The Inflation of the Seed Round
The majority of angel investors that I have met like to put in about $25-100K into a round. Of course there are the outliers but people who are consistently investing in companies with their own capital at the early stage are within that range. These people are the real financial risk takers who hope to catapult a founder and their company to becoming a well-oiled machine that can go on to raise institutional money and grow. Sometimes it works and many times it fails.
In the past couple of years I have witnessed the slow creep of the seed round. In the 90’s when technology was just starting to make an impact in the start-up world creating a frenzy of first time internet companies the cost to start those was much higher. There wasn’t any open source platforms to build companies on. Then of course the mortgage crisis came along and the start-up industry went through a bit of an implosion before returning to the slow build of what we see today.
When the next generation of founders came back with new ideas the cost to prove out the model, aka raise the seed round, was not that high. That has changed. In the past year the majority of companies that I have talked to believe that they are worth $7-10m if not more prior to proving out the model and are raising seed rounds of $2-3m. I actually asked two founders why did they think they were worth $7M when they had not really built anything yet? The answer was that is what everyone else in their vertical was getting. Then I saw another one where they had raised $500K from an accelerator and the next round was a seed round for $2.5. That is not what I would consider a seed round. The next round should give you an 18- month run-way so that is a lot of capital to piss through to figure out the model on stage 2.
What this all says to me is this will not end well. Companies who raised at high valuations who are even doing well, who have done everything right, will find themselves with down rounds as they grow because the smart investors and the later stage people who invest on analytics not a hope and a dream, won’t write the check. And not every vertical is equal. Hardware, SAAS, CPG, fast-casual, marketplaces to name a few are all valued differently. All you have to do is look at the publicly traded markets to see the real worth.
And so, I will be watching and not participating in supposed seed rounds where I can’t own enough of the company to make it worth my financial thesis. It doesn’t make sense. Why others do, is beyond me.
Comments (Archived):
With you, 100%.I’m seeing the same thing and walk away from those deals. Others that do it are probably less experienced and think that everything will always go well and multiples are there to be had for that company, but for the disciplined investor, it doesn’t make any sense, financially speaking.
Totally.
Yup. I am starting to see valuations drop a wee bit though given what has happened in the market and the rise in interest rates. I’d love to see the discount rate at 3.5% to 4%. Then we would be back to “normal’ WACC. This 0% thing the Fed did for so long was an exercise in stupidity and has created several bubbles that hopefully will deflate and not pop. Or, if they pop hopefully they aren’t large enough to shock anything. Bitcoin was a bubble and the deflation hasn’t hurt anything except the HODL people.Our seed fund has taken the position that if we can’t write a big enough check and if we are also “commodity money” in the deal we won’t write the check. We have been pretty disciplined about valuations and have a long discussion with entrepreneurs about it. Those discussions can be telling. So far it is working out.
I have had many of those convos too. You have to be disciplined.
Comes with the territory. I remember trading in 1999…..
I wonder to what extent when you have conversations with entrepreneurs how receptive they are to the idea of why it’s better to take your money at a lower valuation than someone else’s money at a higher valuation? Does that ever come up? Is it possible to convince someone by selling them that getting more isn’t a necessarily a good idea?
Amen.
I would think that there is a ‘gambler’ component that is playing into the money that is being ‘invested’.Generally by ‘old school’ thinking a company that hasn’t even launched yet or is losing money would not be valued at much at all if anything. It’s not a company. It’s a bunch of people (or even 1 or 2) so how can that have real value? It would just be a bet that the idea would pay off or the people will figure it all out.So what is really happening is an adjustment upwards of the gamble by someone (the investor) who wants to entertain themselves and keep themselves busy with something to do. And if it works out then great. After all people spend money in Casinos even knowing they will lose (and they do lose). So this is perhaps a variation of that. (Ditto for sports gambling).That said I wonder to what extent the inflation actually impacts things in the end. Reason is if the idea hits then it doesn’t matter and if it doesn’t hit then it doesn’t matter. The only thing that investing less allows you to do is make more bets. But if you pay more and things work out then does that matter?Not my thing and I have zero plans to invest in this type of thing (and never wanted to do so).
As a founder, I wouldn’t want to risk having a down round impact early investors as we grow, or to scare off later stage investors, so would think even startups would get this!
You would think so but not necessarily. Founders prefer to get the highest valuation possible and to sell the least amount
Indeed, and possibly many of those founders miss out on the right partners when it’s all about valuation (too bad). Seems like the most plugged-in investors who can offer real guidance, also are the least likely to over-value a company.
From what I’ve seen this inflation seems to have arisen as a result of founders pulling a valuation out of thin air. Usually because as mentioned, another company in their vertical had a similar valuation. It is a departure from ariving at valuation through conversation with investors about how much they need own and how much runway the company needs to make it to the next round.
Yes, that is true in some circumstances.