- Giant, multi-billion venture firms have grown enamored with seed-stage investing.
- They’re winning Silicon Valley’s hottest early-stage deals by bidding up prices.
- Insiders say traditional seed firms, and the support they offer fledgling founders, are under ‘existential’ threat.
- Visit the Business section of Insider for more stories.
When a tiny two-person San Francisco startup named Stytch began pitching venture capital firms for its first-ever round of funding early last year, known as a “seed” round, the partners at venerable seed firm First Round Capital thought they were a shoo-in as the lead investor.
Instead another, bigger fund — Index Ventures — wanted a piece of the company and offered to buy shares at a higher price, setting off a bidding war, sources said. Word among the tech industry’s close-knit venture community got out about the heavy interest in Stych, and other big investors entered the fray.
The startup still hadn’t launched a product yet but investors were attracted to its two cofounders, Julianna Lamb and Reed McGinley-Stempel, who had both worked for the red-hot fintech Plaid.
It was Benchmark that won out as the lead investor, sources said. This was eyebrow-raising in the venture world, as Benchmark is best known as a firm that buys in at later stages. It’s backed Twitter, Uber, and Snap, has billions of dollars of assets under management, and has, until recently, largely ignored seed funding, the riskiest of bets in venture.
Stytch ended up raising a hefty $6 million seed round at a post-money valuation of around $25 million, according to two people familiar with the deal. The valuation has not been previously reported and the company declined comment.
Benchmark’s lead check size of around $5 million was too high for First Round to match, given that its fund sizes are much smaller than Benchmark’s. The seed firm bowed out as the competition ramped up, people close to the deal said.
Stytch’s bidding war is just one example of a major trend for seed-stage tech investing. Wealthier, “multistage” firms have descending into seed investing with a fervor not seen since the early 2010s, data shows. They’re enticed by the tiny price-per-share they can obtain in a seed round, and the prospect of massive returns those early investments can bring.
For instance, last December, Coatue, the secretive hedge fund run by billionaire Philippe Laffont, won the contest to lead Supabase’s seed round by offering a term sheet no seed firm could match: a $6 million round at a staggering $40 million post-money valuation, according to an investor familiar with the deal. The company’s valuation has not been previously reported.
Read: Hedge fund Coatue has become one of the most powerful startup investors of 2020, nabbing stakes in 14 unicorns so far
It’s adapt or die for the seed firms, multiple investors told Insider.
“I think this is actually quite an existential threat if it persists,” Terrence Rohan, a former general partner at Index Ventures, said.
While bigger seed checks can be great news for founders, there are risks for them, too. Overpriced seed rounds can ramp up pressure for startups to scale too fast to prove they were worth the money. And they may struggle to raise the next round.
“I can’t tell you how many times I’ve seen companies where they over-raised on their first round, and it made it ten times harder to raise a subsequent round,” Chris Farmer, the founder and CEO of early-stage firm SignalFire, told Insider. “If you build a weak foundation, you can’t build very high.”
‘We’re going to f— you over’
Lee Edwards joined seed firm Root Ventures in 2018, when the firm closed its second fund of $76 million.
The firm’s goal then was to write lead checks of $1-2 million to hit double-digit ownership of the companies it invested in, capping the valuations after investment (aka “post money” valuation) at around $20 million.
That’s a common approach for traditional seed investors. They believe they need to own at least 10% — and typically 20% — at the seed stage in order to generate worthwhile returns.
Root’s investors were also technical founders and engineers, which the firm believed would give it an edge in scouting young companies and winning competitive rounds. Many founders want their first investors to advise and help them grow.
In the last couple of years, however, Edwards says he’s watched money from the venture giants flood into seed-stage startups.
Sequoia, for example, made more seed than Series A investments in 2019 and 2020, according to a source familiar with the matter. And Lightspeed put over $100 million in US seed rounds last year, more than double the amount it invested at that stage in 2019, according to data provided by Pitchbook.
Gaurav Jain, the cofounder of pre-seed firm Afore Capital, told Insider that more than 90% of his portfolio companies’ seed rounds are now led by these bigger multi-stage investors who can invest double the money of traditional seed firms. That’s around 30% higher than in 2016, when he founded Afore.
Even hedge funds are entering the mix. Coatue made its first-ever seed investment in 2019, when it raised a $700 million early-stage fund. Since then, it’s invested more than $56 million into at least twelve seed deals, according to Pitchbook.
Edwards’s firm is now under pressure as competition from such wealthy funds has escalated.
The massive check sizes big investors offer, often for a smaller chunk of startup equity, are usually too tempting for most founders to reject.
“I’ve had some of them tell me over drinks: we’re going to f— you over, and we’ll never let you in a deal,” Edwards said of his friends that work at these bigger funds.
Sometimes great, sometimes bad for founders
Edwards says he’s winning deals by emphasizing his commitment, promising founders that he’d take their call even if it was “at midnight, on my birthday, in another country,” he told Insider.
“If a big-name VC does your seed round, and they’re working on three SPACs right now, do you think that you’re going to get the time of day from them?” Edwards said.
For sure, big checks can be a blessing for seed founders, giving them more time to build their companies without worrying about money.
The big risk has historically been what the industry calls “negative signaling.” That’s the black stain that comes when a prominent investor who grabbed the seed round then refuses to buy shares in a startup’s Series A, the round after the seed round.
For this reason, former Index investor Terrence Rohan used to advise founders to always raise their seed round from traditional seed firms. But when a friend recently told him that he was offered a $5 million lead check from Sequoia, the investor struggled to convince him to turn it down.
That money, Rohan realized, could last up to four years. If his friend’s company failed after that, it would be because the business wasn’t sound, not because of any failure in its fundraising strategy.
So Rohan no longer offers that advice.
“I think the big difference now is that the runways are so large,” Rohan said. “And so I don’t think the historical arguments of signaling hold anymore.”
On the other hand, if young founders don’t use those big checks wisely, the risks escalate. A hot seed round can create pressure to grow at breakneck speed to validate the investor hype.
“If you take money at a high price and a lot of money, that money needs to multiply,” SignalFire’s Farmer said. “And so if you raise money at an overprice, and don’t hit traction commensurate with that, you can screw yourself.”
Seed firms are adapting
To stay competitive, investors at top seed-stage firms are now deploying larger checks for rounds they’re determined to lead.
Early-stage firm Susa Ventures, for example, just offered one startup $2.5 million at a $25 million post-money valuation, in part because bigger competitors drove up the round’s price. The number is more than twice Susa’s normal check size, the firm’s cofounder and general partner Chad Byers told Insider.
However, Byers and other investors say that the strategy isn’t sustainable, because their fund’s investors want the fund to spread money over as many young, unproven startups as possible to reduce the amount of money lost when some of those startups fail.
“You can make exceptions a couple of times in the portfolio,” Byers said. “You just can’t make the exception the rule. That’s when you start to get into changing your entire fund model.”
Some seed funds are trying to invest earlier in a round of funding known as “pre-seed.” This was classically the angel-investment round, a stage where founders still haven’t developed a working product for their startups, much less revenue. Edwards, for example, says he wrote his first pre-seed check of less than $1 million this year.
Ann Miura-Ko, a cofounding partner of seed firm Floodgate, is doing a similar thing. She’s tapping the founder network she’s developed as a Stanford professor to “double down” on pre-seed investing, she said.
She points out that traditional seed funds are facing yet another threat: a new type of seed investor known as the solo general partner (GP) who is also competing to invest, and sometimes even lead, competitive, early-stage rounds. Unlike angel investors, who invest their own money, solo GPs manage funds with other investors’ money.
Read more: Inside the rise of ‘super angels,’ a special breed of investor that’s carving out a valuable niche in a landscape dominated by VC giants
“The more you see individual GPs coming into the market, multi-stage firms coming into the market, you just have to double down on what you are really good at and market the heck out of that,” Miura-Ko told Insider.
Some seed firms, like Susa Ventures and Initialized Capital, are also trying to invest more heavily in follow-on rounds, buying more stakes in their portfolio companies as they grow, they say.
For new, seed-stage investors, the best option may be to raise smaller funds and write smaller checks in more companies, avoiding direct competition with the multistage firms altogether while competing on service like Root Ventures does.
“Focusing on the types of ownership that seed funds traditionally require may be a vestige of the past,” Lee Jacobs, the investor who founded seed firm Long Journey Ventures this year, told Insider.
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