Tightening the Series A funnel

These are the best of times to get a company off the ground. Seed capital is available from more sources than ever, including accelerators, pre-seed funds, crowdfund sites, and friends and family, all before an institutional seed fund takes notice.

Yet seed deals are sliding in the United States and the Series A funnel remains tight for many budding companies looking for a next round.

“The whole way that you form your company, the way that you raise money, the way that you exit is so unbelievably different now than it was five years ago,” notes Bullpen Capital General Partner Paul Martino.

The question is what happens after the first $1 million. “It’s like a meteorite hit over the last couple of years,” Martino said. “We’re just in a different world.”

Paul Martino, general partner, Bullpen Capital. Photo courtesy of the firm.

That world is one where the Series A crunch continues to narrow the path to new money. Follow-on funding rates have tumbled in the past 18 months, he said.

This is because competition for investors has grown, and bigger funds mean bigger rounds and more demanding milestones. It is hard to know how it all ends.

For Martino, paying attention to the raw company formation numbers each quarter is of special importance. It is not just the valuations of the rounds, but the volume of companies entering the system that is telling, and which has led to big changes in the Bullpen model.

“That matters a lot to our model working,” he said.

VCJ recently discussed company formation, the Series A crunch and Bullpen’s investing model with Martino. An edited transcript of the conversation follows.

Q: Seed company deals probably reached a peak in late 2014 or early 2015 and have been falling since. What do you see happening in the market?

A: The number of deals always goes down before the prices go down. We’re now in the spot where the prices are going down. It’s pretty telling. We think the number of seeded companies now vs. three years ago is almost half. The pace is noticeably different.

We think the peak was somewhere between 1,400 to 1,500 a year that got institutional seed of some kind. Now we think it is more like 800. So that’s a pretty big drop over the last two years, where we’ve seen the correction.

Q: Do you expect the numbers of seed deals to rebound?

A: I think those 1,400 and 1,500 were never sustainable numbers and they were the outliers. The intrinsic number is somewhere in the range of 900 to 1,000, and now maybe we are a little bit under it.

Q: With Series A deal volume 50 percent to 60 percent of seed deal volume, would you argue the Series A crunch never ended?

A: It not only never ended, it accelerated. The Series A crunch is deep and wider than we anticipated when we started the fund.

When we started the fund, it was a very mathematical assignment. We were literally taking a look at valuations and prices. And we made specific predictions how deep it would be and what it would look like.

But since the A funds got so big, which is a piece of the prediction nobody could have guessed, the depth of the crunch got much deeper.

Martino Venture Alpha
Paul Martino, speaking at VCJ’s Venture Alpha West in Half Moon Bay, California, in 2013. Photo by Oscar Urizar, Red Eye Collection, for VCJ.

Q: How can you quantify this?

A: Here’s a statistic for that. Go back to 2011. If you were a seeded company, your odds for raising Series A were about one in three. If you were a seeded company from a Floodgate or a True Ventures or a First Round Capital, your odds were like 60 percent.

Those numbers now are very different. The seed follow-on rates industry-wide are in the low teens, maybe only as high as 8 to 10 percent. If the industry average follow-on rate is 12 percent or 13 percent vs. 33 percent a couple years ago, that means that Series A crunch is way deeper than we thought it would be when we started the fund.

Q: The way emerging companies raise money seems very different than five years ago. How has seed funding changed?

A: I’ll give you one example. A lot of the CEOs who are second and third timers, they actually don’t even view seed financing as a discreet process. It’s like a continuous process. I’m going to take $500 grand right now. I’m going to hit a milestone. I’m going to go take another million bucks. I’m going to hit another milestone. I’m going to take another million bucks.

The next thing you know you’ve three stacked notes at three different prices. You cobbled together 2-and-a-half million bucks over a year and a half. That did not exist five years ago. Now you have this very efficient capital flow among the angels, among the early-stage investors, etc.

Q; Is this a good thing?

A: When they do it right, they preserve a lot of ownership. Each one of those raises was at a higher price because they proved more. Then by the time they are ready to do their Series A, they might be on their fourth, or fifth, or sixth close.

Still, everyone calls it a Series A and that’s one of my pet peeves. It’s the sixth institutional close in your company, but we’re going to call it a Series A. I think that’s because a lot of the bigger funds like to call their round of investment the Series A, even though it is the sixth round of financing for the company.

Q: So would you suggest Series A and follow-on investors need to think differently about their investments?

A: The fact that CEOs have more ways to play the game is good for the ecosystem. It means, though, that a lot of the later-stage investors need to modify their game.

And that’s where I think some really unusual and bad behavior has shown up. You go back five years ago and you want to raise a Series A for a SaaS company. If you’re doing $1 million in revenue, people are pretty damn excited to meet with you. That same company five years later goes to the same set of venture funds and they say, ‘Come back when you are doing $5 million.’

It’s not because the world has changed in terms of how much traction the company has and how interesting it is. That fund five years ago was a $250 million fund. Now it’s a $750 million fund, and that venture person has to jam $8 million or $12 million in instead of putting $3 million into a $5 million round.

That to me is one of the very negative things that has happened in this ecosystem over the last five years.

Q: Does that mean fund sizes are placing a restraint on the early stage ecosystem?

A: As much as there is all this very great stuff at the early front end of the company formation, the late-stage funnel has gotten tighter and tighter. The milestones have gotten higher and higher because of the perversity of the funds being too big for the opportunities in front of them.

We’ll frequently get introduced to a company where they say to us, ‘I brought this up to (a) partnership and they said we can do this in nine months when you’re a couple million. Can you babysit it?’

They are basically saying, ‘Martino and Bullpen, go help the CEO for nine months and I don’t mind paying three times as much a year from now. But only when that happens can I put the money in.’

Something seems very off about that. When your fund is $750 million and the company only needs $3 million, you need a company like Bullpen to babysit it for those nine to 12 months so you can jam $12 million in it. I don’t think that is healthy.

Q: Would you argue there’s an unmet opportunity for a true Series A investor?

A: There is definitely a hole in the ecosystem for a small A product. If you want to look for white space here, go run a $200 million small A fund. You would do really well.

There is not a lot of that out there right now and there is a good need for that kind of products for entrepreneurs.

Q: How has the environment changed what you do?

A: It means a very funny thing happens to us. We’re investing in companies at a later stage than we ever thought would come to us for our money, companies that need more money than we thought to get to milestones at a level we never thought we would fund the risk for.

We started our fund investing in SaaS companies doing $25 grand a month that needed to get to a half million dollars. Now were investing at a million with companies that need to get to $4 million.

And so instead of the round being $1 million to $2 million, our round is more $3 million to $5 million. It also means the level to which company is de-risked by the time I see it is mind boggling to me.

Q: This is a big change for you.

A: I’ll give you some stats from fund I and II, In fund I, our average pre-money valuation was $9 million. That company on average was doing about half a million dollars in revenue.

In fund II, which was three years later, our average pre-money is $11 million for a company doing almost $2 million in revenue. A really big change.

For 20 percent more in pre money, we’re getting four times as much revenue.

Photo courtesy ©iStock/amenic181