Earlier and Smaller

A few weeks ago, I was speaking at an event and predicted that we were going to see an interesting correction in the early stage market as more funds start to going earlier and invest in smaller rounds. This was actually a contrarian opinion, as most folks believed that rounds were only getting bigger and funds are investing later.

I’ve noticed this prediction start to come to fruition recently and shared this tweet

This seems to have resonated with folks, so I thought I’d share a bit more:

I think the rationale for this shift is that the most common early stage round profiles are increasingly becoming bad risk-adjusted bets. Over the last several years, seed and series A rounds seemed to settle into a few common clusters. The first is the ~$3M large seed. Several years ago, these were done at somewhat acceptable valuations, with post-moneys at $10M or under. But the market didn’t bear that for long. As the $3M round became more of the standard institutional seed, you started to see post-money valuations in the low to mid teens or even higher.

At the same time, you saw an expansion in series A rounds as well. This happened because many funds found that the froth in the late stage market allowed them to be temporarily rewarded for chasing companies with more traction, and paying high prices. This means that what used to be a relatively large series A (say, $7–10M) became pretty average, and some series A’s were more like $10-$15M or more.

The best seed investors I know are pretty disciplined on price, and doing a true seed investment at a double-digit pre-money valuation is often out of their range. The market had settled at a sub-optimal place, so I’ve seen these investors start to seek other round profiles that are a better fit. A number of rounds I’ve seen recently are $750K — $1.5M at relatively modest valuations. You could call these pre-seed rounds, but not always. I think of some of these as tranched financings, where the lead investor would be willing to write a meaningful check at the next round with the knowledge that it isn’t likely to be a $10M series A. These next rounds may not happen in 12–18 months, but may happen much sooner if the company is able to hit an important near term milestone. We’ve actually done this sort of financing ourselves recently, and I’ve seen a number of investors that aren’t classically thought of as “pre-seed” funds effectively make these sorts of smaller, earlier stage bets.

At the series A level, there is a slightly different but related dynamic. Competing to invest in startups with significant traction is extremely fierce, and in some cases, the ability to win these deals largely comes down to who has the biggest fund and can write the biggest checks. This is because most series A funds have fairly similar ownership targets even though their fund sizes may be quite different (this is puzzling, I know). So, if you are targeting 15% ownership after the series A, the bigger fund may be more willing to pay a higher price and just write a bigger check to hit their target.

This means that some smaller funds or the funds that aren’t in the top 10 will have a lot of trouble slugging it out with the brand name mega-funds. At the same time, because the market has been so fixated with large rounds with significant traction, there are many good companies that have been seeded and may be a great candidate for a smaller $4–7M round to get the business to a significant inflection point. This becomes and interesting opportunity for series A funds to go earlier and perhaps achieve better than average ownership for a relatively modest investment. The investor may think, instead of stretching to write one $15M check, maybe I should take more risk and instead make three $5M investments instead. Some founders may also prefer the idea of taking less capital at a fair price to avoid a price overhang and to maintain a bit more optionality.

So what I’ve seen recently is that you have more diversity in the profiles of rounds that good investors are leading. The classic $3M seeds are still happening, but so are a bunch of other permutations across the spectrum of the seed landscape. The big mega series A’s are still happening too, but I’m also seeing good investors trying to shy away from these sorts of rounds, and looking to invest either in more mature seed companies or smaller series A’s.

Overall, I think this is a good thing for founders. There are many different paths to building a business, and it’s a disservice to the ecosystem if there is only one funding path that is deemed successful. More investors willing to take more risk in more rationally sized rounds seems like a good thing to me. And I think this will persist from some time. Then again, I am writing this right before YC demo day, so my bubble may be burst pretty quickly. Also, the Lyft IPO and those that follow may inject more frenzy into the market and change everything once again. Fun times!