State of Venture Capital: Founders, Be Careful What You Ask for When You Raise Capital

June 9th, 2015 / Comments Off on State of Venture Capital: Founders, Be Careful What You Ask for When You Raise Capital

I’ve been angel investing since 1997, but I became more serious about in 2010 when I founded the Webb Investment Network. In the last five years, I’ve seen the industry evolve quite a bit and in some ways I wouldn’t have imagined.

The most interesting changes are related to three trends.

1. It’s easier and cheaper to start a company than ever before. With the advent of cloud computing, open-source software, and app stores, the barrier to entry is not that high. Anyone can get started.

2. There’s more money coming into the seed market than ever before — some reports cite a 4x increase in the last five years. There are also more seed funds, fueled by more angels and founders who have had meaningful exits and choose to invest their money in other startups. Money is coming from all corners: hedge funds, celebrities, angel investors, and even from crowdfunding. 

3. Some successful, growth-stage companies are choosing to stay private, rather than turn to the public markets.   

This sea change has led to a bit of chaos in terms of typical “sandboxes.” As firms traditionally focused on the public market turn to mega growth-stage rounds to secure access to the hottest companies pre-IPO, traditional early-stage firms are also moving down-market and giving promising seed companies much more money than they would have in the past. We are frequently seeing $10-20MM valuations for a pre-product company with great founders or idea. With numbers like that, a seed round is now more like a traditional Series A. 

This development has ramifications for the rest of the funding trajectory. With big money and a big valuation come big expectations. The bar for what these companies must achieve in their early days is higher than ever. VCs expect companies with large seed investments to have serious traction by the time they get to a Series A — they expect them to be more where we would have historically expected companies to be at their Series B. For companies that raised money, but are not yet a super hit, getting the next round of money becomes very difficult.

The Series A Crunch has led to an increase in extension rounds. We used to say, “Be careful of bridge rounds, they are a bridge to nowhere,” but now some companies have no choice and we are frequently seeing seed extensions. Sometimes we see two or more rounds of this before a company gets to a Series A.

Venture capital has thus become bi-modal: either you are a hot deal that can command a very high valuation, or you are a company that hasn’t yet gotten the flywheel spinning and funding is hard to get.

None of this necessarily changes the success rates of startups. The probability of success from a seed round is still low (and the potential return is still high). The later you fund, the less risky the investment becomes and the more probable success becomes. However, even in later rounds, companies are still not fully baked. Even being valued at a billion dollars doesn’t necessarily mean long-term success, although these companies certainly will have the funding needed to accelerate growth.

Despite the change in the funding trajectory, make no mistakes — picking the winners and predicting the break-outs is still very hard to do. Perhaps it’s even harder. When the hottest deals are oversubscribed and prices are frothy in the hopes of funding a unicorn, and then when the metrics don’t catch up to the hype, the fall is harder and more epic than ever. CEOs are fired, investors are wiped out, and the fairytale becomes a real nightmare.

What does this mean for those going out to raise their first round of financing? Often startups don’t need that much money, so I advise entrepreneurs to consistently check in with their gut before taking cash. Be sure of how much money you need and don’t take more than you need.  

Questions to ask yourself include: 

  • How much do you need, how much do you want to raise, and at what price?
  • How much dilution do you want to give up?

The people across the table won’t say that the amount they’re offering is too much, and picking a partner who is in it for the long haul is more important than ever. It’s easy to get caught up in hype, but it’s important to remain humble and centered on building a business that can be sustained and that can last far enough into the future to change it. Think long.

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