In May 2011, I wrote the post: Investor Nomenclature and the Venture Spiral.
That post got a lot of attention because back then all the buzz was about “Super Angels.” The venture landscape was evolving and had reached a point where Super Angels were an important part of the ecosystem. Well, now in 2014, almost 3 years to the date, things have changed again. The funding landscape has shifted and is now even more confusing than ever.
On May 6-7, I'll be at Vator Splash Oakland judging the global startup competition, right after MC Hammer takes the stage in a Fireside Chat with Erik Moore, an early investor in Zappos. The 2-day event is not only a competition, but an educational forum for entrepreneurs and investors to learn how to build their companies and to understand the financing landscape. For entrepreneurs I'll be addressing and giving feedback too, here's my thoughts on how the venture landscape has changed.
The Super Angels are now Micro-VCs
Yes, almost everyone who was operating as a Super Angel, went on to raise a venture fund. Most of these funds are <$100M, with the majority of them being clustered around the $40M mark (that’s the point where the fund economics start to work in terms of management fee and ability to take a meaningful stake in portfolio companies).
In keeping with the thesis of the Venture Spiral, as the Super Angels matured into Micro-VCs, the style of investing changed because now the Micro-VCs had more dollars to put to work, and became sensitive to ownership. The party rounds, which were the range in late 2010 and early 2011, became less common and we started to see the smaller funds begin to lead rounds.
Significant tightening for follow on rounds
We heard about this in the press as the Series A crunch, but it wasn’t really a Series A crunch. Instead, it was more of a result of over-funding at the seed stage. There was simply too much money coming in to the seed stage, which increased the supply of companies at the seed stage. The Series A investors could therefore be a lot more picky. Even if they did the same number of deals as they did before, it felt like a crunch because of the increased supply of funded seed stage companies.
Massive late-stage rounds
The late stage (Series B and Series C) investors are hunting for breakout companies that have serious traction. But there are few companies that breakout, and there is a high supply of capital looking to invest in the companies. The low supply and high demand is driving up the valuations and deal sizes. The companies that get to traction have a lot of capital chasing them. But scaling is hard, and these companies can suffer from The Curse of Over Capitalization. However, the bet that these investors are making is that it will be a winner takes all market.
Threshold for an IPO is higher
Ten years ago, if you had $20M in revenue you were ready to go public. Today, you need almost 5x or 10x that number to even be eligible. If you have <$100M in revenue, you’re probably going to stay private. These companies now end up raising more capital in private rounds than they raised in public offerings 10-15 years ago. And the players for these massive rounds basically decided that they can’t wait for these companies to go public and so the hedge funds that used to take positions in companies once they IPO’d are now taking those positions before the companies go public in these mega rounds.
Hiring costs are up dramatically
The cost of hiring top quality talent in the bay area has gone up dramatically. Top engineering talent today has a bimodal distribution. You will find top engineers either being founders or working at super early stage startups where they can expect a big outcome based on their equity if the company succeeds, or, you will find the top engineers at companies that can pay top dollar, sometimes with pay packages (salary+benefits+equity) that approach low to mid hundreds of thousands of dollars and sometimes even hitting the million dollars a year mark for select super stars.
Now what are the implications of all this? Well…
It hard out there for a Startup
Companies that are just starting out have it really tough for getting to the next round. They can probably cobble together an initial round of funding because a) there’s a lot of money in the early stage ecosystem right now (both individual money and institutional money), and, b) they’re raising the initial round on hope (see Hope and Numbers). But in order to get to a “Series A” they need to show a lot more traction than they did before (because the supply is higher and the Series A investors will pick the best companies).
At the same time, since the hiring costs are much higher, the companies need to spend more money on recruiting and retaining top talent. Remember all the rhetoric about how it’s so much cheaper to start a company these days? It’s not true in my opinion. Yes, the CapEx is significantly lower and has been replaced mostly by variable costs, but the people costs are a lot higher than they used to be. Also it’s becoming harder for companies to break out of the noise and so the marketing costs are a lot higher than they used to be.
The traction bar is higher, which means the companies need to survive longer in order to cross that threshold. And the hiring costs are higher. Taken together, it means an early stage company needs to survive longer, with higher expenses. Startups have realized this and investors have realized this, which is why these days a “seed round” is usually closer to $2M! Yes, a $2M “seed round.”
Re-jiggering of deal stages and sizes
Two years ago, a seed round used to be $500K, now it is $2M+. A Series A round used to be $3M – $4M, now it’s $6M – $15M. A Series B round used to be $10M-$15M, now it’s… well, you get the picture. The deal stage and sizes have changed dramatically.
Seed is not the first round of financing any more. In fact after noticing this trend last year, I have transitioned to calling most of my initial investments “pre-seed” rounds, where the company raises close to $500K, before raising a full seed round. The Seed round is larger — closer to and sometimes upwards of $2M. The Series A is now the fourth round of funding for a company — the first is usually friends and family, or an incubator (~$50K), then pre-seed (~$500K), then seed (~$2M), then Series A (~$6M-$15M).
Note that I’m describing what I’m seeing these days as a typical fundraising pattern and it is somewhat simplified. Some companies may be able to “skip stages,” others may end up raising money on a rolling basis. In fact, I’ve seen companies use a convertible notes to do an add-on or “seed-extension” round as well. Sometimes the seed-extension round can be done to just provide more cushion for hitting the Series A traction mark, in other cases it is because the company mis-executed, or didn’t achieve product-market fit and wants to get another shot at the Series A goal.
The new normal and new nomenclature
The institutionalization of the early stage means that it has now matured (Super Angels are now Micro-VCs). They’re starting to use similar metrics and structures as what the old Series A folks used to. For example, doing equity rounds only, no convertible notes, leading rounds and taking on board seats. The seed round is bigger. The Series A is bigger too, and the Series C/D are even bigger yet. Effectively, we’re approaching a new normal in the venture landscape, where the criteria for and the size of the round has shifted up a level, but we simply forgot to adjust the nomenclature (yet again).
Here is how I think about it today:
Pre-Seed is the new Seed. (~$500K used for building team and initial product/prototype)
Seed is the new Series A. (~$2M used get for building product, establishing product-market fit and early revenue)
Series A is the new Series B. (~6M-$15M used to scale customer acquisition and revenue)
Series B is the new Series C.
Series C/D is the new Mezzanine
Welcome to the new venture landscape!
(When I was starting K9 Ventures, I used to describe it as a “seed stage fund”. I’m now adapting to this new nomenclature by coining the “pre-seed” phrase for the stage at which K9 likes to invest. The goal for K9 is to be the first significant round of funding for a company regardless of the nomenclature.)