Ungerminated: Trouble with Seeds

Quantity, quality, and size of early-stage seed financing has recently given rise to speculation about a seed funding bubble.  Ex-founders, Hollywood personalities, the rich and the powerful, the smart and the cool, all seem to be foregoing or, at least, de-emphasizing the usual trappings of wealth (homes, cars, planes, baubles) and taking center stage at pep rallies preaching  lean, capital-efficient startups poised to change the social fabric and consumer experiences, all for a few hundred thousand dollars invested.  Money is available, some will say, easy to get.  There are pitch sessions, pitch presentations, and a slew of incubators, accelerators, germinators that are ready to provide a cubicle and an internet connection in exchange for some equity.  The process is quick and painless.  I have witnessed angel investors flash their cash and write checks on stage.  Founders who have never raised a real VC funding round have all been made to believe that the traditional funding process of overly lengthy, way too expensive, and, in general, unnecessary.  Dropping out of college is suddenly cool, venture capital is stuffy and bad, and a big company can be built with almost no cash.

Early signs of trouble.

Many more companies that should not be funded are getting funded — micro-funded, to be exact.  Founding teams lack critical mass (witness the “find a technical co-founder” craze) because instead of three guys with an idea and a prototype looking to build a company you have three distinct embryonic ideas looking for money, pitching a promise of hiring a top notch team that is nowhere to be found.  Nowhere to be found because everyone who’s any good also has a company of his own to build.  But these thoughts have been aired before and are now part of the usual rhetoric about the seed bubble.  For me, the real danger started to manifest itself over the last couple of months as I saw some very good seed-funded companies looking to raise their Series A.  These companies could have easily been winners, but, unfortunately, drank the wrong Kool Aid.  I call these “ungerminated seeds.”

The real problem: little to show.

Ungerminated seeds are startups that raised a big seed round, often from prominent investors or VC funds, and have expectations and sense of entitlement that is completely out of proportion with what they’ve been able to accomplish using the money raised.  The ideas are often good.  The founders are often smart.  But there’s trouble.  I have spoken to a number of startups coming to the end of their $700K+ in seed funding.  “That’s a lot of money,” I said, “… and what do you have to show for it?”  Often, the result is a beta launch, a team of hired guns, trickling early signups, some indication of traffic to the site.  Maybe a pilot in early stages if it’s an enterprise company.  To me, it feels like a Series A…  but it’s not a Series A.    The “cap” on the convertible note is often mistakenly seen as a post-money valuation (which it isn’t).  There are egos (founders’ and investors’), there are appearances to be maintained.

The company seems to feel that burning through a million dollars of someone else’s cash entitles them to more cash from another group of investors.  Founders, reality distorted, have expectations of valuations that make little sense to a professional investor because they are based on an implied seed valuation that should have been dubbed a “small Series A”.  I am talking about good companies and good ideas, companies that could have traveled the normal Series A, B, C + IPO path that startups have taken for decades.  Their  early stage financial shenanigans make them, in my mind, un-fundable.  Sad because if they had only taken less cash and not listened to the angels’ siren songs they would have been great Series A candidates.

This is not “sour grapes” from a small fund that can not afford to invest $10M in a Series A….  my fund certainly has the financial resources to do that.  But, just having capital to deploy does not make you a drunken sailor that walks into a port of call ready to blow all his money and befriend the natives.   There are responsibilities VCs have to their LPs — and one of them is not being stupid.

There’s nothing wrong with seed funding

However, there is absolutely nothing wrong with getting some early-stage money together to get a company off the ground.  But founders need to be careful and make sure they are doing it right and are planning for the long-term financial success of their business.  Some advice….

Before seed funding:

Look for professional organizations vs. individual angels.  There are several smaller funds that make seed-stage investments.   There are organized angel groups with screening committees consisting of industry experts. They are doing this because this is what they do, not because it’s some big VC fund partners’ experiment in ecosystem building or a bone thrown to a junior member of a VC team.  There are funds I support, help, and ones to which I send promising early-stage investments.  They are professional organizations managed by professional investors.  They work very much like VC funds work (sometimes earning the label of micro-VC or super-angel funds).  They manage their investments and the founders’ expectations.  They prepare them for their next round and they make sure the company stays fundable.  These funds are known.  Drop me a line and I’ll give you a list of my favorites.  Individual angels tend to be hobbyists.  I am not talking about Ron Conway or Paul Graham — they are organizations, not individuals.

Raise just enough to show results.  Avoid the piling on that is all too common these days.  Don’t “leave room in the note” for people who want to join the round after learning that Ashton Kutcher is on board.  The math that VCs do in their head is still the same.  A dollar of post-money valuation should be worth about 3x in the next round.  If you raise $1M in seed, assuming a normal 25% dilution, you are expected to have a company that is worth around $10M in about 18 months.  $10M is a lot of money despite what you may think.  Given that seed money is often used to experiment, the more money you raise the higher the expectations are for the experiments’ results.  Saying “we did all this with $250K” sounds WAY better than “we only did this much with $1M”.  Once you take big money, the meter is running.

Avoid big VCs with angel projects.  Large VCs have started participating in seed funding frenzies.  I saw one fund, on stage, talking up the advantage of taking seed money from them explaining that seed investments don’t need to go through the normal investment committee process and don’t require full partnership approval.  Isn’t there a problem there?  What happens in 18 months when a fund that typically writes $10M+ checks and requires all those approvals looks at your barely off the ground startup?  It won’t be that easy.  Signaling is an age-old problem with VCs.  What will happen when the big VC that gave you $500K refuses to participate in your Series A?  Think it will attract or repel investors?  And, needless to say, there are issues with time commitments, prioritization, caring.

Look for accelerators with real infrastructure and industry support.  There’s TechStars, there’s Y-Combinator, and a few others.  All have a brand names, VC industry support, and professionals running the program.  They do convertible notes, they do ask for a lot, they do put the companies through their paces, they are hard to get into.  But all is done for a reason… to get the companies graduated and funded.  I know that demo days sometimes feel like Hollywood productions.  But there’s method to the madness.  And those guys know what they are doing, certainly as far as financing is concerned.

After seed funding:

Pretend there’s a Board of Directors. Many seed-stage companies don’t have real boards.  Some do, but many settle for loosely formed advisory committees.  Either is fine, but there’s a real discipline that comes from being forced to give regular, structured updates on your progress to a small group of people that know what they are doing and who see these updates month after month.  Get into the habit of having regularly scheduled meetings with several investors at once.  Yes, in person.  Yes in a conference room.  Yes, with slides, reports, and financials.  It will put what you are doing into the right perspective.  Run through decks, introduce the teams, air your grievances, ask for help.  This is another argument for professional funds vs. individual angels.  These funds care enough about you and your company to devote the time and effort that’s needed.

Talk about the next round ASAP.  As soon as the seed funding is closed, start thinking about the Series A.  Immediately.  Have a good understanding of when it’s going to happen, when you need to start raising more money, and what the required milestones need to be.  Adjust and maneuver to hit dates.  Expect to be chastised for missing them.  Yes, your goal may be to find product-market fit, or to build something wonderful and exciting.  All will be for naught if you can’t get more money.  So, that’s the real goal.  Good accelerators and professional early investors know this very well.  There’s a reason TechStars companies prep for “demo day” the moment they land in the program’s city of choice.  You should be prepping for your demo days as soon as the first checks hit the bank.

Focus on one simple goal.  There’s a Russian saying:  “if you chase two rabbits, you won’t catch either one.”  Figure out what the one KPI the company will obsess about and watch it like a hawk.  If it’s user signups, if it’s conversion, if it’s enterprise pilots, if it’s a set of features that blows everyone’s mind… decide and focus.  Don’t chase too many rabbits and experiment too much.  You need to be able to show improvements in the chose KPI over time, and time is scarce.

Going for Series A:

**Focus on how much you were able to get done with limited resources.**  This is what seed rounds are all about.  It’s not about slick presentations and SXSW parties.  It’s not about how much you tweet or what your friends re-blog.  It’s about being frugal and getting a lot done with little money.  If you raised a big seed round, you’re expected to produce some big results.  If you don’t have big results, there will be trouble.  You should focus on how far you’ve stretched the $250K you got, how much progress you’ve made, or how long it’s lasted.  The thought you want the VC to have is “wow, if this is what they can build with $250K, imagine if they had $5M!”  vs.  “well, they did zero with $1M, and now with $5M more, zero times zero is still zero.”
**Keep seed VC expectations under control.  **If you took money from VCs in your seed, don’t expect them to participate in a Series A.  This sounds terrible, but that’s a fact… and a reason to avoid seed money from VCs.  This can easily be explained if your Series A round is still below the dollar amount your seeding VC likes, but if it’s in their comfort zone and in their core area of focus, be sure you have a story.  And be sure that story will be corroborated by the VC because he will definitely get a phone call about it.
**Drop the “entitlement” posture.**  Just because you raised money, doesn’t mean someone is obligated to keep funding you.  The bar is significantly higher once you’re funded and no one owes you a step up in valuation that you did not earn.  Your cap is not a valuation and no one actually “valued” you yet.  And the exit is still a distant promise.