Right now, in late 2023, the IPO market is halted, and late-stage deals rarely happen because funds and entrepreneurs cannot find common ground on pricing. The seed-stage arena has become more attractive for larger multistage firms because exit opportunities and late-stage funding are few and far between. Multistage funds have channeled funds into early-stage startups and will continue in 2024.
As a result of this increased demand, seed-stage valuations are breaking records, and deal sizes are growing, driven by multistage firms making big moves into seed-stage startups. This increased activity does create many downsides for founders and their companies, raising essential questions: Is the allure of name-brand firms, access to larger pools of capital, and sometimes higher-than-market valuations always a blessing, or does it come with hidden costs and strategic implications that may come back to haunt them?
Without multistage firms, we wouldn’t have multi-billion-dollar companies, and our society would miss out on many big ideas. But when it comes to pre-seed and seed-stage companies, in most cases, seed founders shouldn’t accept capital from multistage funds; instead, they should take money from firms specialized in seed and pre-seed rounds.
Why you shouldn’t take money from a multistage fund
They don’t have a rational incentive to give you hands-on support and time
One primary consideration is the level of hands-on involvement a founder can expect from a multistage investor. For example, a $1 billion multistage firm that invests $2 million in your company will provide a different level of hands-on guidance and support than specialized seed funds and angels. You’d represent 0.2% of their portfolio. The incentive for deep engagement is just not there. You’d either be competing for the partners’ attention with companies where they put eight- to nine-figure checks or end up working with a more junior investor who’s likely less experienced than GPs of seed firms.
Seed-stage companies will much better benefit from the close collaboration and mentorship that pre-seed and seed-focused funds and angels can provide.
Seed-stage companies will better benefit from the close collaboration and mentorship that pre-seed and seed-focused funds and angels can provide. These investors can be intimate partners on growth strategies, market nuances, regulatory challenges, and PR and communications. They won’t hesitate to tap into their network to send you customers/advisers and foster valuable partnerships.
Individual angels on your cap table with operational experience can help you navigate the challenges of early-stage growth and avoid common pitfalls. These folks will be your superpower to reach the next level.
Seed-focused firms only get markups and outcomes when you raise a Series A, so they work harder to help you secure the next round. They won’t compete for your Series A allocation and will provide better access to Series A investors in their network. They will be incentivized to open more doors and to help you secure a better valuation (while a multistage firm will be optimized toward ownership and getting a lower price on the next round).
From my experience, multistage firms will also invest in multiple competitors of a pre-seed or seed-stage company since it’s not very risky for them from a capital or brand perspective (they’re not afraid of founders saying negative things about them). It’s much more difficult for pre-seed and seed-stage funds to invest in multiple competitors, so they don’t.
They can cause increased dilution and reduced control over your company’s future
Increased dilution and reduced control are critical concerns for seed-stage founders. While the immediate cash injection from a multistage firm can be appealing, it’s essential to calculate the long-term impact on ownership and control, as you may lose a meaningful degree of control over your company’s direction and decision-making processes.
Consider two hypothetical scenarios: A founder is raising $2 million for their startup. A multistage VC takes up the entire round in Deal A, leaving no space for pre-seed and seed funds and angels. This affair is a prevalent scenario when multistage firms invest at seed. In Deal B, a founder accepts a mix of value-add seed funds and angels, each contributing smaller amounts to make up the round collectively. Multistage firms will also more frequently demand board seats.
In Deal A, the founder has one firm with total influence over their decision-making processes. Even if these rights are codified in round documents, it’s still a significantly tilted power dynamic against the founder. Meanwhile, in Deal B, no one investor has an outsized say.
In Deal A, the post-money valuation is set at $10 million, and for a $2 million check, the multistage VC owns 20% of the company. Because there’s less competition and momentum in the round, the multistage firm sets the price at whatever it wants. In Deal B, with a more diverse set of investors, we see the post-money valuation set at $20 million to even $30 million because the founder creates the round terms and sets the momentum, resulting in 7% to 10% owned by the investors.
There will be a signaling risk if they don’t invest in Series A
Another significant concern is signaling risk. While securing funding from a big-name multistage firm at the seed stage might be tempting, it could pose challenges while raising a Series A. If the multistage VC does not lead the Series A round, it may signal to other potential investors that the initial backer isn’t fully committed and make them wonder why. Even if the company is performing well, signaling risk can impact the perception of future investors and hinder fundraising. In my experience, multistage firms rarely take the lead in Series A rounds for their seed portfolio companies, even when the companies are doing quite well.
While I largely believe seed-stage founders shouldn’t take money from a multistage VC, there are exceptions. They may have a track record of leading proper Series A rounds in their seed-stage investments, or the partner you’d work with has founded a similar type of company in the past, and you could learn from their expertise.
If you’re still deciding whether to take money from a multistage firm, here are the considerations
Do reference checks on other founders’ experience with the particular investor (both partner and the firm)
Before committing to a multistage VC:
- Conduct thorough reference checks on the specific partner and firm involved.
- Ask to speak to founders from their prior seed-stage investments so you can assess the depth of their engagement and strategic support beyond capital.
- See if the partner is actually putting in the time.
Reviewing the firm’s and partner’s track record in leading subsequent funding rounds is essential. Ask about the percentage of seed-stage companies that later went on to lead their Series A fundraising.
Understand the partner’s position within the multistage VC firm and evaluate whether the partner has the influence to champion your company for a Series A round. Ask about their success in securing lead positions for other portfolio companies, gaining insights into their ability to drive decisions internally.
Make sure you have allocation left for a few seed-stage firms and angels
Ensure ample room is left in the round for participation from value-added early-stage funds and individual angels. Multistage VCs may attempt to fill a substantial portion of the round, leaving limited space for other contributors. For instance, in a $5 million round, be cautious if a multistage firm aims to take $4.5 million, restricting the ability to include essential early-stage participants. In this example, try to have the multistage firm take less than $4 million so that you can build a proper cap table to support you.
Get clear on where you need to be before a proper Series A round
Clarify the specific metrics and milestones expected by the multistage VC for a successful Series A funding round. Obtain a clear understanding of the criteria that need to be met to receive a term sheet. Inquire about the firm’s recent Series A investments, understanding their criteria and success metrics. This information will guide your company’s trajectory to align with the expectations of potential Series A lead investors from the specific multistage VC you’re speaking to and others.
De-risk the round by creating competition
Consider involving multiple multistage VCs in the early round to create competition. Having two multistage firms, a reputable seed-stage fund, and other angels can be a strategic move to make optionality for you as a founder in the future. This approach increases the chances of securing a Series A term sheet and communicates to investors that there are multiple credible players on the cap table. Make sure it’s still with low dilution, and know this will be difficult to pull off.
My advice:
- Push for 15% dilution for a seed round.
- Have the lead(s) take 50% to 60% of the round.
- Leave the rest for follow-on investors.
While significant capital and brand may be tempting, founders should consider the potential risks. Seed-stage founders must carefully weigh their options, considering the hands-on support, ownership/dilution concerns, signaling risks, and active engagement of the partner and firm. Ultimately, a well-informed decision must be grounded in your startup’s unique needs and create optionality and independence in future rounds. Your decision about financing today will shape your company’s future.