How a Seed Financing Can Put You at the Head of the Class
In the early days of a startup company, founders may be fortunate enough to be faced with a dilemma: raise a seed round or try to go straight to Series A? To some, this question has an obvious answer: raise a Series A if you can. It’s much more money for only slightly more dilution.
That simple answer, however, neglects a critical dynamic in the startup market, and may shortchange your startup for the long term. Now if you are a repeat entrepreneur like Russ Fradin or Diane Greene and have a string of successful ventures under your belt, the logic of this post doesn’t really apply to you. For the mere mortal founders, however, there is more to consider than simple dilution math.
Power law distributions
At any given time there is a cadre of companies that are viewed by the tech community as being at the head of their class. These companies reap a tremendous reward from this perception in terms of the quality of people, investors, partners, service providers and media coverage they are able to attract. This in turn increases that company’s chances of success. So while startups usually view their competition as companies that offer a similar product or service, in reality, all startups are in competition with each other. Your financing strategy should take into account how to become one of these top companies.
Being a top company is not simply a nice to have; in this environment it is a matter of survival. While the number of startup companies has exploded over the last decade, the number of Series B financings has remained relatively constant per Crunchbase data. In short, more companies than ever are competing for the same number of Series B rounds. By raising a seed round, a company buys itself more time and money to get to the Series B financing and therefore increases its chances of making it through this critical milestone.
Nine women x one month ≠ baby
Another benefit of a seed financing is it gives a company more time to find its footing. A seed round gives the founders 18–24 months to build a team, bring an initial product to market and iterate on that product. During this time, the team can deeply understand customers, find the segment of the market where the product solves a real need and start to figure out the right go to market strategy.
Product development can’t be accelerated by throwing more resources at the problem. After having worked with hundreds of companies over the past 20 years — I’ve observed that successful startups are born from a series of tiny “aha” moments, each of which aggregate to create a truly unique and differentiated product and go to market. This simply takes time and much trial and error. Knowing the bar for a Series B financing is higher than ever, why not give your startup more time for this critical exploration?
Money burns a hole in your startup
Some will argue that a startup could just raise a larger round and not spend it. It’s just really hard to do this in practice. While many early stage companies show excellent discipline around spending, as Fred Wilson says, there are simply too many temptations. A startup with cash on the balance sheet is just more likely to spend more on a nice office, stretch to pay an executive who is making big money in her current job, or even start spending a bit more on customer acquisition to reach growth goals. Like the astronauts on Apollo 13, startups with limited resources seem to miraculously solve intractable problems without additional spending. I try not to keep cookies in my house because, when they’re on the shelves, I eat them. Why tempt yourself?
The main thing is to keep the main thing the main thing
Raising a Series A round requires fewer proof points than a Series B. Accordingly, a seed round gives founders the opportunity to focus on a smaller number of milestones for the next fundraising. This in turn makes it more likely these milestones will be reached. For example, a seed stage company CEO in a software company can be focused on obtaining and delighting a few key customers in order to show sufficient traction for a Series A. To raise a Series B, that same CEO must scale the sales team so that it can hit a series of subsequent quarters, ensure that churn is low, build out customer a success function and round out the executive team. Why not lessen the degree of difficulty of the dive and allow yourself to manage fewer key milestones?
Whether madness is or is not the loftiest intelligence
I hear what you are thinking. “So let me get this straight, are you saying to take less money instead of more and intentionally give myself a shorter runway? Are you insane?” Maybe (and there are many who will tell you so) but consider this scenario I’ve seen play out a number of times: A talented person from industry decides to start a company. Because of her tremendous track record, she is able to raise a respectable $4 million Series A. She quickly builds a solid team of other talented folks and they go to work building the product, creating a marketing plan for the big product launch and, hiring a sales people and an engineering team to rapidly build and sell the many features that are envisioned. The product launches to much fanfare, but initial sales traction is slow. The company now finds itself in the unfortunate position of having burnt a good chunk of the cash and needing to both cut the burn to buy some time AND ramp up sluggish sales. Not a pretty picture.
Almost every one of the best companies I worked with over the last 20 years had a period of time during which the team was solely focused on building a delightful product and designing a thoughtful go to market. So while a seed financing might seem like you are putting your company at risk by giving your company less runway,a seed round may actually give you more runway for the truly difficult Series B round with fewer distractions and temptations and, that’s a good thing.
Originally published at http://cowboy.vc on September 8, 2017.