Seed Investing Doesn’t Buy You Series A Traction

During my first year at Techstars, I’ve spent a good deal of of time working with founders helping them to prepare for raising their first round of seed capital. I’m sure it’s not lost on anyone reading this that seed investing has been riding a pretty sizable wave over the last couple of years. This wave has provided both positives and negatives for entrepreneurs. On the positive side, there’s more capital targeting seed-stage opportunities and methods to find that capital than I can ever remember in my career. (I’m happy to let the pundits debate the extent to which this has created a “Series A crunch.”)

Seed

However, there’s also a downside to the recent proliferation of angel investors. More and more, I’m observing angel groups acting like VCs as it relates to diligence, terms and valuations. I’ve made dozens of both seed-stage and Series A investments in my career and they’re different animals.

I’ve always look for two things in seed opportunities: 1) a compelling market opportunity and 2) a talented team committed to solving it. That’s it. I never thought I deserved more than that in making an investment at a sub $5 million pre-money valuation. My Series A criteria added one more component, traction. For example, I always look for things like a few significant enterprise contracts or real MRR (for a SaaS business) or evidence of a hyper-engaged customer community.

Unfortunately, I’m seeing more and more angel groups looking for Series A traction at seed-stage pricing. They want to see considerable business momentum but also want pay sub $5 million pre-money valuations. They spend oodles of time doing “due diligence” when what they should be doing is spending time with the founders and determining if they think they’ve got the chops, commitment and experience to make a go at it. At Techstars we always say that we look for six things when evaluating applications: Team, Team, Team, Market, Progress, Idea. If you distill that, it’s the same thing I describe above: team and opportunity.

If you’re relatively new to seed-investing, first let me say thanks. It’s fantastic to see people wanting to support entrepreneurs and startups with their hard-earned money. It’s behavior like this that will foster the next generation of great companies and help keep America on the forefront of global innovation. One suggestion though; keep your expectations in check with regard to what to expect for your seed-stage dollars. From my perspective, it buys you a small team of bright, hardworking entrepreneurs with a vision about how to tackle a significant market opportunity who are willing to work for peanuts for a few years in order to tackle it. It doesn’t buy you more and you shouldn’t settle for less…

24 Comments »

  1. I think what also makes this article great is that you’ve just laid out what a founder needs to do after they’ve raised that seed funding; get traction. I think a lot of founders think they’ve just bought some runway to develop their idea some more, but they’ve got to take it a step further and prove out that great idea by gaining some traction.

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  2. I’m interested to hear your perspective on the cause of this shift. Personally, I’ve experienced a wide range of sophistication from angel investors. The more sophisticated ones often push back on valuation, deal terms, etc, but they also understand that their investment is largely to *prove* the business model. Is the trend you’re noticing because there are so many more seed-stage deals? Or is it that early stage companies are doing more faster, and the market is changing. I mean, angels today are being presenting seed-stage companies with decent early traction (1-2 enterprise accounts, 250k+ app downloads, etc.), mostly because entrepreneurs have access to stuff like Steve Blank’s work and the Lean Startup. So is the market just changing?

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    • Ryan, really thoughtful analysis and questions. My hunch is that it’s a combination of the things you describe here plus more, including the veil lifted off the venture industry by people like Brad and Fred (and many more) who gave angels a look into how the venture industry works and how great VCs think . Subsequently, their blogging gave angels tools to become “their own VCs” only they didn’t get all the mentoring that Brad, Fred and the rest of us received from the previous generation of VCs. I’ve heard it said that it takes five years and $30mm to train a good VC and I think there’s some truth to that. A lot of recently wealthy angels are incredibly well-intentioned but haven’t had the benefit of good training. Its worth noting that this isn’t just an angel phenomenon. I’ve seen VCs doing seed rounds for the first time also have the wrong expectations regarding what seed dollars should buy.

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      • Man, this stuff is gold you all are talking about. There is so much signal vs. noise these days – not sure what the interest would be, but in this era where people are so spread out living in different urban, suburban and rural areas, with technologies like Google+ Hangouts becoming the norm, I wish someone would do a once a month hangout on startups with a few spots for founders and a few spots for angels/VCs. It could be scheduled so that it’d be over coffee in the morning or over a virtual BYOB in the afternoon. Any topic is fair game for either founders or investors to bring up. You’d probably need one founder who is the always the same every month and one angel who is always the same every month – the founder would make sure the other founders are all getting a chance to talk and the angel would be responsible for the same, but on his/her end – you could call this monthly virtual group “4+4=Startups” or “4+4” for short, something like that.

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      • In thinking about this more, I wanted to give some founder perspective on this issue because I’ve experienced it first hand. I can’t speak to consumer tech, because my company is enterprise focused. The great thing about enterprise is that we’re getting a substantial amount of money immediately from customers. Given this, I’m not sure that we’ll ever have to get an institutional round. For each deal, I can afford to hire another sales person that I expect will do a new deal per month. The company scales nicely on its own with these economics, but we have still needed cash to get started.

        I say all of that to make this point: We have been able to reduce the risk for angels in multiple ways by getting really far without raising significant capital, and that has made getting wallet share a lot easier. In my opinion, it’s just too hard to inspire angels with vision and team. The path of least resistance, and the best use of our time, has been to prove it first, then go to the investors. I’ve personally found that convincing customers is 90% of convincing investors. I guess this is evidence of your point.

        But they do still want reasonable valuations. Being outside one of the Big 3 tech hubs, investors seem to be much more interested in revenue and traction. We just decided to bring them what they want to see rather then trying to convince them of how visionary we are and how smart the team is. Let’s face it, most investors have no great barometer for early stage deals. It’s all about proof points, and customers are the best proof points.

        It occurs to me also that perhaps what we’re seeing in the market today isn’t so much a change in investor attitudes as much as it is a change in founder attitudes about raising capital. You don’t have to be in this industry too long before you start meeting entrepreneurs that feel they got screwed over by their investors. Given that it’s pretty cheap to get a company going these days, I’m meeting more and more founders that happily give up more equity to high quality angels under the assumption that they will never raise institutional capital at all. I am one of them.

        Traditionally, raising capital has been a necessary evil. Maybe today it’s less necessary, but still equally as evil.

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        • “In my opinion, it’s just too hard to inspire angels with vision and team. The path of least resistance, and the best use of our time, has been to prove it first, then go to the investors. I’ve personally found that convincing customers is 90% of convincing investors.”  — I think this hits the nail on the head.  All things being relatively equal, when you’re forced to decide between multiple “kick ass teams” with multiple “compelling market opportunities” the key differentiators may well be customers and traction.  It seems as if, due to the share saturation of the market for good ideas, the minimum criteria at even the seed stage has raised.  The only people you can convince now to fund your brilliant idea with your kick ass team are friends and family… and even they are sophisticated enough now to ask for certain hedges.  I do believe that in the recent past, Mark, team and idea were enough.  Be that as it may, sitting across from an angel investor it may be a bit unrealistic to expect them to ignore what the blogs of well respected VC’s have exposed them to.  Therefore, if energy and time, our most important resources as entrepreneurs, have to be placed somewhere the biggest payoff may lay as Ryan said, with the customers.

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  3. Mark, I have great respect for you and your Tech Stars colleagues. However, as a leader of a group of seed stage angels, I have to disagree with your implication that we should not be doing due diligence. As a matter of fact, in the only decent research I have seen on angel returns, Wiltbank (Returns to Angel Investors, Wiltbank and Boeker, 2007) found that the one factor that correlated with returns in the angel space was the degree to which the angels conducted due diligence. It’s all well and good to say that the only things that matter are the team and a compelling market opportunity, but we believe a certain amount of due diligence is required to ascertain a compelling market opportunity.

    And our group strongly believes that valuation is important. I suppose what we’re really saying is that we believe many angels over pay for early stage companies. We focus on SW Idaho. As you know, the market here is immature. We don’t have the luxury of a lot of world class teams proposing compelling market opportunities here. But we are dedicated to supporting the local entrepreneurial eco system and provide a supportive place where local entrepreneurs can seek counsel and when appropriate funding. The trade off is we are hard on valuation and we conduct due diligence before we write a check. We also work closely with about 15 other organized angel groups from Salt Lake to Seattle, and I believe among these active angel groups there would be little disagreement to my points that due diligence and valuation are important.

    Kevin Learned, Boise Angel Alliance and related funds

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    • Kevin,

      My “quotation” around due diligence was intended to add a degree of glibness to my point. Of course a certain amount of due diligence is necessary for these types of investments. Sorry if that didn’t come across better. I don’t think any entrepreneurs expect to receive a check without some work being done. What I’m referring to is months of work while putting an entrepreneur through a “diligence hell.” The spirit of this post is that after almost 20 years of investing in seed and early-stage opportunities, it’s my observation that at the end of the day it’s the quality of the team and particularly the CEO which matters most in the early days of trying to scale a business. Without that, the best business models chasing the biggest opportunities will certainly fail. No amount of due diligence on the front end is going to change that. I’ve learned over time that very, very few entrepreneurs get the product-market fit from the get-go and that once I determine that they’re going after a large opportunity, most of my time is spent determining if they’ve got what it takes to triangulate on that product-market fit. Most of the companies I’ve invested in that have reached scale look quite different today then when I first invested. Balihoo in our own backyard is a great example. The reason that’s a great investment for us is that when the market turned, Pete Gombert was able see it, act quickly and change tact. It didn’t take us long to determine Pete was going after a big opportunity, but all the diligence in the world wouldn’t have mattered if we didn’t know he had what it took to navigate the high seas of 2009.

      As for your point on valuation, I couldn’t agree more with you and I”m not sure why you bring this up. I am constantly telling founders that their valuation expectations are too high for seed stage and that seed investors deserve to be compensated for the risk they’re taking. On this we couldn’t agree more, so there’s that!

      I have a great deal of respect for the BAA and what they are doing for the Boise startup ecosystem and always point local entrepreneurs there. As you know, my partner Phil co-founded the BAA and believes deeply in its mission. But look at the first comment on this post Kevin. Phil recognizes the dynamics happening at the seed stage and shares my perspective.

      Finally, you should know that this post wasn’t at all focused locally but was based upon my observations from visiting and working with hundreds of TechStars founders all over the country during the last year. Looking forward to seeing you soon and continuing to work together to build a great startup community in Boise!

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  4. Great post and, as an entrepreneur, I really appreciate you writing this as it would come off as sour grapes if an entrepreneur wrote something similar. I’ve seen Angels asking for not just revenue, but a thorough understanding of the business model including stuff like an understanding of churn and a cohort analysis. It’s simply not reasonable to expect that startups that are taking on enough risk to innovate or disrupt a market can reliably achieve these milestones without taking on outside capital. Thus, the companies getting angel/seed funding right now are the low hanging fruit….the Kickstarter clones, the AirBnB clones, because they can get to revenue/traction quickly.

    The reality is that seed stage traction (or lack thereof) is, almost always a false positive or a false negative. About a year into their respective existences, none of Twitter, AirBnB or Pinterest had what would pass for the levels of traction that are currently expected to close a seed round. That, and the mantra of the incubators seems to be “find any number and make it go ‘up and to the right'” at the expense of creating a company that can create a defensible or lasting advantage. So this development appears unhealthy for the ecosystem and something that will inevitably cycle out.

    It always comes back to the team and the product/technology as eventual success will certainly be determined by those factors and the ability to navigate inevitable challenges rather than the speed with which companies reach certain, arguably arbitrary, milestones.

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    • “It’s simply not reasonable to expect that startups that are taking on enough risk to innovate or disrupt a market can reliably achieve these milestones without taking on outside capital.”

      I’m not sure I agree. I think that startups can definitely create innovative MVPs without taking on capital. In fact, what I see more often is founders using lack of capital as an excuse for their failure to produce innovative MVPs.

      As for ‘disruption’, I’m not sure what that even means. People pay for solutions, not for “disruption”. And when founders think in terms of concrete solutions rather than fluffy ideas like disruption, those are the founders that find early traction with only sweat equity investment.

      I’ve found that its a lot easier to raise capital when you have customers paying you money. Turns out that this isn’t actually that hard to achieve if you focus uncovering the right problems. (Ok, easier said than done.) I’ve raise capital in Durham, Kansas City, and Dallas. All in all, my experience is that angels focus on business fundamentals first, and they’re looking for proof points of a viable business. Never in my life have I heard an investor use the term ‘disruptive’. I agree that it’s hard for startups to provide a comprehensive picture of cohort analysis, etc. But I’ve found that most investors are fine with the answer, “you know, we just don’t know the answer to that right now. But I’ve thought a lot about that and here’s what I think….” IF you have customers.

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      • Ryan,

        I didn’t say that it isn’t possible to create MVPs without raising capital. The fact is that if you are trying something new or innovative, i.e., not a Kickstarter clone where some experimentation needs to be done, you may need to do a few iterations of that MVP before identifying product/market fit, or a path to P/M fit. In order to do a few iterations on a product, you are talking about a team working together for a year or more. As an investor, if you think you have the right team focused on solving the right problem, a seed round should be appropriate and available. Hence the term “seed”.

        That investors are (collectively) eschewing that common sense and requiring arbitrary metrics that historically have no correlation with success (i.e., a social app needing 100K registered users), investors are placing a “tax” on companies trying to solve hard problems. Again, many of the companies that are getting seed funding today are “me too” companies for that reason.

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        • I agree that those iterations on MVP need to be done. I’m just suggesting that you don’t need to raise capital in order to do them. I’m not at all convinced that anyone should give us any money just because we’re smart people working on a hard problem. And further, I don’t see how investors are “eschewing common sense” by not giving me money. Indeed, I would argue that investors are acting much more rationally by waiting until I have proven a business model before giving me money. By what logic would investors put money into a company that you describe when they can either 1) wait until it’s more proven, or 2) invest in something else that is more proven?

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        • Ryan,

          If a company has already reached a proven business model, then in many or most cases it’s probably not the best course of action for the company to raise venture capital-style investment capital. If it needs some capital to accelerate growth and reach profitability, you could argue that debt would even be appropriate.

          There are also the generalizations that say that if you can prove the business model before taking on capital, that could be a sign of a very low barrier to entry or an unsustainable advantage.

          The kinds of companies that Techstars (presumably) wants to fund are companies that are fundamentally changing a market in some innovative way. The ONLY way to accomplish that while proving the business model up front is a business model innovation. You cannot compete on technology or create new markets simply by bootstrapping. Traction at the seed stage is very frequently the wrong lens with which to view the kinds of startups that become Facebook or Google or eBay.

          Waiting for metrics to be “proven” is also the definition of momentum investing, and that’s not likely to be a winning strategy at the angel/seed stage. False positives and false negatives abound.

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        • “If a company has already reached a proven business model, then in many or most cases it’s probably not the best course of action for the company to raise venture capital-style investment capital.”

          I would argue the exact opposite: That after finding the business model is the *only* time you need venture capital in order to scale up. When you take venture money before you have your business model you take highly dilutive capital at terrible terms, in an environment where you are almost certain to raise a down round in the future and probably be ousted from the company.

          “There are also the generalizations that say that if you can prove the business model before taking on capital, that could be a sign of a very low barrier to entry or an unsustainable advantage.”

          Fair enough. To the investors that think that, I say take your money elsewhere. I don’t know what it’s like in the Valley. But outside the Valley, you will be extremely hard pressed to raise any capital at all if you don’t have a product and a business model. I’ve never in my life heard any investor take it as a negative that we have a business model figured out. In fact, having a business model is taken as a given in my experience because in most of the world having a business model is a pre-requisite to getting investor capital.

          “You cannot compete on technology or create new markets simply by bootstrapping.”

          This is objectively false. You can do both of those things and get early customers. I’ve seen no evidence to the contrary. Even your supporting examples don’t make your point. Facebook and Google both had tremendous traction before taking investor money. I’m not so sure about eBay. But in any case, Zuck and Larry & Sergey started by building the innovation not buy raising capital.

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        • Ryan,

          You said:
          “That after finding the business model is the *only* time you need venture capital in order to scale up.”

          And that’s exactly correct. The title and purpose of the original blog post are referring to seed stage investing, which up until very recently was NOT considered venture capital. Angel and seed investing used to be an entirely different asset class until recent structural changes in the market.

          Also, the examples you provided are false. Google had raised six figures of capital before they had even incorporated or had a bank account with which to deposit their check. They were a team of 2 founders working in a garage when they got funding. In fact, Facebook is probably the sole example of a company that had “traction” before taking on outside capital. Twitter would never have survived long enough to reach “traction”, which took almost a year post launch, without plenty of outside capital. And we know that a lack of traction caused plenty of folks to pass on AirBnB and Pinterest. Really, short of Facebook, there aren’t any obvious examples of companies that reached that kind of scale that didn’t take on capital pre-traction. There are plenty of example of companies that bootstrapped for many years before taking on capital, but those are the exception not the rule. The idea behind seed/angel capital is to accelerate the growth of innovative companies.

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        • Joseph –

          You’re nitpicking. I said “venture money”. Remove “venture”, replace “angel”. The point still stands. Don’t raise money until you have your business figured out.

          I hate arguing over facts, so I’m going to end the Google/Facebook traction debate now. According to the Wayback Machine, BackRub (what became Google), had 207G of data downloads and 30.6M views between it’s launch in 1995 and the date these stats were logged August 1996 http://web.archive.org/web/19971210065425/backrub.stanford.edu/backrub.html. Again, this was *1996* so that is big traction for those days. They didn’t raise their first dollar of capital until 1998, two full years after they were posting these numbers. When the did raise, it was only a $100k angel investment (according to Google’s official history). Clearly Google had tremendous traction before raising capital. Granted, they didn’t have a bank account to deposit the check into. But they *did* have traction.

          With regard to Twitter, the company was a spinout from guys that had previous successes. Totally different. Go build a company like Blogger and sell it go Google and you’ll have a lot easier time raising money for a hair brained idea like Twitter too. You’re making an apples and oranges comparison. Of course Twitter got money without traction. They had *other proof points* pointing toward a success.

          And that’s the heart of the matter. With investors it’s all about proof points. The ultimate proof point is traction. So make your life easier and just go get traction first. If you really have an innovation that solves a problem people are willing to pay for, then bootstrapping to an MVP isn’t all that hard. Further, having an MVP isn’t even a requirement. In the past I’ve sold $150,000 of a product that wasn’t even built. I used the orders to get the investor capital to build it.

          It bothers me somewhat to hear founders complain about raising capital, and believe me I do it as much as anyone. This is what we signed up for. It’s like a garbage man complaining about having to pick up trash. If you don’t like it, get a different job.

          In any case, it seems to me like the crux of your argument is that angels *should* be funding without traction. I have no opinion on this one way or another per se. I think that founders should be focused on creating a sustainable business, and I see no reason why investor capital is needed to figure out a business model.

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      • Faragut,

        Everything is possible. RJ Metrics is an awesome company and an example of how to do it bootstrapped. But the founders put in $20K as they had enough resources, both human and capital, to execute on their vision with that. That is the rare exception, and not the rule. Just like using Facebook as an example of a company that had traction before raising capital, you can’t cite the rare exception and consider it the rule. Just because it is possible doesn’t mean it’s in the best interests of most entrepreneurs OR investors, who will inevitably have a losing investment strategy as they wait for that once a year exception and then probably not have access to participate in the deal.

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  5. I read this quote about an hour ago and thought I would share as it seems relevant to this post and thread… love it:

    A ‘startup’ is a company that is confused about – 1. What its product is, 2. Who its customers are. 3. How to make money. – Dave McClure

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