The venture capital market is constantly changing with supply / demand dynamics fluctuating from one geography to another, sector-to-sector and weekly shifts in micro and macro economic confidence. Here’s my current perspective on the differences among 1) Seed, 2) Series A & B and 3) Later Stage Growth financings.
1) Seed is over priced where startup valuations are higher than these companies can be sold for today – investors betting on the future potential – increasingly easy for all investors to access seed financings
2) Series A & B rounds are priced lower than the company could be sold for today – optimal risk / reward inflection point – difficult for most investor to access these financings
3) Later stage growth values the company higher than it could IPO or be sold for today but build in protections for newest investors – very hard for average investor to access yet increasingly crowded
Seed market has become crowded and valuations are higher than you could sell the company for today
The seed market had transformed from a small set of angel and seed stage institutional investors accessing elite deal flow via personal relationships and networks to a new world of a larger number of active angels funding a bigger pool of non-elite seed stage deals. We now have more entrepreneurship than ever before with thousands of seed stage deals augmented by thousands of accelerators each churning out constant cohorts of startup batches continuously where any angel or seed stage investor can attend demo days and get introduced to the founders for direct investments. The number of players in seed is growing quickly with many investors more accustomed to investing in restaurants and films excited by the entrepreneur’s year-3 revenue projections and not a lot of experience sitting in a deal for 3 to 10 years and knowing how this really plays out. In many cases the amateurs are driving deal pricing.
AngelList has further democratized access to seed stage investment opportunities where any plastic surgeon in Alabama can be an active investor in startups from Silicon Valley to Boulder to London investing into deals she finds or jumping in on AngelList syndicates following someone who theoretically knows how to spot the good ones.
Typically the valuations of these seed stage rounds at the demo day stage coming out of decent accelerators like Y Combinator, TechStarts, 500Startups, etc. will range between $3m to $12m. YC is famous for putting their ventures foolishly at risk by starting off with super high valuations (good luck with the next financing if you hit a bump). These companies cannot be sold for valuations equal to or greater than the valuation of their demo day financings. Investors are betting on the future exit potential and know that if they want to play in that market they need to pay up. A new asset class in the venture spectrum has emerged called “pre-seed”. These funds and many individuals become mentors at accelerators and try to invest cash into these startups during accelerator programs and before demo day or just seed startups that do not go the accelerator route. Investors that invest in pre-Seed at scale are probably better off than those attempting to invest in Seed at scale. Investing in pre-Seed or Seed in fewer than 20 deals per year is probably a formula to loose money. This is clearly a lot of work to get it right. The point here is that this is a full time job and not a side activity as it is for most angles.
I often imagine what my wife would take if offered the choice: a house in Woodside, California for $8m or a startup with a few young entrepreneurs in their 20s, a logo and 3 months in an accelerator and an MVP with limited traction also valued at $8m. I know my wife and she would take the $8m house. My wife has been around enough venture financings over the past 20 years that if you offered her the choice of owning a house in Woodside worth $15m or a startup whose Series A financing is being led by Sequoia, she might take that startup for $15m thinking the exit might be worth at least $250m.
Series A & B (and later stage Seed which is where Series A used to be)
By the time a startup has raised one or many seed stage rounds and is now getting to the coveted Series A stage they are probably already turning down offers to sell the company for $15m or $45m and are willing to price their Series A round at a pre-money valuation at $15m to $40m and take 20 – 40% dilution in order to get some cash in the door and make the buyer add a few zeros to the purchase price of their startup in an M&A transaction. At this point the founders believe that brining in a strong syndicate of Silicon Valley or other reputable VCs will add value beyond just capital and they will be able to either sell at a much bigger price, much more than 30% more than current offers on the table; so the dilution to top VCs is a no brainer and now they are on a path to go for very rapid growth in their valuation and enter the later stage growth zone. I view this as the optimal risk / reward inflection point where the increased number of seed financed companies gives us a huge selection to choose from and we get into the A and B rounds alongside top name VCs and do our thing of adding value to justify our seat at the table. In many cases, these financings are priced below the value these companies could be sold for. The plausible exit value for these companies is typically 10x+ the pre-money valuation we invest at. 100x+ returns are often still realistic.
Later Stage Growth Deals are Priced Higher than they can Sell or IPO at today
The VC market has witnessed many new entrants to the later stage growth market. VCs raised larger funds and became mega funds seeking to write bigger checks. Hedge funds entered the game, family offices have become aggressive getting into growth and many traditional IPO buyers like Fidelity have dipped down into the private market. A few years ago I thought about raising a growth stage VC fund that would leverage my 20 year VC network of relationships and pick up deals after the classic Series A and B rounds and invest large amounts of capital at much higher valuations and even provide some liquidity to early investors, founders, and fund employee-wide liquidity programs buying both primary and secondary shares in growth deals. A few years later this part of the market looks more like a blood bath. Let me temper that and say it’s become crowded, but still attractive. The many new entrants to this market are willing to pay up big valuations to buy growth. Often the new investors get a senior 1x liquidation preference where upon liquidation of the company via IPO or M&A the newest investors get 100% of their cash investment back before any of the other Seed, A, B or C investors. Then the other investors get their cash back and after all that it’s pari-passu with each investor, founder and employee getting their ownership percentage of the exit consideration.
Imagine Uber raises $1.5bn from a sovereign wealth fund. They get a 1x senior liquidation pref and they know that $1.5bn is a faction of the liquidation consideration they can expect for the company and they are at the top of the waterfall to get all of their capital out. So their downside is pretty much set at getting a 1x return in a worst-case scenario. They are nearly assured that they will not loose any money on this investment (something you do not have when investing in accelerator demo days or A & B rounds). The upside is probably 2x to 4x if you are lucky and there is always a lotto ticket dream that the upside could be greater. If Uber’s last pre-money valuation was $39.5bn (let’s just call that $40B’s), then to make a 10x return Uber would need to IPO with liquidity at a valuation of $400bn. Give that a sanity check and consider that $400bn is a bigger market cap than Google, Microsoft, IBM, Samsung or Intel. Will that really happen in 2 to 3 years, which is often the VC investor time horizon for later stage growth investing? Who knows, but it is not mathematically or statistically probable.
Back to reality we are seeing big valuations for growth deals achieved because of the increased demand of investors piling into this part of the market and the fact that these deals are structured to protect that new investor. They limit their down side and the company can “grow into its new valuation” over time. Hey, if you just got your daughter into Stanford and need to come up with $250k tuition fees within 4 years, investing in a growth deal and making 2x in 2 years could be a wise investment for you as an individual – not too crazy despite the big valuations.
1x, 2x and 4x does not however satisfy our VC target returns at Rubicon. We like 10x. We think Later Stage Seed (what used to be Series A), Series A and B is where it’s at. This is where we are investing at valuations lower than the company could be sold for today (most cases) and where achieving a 10x return is still realistic. With the growth markets evolving as they are with Karl Icahn investing $100m into an extension of a $680m round into Lyft last week (see my analysis on CNBC last week), we even think we can achieve some liquidity prior to a definitive liquidity event for the company, while offering our own LP investors in our fund access to our sidecar funds that invest in these companies all the way to exit. Startups are staying private longer. Why IPO if you can raise $500m+ in growth rounds from investors like Fidelity and Karl Icahn, who in ancient times invested at the IPO, not before? This benefits the early stage investors, employees and management. Hello new world! No more complaining about Sarbanes–Oxley.
For Rubicon, we are active in later stage seed. We expect to deploy most of our fund dollars into Series A and B rounds. We support our companies with additional capital all the way to exit in the growth stages and enable our existing LPs to co-invest with our fund via our Special Purpose Vehicle (SPV) sidecars for as many of these financings as possible and then when our portfolio companies get to Series C and later growth, we examine the downside and upside and create sidecar funds to invest in the growth market on a selective basis.
Angel investors are typically shut out of the market once the startup gets to Series A. One typically only sees an angel in an A or B round if they were in the Seed rounds and are exercising their pro rata rights to maintain some or all of their ownership percentage. You rarely see angels enter into the financing at the time of A, B, C or later. Rubicon enables this for our angel LPs as well as our family office, corporate and institutional LPs on a deal-by-deal basis via our sidecar fund model.
Come and meet us at our upcoming events.
Next Rubicon San Francisco event June 23rd: Big in Japan: Meet the Japanese VCs actively investing in US startups