I’ve lived through bubbles. Lots of them. They are powerful, make a few extremely rich and many wondering what happened to their pocketbooks and their pride. What I’ve witnessed in the seed stage venture environment has not had these hallmarks. Sure, some prices for pre-revenue and often pre-product companies in certain geographies, e.g., Silicon Valley, have gotten bid up, it hasn’t felt to me as if the market has become untethered from any sense of reality. What has become divorced from what I consider to be good investment discipline, however, is the structure of many “hot” seed stage financing rounds. And even more than poor investment discipline, I think these structures are placing the start-ups raising the capital in a very precarious, high-volatility position. What seems like sound fund-raising advice might, in fact, backfire to the detriment of the founders and their stake in the company.
The structure to which I’m referring? “Party rounds.” These generally come together in the form of a convertible note that is either uncapped or with cap prices substantially above where a priced round could get done, or if there is a priced round there is no ostensible syndicate lead. Seed rounds of $2-$4 million are not uncommon, and the syndicate is generally made up of a large group of angels with some participation by large institutions writing very small checks relative to their fund size. Frequently there is no Board at this stage, merely an informal confederacy of advisers and mentors working to support the founders.
All seems rosy, right? Raise a lot while the sun is shining and to the extent we can push off valuing the equity, all the better for us as price is going up, up, up. Higher price means less dilution which means more for us and less for investors. Hooray! Unless…
What if things don’t happen according to plan? We’re building fast but we’re burning cash. Revenues? Still a ways off. Engineers cost more, we hit bumps in our development pipeline, and there are material delays in shipping v1.0 of our software. All this spells a worsening cash position with no help in sight. Lack of hitting key operational milestones makes raising from outsiders unlikely or at terms brutally punitive. What about insiders? Isn’t this the time that the deal lead steps up to lead a bridge round assuming management is executing well but simply needs more time? Yes. But wait, we have no deal lead. We don’t have an investor with enough skin in the game to care. But what about that rapidly rising valuation that was going to blow through the caps and beyond? How about a bridge at 50% of the strike of the caps, if it’s even offered at all? By not having a lead, a partner who takes the long view and has the resources to back it up, the founders have placed themselves in a very risky situation. Yet the party round seems to be the recommendation du jour among the West Coast technorati. The reason for this is beyond me.
Sometimes I hear that founders get advice that they shouldn’t engage with institutions too early, that they’ll “lose control” and give up too much of their company. Let me tell you, any institution that is in the seed round for “control” is a jerk and shouldn’t be in the business. But I don’t know too many firms that roll this way. An institution who is a true partner is going to work with the founders to create the best syndicate possible, which often includes several strategic angels along with their own investment. Term sheets are clean and founder friendly, but contain essential elements such as pro rata rights and information rights.
As for the claim that having an institutional lead will introduce potentially fatal “signaling risk” should the lead not re-up in the next round, in actual fact this point is specious and absolute garbage. Every seed stage firm we co-invest with supports their companies through their pro rata in the next round unless there are dire circumstances, the same circumstances that would make it unlikely for the company to be able raise outside capital, anyway. Everyone has their horror stories: I’ve just never witnessed one or been part of one. In most circumstances seed stage investing involves buying a “two ride ticket,” where the founding team is given time through the seed and either an extension round or a Series A to achieve product/market fit and prove out the business. A possible exception to this would include incubation-type R&D dollars to hack on an idea. If the hack doesn’t work, no harm, no foul, but no more dollars, either. And this covenant is communicated clearly and right upfront so there are no misunderstandings when the financing decision comes around.
Bottom line, I hate party rounds and think they do a disservice to startups. Cynics will say I’m talking my book and I’ll say no, I simply won’t make those investments because I think they aren’t healthy. They look fantastic in a market that is only going up. But let’s see what happens when the market softens and go-go West Coast start-ups have to go fishing for Series A rounds with their legacy $15-$25 million strike caps on their no-lead, broadly distributed convertible note offerings. Things won’t look quite so pretty then. And then you can bet the party will be over.