Signaling Risk and the Error of Conventional Wisdom
There are a lot of investment myths floating around the startup scene. This is one of the most prevalent from founders at seed stage:
Don’t take investment from a Series A fund at Seed because of signalling risk.
To me, this is a fallacy. Don’t get me wrong, I believe seed funds are best equipped to lead seed rounds, which I’ll explain later. But, like many things in the world of venture, signaling risk associated with Series A funds investing at seed seems to have spread through our echo chamber like wildfire.
Countless founders I’ve spoken to over the years think a Series A investor participating at Seed is particularly dangerous. I believe this is inaccurate, and the benefits for founders can easily outweigh the risks. Empirical evidence is hard to come by, but a CB Insights study from a few years ago indicates you are twice as likely to raise your Series A round if a larger fund participates in your Seed round. Here’s how I think about it…
- If product and traction is looking good but you need a bit more time before your Series A, it’s extremely helpful to have a deep pocket or two around the table. Obviously any fund will evaluate the investment on its own merits, and there’s never a guaranteed safety net, but there are practical reasons why you might need a bit more traction to justify the type of round you think you’ll need next. I’ve seen this happen countless times with what turned out to be exceptional companies. Bullpen Capital estimated several years ago that 1/3 of seed closings were post-seed rounds.
- If your business is progressing well, having an existing investor eager to increase ownership can create a healthy competitive dynamic with other Series A investors. This happened recently with a company we backed at seed, and we were happy to increase our position alongside their Series A investor. The founders raised a bit more capital at the same dilution.
- The risk is really no different in your Series A, B, C, D, or later round of financing. If a big growth fund jumps in and makes an early bet below their typical target ownership, you rarely hear people get nervous. Tiger Global, General Atlantic, and Insight Venture Partners are just a few of the Tier 1 growth investors that frequently place early stage bets.
- Funds have different strategies. Some go heavy on reserves for follow-on rounds, some go light. Sometimes funds blow through their reserves faster than they planned, and sometimes they can’t deploy the capital fast enough. No two funds are ever the same, despite their size. It’s always a strong signal if your existing investors double down on your business and helpful for driving competitive tension as described above. But, if an existing investor doesn’t lead your next round, it’s really not a big deal.
- The hard truth that you may not want to hear: if your company doesn’t grow as planned and the funds that participated in your seed don’t “step up” to lead your A, there’s a chance your business isn’t VC-backable. If any of your investors don’t participate in the way you want them to, and you can’t find a 3rd party to lead your round anyway, the business may not be that exciting for a venture investor, or your pitch just isn’t resonating.
Expanding a bit on point 5 above (where 52% of seed-funded startups end up) it’s worth taking a slight diversion to clarify that not raising follow-on capital is perfectly fine. We place far too much importance in the startup world on how much capital is raised at a particular valuation. These headlines support the VC/LP fundraising treadmill more than the startups themselves.If you’ve got a healthy business that you can run without capital, great. TechCrunch fundraising announcements are short-lived. You can still create a high-impact company and generate life-changing wealth for you and your team without venture capital.If the business simply isn’t what you hoped, consider wrapping it up, responsibly, so you can start the next one. There are countless successful founders that hit a dead end with prior businesses, and if you ask them I guarantee they wouldn’t blame a mediocre outcome or outright failure on signaling risk. Instead, they will undoubtedly have some level of appreciation that their investors didn’t let them waste any more time on that concept, so they could move onto the next, much more successful, one.
When I hear talk of signaling risk at seed, I interpret this as trying to manage a startup’s downside.
While I appreciate the need for investors and founders to manage downside, this is the wrong way to select your investors. Some of the best investors I’ve worked with and respect the most have $1bn+ funds and will still write a $500k seed check alongside a great seed fund or group of angels because they believe in the founder and their vision.
Seed stage companies have unique needs compared to later stage companies. So, although this may go against our interests at Northzone at times, my advice to founders is to prioritise finding a great seed investor to lead your seed round. Series A funds are not as well equipped to be your lead seed investor as seed funds (unless they have a specific seed team), so I would think long and hard before skipping seed stage investors altogether. Seed funds create valuable resources, community, and expertise in certain topics that later stage funds don’t prioritise.
If, however, in your process you identify a partner at a Series A fund that you think would be great to have involved, you can try to bring them into the round. There is usually enough ownership to go around, and Series A funds often have different ownership targets for their seed investments.
There are a few things I’d watch out for…
- If you feel like a Series A investor wants to come in purely for optionality and inside knowledge on the next round, I would be more cautious. Signalling issues aside, you want to avoid having lazy equity on your cap table. It will frustrate you, and is unfair to other investors that might have wanted to own more of your business, and are willing to do the hard work to earn it.
- If your Series A investor wants to add non-standard terms like super pro-rata rights, right of first refusal (in the case of a strategic investor or PE firm), etc then I believe there is a legitimate risk for you as the founder in bringing them on board. In a competitive subsequent investment situation, this problem quickly goes away, but if you are in a business where there aren’t many investors/acquirers, I agree it makes sense to think twice or at the very least soften some of these strings.
In summary, if you’re a hot startup raising a seed round and you have multiple options, my suggestion is to find the very best seed fund out there that understands your market, aligns culturally with your startup, and negotiate a good term sheet from them to lead the round. If there’s a partner in a Series A (or larger) fund that has a genuine interest in you or your startup, is willing to dedicate real time, and wants to participate in the round, I would consider letting them in but make it clear the seed fund is your lead.
A number of my Northzone colleagues and other investors I respect have varying perspectives on this topic. So I suggest reading their thoughts.
