Welcome to Equity on Extra Crunch, a semi-regular series of interviews between the Equity team, venture capitalists, and operating executives at the neatest startups. The goal of this irregular medium is to dig into topics that don’t fit inside of the standard Equity format, but are still critical to understanding what’s happening in the private markets.
To kick things off, we invited two of our favorite early-stage investors over to TechCrunch’s offices in San Francisco for a video chat. But for those of you who prefer to read things, we’ve also summarized the questions and answers.
Equity was happy to have Floodgate’s Iris Choi back in the studio, and we’re also excited to have Cowboy Ventures’ Jomayra Herrera around for the first time. Choi is an Equity regular, and Herrera recently took part in a piece we published digging into the split between enterprise and consumer seed deals. That’s what we call foreshadowing. Let’s begin.
We wanted to get advice from our two investors as to what founders seeking seed deals might want to do to avoid unnecessary agony.
Choi notes that round size is important in terms of how much capital founders are looking for and how much capital Floodgate can provide, and what the startup intends to do with it. While Floodgate can only deploy so much money per round, the firm is willing to co-lead with other investors when it makes sense.
To entice a check from her team, she says to justify the capital, detailing what your startup will achieve with it and, reading between the lines, how close it will get the company toward Series A readiness (more on that below).
Herrera agrees. She says founders should raise the capital they need to hit their expected milestones, but not more. You can always ask for more, but it’s hard to ask for less: If a founder or startup goes to market looking for a certain figure and fails, it’s very difficult to go back out and seek less.
Perhaps a simpler summary would be to know precisely how far your startup can get with a particular dollar amount and why that set of results is compelling for either proving that you deserve more seed capital or that your startup will be Series A-ready.
Sticking to the theme of seed-deal size, I was amazed at the rising size of seed rounds. My first question on the matter was whether, given how large seed rounds have become, if they are nearly more go-to-market focused.
Choi thinks that the edges have blurred because there are Series A-focused firms (with more capital to deploy than seed-focused firms, in general) are at times writing half their checks at the seed stage. In case that makes little sense to you, think about those small (for the Series A firm with its larger war chest) checks being options instead of equity bets. If the seed-stage company does well, the Series A firm can run its next funding process, and wind up with back-to-back leads in a hot company. That means a high ownership percentage relative to the stage and invested amount for the firm.
The flip of that is that the Series A firm probably wants to put more capital to work than a seed fund, inflating average seed deal size and average seed deal valuations. This is what Choi calls being “valuation insensitive,” which we have already framed and added to the euphemism hall of fame.
But let’s talk about Series A deals, especially in the context of rising (average!) seed deal sizes. It feels that the bar for raising a Series A has gotten higher. I wanted to ask our pair about that, and how they are preparing their portfolio companies for graduation from seed to Series A:
Herrera calls the purported $1 million ARR threshold effectively a myth. In times past, when Series A rounds were smaller, it might have been a pretty good benchmark for preparedness. No more. She adds that her firm focuses on revenue quality instead of revenue quantity; by that she cited highly engaged customers that are spending money with the startup in question “over time.”
Obviously this is an enterprise-focused answer, but it does help explain why some companies do manage a Series A while sporting less than $1 million ARR, and why, with more, they can’t seem to close a deal.
Herrera did note a generally rising bar for Series A deals, especially for consumer-focused startups.
Digging into the size of checks that Choi said that her firm likes to write, I was curious if it is possible to meet those thresholds (repeatability of revenue, proven CAC, and longitudinal SaaS metrics that look bright, per Herrera) without more capital?
The investor pointed out that their seed extensions are filling the gap between normal seed deals and higher Series A expectations. Formerly a sign of Bad Times, extensions are now pretty standard; indeed, Choi points out that seed leads often handle extensions, making the broader seed deal effectively tranched.
Before we scratch our B2B v. B2C itch that we noted was coming, let’s spare a moment for profits. As anyone paying attention can tell you, there has been a growing focus on profits, or close-to-profits, in the world of venture capital and its constituent startup investments.
I wanted to drill down into what that might mean for seed-stage companies, or, the firms least likely in startupdom to make money.
On the question of startup efficiency, especially regarding seed, Choi stressed the importance of “efficient growth.” She joked that her firm’s model might have been out of fashion in the past few years, implying that the market has come around to their view. What is that model? That seed deals are designed to provide enough capital to run a number of “experiments” to demonstrate the marks of product-market fit. Seed deal to experiments to traction: That is the Floodgate way. And in a market that is suddenly enamored with more stable companies with more durable metrics, that probably fits the current narrative.
On the question of fear, Herrera focuses on the idea of efficient experimentation — the idea that companies should make intelligent bets with their ever-dwindling cash runway. This boils down to “quarter-by-quarter” sets of choices regarding cash deployment, something that she’s seen investors get better at recently. You can guess why.
After getting through all of that, the nuts and bolts, or mechanics and (go-to market) motions of seed, we dig into a number of other topics, including the issue of what sort of company to launch. Should it focus on consumers? Or should it focus on selling to other companies?
Thinking about consumer-focused startups, Choi notes that a regular point regarding such firms is that once they reach a certain scale, they will be able to monetize. An “if you build and they come they will also pay you” model, if you will.
However, advertising has only worked for a handful of companies. And none of them are your startup.
After Choi connects the efficacy of ads only working for a few, we ask Herrera about those few companies, the Amazons and the Googles. We brought them up to her as she had noted previously that the cost of acquiring customers through the ad channels that Choi had cited can be quite expensive. So what impact does that have on consumer-focused companies that use ads to drive adoption?
Herrera points out that vertical social networks and more-targeted social services probably have a good shot. She said that taking on Facebook is going to be hard, but there are lots more spaces to work in than just mass market social. More niche stuff, she said, is “starting to see some success,” which is neat. Because surely, surely Instagram is not the end of social-network development.
Choi took the trend a step further, pointing out that VCs are hunting for platforms that are consumer-facing and where The Big Platforms are not taking up all the oxygen in the room.
We talked about two more things. The first, valuations. But not in the sense of “are things expensive,” because they are. A small rock you found on the curb next to an electrical box attached to a building that houses VCs could tell you that seed-stage deals are expensive. What we want to know is whether they are going to continue to rise:
Herrera thinks that seed-stage valuations will level off, which is probably good news for investors. But more, she sees the market splitting into two pieces. Some folks have it super good today at seed, and some are struggling to raise any. This is a thesis that Elizabeth Yin raised that we’ve covered as well.
Choi frames the valuation argument in terms of ownership percentages, as VCs need to own a certain chunk of a company to make their own economics work out. She also wonders if the current data about average seed-stage investments include capped SAFEs, which could mess up the numbers.
And, finally, ask what might be happening to the founders out there who might have historically started a company, but recently got paid a king’s ransom for their stayed-putness.
If you just watched that clip and said to yourself, Alex, of course those people making god’s-own hourly wage at Google aren’t the same folks starting companies, all I can say is yeah, I should have thought of that.
More soon! Thanks for hanging out with Equity on Extra Crunch.