Seed funding is not what it used to be

Early stage seed rounds increased to around $2.2 million in 2016. At first, it may sound like an accomplishment for a startup to raise such a large sum, however for a pre-revenue startup this should be frightening.

Such large seed rounds can seriously disincentivize nimble and lean operations. Such startups focus on growth before revenue is even made and the product-market fit can be quite uncertain in many cases. A fund with $2 million would be able to invest into 10 startups ten years ago, however the fund would only invest in one startup today — not so much left for diversification and the words one egg one basket spring to mind.

The craziest part of this figure is that seed rounds are consistently growing way beyond inflation, and costs to build a software startup have been consistently declining for the last decade.

With frameworks, open source code, APIs, cloud computing and collaboration tools, a new application or web service can be developed with a very small investment . What is driving seed rounds to such large sums? In many cases it is user acquisition — Sadly, a more hip way of saying marketing with a negative ROI.

In a world of cheap software development where a small team can build a clone of twitter in a matter of weeks, user acquisition became king to some investors as the only metric that matters. The danger is that user acquisition by itself can lead to a treacherous path. There is no loyalty in app usage, and many users may never generate any income.

MySpace and Orkut had a very large number of active users, with Orkut being the largest social network in South America and India circa 2008. Unfortunately both networks could not convert such large user base into a solid business. When Facebook became more popular, MySpace and Orkut users left in droves in a digital diaspora.

It may sound silly to lay the following numbers, but a service bringing $1,000 per user per year with 1000 users will most likely receive a smaller valuation and investment than App with 1 million users and no income — Insanity? Perhaps.

The customer-acqusition-seed-funding-insanity gave birth to pre-seed rounds, generally under $200k. Pre-seed enables the development, market-fit and organic user acquisition to happen in a more sustainable and efficient way. Many accelerators and incubators are filling the pre-seed demand, with hundreds of accelerators popping up around the world.

Because of the crazy amount of cheap capital circling the World with interest rates near zero (or negative), there is a new found thirst for investors to replace the traditional FFF — Family, Friends and Fools who used to invest as Angels in pre-seed stages. Perhaps we should leave the last F to describe such funds.

This leads to a new paradigm in seed funding. More than ever before, startups need to be efficient, lean, nimble and agile. It is also imperative to have a customer acquisition plan that does not involve paying for customers with funding. A pre-seed startup that can deliver what a seed funded startup can deliver will certainly have much better odds of growing quickly and sustainably.

Seed funded startups also risk losing the race against Venture Builders that are leaner. Rocket-Internet is a good example of a Venture Builder that managed to beat well funded startups in a wide range of areas in geographical locations.

The drive for even more efficient startups led my Venture Building firm Outroll to invest in pre-seed startups while handling all development and business operations. This approach leverages existing infrastructure, talent and expertise. I strongly believe that Venture Building will become more and more commonplace and competitive against the plentiful routes a startup can take, from incubators and accelerators to insane seed rounds.