As Q4 2018 draws near, we receive more and more confirmations of what cannot be called a chance anymore: Seed rounds are dead.
Important voices of the startup financing world pointed to the trend already in July. Tomasz Tunguz of RedPoint Ventures has highlighted the changing situation of earliest stage fundraising in two articles, a first one showing an ecosystem with larger and later Series A rounds, and a follow-up exploring the sheer decrease in the number of Seed fundings (-62% since the peak in Q1 2015).
PitchBook and NVCA confirmed these findings in their quarterly overview of the industry. Their overall taking on the current situation is an environment with bloating deal value and a clear direction of the liquidity toward the largest companies, whose time to exit is extending.
Could this all be caused by the delayed and fewer exits, which, by reducing resources for Angels and Seed investors, are changing the financing process of pre-revenue startups and affecting the entire funding cycle?
By digging deeper into PitchBook’s data, four trends become apparent:
- Exits are taking longer (5 years in 2008, 6 in 2018) and are fewer than they have ever been since 2011 (-22% projected for 2018 since their peak at 1,073 in 2014). Investment returns are, instead, fairly stable, showing that larger than average exits are barely sufficient to offset the scarcity of thereof. Fewer exits are driven by slacking acquisitions, and, to some extent, the disaffection of the innovative economy for IPOs. Even ignoring all the recent buzz about Elon Musk’s decisions, it’s a fact that the number of public companies in the US has heavily decreased since late 90s. Barry McCarthy – CFO of the recently listed Spotify – bluntly expressed the idea that public market and fundraising are no longer related: “There is no reason that going public has to be part of a company’s decision about how to finance its growth.” Private investments for later stage companies are, indeed, at a 12 years record high (Q1 2018) with almost USD 18B invested in the US.
- The number of deals in the Angel/Seed realm has sheerly decreased in number (-47% since the all time high in 2015 – a slightly different result from what was reported by Tomasz Tunguz, but definitely going in the same direction) and increased in size, with deals between USD 1M and 5M representing now almost 50% of the rounds at this stage.
- Startups raise money later. Angel/Seed and Series A fundings saw the median age of the company at the round almost double since 2008 (from 1.5 years to projected 3.1, and from 2.2 to 3.9 respectively). This has reflected onto intermediate Series B’s and C’s where the median age increased by 40% and 20% respectively.
- Deals are closed for higher valuations at any stage, with increases of median pre-money valuations ranging from 56% for Angel/Seed stage to 100% in later ones.
These findings have also been confirmed by recent research by Equidam on pre-money valuations since January 2016 (source: CrunchBase), and got described by Tomasz Tunguz as a “Jacob’s Ladder” effect in the startups’ fundraising process.
Reduced exits threaten the foundations of startup funding
One of the likeliest reasons for the success of the Silicon Valley model is the possibility of a remunerative exit in a comparatively shorter time. Exits have fed the environment with hope and money for founders, investors, and option rewarded employees. It is indeed not by chance that the last bullish trend of Angel/Seed rounds in the first part of the 2010s followed an equivalent upward dynamic of exits.
Exits are the foremost driver of entrepreneurial energy in the Valley. Therefore, small changes in this aspect of the ecosystem can have a tremendous impact on the rest of it.
The first step of this domino is a change in risk perception of Angels and Seed investors. A lower frequency of exits forces investors to hold their positions longer, and increasing their overall portfolio risk. To counteract this increase in risk, an obvious solution is investing in less risky deals, which, in a non-diversifiable market, translates into a deeper scrutiny of the proposals. For startups, this means longer track records and more achieved milestones, which require time and delay Seed rounds.
At this point, however, a startup will ask for a higher valuation. Investors are fine with this, they will need more money to keep up with the desired ownership, but investing in fewer deals make this additional resources available. At this point deals are configured more like Series As rather than old-fashioned Seeds.
If current Seeds are the old Series A rounds, the whole cycle is naturally postponed.
The natural consequence is the increase in valuations for all rounds. Unicorns – the ultimate step of the startup ladder – are multiplying and raising in valuation. Moreover, investors keep feeding these gargantuan entities with record funding, sufficient to make the public market nothing more than an option.
The higher valuations lead to two main consequences that are particularly relevant to this discussion:
- Buyers (corporations, PEs, etc.) hesitate to acquire new companies because of the high prices. This further slows the M&A market, intensifying the original cause of the trends.
- As higher valuations translate mainly in investment funds’ balance sheets rather than cash (and not always in the best way), only VC, PE and other institutionalized subjects that can raise from external sources will be able to keep having liquidity to invest. Contrary to that, small Angels and Seed investors working with the money coming from previous investing-exit cycles will have less and less money available.
Distressing effect on pre-revenues, seed stage companies
In this feedback mechanism, the most damaged party is pre-revenues companies, once able to raise on ideas, and now left behind.
This is not necessarily bad for all of them. Some, that enjoyed above average “hype”, will be pushed towards capital efficiency and sustainable business propositions. However, many sectors where the very nature of the activity prevents early self-support (e.g. research intensive industries) might suffer from the lack of recognition by earliest stage investors.
Startups in this period have the possibility to rely on a number of early stage financing tools, which are getting more and more widespread. Crowdfunding is seemingly increasing in volumes and number of deals, ICOs are a new frontier that may prove viable for many companies of the soaring blockchain economy, and a new attitude toward debt even in early stages can be observed.
Unfortunately, it is difficult to draw conclusions from the effectiveness of these instruments due to lack of data: as of today, few surveys have been published on these topics, and none has touched upon the share of the liquidity going to early stage companies. A risk is that the overall capital involved is still too little to represent a substitute for Angels and Seed investors.
Another potential breakthrough could be the IPOs of few, but extremely valuable companies. That would recreate an early 2010s, post-Facebook’s IPO situation, with new liquidity poured into the system and the birth of a new class of risk-taking Angels, former employees of the most successful companies. The momentum for this direction seems to be right, however likely corrections of the longest bullish stock market in history may end this time-window that is ideal for new, profitable IPOs.
The future of the startup world is even more uncertain at this point in time, and further exploration of the ongoing trends’ consequences may shed some light on the risks threatening the ecosystem.