What’s a Seed Fund to Do When a Seed Round is $20 Million?

There’s a funding phenomena I’m wrestling with these days – the Straight to A. As VC Matt Turck notes, there’s been an increase in startups whose initial round of institutional funding looks more like an A Round than a Seed Round. That is, raising $5m+ at a $20m+ post-money, lead by a large multistage VC. These rounds most frequently occur when it’s a repeat founder with pre-existing relationships to a fund, but we’ve also seen them occur because a company didn’t raise institutional funding until later in its development or because some combination of their fast growth and competitive dynamics mutated what was originally intended to be a seed round.

With Homebrew we’re focused on being ‘partners of conviction’ to founders during the first few years of their companies. This traditionally means entering at the seed round stage (an initial financing of < $3m, lead or co-lead by us), but we’ve got access to these Straight to A rounds as well via pre-existing relationships with their founders or the lead VCs. So what’s a seed fund to do when a “seed” round is $20m? It’s something we’re wrestling with because in many cases I don’t think these rounds are necessarily right for us or the founders (the risks of raising ‘too much money’ we’ll save for a future post).

Here’s what we’ve observed and how we currently think of these rounds

  • When evaluating any metrics around the state of seed financings, I believe valuations have plateaued a bit and one reason is the increase of Straight to A from experienced founders (and these A Rounds not getting tallied in seed data.
  • In Homebrew I we participated in three rounds that I’d describe as Straight to A. In all cases we wrote a check that was on the average to high side for us. We did so because (a) we felt like the potential return could be meaningful to our fund despite smaller ownership percentage, (b) the founder and/or industry was well-known to us and (c) we had working experience with the lead investor.
  • Heading into Homebrew II, Satya and I are still discussing our framework for evaluating these opportunities. I think they’ll continue to be exceptions for us – the dynamics are so totally different from the majority of our investments.

What are the risks of seed funds participating in these Straight to As?

  • Investor Misalignment: When seed funds participate in these deals they need to feel confident that their interests are aligned with those of the lead investor (which will usually be a much larger fund with a different returns model).
  • Second Seat Syndrome: While an investor’s credibility with founders always needs to be earned, it can be more difficult to do when there’s a much larger lead VC leaning in at the earliest stages of the company (for better or worse!).
  • Misjudging Good vs Great: Seed investors aren’t spending their time evaluating A Round companies so when you look at Straight to As, many of them look “better” than the average seed investment because there’s more of a team in place, or more progress made or more ‘polish’ etc. But it’s important to not compare them to just other new seed deals you could do but to what a top A Round company should look like. That is to say, if you’re paying 5-10x post-money, that company should have 5-10x the potential.
  • Check Creep: You start writing larger checks, committing both your initial average check and your reserves for that company in a single instance.

So I think in 2015 we’ll see a continued increase in Straight to A Rounds, there’s enough money raised by large funds and repeat founders to sustain for a while until the industry figures out whether these funding strategies are helpful or counter-productive to the entrepreneurs. And I think we’ll be refreshing our own POV over the coming weeks.