Editor’s note: Jeff Jordan is a partner at Andreessen Horowitz and is on the boards of Airbnb, Belly, Fab, Circle, Crowdtilt, Lookout and Pinterest, as well as Wealthfront and Zoosk. Previously, Jeff was president and CEO of OpenTable, which he took public in 2009. Before OpenTable, Jeff was president of PayPal, and he was previously the SVP and general manager of eBay North America. Follow him on his blog and on Twitter @jeff_jordan.
The venture industry is awash with talk of the “Series A Crunch”, where it’s getting progressively more challenging for seed companies to land follow-on financing. In my short two-year tenure as a full-time investor, I’ve seen this crunch hit very hard at a number of quality, early-stage consumer companies. Why is this happening? A number of factors are coming together to create this crunch.
A significant supply/demand imbalance has emerged between seed and Series A financings coming out of the economic near-meltdown of 2008-2009. In 2009, there were about the same number of seed and Series A financings, but the number of seed deals have exploded since then while the number of A rounds grew only modestly. In 2012, there were 2.5x as many seed financings as A-round financings, whereas historically these were more in balance. This suggests something like 60 percent of seeds could be stranded.
A number of our recent Series A investments built multi-million dollar revenue run rates on their seed rounds. We’re getting spoiled.
Investor expectations have expanded substantially. It’s become steadily less expensive to launch many consumer-oriented Internet businesses over the years due to things like Moore’s law, improving programming tools, the cloud and the ability to access users from multiple large platforms. Now we often see the kind of traction that we used to expect from Series B companies in Series A companies, and from Series A companies in seed companies. For example, a number of our recent Series A investments built multi-million dollar revenue run rates on their seed rounds. We’re getting spoiled. Combine this with the above supply/demand imbalance and you’ve got a situation where the bar is being raised exactly when the competition for the A round is becoming particularly fierce.
The source of seed capital has been changing. In recent years, the amount of seed investment from non-traditional institutional sources has increased dramatically. More and more seed capital is coming from sources like angels, “super angels,” micro-VCs and incubators. To under-score this point, we have close to a thousand separate angels as co-investors in the consumer companies in our less-than-four-year old portfolio. This influx of new capital has arguably had an inflationary impact on seed valuations, which obviously has an initial attraction to many entrepreneurs but can create challenges in a “crunch” scenario. These non-institutional sources of capital are not inclined or structured to potentially help a company secure additional capital in a crunch. And the higher valuations provide a higher hurdle that must be overcome by potential new investors in a crunched company.
The number of potential Series A investors appears to be contracting. The venture business is showing early signs of a significant consolidation. The amount of capital invested has trailed the amount raised for a number of years, and the capital that is being raised is increasingly consolidating among fewer, larger firms. The number of investors who can write that Series A check is starting to fall.
The impact of these factors is playing out before our eyes. We’re seeing more and more potentially promising companies who have spent much of their seed rounds to generate solid early traction, but not the kind of traction that sets them up well for a Series A financing these days given the higher bar. These companies face a brutal situation. They are running low on money. Prospective new investors want more proof, particularly given the higher seed valuations. And many of the existing investors, particularly on the angel side, become “tapped out” or “want to stay diversified” when approached for bridge financing. These companies’ futures are rapidly called into question. It’s been very painful to watch.
So here are a few suggestions for entrepreneurs who are trying to start consumer-oriented Internet businesses:
You should consider suffering a bit more dilution early on…
Raise more money in the seed round to give yourself runway to make the progress you’ll need for a Series A, along with some contingency if things don’t go perfectly along the way. The size of seed rounds has increased substantially in our firm’s short history, from under $1 million a few years back to almost $2 million this year.
But I’d argue that even these larger new rounds are often too small given the rising Series A bar. Increasingly, a $1 million to $2 million raise requires absolute perfection on the part of the entrepreneur. You should consider suffering a bit more dilution early on to secure the resources to deliver the metrics that will attract the more demanding Series A investors: things like up-and-to-the-right user and revenue results, deep engagement, compelling cohort economics, and a proven ability to acquire users with a positive ROI on their marketing spend.
Structure your round differently. I’d suggest getting more institutional participation in your seed round, as institutions are more likely to support a high potential but not-yet-ready-for-Series-A company in the event it encounters the crunch. That in no way suggests that follow-on financing from institutions is a certainty or even more likely than not, but my observations suggest the odds are higher. Similarly, consider structuring your seed deal in a way that doesn’t scare off potential new investors in the event that you’re facing a potential crunch. Obviously these recommendations can be interpreted as self-serving given my role as an institutional investor, but my motivation for writing this is in the hopes of helping even one entrepreneur avoid the pain and suffering I’ve been witnessing by those who have been caught in the crunch.
Raise from multiple institutional investors. This can help accomplish a few things. First, it brings more deep pockets to the table that can fund a Series A or a bridge if needed. Second, it can fire up the competitive juices of the participating VCs who don’t want to risk losing out to a rival on the A round at a hot seed company in which they’re both invested. Lastly, having multiple VCs can diminish any potential negative signaling issues down the road if an institutional investor in your seed round does not do the A.
Cultivate these institutional investors as you launch the company, updating them periodically on your progress and learning. Some entrepreneurs do this extremely well, managing to stay top-of-mind with investors and building a relationship, a track record and credibility. These can come in very handy with investors if you find yourself potentially entering crunch territory.
Resist the temptation to raise too early. We often encounter companies that come to us saying that they had inbound interest from another/other firm(s) and elected to use this as a signal to start broader fundraising conversations. But there’s interest and then there’s interest. One of the jobs of a VC is to network broadly with potentially interesting companies, and their “interest” more often than not does not result in funding. And if you swing and miss at an early round, it can be much harder to create positive momentum behind an A round once you go out again. You need to be disciplined. Wait until you have multiple months of metrics moving in the right direction before you start fundraising. Resist the temptation to talk to every prospective investor who calls when you’re not fundraising. Ironically, nothing piques the interest of an investor more than an entrepreneur who remains relatively inaccessible.
There are signs that the startup ecosystem is already correcting to mitigate the crunch going forward. The number of new seed financings is down meaningfully so far in 2013, which would help to correct the supply-demand imbalance. And capital is starting to be attracted to the gap between seed and traditional A rounds, which some term “mango seeds.” But higher investor expectations earlier in a startup’s life are here to stay, and the smart entrepreneur will take steps to mitigate follow-on financing risk. On each and every financing, they should ask themselves one key question: What do I need to prove in this round to get the next round?
I’d like to thank my partner Chaz Flexman for his many insights on this post!