Editor’s note: Nnamdi Okike is a co-founder and General Partner at 645 Ventures, a seed to Series A stage venture capital firm that applies a data-intensive approach to deal sourcing and value creation.
Over the past five years, there has been roughly $3 billion of capital invested in nearly 3,500 seed-stage companies, with the number of seed investments rising every year. According to CB Insights, 2014 saw the largest year of seed investing since 2009, with a record $1.3 billion of capital invested in almost 1,000 seed companies. Many of these seed founders have high hopes of raising the subsequent up rounds that can lead to a defining moment for their team, investors and advisers: an attractive acquisition or an IPO.
The reality is that raising seed capital is only the beginning of a long and sometimes turbulent journey of startup experimentation, and only a small percentage of seed companies will emerge from the gulf of experimentation to reach a Series A round.
An even smaller percentage of companies will reach a “highly competitive” Series A round, which my partner and I define as an equity round where a company raises greater than $5 million led by an influential partner at a top-quartile venture capital firm, and where the round is set at the right valuation. The right valuation is counterintuitive because it does not necessarily mean the highest dollar value and the smallest equity percentage for the new A investors.
The right valuation is one that accurately reflects the milestones reached by the startup team, while at the same time reflecting reasonable future performance of the company. Most importantly, the valuation should be low enough to leave room for future up rounds and high enough not to deter meaningful acquirers.
Our team works closely with seed-stage founders to help them develop and execute strategies to reach highly competitive Series A rounds. We have funded, studied and built personal relationships with several founders who have reached the Series A milestone. The principles and guidelines we gathered have helped several of these founders and is information that we hope will be used by all seed-stage founders who aspire to lead their teams to a highly competitive Series A.
Systematic Reduction of Product, Market and Execution Risk
Companies that reach highly competitive Series A rounds typically have systematically reduced their company’s product, market and execution risk during the seed stage. The founders of these companies use their seed capital to efficiently orchestrate a process-oriented set of experiments that culminate in evidence of product-market fit.
From a product perspective, their product teams are characterized by product, technical, and/or domain experts who can build compelling products that address concrete market needs. These teams study the engagement of their users/customers, and discover how users/customers are interacting with their products and the value customers are deriving. These companies have multi-talented, growing, and disciplined product teams that sometimes execute against a product roadmap that has feedback loops to help inform product development.
The team leads are aware of the amount of capital needed to launch new products and typically ensure that the culture of the startup leaves room for new product experimentation.
From a market perspective, top seed teams understand their markets in intimate detail, both microscopically and macroscopically. This involves understanding customer unit economics, market demographics, customer demand and behavior, and rates of user adoption and retention. This also entails understanding exactly which segments of a market are addressable and which are not.
Top teams gather evidence to prove that the market is large enough to sustain a multi-hundred-million-dollar exit or potentially a billion-dollar revenue company. These companies typically demonstrate this evidence through a bottoms-up market analysis, starting with evidence achieved by the company and concluding with reasonable scaling assumptions supported by accurate research and trends.
The highest-potential seed companies marshal evidence to show that they can be at least No. 1 or No. 2 in the competitive market. This requires having a detailed awareness of competitors, and understanding their strengths and weaknesses. Intel’s Andy Grove famously stated that “Only the paranoid survive.” We find that a healthy level of competitive paranoia also characterizes the seed companies that reach highly competitiveSeries A rounds.
Finally, these seed teams typically reduce execution risk by the time they reach Series A. Put simply, they assemble the best team possible to execute on the market opportunity. In the gulf of startup experimentation, the best seed companies are engaging in an iterative process of putting together a core team of employees, experienced advisers and investors; this rarely happens without an occasional misstep.
However, when a company reaches Series A, there should be no major holes in the team, and no big gaps that raise questions of whether the company can recruit an incredible talent and build, market and sell the right product.
Tracking and Hitting the Right Metrics
The best companies track key metrics that accurately reflect underlying performance and provide significant insight into why a company will succeed in the future. Three of the best tools we’ve seen founders use to track these metrics are Mixpanel, RJMetrics and KISSmetrics.
For example, top enterprise and SMB companies know their Cost of Customer Acquisition (COCA), Customer Lifetime Value (CLTV), and customer and revenue churn rates. Enterprise and SMB founders track these metrics religiously and benchmark themselves against their peers. Consumer companies not only track absolute growth in users/consumers, as well as COCA/CLTV, but they also track user engagement, as reflected by time on site, time in app, bounce rates, click-through rates, etc.
Both enterprise and consumer companies religiously track their cash runway, and manage expenses to ensure that they don’t prematurely run out of cash. In addition to tracking these metrics, the top companies understand what these metrics reflect about their companies and what story these metrics will tell investors.
Outstanding seed founders are conscious of the metrics that are relevant to Series A investors and to future investors/acquirers, and they attempt to reach the key metric thresholds before going out to market to raise capital. These founders are well-prepared, and by the time they have reached the fundraising process, they know exactly the questions the top firms will be asking.
For example, they know that a top-quartile enterprise-focused VC firm may have a $1 million ARR hurdle for a SaaS deal, or that a top-quartile consumer investor may have a $2 million run-rate revenue hurdle for an e-commerce company. Also for revenue-generating businesses, future growth plans are created that articulate a clear path to becoming a large revenue company with attractive future profit margins.
Avoiding Financing Pitfalls
Optimizing for a highly competitive A round requires taking several factors into account, including the track record of the lead firm, the track record of the individual GP leading your deal and of course the valuation/terms of the round.
When evaluating a lead firm, the best seed companies typically evaluate the firm’s investment track record, historical exits, networks and the deal lead’s ability to add value. Venture capital in its best form represents true partnership, whereby the lead GP plays an integral role in the company’s growth. In addition to bringing a track record of successful exits to the table, the GP should be able to form a strong relationship with the founders and become a trusted adviser.
We guide our founders to raise Series A rounds at the right valuations that reflect a company’s actual performance and that ideally enable founders to continue to own a substantial ownership percentage in the company. Companies with limited historical performance that raise A rounds at lofty valuations often find themselves facing difficult funding circumstances during later rounds.
While a valuation can consider potential future rapid growth, it also should be based on demonstrated historical evidence based on product adoption and user/revenue growth, as well as a team’s unique ability to execute on the company’s future growth plan. The Series A valuation should not make it difficult for a company to raise another round or exit in the future.
Planning for a Successful A Round Begins at the Seed Stage
A poor seed financing strategy can hurt even the most promising seed-stage team, making it difficult for that company to raise a highly competitive Series A round despite strong business performance. The hallmarks of poor seed financing strategies include founders who have already given up the majority of equity before the A round, inflated seed valuations that make it difficult to raise an A round at a reasonable valuation, or a large overhang of convertible debt resulting from numerous convertible note rounds.
Savvy entrepreneurs who reach highly competitive A rounds don’t solely optimize for valuation at the seed round. They instead are well-prepared leading up to the Series A and often choose seed investors who bring real value to the table. They understand that the performance of the startup after the seed round is what transforms a company’s series of startup experiments into a high-growth startup that has achieved product-market fit.
Our Salute to Seed Founders
My partner and I know that closing a seed round is a substantial accomplishment, and we salute the seed founders who reach a Series A. We hope that our notes and guidelines help to ease the path for at least a few of the founders who have recently closed their seed rounds and are hoping to reach highly competitive A rounds in the future.