Seed investing is bifurcating

A curious gap has emerged in the early-stage investment landscape: While emerging startups are able to raise very small, sub-$500,000 rounds, seed and pre-A investors are requiring increasingly higher revenue and market traction milestones before they deploy capital to companies. Lately, it seems as if the single, discrete “seed” round of $1-$2 million has largely disappeared.

The milestones these seed and pre-A investors require today resemble those needed for Series A financing pre-unicorn mania (before 2012), but a large majority of these financing rounds are smaller in size, utilize convertible notes and are not priced like a typical Series A round. At the same time, what is today called a Series A requires metrics and milestones that resemble the “classic” Series B.

It’s tempting to dismiss this milestone creep as a cyclical correction, but the emergence of a new category of investment fund and round called “pre-seed” suggests that this change will crystallize this new fundraising landscape for the next couple of years. The pre-seed round is usually smaller than $500,000 (almost never larger than $1 million) and is for companies that have interesting ideas that need to move beyond a potential proof of concept.

What comes after pre-seed is now less clearly defined and organized. As a result of this new status quo, an emerging startup with just an idea or prototype might be able to raise up to $500,000 pre-seed from formal pre-seed funds, angels or “friends and family.” However that amount is often not sufficient to hit the requirements that early-stage investors require for bigger, pre-A raises (often requiring completed pilots, sales, a healthy customer pipeline, proof of accelerating user acquisition).

Many companies I met amid the height of startup frenzy have returned to raise a new round; they fall into one of the following two scenarios:

Scenario A: The Scenario A company raised a full seed round of $1-$3 million at the height of the recent frenzy. Thinking that the growth it bought would stick or that raising additional funds would continue to be equally easy, this company failed to achieve the milestones it claimed would be met with the seed-round proceeds. The company now needs additional capital.

This type of round has traditionally been identified as a “bridge” round, but companies are rebranding the additional capital raise with new terms like “seed plus,” seed prime,” “double seed” or “second seed” to avoid the dreaded “B”-word and its associated negative baggage. These companies are more likely to face a down round or will die if their runways end before they can raise additional funds.

Scenario B: The Scenario B company has bootstrapped itself or previously raised responsible amounts of capital and has achieved meaningful traction and/or promising revenue metrics. While such a company could have raised a Series A round a couple of years ago, Series A investors have dramatically raised their requirements and expectations. Because the goal posts have now moved, this company may receive less-than-favorable terms or no terms at all from traditional Series A investors.

Instead of engaging these traditional Series A investors, this company will raise a convertible note from seed investors. These seed investors typically have not invested at Series A milestones/maturity. But these same investors are also not targeting the pre-seed arena. This strategic move would, in theory, enable the company to build up further momentum in order to raise a healthy and positive Series A round.

Across the board, the market is asking companies to do more, with less, and at a much faster timeline. This new fundraising reality will hit hardest the companies that raised seed rounds in 2012-2015, because these rounds were designed to enable the company to hit the previously lower Series A milestones. Entrepreneurs raising for companies founded after 2016 should also take heed and plan their fundraising pacing and strategy in light of these new rules. If your company is facing this gap, here are some ways to avoid or minimize its impact on your ability to grow:

  • Identify and pursue non-dilutive sources of capital. Make good use of government, academic and nonprofit grants, awards and tax breaks where they are applicable.
  • Keep burn at a minimum from Day One, and avoid vanity expenditures. Anything that does not directly lead to long-term customers and sustained growth must go.
  • Build long-term infrastructure to fuel growth; like it or not, the days of burning cheap VC money to buy growth through subsidies is over.

With support from Ivy Nguyen of NewGen Capital.