Sowing Hardier Seed Rounds

“There are different ways to do innovation. You can plant a lot of seeds [and] not be committed to any particular one of them but just see what grows. And this really isn’t how we’ve approached [Facebook]. We go mission-first then focus on the pieces we need and go deep on them and be committed to them.”

— Mark Zuckerberg, Founder and CEO of Facebook, in an interview with Fast Company, 2015

Facebook has reconfigured investment capital in many ways. For one thing, they’ve changed the model for an IPO. Companies once achieved most of their valuation after going public. (Think Microsoft.) Facebook flipped the script. Now, many companies try to get overvalued through private equity first and then go public. And while an approach toward that end of the spectrum clearly works out better for any company (and its employees) that’s able to pull it off, it has also tamped down the enthusiasm of speculators hoping to become millionaires overnight. That’s not to say no investors got rich on Facebook’s IPO — just that no investors got rich quick.

Shriveling seeds?
There’s an interesting trend in U.S. seed funds, as noted in TechCrunch: “Even though averages and medians are up … the overall dollar amounts invested in seed are down.”

Does that mean investment capital is drying up? No. It means that investors are being much more selective about which companies they fund in the first place — and which ones they’ll continue to fund in successive rounds. More money has shifted toward better, bigger bets and away from a diversified, less judicious package of smaller bets.

Why (and how) did this happen?
More than anything, the shift is a result of the VC market getting more conservative and the process becoming more transparent. Winners emerge earlier and stay private longer. And I wouldn’t necessarily say that investors have become jaded — but they’ve become savvier. Today, you’d better do your homework to be sure your “innovation” hasn’t already been tried 37 times since 1995.

I also think investors have a better understanding of the funding progression. Many people used to say that the seed round was to prove product-market fit. I’ve always thought that’s a bit sophomoric. If you don’t know if there’s a need for your product in the market, you don’t deserve to get the funding to go float the trial balloon. Investors and founders should know the market opportunity from day one. I created a three-pronged rule at the fund I founded. One, is the proposed innovation important enough to move email in a customer’s inbox? Two, is it important enough that the prospective customer will pay for it? Three, is it important enough that it’s worth the effort to fix the pain? (A lot of founders target minor annoyances that people can easily live with.)

A successful seed round should prove that the product worked for the problem it was supposed to solve or the opportunities it was supposed to create. 

Next comes the A round, which is about proving the size of the market. That’s the tough one. Unless you can demonstrate that the market will be big and on an appropriate prices/revenue model and margin, it’s hard to get that additional funding. What’s healthier now, though, is that if a company sees that the opportunity isn’t as big as they thought, they can sell for a decent return and there’s a chance they can get a soft landing and get merged into a bigger opportunity. The deal becomes what I call “a coffee can in the backyard.” Maybe someday somebody digs it up and finds some loot in it but you don’t bank on anything.

And if you get past the A round, the B and C rounds are actually easier today than they were 10 years ago, by far. It’s almost like the level of risk has shifted one to two rounds closer to seed. Ten years ago, the B-round investor was taking the risk of an A-round investor today. Ten years ago, the A round had the risk of a seed round today. 

Why? People can get product live faster on much less capital with smaller teams. And in another five years there will be angel investor or family-and-friends round that takes the level of risk that seed rounds take today. That’s because cloud services and open source software are making the process cheaper and easier. This trend has been happening for 20 years in web services.

Of course, just because it will be cheaper and easier to get friends-and-family funding doesn’t mean that it will be easier to get legitimate venture capitalists to come onboard in later rounds. Again, it all comes down to the soundness of your idea, the size of the market, the quality of your team, etc.

How do you know when you’ve got a sound idea? That’s easy. When a savvy, ex-operating-side investor says they wish they could quit what they were doing so they could go to work for your company, you know you’re on to something.