When does it make sense to follow on, and when do you quit? That is one of the more nuanced things in seed investing. It is one of the things that seed investors are going to be confronted with more and more. With crowdfunding, and the changes in the funding cycle, I think we will see more internal follow on rounds.
A lot of funds are stepping back from even doing seed investing. The math says they are wrong, but I think the major reason they are stepping back is seed valuations were too high. A $3M pre-money is quite a bit different than a $6M pre-money when it comes to venture math. As valuations at the upper tier get crushed, the knock on effects are filtering down to seed and changing risk appetites. When valuations at seed drop, I think you will see a renewed appetite for seed from VCs.
I have passed on internal follow on rounds, and I have written checks. There isn’t a hard and fast formula. One thing I think seed investors should do is get together before they do that first round and discuss possibilities. I’d make sure that there was enough money at the table to get the company to Series A. The Series A metrics have to be generally known before you write a check. Just ask a VC and they can tick them off for you.
Once a company hits that $40M-$60M point in valuation, seed investors are better off using their capital to seed new companies. Angel math tells you that every time you write a check, you look for a 30x return, not a 10x return like VCs. Angels take a lot more risk so they need more return. The problem is psychologically, people feel there is less risk putting money in an established company. Of course, companies that hit that mark fail too!
The funding cycle has changed, and it’s more like this:
Bootstrap—>Friends and family—>Seed—>Re-seed—->Series A
Crowdfunding can enter at any point in the cycle. F+F rounds are crowdfunded now. Seed rounds are crowdfunded. Interestingly what I am seeing is if a seed investor or angel group adds value, entrepreneurs want them in their deal. Otherwise, the money is commodity money.
Since the costs to start a company have gone down tremendously, it’s easier for entrepreneurs to bootstrap longer, F+F rounds are smaller. I am seeing companies raise too small a round at seed which has morphed into a double seed round before Series A.
I think this is why YCombinator came up with the SAFE system of early stage financing. Everyone was doing a note, and in a re-seed often you would have to extend the terms of the note. With a SAFE, you avoid that conversation and risk.
Series A rounds have grown in size since VC’s want to maximize their risk/reward. They don’t want to do the exhaustive work it takes for seed. But once product market fit is there and the company looks like it could be something they want to jump in with both feet.
Here are some of the things you should be thinking about on a re-seed:
- Has the business progressed? Is it closer to finding product market fit?
- Has the team performed, or are they dysfunctional in some way? Can you change the team, keep the business and give it another try?
- What are the clear metrics they have to hit to raise a series A? How much extra runway are they going to need to get there?
- Has any part of the initial hypothesis changed since the original funding? Has the market moved? What have you learned about the market that you didn’t know and can the team execute on it?
- Are there any new funders you can bring into the deal now?
- Are the investors taking too much equity leaving no incentive for the entrepreneur to build a blow out business?
For me, I really take a hard look at team. At seed, the team is everything. If I am comfortable with the team, I look at the business. Sometimes, businesses just don’t work. I also look and see if I can have a material impact on the company. Can I introduce them to a potential customer to help them grow their top line? And lastly, I look at my own capital. I don’t have a money tree I can shake so there are constraints.