Explaining the Post-Seed gap: why is it happening?

Companies are staying in seed longer, but is it because they can't raise a Series A?

Next week, Vator will be holding its annual venture capital event and inaugural “Post-Seed” Conference to discuss how venture capital is changing, due to a landscape being altered by new financing options, including crowdfunding and debt financing. (Get your tickets here!) Post Seed is being hosted by Vator, Bullpen Capital and Venture51.

So what is the post-seed gap? It's the emergence of a new timeframe in a startup's life cycle. It's the stage after a startup gets its initial seed round, but before the startup gets a traditional Series A, which today appears to be larger, or around $6 million to $8 million, sometimes even $10-plus million. But given the small amount of seed startups are taking in, many of them need more capital to land those traditional A's. 

One factor that has led to this need for additional early-stage funding is the emergence of a shadow venture system, in which early-stage founders have many more financing options at their disposal. That includes crowdfunding, debt financing, as well as vibrant angel investing environment, making the options available to founders plentiful to at least get initial funding.

"The post-seed round is not so much a gap as a choice: stay lean, raise modest, and go for a super-sized A in a year, or raise bigger now," Duncan Davidson, Managing Director at Bullpen Capital, told me in an interview. "A class of seed-funded companies do much better taking post seed: ones confident of scaling but needing time and assistance to nail their business model. Taking a traditional Series A too early often lessens agility, and worse, if it's successful, it lessens the leverage of a bigger A, less dilution and more momentum." 

Part of what has caused the gap, he said, has to do with the fact that the cost of building a company has dropped exponentially in the last few years.

"It used to cost $5 million to start a company. You had to license a database, get a bunch of servers, and write stuff in the stack. You had to be in the server business," he said. 

That number dropped to around $500,000 by 2005 thanks to the cloud and open stack, making it so that companies simply did not have to raise as much funding as they used to stay in business. At the same time, though, that same $5 million check can now start 10 companies. The end result has been a larger number of startups, which now take less funding to get started and can wait to raise that next, big  round. 

"The exuberance of the seed guys has caused this gap," he said, and this has been "the greatest disruption of the venture capital market in 30 years."

This assessment was backed up by Alastair Goldfisher, Editor-in-Charge at Venture Capital Journal, who has often moderated panels at our Vator events. 

"A rise in incubators and accelerators, as well as a rise in angel investing and syndicates, in addition to a low cost to entry, and greater access to funding, have spawned a lot of seed-stage startups," he told me. "Seed investors, including incubators like Lemnos Labs as well as institutionally backed funds like Data Collective and ff Venture Capital, are quick to raise money and they’re not going away."

Bloated at the later stage

Still others, though, do not  see the gap as a much as a choice, but as a result of a venture capital system that has become bloated, and unwilling to take the risk on the types of smaller Series A rounds that they used to fund.

"There has been a  huge shakeup in the venture business and a lot of dynamics have changed. The amount of money raised has changed," Ryan Floyd, Founding Managing Director at Storm Ventures, told me. "Firms really decided to grow and get big. Even firms like Benchmark, which make the claim to be small, aren’t small."

Because the fund sizes have gotten larger, he told me, "not many firms are interested in investing $2 million to $4 million. Firms can make larger multiples on bigger deals."

Entrepreneurs, however, don’t want to do that big round.

"It dilutes the founders. They would be taking a tremendous amount of risk, and would not have as much ownership, and that's not a good thing," he said. "Also there is tendency, despite best efforts, to spend the money if you have it. If you take $20 to go shopping, you are likely going to spend $20. Even with the best intentions to keep burn rates low, companies will keep spending, and it manifests in things like overpaying for certain positions."

The gap, he said, is partially funds not wanting to give out the small checks, and companies not feeling ready to take on the larger ones.

Does the data back this up?

Interestingly, the data does not show a large gap between Seed and Series A. In fact, it seems as though that gap has actually gotten smaller over time.

In the first three quarters of 2014, there have so far been 204 seed stages deals, with a total amount of $200.09 million invested, according to data supplied to Vator by Dow Jones Venturesource. At the same time, there have been 947 Series A deals, with $5.3 billion invested, giving those rounds a median of $3 million, about 3.2 times than the median Seed deal. 

In all of 2009, there were 181 seed stages deals, with a total amount of $129.88 million invested, while Series A saw 785 deals. Going back all way to 2004, there were 105 seed stages deals, with a total amount of $138.51 million invested, creating a median class round size of $1 million. With 720 Series A deals, and $5.1 billion invested the median was $5 million. That puts the median Series A deal at 5 times Seed.

So, based on that data, the median size of Seed deals is now closer to the median Series A than it was either five, or 10, years ago. 

So why doesn't the data line up? Because the very definitions of what is a seed round, and what a Series A round, is no longer work.

"The whole concept of a seed and series A in my mind is basically meaningless now. It used to have a definition but for many reasons, they have become terms that don’t mean much," said Floyd. "Really, from my perspective, a seed or A round are reflective of valuation and risk. A $4 million seed really is an A round in many respects. That’s why I think looking at any data around an A round or Seed round won't yield anything really rigorous in terms of analysis."

"A lot of it is definitional. The actual number of Series A rounds hasn’t changed much. It's how you define a round that comes after Seed that’s increased," Davidson told me. "What was traditionally a Seed is now A Series A. The hardest round to raise back then was a Series B, and no more than half got it. Now that's the Series A."

A recent report from CB Insights backs up these statements. It found that that the number of companies that have raised over $3 million in funding without a Series A is seven times what it was in 2010.

And that the number of companies raising over $6 million without a Series A has risen six times in the same timespan.

Mark Suster, partner at GRP, shared some of his thoughts on this subject in a blog post last month. He put the blame for this on the fact that it has become cheaper, thanks to the cloud and mobile, to build a company. This gave the company founders more freedom to choose where they wanted to raise.

"What changed — and why the definition changed — was it became 90+% cheaper to start companies and thus seed funds appeared en masse as did angels so the size of seed rounds actually INCREASED and the size of A-rounds in many instances decreased," Suster wrote. 

"My speculation is that entrepreneurs had more options and wanted to take less dilution so the old $5 million for 33%-40% of your company no longer made sense and on the VC side it made no sense to pay $20 million pre ($25 million post, which implies the VC gets 20% of the company = 5/25)."

What happens next?

So now that we've established that the gap between Seed and Series A exists, what happens next? According to the people I spoke to, not much.

"The number of seed-stage investors will continue to rise before they fall back, which is probably why Bullpen and others are so bullish. Seed investing and the likelihood of a post-seed gap is not going away," said Goldfisher.

To Floyd, it is unlikely that the larger funds will all of the sudden be willing to do smaller deals again. More likely is that the seed funds will start to do slightly larger deals. Ultimately, though, it may just be that companies can do more with less and will not need to raise that post-seed money.

"Part of the answer is that there's so many more ways to go raise $2 million, and it takes you so much further. That helps solve the gap. They can do more with less and go further."

Vator will be holding its inaugural “Post-Seed” Conference in early December, to discuss how venture capital is changing, due to a landscape being altered by new financing options, including crowdfunding and debt financing. Get your tickets here! 

(Image source: keithcraft.org)