I sent a tweet out last week that elicited quite a few responses from both founders and investors:
seed funds that don’t invest pre-traction = 🤔
— Rob Go (@robgo) November 4, 2019
I could hear the internet nodding in violent agreement. I thought I’d share a few additional thoughts on what may be driving this.
First – there are a lot of seed investors out there that don’t actually want to invest in seed.
What they really want to do is be a venture capitalist. Who knows what their motivation is – but the easiest way to get started is to be a seed VC. It requires the least amount of capital to get going, and it seems relatively easy to do because of the amount of seed deals that seem to get done. However, these investors have no desire to really work with founders through the messy earliest stages of company building, and would much rather try to find something that is already working and just write a check. Seed investing is a means to an end, and the later they are able to invest, the more comfortable they feel.
Second – the distance between company formation and series A is probably further than it has ever been.
For very well known founders, a series A can happen well before traction. But for less well known founders, a series A requires pretty significant revenue, growth, and retention metrics. Because of this, there is a glut of companies out there that can’t quite get to a series A and are raising second or third seed rounds. This creates the illusion that there are a lot of great companies at the seed stage that are actually post-product/market fit. So, investors can wait around asking for more traction.
Third – investors have an incentive to market themselves as investing in companies at the earliest possible stages.
There is no downside for the investor to get an early look, but there is downside to missing an opportunity because founders assume they are too early. So it is entirely rational for investors to claim that they are seed investors when they are actually looking for companies that are at a series A stage but are raising a smaller seed round.
Fourth – I think psychologically, many investors are nervous about the macro environment.
It takes a real contrarian to believe that we aren’t super late in the current economic cycle. So there is some comfort in investing in a business with more market traction when the future of the overall market seems uncertain.
The problem with the “wait for traction” strategy of seed investing is that it appears easy but probably has the highest degree of difficulty. This is because seed stage companies that do have impressive traction will fall into one of four buckets:
- They raise a series A
- Existing investors will love what’s happening and end up doing most if not all of the second seed themselves
- There is something very flawed about the company that is very difficult to overcome
- There appears to be something very flawed about the company, but actually, there is not
In the case of #4, only a tiny handful of investors I believe are really great at this. Mark Sugarman at MHS is one of those, but I’m not sure I can think of anyone else that seems to consistently find these kinds of companies and make the right call.
What is the alternative? I think it’s to back great founders in exciting markets and to do so super early. This requires establishing trusting relationships with founders before they raise capital and having some unique perspective on markets that are not obvious to everyone else. This tends to be our model (and the one I think most of our favorite co-investors pursue). The problem is that we only invest in about 10 companies a year, so we end up not being able to pursue 99% of the opportunities that we are presented with. That’s a bummer.
Despite all this, I think there is a case to be made that this situation is going to improve. I’ve noticed in recent months that more and more series A firms are starting to invest earlier in these post-traction big seeds. So in a way, these firms are doing more of the classic, early series A rounds of old. This puts some serious pressure on seed funds because they can’t compete with much bigger funds in terms of price. So my prediction is that you’ll see seed investors going earlier again as a response, which should hopefully create a healthier ecosystem in the coming months than we’ve had over the last couple years.