Founders and Investors Beware: Why large seed rounds are a train wreck waiting to happen
Office rent has dropped, engineering talent pools have expanded to lower cost, yet equally accessible regions, and Zoom has reduced the cost for travel & time to revenue. Yet in the last several weeks I’ve met companies targeting $6-$8m to get to $1m ARR (if everything goes well) with nothing but a powerpoint and a design partner, if I’m lucky. When I look at the most recent Israeli seed funding announcements in the news, I see similar round sizes. From what I’m reading in Term Sheet and Crunchbase, mega & jumbo seed rounds are occurring more often in Israel in the last 12 months than Silicon Valley! Why, in a world with dropping input costs are round sizes doubling while target achievements stay constant?
In May 2019, Elad Gil floated the idea that the maturity of the internet and connectivity has enabled unprecedented velocity in revenue & user growth for breakout companies, and has created a fertile ground for $10b to become the new $1b. With this mindset starting to penetrate early-stage VC and investors becoming less price-sensitive at seed to get into the outliers at any cost, COVID spilled trillions in liquidity into public markets, software’s ubiquity accelerated due to lockdowns leading to steeper growth curve assumptions for established software businesses, and EV/revenue SaaS multiples essentially doubled YoY. On top of that, SPACs exploded, providing liquidity to less established & well-oiled businesses, distorting the traditionally required fundamentals ($100m ARR) to achieve public market status.
The excess of SPACs acquiring less proven businesses combined with the public market euphoria for Shopify, Zoom, Airbnb, Doordash, and many others, has accelerated an overconfidence bias in early-stage investing, the likes of which I’ve never seen. The willingness for seed stage investors to underwrite to current multiples, rather that historical multiples, represents a significant logical fallacy. If/when public market multiples compress from their stimulus-induced all-time highs, public companies will still have enough cash on the balance sheet to continue operating for quite some time. Private early-stage companies on the other hand will still need to go out and raise money, and follow-on investors will have no choice but to underwrite to lower public market multiples.
A public market contraction over the next 3–5 years seems inevitable, and when that happens a year before a company goes public (see Airbnb), it is usually a highly dilutive event that can wipe out early investors and founders through aggressive pay-to-play and liquidation preferences. Given today’s prices are based on 0% interest rates and rates will go up before today’s seed stage investments exit, today’s seed stage economics are almost guaranteed to end poorly for founders & seed/A investors. When the music stops, it won’t be pretty.
In addition to interest rate hikes wiping out investors who overpaid at seed & A, raising too much money early on is a simply a bad practice that creates operational, cultural, and economic risks to a company’s long-term health. All things held equal, a company that can turn $2m into $1m ARR should be worth 4x a company that needs $8m to get to $1m ARR. Counterintuitively, the less you raise to get to $1m ARR, more valuable your company becomes at the next financing round. The more you raise, the more assets you need to create to justify the next round’s valuation. A disciplined Series A investor is looking to put $8-10m into a company that is capital efficient, not a company burning $600k/month with 30 employees barely generating $100k in new ARR. To complicate things further, many of the large seed rounds are being led by A round investors, forcing new investors to answer the question: Why does the seed investor with A round capabilities lack the conviction to lead the A? At a minimum, it forces the seed round investor to maintain an expensive pro-rata in a company that they may no longer believe in, in order to keep the company fundable.
Beyond signaling risk, large seed rounds too often lead to luxury spending — gourmet food, designer office space, and other expensive perks. Sure, it’s important that employees are motivated and fed well, but grit & determination are inversely correlated to how cushy & comfortable things feel and company DNA & culture is built from day 1. Not only that, with such a large pre-product, pre-revenue cash balance, the likelihood for capital inefficiency — both from a hiring and budgeting perspective — go up significantly. This misallocation of resources compounds silently over time and creates structural debt that becomes difficult to unwind in a bull market, but impossible to unwind in a bear market. Furthermore, when you don’t have product/market fit, there’s really no reason to have a huge team… it will only slow you down as you pivot / adjust your feature set and MVP to meet the needs of the market. Lastly, necessity is the mother of all invention and having too much money creates a false sense of security and diminishes this key innovation engine.
To founders thinking about raising seed expecting a future where discount rates aren’t 0 and expected future cash flows actually mean something? Don’t overcapitalize and take tons of money at the seed stage just because you can. Short-term payoffs have long-term tradeoffs. And if you’re really in it for the next decade, you don’t want your holdings to get cut by 50% a year or two before you see liquidity. Nor do you want to build a capital inefficient company slowed down by largesse.
To investors that are myopically plowing into seed rounds with a complete lack of price sensitivity or appreciation for economic cyclicality, let’s just do a quick sanity check on what assumptions you need to believe in order to justify these unprecedented valuations.
Let’s take an $8m seed on a $20m post. Assuming you lead with $4m and you target a 15 company portfolio with 50% reserves + management fees, you’re investing out of a $150m fund. The rule of thumb in venture is that your winners should at least 1x your fund without any additional follow-on investment. For simplicity let’s assume you don’t follow-on and hold your 20% through 6 rounds and end up with 4% at exit (±20% dilution each round). You need the company to be worth $4b to return your fund, and this exercise assumes each subsequent round will be a step function in valuation, which given the current market situation, seems hard to believe over a 5–7 year hold.
That’s not to say there aren’t the Lemonades of the world (although we can argue whether or not they are a meme stock) and exceptional situations where companies can take a large seed round to the moon without hinderance. But in the aggregate, investors who overcapitalize companies at the seed are creating a trainwreck, and the employees and founders of these companies are the ones who will suffer the most.