In mid-February, Upfront Ventures investor and blogger Mark Suster took on one of venture’s most vexing questions: Why has seed investing tumbled?
His conclusion: A growing maturity of the seed business and a static level of A-round activity. He is right on both accounts. But there may be more behind this multi-year nosedive, according to series of VCJ interviews with investors.
Also contributing to this fall are splintering seed rounds, rising developer costs, the expanding role of accelerators, a renewed desire for stealth, small seed fund sizes and perhaps some deal caution. Tied together they are sending disruptive ripples through seed investing and into early-stage deal making that could alter funding decisions for years to come.
The tale of the modern seed market is a dramatic one. In the four years from 2012 to 2015, the number of seed and angel deals in the United States more than doubled to 5,716, as seed funds multiplied, only to mysteriously retreat over the next three years. From 2016 to 2018, they feel by about a third to 3,760, according to data from PitchBook and the National Venture Capital Association.
The rise was profound and produced an abundance of promising young companies during an ebullient period in venture. Many VCs saw an era of heightened innovation and a democratization of entrepreneurship.
In the years from 2012 to 2018, investors backed up their beliefs with capital, raising 1,098 funds of $100 million or less and a total of $27.4 billion. This capital became part of a $49 billion surge that went into angel and seed deals nationwide during the period, according to the data.
A stampede was on. Costs to start a company had collapsed due to commodity hardware, open source software and cloud computing. New ways to fund companies emerged using capped convertible notes, party rounds, crowdfunding sites such as Kickstarter, and a new generation of seed investors took hold, known as the super angels. Younger founders came along who didn’t have Stanford University graduates.
But the enthusiasm ebbed with the start of 2016.
Perhaps the principal reason for the seed decline is higher round sizes. The median deal size in seed quadrupled over the past decade and doubled in the past three years to $2 million last year, according to PitchBook and the NVCA.
Several reasons contributed to this, investors say. For one, Series A financings grew larger and more demanding, as an abundance of companies allowed Series A investors to be more choosy and require more of candidate companies.
What’s more, while seed financings became more numerous, Series A deals did not. Since 2015, Series A transactions have risen just 3 percent, creating a choke point for young companies.
As a result, “startups need to be more fully baked with greater traction before they can raise a Series A,” said Michael Kim, a managing partner at Cendana Capital. “That suggests a longer runway” and more backing from seed investors.
Also contributing to the larger seed rounds are rising costs for developers in places such as the San Francisco Bay Area. When large tech firms make lucrative offers for developers, startups have to compete with attractive offers of their own.
“We definitely see that,” Kim said. “Seed rounds are larger because it costs a lot more to hire developers.”
Greater round sizes also are the result of increased competition to get into the hot deals and higher ownership targets at top funds.
Meanwhile, as the funding runway has lengthened, financing structures have changed. In order to give companies more time to develop, smaller rounds take place and then become folded together into single round. So a startup might raise a $500,000 pre-seed round, then another $300,000 extension before doing a larger $2.5 million seed. Eventually they get rolled in together and announced.
“The seed funds need to stretch their capital across multiple rounds more than before,” said Brian Hirsch, a managing partner at Tribeca Venture Partners. “And many of those rounds are unannounced.”
Companies also may be choosing to stay in stealth during their early years more than in the recent past. Part of the reason is that publicity for smaller rounds, even a $1 million seed, is harder to drum up as round size has grown.
Another factor in the changing seed market comes from the supply side of the ecosystem. Seed funds grew in number, but the majority remained quite small. Of the 1,098 seed funds raised from 2012 to 2018, 79 percent are under $50 million, and many are well below.
What this suggests is that while resources to back companies look substantial, many of the new funds have limited bandwidth.
Investors estimate that less than 10 percent of seed funds in the United States are institutionally backed and likely to lead investments. Sub $25 million funds act a lot like angel funds, said Lindel Eakman, a partner at the Foundry Group. Four or five or them will invest together.
Also holding back the market is a change in traditional Series A-round venture investors. Many top firms stepped up with seed programs as the super angels emerged, but many of these efforts appear to have waned.
Portfolios grew unwieldy and signaling issues popped up when funding stopped. As a result, seed programs now appear more active at second- and third-tier firms, which use them to gain access to top deals before big-name firms step in for a Series A.
“There was a period when we saw a lot of large venture funds aggressively investing at seed and we’ve seen a marked decline over the past couple years,” Hirsch said.
Accelerators also may be playing a role by siphoning away some pre-seed funding traffic. The number of accelerators in the United States grew more than tenfold earlier this decade and some have increased class size.
Y Combinator, for instance, has a winter 2019 batch of 200 companies.
A final explanation for the shift in seed investing might be due to changes in seed fund decision-making. Seed portfolios have filled up in recent years and likely pushed more resources to company building rather than new deal sourcing. This would be particularly true for funds raised between 2014 and 2016, the peak years for seed fund creation.
Conjecture also has arisen that higher valuations and the difficult Series A threshold could have triggered some risk aversion. Outlaw, which announced a $2 million seed round in February, saw some of this in its financing.
“It wasn’t hard to get first meetings,” said Outlaw CEO and repeat entrepreneur Evan Schneyer, who talked to as many as 30 firms. Many conversations advanced to a second meeting.
Yet offers were slow to come, even though the company had a product in the market and two months of data on its adoption. Everyone seemed to be waiting for someone else to make the first move, he said. “It’s this grueling process.”
Only after Bowery Capital committed to lead the deal did the risk aversion ease. With the Bowery term sheet in hand, it was as if the company was a different company.
“They all want to get on board as you’re taking off,” Schneyer said. “Nobody wants to be the first.”
For Paul Martino, a general partner at Bullpen Capital, the changing market may suggest something else as well.
“I think we ran out of entrepreneurs,” Martino conjectured. “I think we hit peak entrepreneurship.”
He noted that he doesn’t see as many people knocking on his door, and, among the people he sees, there is a homogeneity to them.
“There is no doubt the number of companies peaked in 2014,” Martino said. “Until the next thing happens, I think we’ll continue to see a decline in company formation.”
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