Why Has Seed Investing Declined? And What Does this Mean for the Future?

Seed investments are down by any measure (funds, deals, dollars) over the past 3 years in deals < $1 million AND in deals between $1–5 million. What gives?

Over the past month a colleague (Chang Xu) and I sifted through data on the venture capital industry (as we do every year) and made a bunch of calls to VCs and LPs to confirm our hypotheses. We published our initial findings in our deep dive on the VC industry in which we showed that:

• Venture Financings for “traditional VC” is relatively flat over the past 5 years (up only 4% compounded annually)
• The venture industry as a whole grew massively, mostly due to the IPO window for tech startups being pushed from 6–8 years a generation ago to 10–12+ years today.
• As a result of the IPO window shifting we saw a massive inflow of public-market capital into the latest stages of venture. Round sizes of > $100 million or more now account for 47% of all VC dollars (62% if you count rounds > $50 million)
• This has made venture capital significantly more valuable for VCs and LPs who invest in the best companies

As part of our study we noticed a trend many have spotted but few have explained — why the hell has seed financing declined so much in the past 3 years??

In this post I set out to explain why the seed market emerged as its own category in the first place and why it’s declined as of late. (if you want to download the deck it’s here on SlideShare)

Why Did The Seed Market Emerge in the First Place?

You might like to think that a bunch of savvy venture capitalists saw a market niche for raising smaller funds or perhaps there was a generational shift where disgruntled junior partners spun out of bigger firms to start their own gigs. Well, both of those things happened but they were lagging indicators.

The reality is that as a result of two major trends the costs of starting a technology startup went down massively. Between 1999–2005 the costs went down by 90% and between 2005–2010 they went down a further 90%. I launched my first startup in 1999 so I know the economics of launching from first-hand experience.

By 2005 it was significantly less expensive to launch a startup so it should be no surprise that the real innovators in the super early-stage ecosystem were all founded around this time or in the few years to come: Uncork Capital, True Ventures, First Round Capital, Baseline and then shortly thereafter Forerunner Ventures, Founder Collective, IA Ventures, K9 Ventures, Crosscut, Floodgate and so many more that I’m sure to get in trouble for not listing them all.

What’s astonishing and few other than those who lived it as startups (I launched my second startup in this era) realize is how profound of an impact that rise of Amazon AWS (S3 & EC2) had on the startup market. The “A Round” of my startup in 1999 was $16.5 million and my A Round in 2005 was only $500,000 (and that’s all I ever raised).

And this era ushered in by Amazon changed everything from the age of founders to the skill sets required to the structure of the VC industry and even to the layout of cities (yes, I would proclaim that boldly that Amazon AWS affected city development).

So What Impact Did the Drop in Tech Founding Costs Have on VC?

As you can see below the number of seed funds shot up dramatically between 2006 and 2014.

And with so many new funds in the market and looking to put capital to work it’s no surprise that there was an even bigger boom in the numbers of deals being funded in the early-stage markets.

And with more funds and more capital and with funds raising their second and third funds a few predictable things start to happen:

• Seed fund partners start to realize the importance of getting large enough ownership so that their best deals return enough capital to drive fund returns
• Seed funds begin to therefore write larger checks, which drives up both valuation and ownership levels for the best funds
• In this era seed investing developed a very different feel than angel investing (and some funds began to go even earlier — thus the rise of “pre seed” investing).

With Things Going So Well for Seed Funds the Winds Shifted in 2015

Seed investors had a good run and all seemed rosy and then in 2015 the momentum seemed to shift. It’s very noticeable in terms of funds raised, dollars invested and deals completed.

But the strangest thing about the decline in the seed stage only happened in the seed stage. Traditional Venture Capital has grown by 14% and Late-Stage Capital has grown by 60%. In fact, deals of more than $50 million now represent 62% of all dollars invested in our industry.

This begs the question …

Why Has Seed Investing Stagnated?

In order for seed investing to continue to boom one of the following factors would need to hold:

• Series A and / or Series B investing would need to be up commensurately to allow the same deals & dollars at seed to continue; or
• Seed deals would need to become profitable and continue to scale without requiring more capital; or
• Seed deals would need to bypass Series A and Series B investments and go straight to growth rounds or IPOs

None of these things have happened. A rounds (first chart) have been largely flat in terms of deals and dollars as have B rounds (second chart).

With seed up massively between 2006–2014 and A and B rounds relatively flat what you see is a widening of the funnel going into traditional venture. This is why many VCs are waiting and letting deals mature a bit before leaning into rounds. Traditional VCs have raised larger funds that allow them to pay slightly higher prices and still hit preferred ownership sizes.

And when seed deals have no where to go you end up with “seed extensions” where seed funds and angels are buying an extra 6–12 months of runway to try and reach a phase that can attract traditional venture. You can see this trend in the excellent data from Cendana below where the number of seed extension rounds has gone up dramatically in their portfolio and the time from seed to A has extended. This data seems pretty consistent with what we’ve seen across the industry.

What Does This All Mean for Seed Investing?

I have very strong conviction that seed investing will remain its own category. The skills and networks inherent in making the early bet are consistent with the funds that play in this category. Seed investing is really about backing “the start.”

Traditional venture capital (A and B rounds) have stopped obsessing quite as much with competing on seed investing as they’re content to be patient and watch the best companies emerge. The reasons for this is clear:

• Traditional VCs take board seats on all of their deals so ramping up a big seed program is impractical
• VCs who did spray-and-pray seed investing as “options” realized it could have a brand impact on one side and then box them out of competing deals on the other side even though they had small ownership in the seed deal
• VCs have raised bigger funds, which allows them to be patient and simply write larger checks to achieve their ownership needs

Summary

The seed market was a result of the massively declining costs to start a business driven by cloud computing. This trend so a huge rise in funds, dollars and deals in the seed category. As the market segment borders have settled and the seed market has matured a naturally cooling off period was inevitable. Seed investing is here to stay (although the firms may change — with some seed funds becoming A investors).

If you want to download the full deck it is here.