Venture funding into startups dipped significantly in the first quarter of 2016…yet venture funds themselves raised more money than they have in a decade. So where does that leave us today, specifically as it relates to the seed stage market?
We looked at four factors — current seed stage availability, follow-on capital availability, the M&A market, and the historical economics of seed investing — to gauge where things stand today and help investors build a strategy for the current environment (Spoiler: We think the argument for allocating capital to the seed stage remains strong).
1. Seed Capital Availability
At first blush, a funding dip like the one experienced by the seed stage in the first quarter of 2016 seems disconcerting, especially for angel investors or micro VC funds simply interested in participating in (and not leading) deals. If others don’t show up and fill the round like expected, investors could conceivably be left holding the bag on a doomed investment.
The more likely reality is that the most recent 2 or 3 trailing quarters were simply a slight reversion to normal levels and the pace will continue at a strong clip for the foreseeable future. The last few years have seen funds focused on the seed stage raise a historically outsize amount of capital, much of which remains ready to deploy. And despite some handwringing early in the year about a sinking public market derailing the private market, much of that concern seems to have been brushed off.
Startup financing market update: 80% of people have entirely forgotten what happened in public markets in January & February.
— Semil (@semil) March 11, 2016
2. Follow-on Availability
If you have been following the seed stage market with any intensity for any period of time – 1 day or 1 decade – you’re sure to have heard about the almost-about-to-happen Series A crunch. Essentially, as record levels of capital have poured into the earliest stages – via accelerators, individual angels, and the hundreds of seed funds that have been raised in recent years – onlookers have feared that a capital mismatch would take place and a more than usual number of those seed funded startups would be left to wither and die on the vine. To an extent, this started coming true late last year, as Mattermark data showed “graduation rates” (Seed funded companies that go on to raise Series A rounds) continuing their already downward trajectory in 2015. Ultimately, the success of an early stage venture portfolio is dependent on whether companies within that portfolio are able to achieve exits via acquisition or IPO. When investing at the Seed stage, however, exits can take half a decade of more. This makes those graduation rates that we mentioned above a very important metric for early stage investors to track and have a handle on. The concept is pretty simple. If companies in your portfolio continue raising capital, they continue to survive and are more likely to eventually experience some sort of liquidity event. In Q1, a majority of the capital raised was concentrated among a few firms, most of whom invest across stages but allocate a investment dollars to mid and late stage companies. This bodes well for the current and upcoming crop of seed stage startups who will be in the market for further raises in 12-24 months time. Beyond that time frame, we look to our next factor…
3. The M&A Environment
Q1 2016 saw exactly zero venture backed IPOs. Add to that the fact that the software sector — where most venture capital flows — saw the lowest number of exits since 2011 and it is pretty clear that the M&A and IPO markets can’t get much worse then they are now. As we noted above, private follow-on rounds are great…but the real returns for investors come when some sort of liquidity event occurs. And while it is possible that the IPO window may remain firmly closed for the foreseeable future, other factors indicate we may be in for a pickup in M&A activity in the industry.
The Facebook Effect – In recent years, Facebook has become as well known for its purchased properties — What’s App, Instagram, Oculus — as it has for its core app. This acquisitive approach gives the company the ability to buy the future (before it becomes too large and thus desires to stay independent) instead of building it. Large corporates are nothing if not copycats so expect to see a few others follow Facebook’s lead and step on the acquisition gas pedal here shortly.
Corporate Venture on the Rise – This piggybacks on the Facebook Effect, as corporations have record levels of cash on hand and have realized that true innovation is unlikely to come from within. Since 2011, the amount of corporate venture capital — both in gross and relative terms — has steadily crept up. As those portfolios mature, it becomes more likely that corporate acquirers will be eyeing a few of the top performers.
4. The Economics of Being Early
This last factor is one that has not been significantly impacted by recent funding patterns but remains important nonetheless. Per data from Cambridge Associates, relative to other stages of the private venture market — and frankly to almost all other asset classes — the seed stage outperforms. This outperformance was brought to back to the surface recently in a series of Tweets from Horsley Bridge Partners, a prominent LP who has backed many of the industry’s top firms. The firm analyzed over 5,500 realized deals from across their portfolio to understand the risks and rewards of early stage and late stage investing. To pull a page from venture darling Buzzfeed’s book…what they found will shock you! We will let the Tweets speak for themselves.
1/ We’re often asked about the risk/reward trade-offs for early vs late stage venture investing; we look to our data (5,500+ realized deals)
— Horsley Bridge (@HorsleyBridge) April 14, 2016
3/ …yet the odds of achieving the all-important 10x+ investment are 60% greater when investing in earlier rounds at lower valuations
— Horsley Bridge (@HorsleyBridge) April 14, 2016
While we spoiled our conclusion above, it makes sense to reiterate here. Capital is available — both at the seed stage and in follow on rounds — for good companies and that availability will continue for the foreseeable future with the amount of dry powder sitting in the bank accounts of both early and late stage investors. On top of that, M&A headwinds are strong (or at the very least, stronger than they have been) and the economics continue to favor investors who back companies early in their lifecycle.