The Series A Crunch is real.
But while most of the commentary has focused on the past few years of funding ‘bad’ companies, I’ve actually seen a different flavor of this market trend. In fact, I’ve seen a large number of *good* companies, some really good, that have become victims of the Crunch.
Let me upack this a bit.
One of the purported benefits of raising capital from seed focused investors (angels and seed stage VCs) is the implicit flexibility to achieve good outcomes for all constituents with smaller exits (i.e. low-mid 10s of millions of dollars). A consequence of this (intended or otherwise) is that many ‘good’ companies with reasonable pathways to low- to mid- double digit million dollar outcomes were funded over the past few years. I describe these companies as ‘good’ because they generally have smart, thoughtful teams that are solving legitimate pain points for real markets of customers.
The challenge is that while starting a company is less capital intensive than ever, scaling a company still requires lots of coin. As a result, even companies targeting lower range outcomes generally need to raise more than just seed capital to achieve their goals.
And therein lies the structural capitalization problem for many companies recently funded with seed capital. Many of these companies took capital from seed focused investors that lack the capacity to finance the requisite 5-10mm+ of Series A/B capital necessary to bring a product to market and build a company of substantive value. At the same time, these companies that were reasonably attractive to seed investors who were comfortable with lower range outcomes fail to meet the massive market opportunity thresholds that are required by more traditional VC investors.
Unfortunately, structural market realities force many of these companies into a bad situation between a rock and a hard place - they’ve raised capital and have achieved some early product or market traction, but still require more capital to create real value and are boxed out from raising it because of the structural requirements of the traditional venture market.
Does this catch-22 represent an opportunity for new types of liquidity to enter the market and provide critical follow-on financing for companies targeting lower range opportunities?
Maybe. But I’m skeptical that this market dynamic will lead to new pools of capital. There are two major challenges that I see:
- Smaller exit opportunities does not necessarily translate into less risky ventures. There are many markets in which risk and reward are directly and inversely proportional; but in the world of early stage startups, reward is often directly and proportionately linked to the specific size of the target market and does not necessarily imply more or less risk. Series A companies are still fraught with tremendous product, market and execution risk, and as a rule of thumb, investors prefer to accept these risks when the reward for success is massive. When the potential upside is perceived as limited, accepting these prevalent risks becomes a less attractive trade.
- Despite the highly publicized evolution of the venture business (shift to seed, venture platforms, etc), what has not changed is the fundamentals of venture math: many companies will fail, some percentage will return a marginal amount, and the vast majority of portfolio gains will derive from a tiny proportion of home runs. Rarely is it clear at the Series A stage which companies will represent the big winners, and as a result, VCs need to make sure that all of their Series A checks, at very least, have reasonable home run potential.
The fact of the matter is that investing sizable capital beyond the Seed stage requires a fund of scale (for shits and giggles, let’s say $50mm on the low end, though more realistically it is probably multiples of that #), meaning that these funds need to raise capital from traditional venture LPs. Given the challenges I note above, I have a difficult time imagining experienced LPs allocating capital to new strategies that target lower range market opportunities - the risk/reward and venture math just don’t seem to add up.
So what does this all mean?
Well, I’m not really sure…but I have a few pieces of advice to offer companies in this zone:
- If you are raising follow-on capital right now, do everything in your power to tell a realistic and convincing story that the market opportunity you are pursuing is massive.
- If you are receiving push back on your story, extend runway as far as possible and become laser focused on generating cash flow to organically grow the business. Fight your ass off to become cash flow positive, and in doing so, earn the right to control your own destiny.
- If it is clear that you need more capital, seriously consider a seed-extension or small Series A at a marginal bump up in value (or even a down-round). Yes, you will likely be further along than most seed stage companies. Yes, you will have built a functional product with early market traction - generally milestones meriting normal Series A consideration. And yes, this approach will be meaningfully dilutive. But if you keep pricing down enough you may be able to attract good venture capital by offering an attractive risk/reward balance. And even if you are able to raise capital successfully, revert to #2 above for your game plan once you have the money safely in your bank account.