raising capital is a very difficult and intense process that will distract the CEO/founders from the venture’s main business: building product and acquiring customers. In fact, I can’t think of much else that is more distracting other than a major rift between founders. It can easily take six months from the time you start your capital raise to the time your funds are wire transferred into your bank account. That’s a lifetime in a startup.

Resource limits

Draining limited resources – namely the CEO/founder’s time – is perhaps the biggest reason to avoid raising capital, especially from venture capitalists, who can drag out the process unless you can create a strong sense of urgency, which probably has to be a very real threat they will lose a deal they really want. CEOs in startups are completely different than CEOs in mature companies, as CEOs are also individual contributors, either in sales, business development, product development, customer support or all of the above.

Dilution

When I was raising capital way back in the last century the rule of thumb was that VCs would take about 35% to 40% of your equity in the Series A round, leaving the company with 60% to 65%. Today I’m hearing that it’s more likely 50%. I only have a few data points on this, so check with your friends in the founder ecosystem. VC’s also insist on the founders setting aside roughly 20% for future hires – note well that the company takes this dilution, not the VCs! So the founders now are left with about 40% to 45% of the company they started – a minority interest! There are two good ways to avoid dilution: one, finance your company with customer revenue, grants, and friends and family money; the second is to build substantial value before raising money: large numbers of customers, very rapid growth in customer base, and running the company on customer revenue and perhaps friends and family money. The longer you wait to raise capital the less equity you have to sell to acquire the same amount of funding. That’s why it’s not now, but perhaps later.

The battle over equity allocation

Here’s another rule of thumb, mine: the earlier the stage of the company the more difficult it is to allocate equity fairly. For example, let’s say you haven’t yet built your product. How do you measure the contribution of the tech team? You have to bet something on the future value of their contributions. Similarly how can you evaluate the contribution of sales, marketing or business development team members when you are pre first customer ship or even pre-revenue! Again waiting until you hit some major milestones like first paying customer or even breakeven will enable you to better evaluate the contribution and thus the equity allocation of each team member. See Chapter Six: Reward Dilemmas: Equity Splits and Cash Compensation in The Founder’s Dilemma by Noam Wasserman.

Giving up control

With a Series A round your investor will most certainly take a Board seat. If you syndicate your round you might end up with two VCs on your Board. And if you have given up 50% of your equity on the first round the second round will put the VCs firmly in the driver’s seat, if they aren’t already. As CEO are you prepared to report to a Board of Directors? Are you certain your investor is as much aligned with your interests as possible? Giving up control is one of the major reasons I hear from founders for not raising capital, now.

Constant pressure for hyper-growth

Once you accept VC money you have bought a ticket on a rocket ship which must reach escape velocity or fall back to earth in a ball of fire. The pressure to grow at virtually all costs will be unrelenting. If you thrive under this type of pressure that’s good. Otherwise you might want to think of another way to finance your venture.

To sum up, the key word in both this and the previous post on reasons to raise capital now is now. You and your team need to establish measurable milestones for at least the first 12 months of the company’s life. Then you need to decide what will be the triggering event to start to raise money. Absolutely the best time is when investors are calling you. That’s why, while you are building your product and your company, you also need to create buzz. Buzz will help generate incoming contacts by job candidates, prospective partners, and it is hoped, investors.

Finally if you decide the time is now, take a look at my post Are you investor ready?

 

 

Why raise money now?

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We got into this discussion at a recent MIT mentoring session. So I thought it would be helpful  to list some of the ways it is worth raising money, primarily from VCs.

Validation: With all four of my venture-backed startups I found that prospective partners, customers and even vendors saw us as more credible after raising a 7-figure Series A. Round. This is also true of job candidates as Tim Chen, founder of Nerdwallet says in a Forbes  article:

What’s a good reason to raise money? Tim says the problem was that even though they didn’t need the money, great talent wants social validation. They want to know who your investors are. So, they raised a big round.

Timing: I was taught by a VC that the best time to raise money is when you don’t need it (but will at some point in the future). By raising money when you don’t need it you have much more leverage with investors. You will reduce the stress and strain of raising money when you do need it. Believe me, investors can smell desperation!

Time: without pressure of needing more  capital you can take your time building  your pitch deck, and very importantly, practicing your pitch.  You also have more time to find prospective investors who are a good match for your venture.

Flexibility: Though you need to outline a “use of proceeds” in your pitch to investors, since you don’t need the money immediately you will have the option of changing how you spend (invest) that money in the future.

Competition: Competition amongst VCs does two important things for founders: one it generates FOMO – Fear of Missing Out – driving a sense of urgency; and two, competition drives valuation. Since you aren’t in immediate need of capital you will have the time to to perform proper due diligence on your investors and to garner more than one term sheet.

More resources: with more capital in hand you can hire more staff, spend more on customer acquisition, and make other important investments in  your venture.

Creating value: the longer you wait to raise money the higher your valuation should be, which translates into getting more capital for the same amount of  equity – leverage. And you are focused on these two things: your customers and creating value in your venture, right?

Access to investor’s value: investors don’t just provide capital. The best can help you recruit for your management team; provide good advice, feedback and guidance on your strategy; and provide helpful contacts of all sorts.  Value-added is one way VCs compete for the best deals.

Of course, there are downsides to raising venture capital. Food for a following blog post.

 

Some less than usual VC questions you may need to answer

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No doubt that most readers of this blog, if not this blog post, have seen at least one list of the important elements you need to communicate to an investor. But Jeff Schumacher, founder of BDG Digital Ventures, has a few that I don’t often see in pitch decks in his Entrepreneur.com article How to Become Investable in 13 Steps sub-titled If you want investors to take you seriously, you need to know the answers to these questions. You don’t necessarily need to include these in your deck but be prepared to respond to each and every one.

3. Why now?

Too many founders just assume that now is the right time for their venture because now is when they started up. There are two precursors for a timely startup: the availability of enabling infrastructure at low cost, like Amazon’s AWS, and market readiness, for example the market doesn’t seem quite ready for crypto currency in my estimation.

4. Corporate alignment

What Jeff calls corporate alignment I call partnerships or M & A. How can being aligned with a large company benefit the startup? After Course Technology was acquired by Thomson we were given access to their Canadian field sales force which enabled our Canadian sales at much lower cost to us than building our own Canadian salesforce would have cost. You do have to be careful about how aligning with a corporate partner will look to other players in the market; it may drive away other prospective partners if you get in bed with one dominant corporation.

11. Ecosystem

I recommend to my mentees that they diagram the ecosystem for their product: prospective customers, competitors, vendors, investors, analysts and other stakeholders. This is especially necessary in the case of startups that aim to become platforms. What elements of the ecosystem will join your platform and why?

13. Road map

As founders you need to plan where you want to be in the next 12 months, the next 18 months and the next three years (beyond that is in the realm of fantasy, not planning). You also need to know what resources you will require on your roadmap and how you will acquire them (raising capital, customer revenue, debt, etc.) Keep in mind the revenues tend to lag expenditures, often by weeks if not months.

As I’ve said before, I applaud the efforts of VCs to educate founders through their blogs, books, and presentations at conference. What was an opaque business to us when we started our first company in 1989 has become much more transparent, with the help of sites like TechCrunch and Pitchfork as well as VCs like Jeff Schumacher.