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Startup Seed Funding, VCs and The Series A Signalling Risk

By Ryan Law on Mon, Feb 17, 2020

Seed investment has evolved, and Venture Capital-lead "mega seeds" are more and more common. But despite the allure of big name investors and big money rounds, allowing a VC into your seed isn't without its risks.

Today, I'm weighing up the pros and cons of VC-led seed rounds, and stopping you from killing your Series A before it's even begun.

The Evolution of Seed Funding

There was a time when seed funding was the reserve of angel investors. But in recent years, larger VC firms have started entering into the fray. This often takes the form of very large VC funds making lots of (by their standards) very small seed investments into a large number of early-stage startups.

So what's driven this change?

As Christoph Janz points out, the returns generated by these investments aren't typically enough to move the needle for these big firms: even 100x returns on a small investment aren't of the same magnitude as the returns VCs usually aim for.

Instead, many VCs have started making speculative seed investments, designed to pave the way for far more lucrative Series A rounds. For the cost of a small seed investment, the VC firm is granted privileged access to later-stage rounds, effectively allowing them first dibs on the startups that perform the best.

So how does this impact your strategy for raising investment?

The Upsides of VC Seed Funding

1) Access to More Capital

The primary motivation for seeking seed investment is capital to fund growth. Increasing involvement from VCs has had a dramatic impact on the amounts of capital raised during seed funding: the median angel-funded seed round is in the region of $150,000, but once VCs become involved, the average jumps to a staggering $1.5 million.

2) "Smart Money"

Another motivation for funding is access to skills and expertise. Angel investors often bring with them experience and advice, but VCs simply have more resources, and more connections, to bring to bear on your startup (if they choose to). These so-called "smart money" VCs bring much more to the table than capital alone.

Access to a "brand name" VC can be also a huge boon for a startup, allowing some of their "social proof" to rub-off on the fresh-faced company.

3) Better Chance at a Series A

Research from CBInsights suggests that 35% of VC-backed seed companies raise a Series A, but if those investments come from so-called "smart money" VCs (those that provide knowledge, experience and networking in addition to capital), that rate jumps to 51%. If you want the best shot at a Series A, it can pay to have a smart money VC behind you.

The Downsides of VC Seed Funding

1) signalling Risk

Being a seed investor grants VCs privileged access to a startup's inner workings. So, when the time comes to raise a Series A, if your VC chooses to lead the round, that sends a powerful signal to the market: something good is happening behind the scenes of Startup X, and it'd be a smart move to get involved.

But what happens if your VC doesn't follow on?

Regardless of their specific motivations, the market gets the same message: the people with the best insight into Startup X's performance haven't lead their Series A, so we need to stay away. If they won't put their capital at risk, why should we?

This is the signalling risk of VC seed funding.

If we return to the CBInsights data from earlier, the average VC-backed seed company raises a Series A 35% of the time, or 51% of the time if it's a smart money VC. 

But if that smart money VC doesn't follow-on, the chances of raising a Series A round plummet to 27%.

Seed Funding and Signaling Risk - Chris Dixon.pngThis investor signalling has a huge effect on venture financing dynamics.

If Sequoia wants to invest, so will every other investor.

If Sequoia gave you seed money before but now doesn’t want to follow on, you’re probably dead.

Chris Dixon, Andreessen Horowitz

2) Potential Collusion

The VC ecosystem is pretty small, and information travels quickly. If your VC doesn't follow-on, there's no guarantee you'll still get a "fair" Series A valuation from other investors, because it's so easy to talk to your seed.

Their reasons for not investing will likely rub off on other investors, and in some instances, even lead to collusion to drive down your price. Either way, there's a chance you'll end up with a lower valuation, less capital and less equity.

3) Access to More Capital

More isn't always better, especially in the case of investment where the more capital you raise, the greater the dilution.

If you're on the receiving end of a big seed round, think about your motivations for raising finance: is the extra capital in the best interests of your startup? Or is the capital being pushed-up by VC involvement for the sake of VC involvement?

Seed Funding and Signaling Risk - Chris Dixon.pngIf you get a great investor to lead a follow-on round, expect your existing investors to want to invest pro-rata or more, even if they previously indicated otherwise.  

This often creates complicated situations because the new investor usually has minimum ownership thresholds (15-20%) and combining this with pro-rata for existing investors usually means raising far more money than the company needs.

Chris Dixon, Andreessen Horowitz

How to Avoid Killing Your Series A

Vet Your VC

Some VCs will be passionate about your business, and be utterly willing to invest time, energy and, yes, more capital into the success of your business. Others will view you as a speculative bet that may or may not pay off in the future. The key to making a VC-led seed round work is differentiating between the two.

  • As a rule of thumb, only work with VCs that are bringing more than capital to the table. The more active and involved your VC, the better the chances they'll lead on.
  • The bigger the VC, the more scrutiny you need to apply to their motives. Big VCs mean big benefits tempered by big signalling risk.
  • Remember that you aren't looking for a seed investor: you're looking for a seed and Series A investor.

Seed Funding and Signaling Risk -  Mark Suster...you need to be careful with funds that have done 20–30 seeds deals in fairly rapid succession.

Talk to companies that have taken this money and see if they’ve gotten support. I have spoken at length to one such entrepreneur who tells me that he hardly hears from his VC. He was told informally that they view him as an “option” whereby they can wait and see if another VC makes an offer. If a VC term sheet comes in they begin their due diligence process.

I recommend you do your own due diligence before deciding whether to take this money.

Mark Suster, Upfront Ventures

Get to Traction

Though easier said than done, the only surefire way to negate signalling risk is to become a truly irresistible investment. The stronger your growth, the more investors you'll have queuing up, whether or not your seed VC has followed-on. More competition means a fairer valuation and less equity loss, while still maintaining the benefits of a VC's expertise.

How to actually do that is the billion dollar question: VC-led seed rounds could definitely help you on the path to growth; but, as we've covered here, there's no guarantee.

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