What Percentage of 2010 Seed Deals Won’t Raise The Next Round?

There have been a number of thoughtful “early warning sign” posts in the past few days including one from Fred Wilson (Storm Clouds), one from Mark Suster (What Angel Investing & Florida Condos Have in Common), and Roger Ehrenberg (Investing in a frenzied market).

The seed investing phenomenon of 2010 has been awesome to watch and participate in.  The velocity of activity from individual angels, angel groups, seed VCs (the correct phrase for most of the “super angels” which have now raised actual funds), and even traditional VCs has been on a steep climb throughout the year.  When the numbers are tallied up at the end of the year (I’m sure someone will do it – and it won’t be me) I expect there will be all kinds of new records set.

But the warning signs from Fred, Mark, and Roger are worth reading and pondering carefully.  I have a few choice quotes to add to the mix that I’ve heard over the past thirty days.

  • Prolific Seed VC: I only expect that 30% of the companies I funded this year will raise another round.
  • Established VC With A New Seed Program: We are planning to make 30 seed investments out of our new fund.  We’ll do follow on investments in 10 of them.

In both cases, when I speculate on the next sentence they would have said if they were being direct and blunt, it would be something like “I expect the balance of them will go out of business after thrashing around for a while.”  The optimist would have a different view (e.g. that they would be quickly acquired or they would never need additional capital), but anyone that has been investing for a while knows this isn’t the likely outcome for any but a small number of these companies.

Mid-year I felt compelled to write a post titled Suggestions for Angel Investors. When I reflect on that post, my fear is that most seed investors aren’t implementing a “double down on the first round” strategy.  Some percentage of seed deals will quickly raise their next round (30% if you believe the two anecdotes above.)  Some percentage of seed deals will fizzle out.  But some percentage will get stuck in the middle.  They will be interesting ideas with solid teams that realize their first idea out of the gate needs a pivot.  Or they’ll be in the middle of a pivot when they run out of cash.  In the absence of the existing seed investors stepping up and writing another check (without any new / outside validation) it’s going to be hard for these companies to get to the place where they raise a next round financing.

While all entrepreneurs are optimistic on the day they raise their seed round that they’ll be one of the hot deals that easily raises a significant next round, it’s worth starting to plan from the beginning for the case where you “are interesting, but not unambiguously compelling.”  In these cases, you need more time and the only place you are likely to get it is from your existing investors.  If they are willing to keep investing on their own without a new outside lead, you’ll at least have a chance to get to the next level.  But if they aren’t, you could find yourself in a very uncomfortable situation.

I’ll end with Fred’s money quote:

“Anything that is unsustainable will eventually stop happening. And when it stops happening, there will be a dislocation event that will cause people to change their behavior. ,,, When will it stop? Who knows? But be prepared for it to end. And when it does, things will be different. And we should all be prepared for that time.”

Having worked alongside Fred for a long time in a number of companies through several cycles, I can assure you these words come from a place of wisdom, experience, and shared pain.

  • http://sawickipedia.com/ todd sawicki

    Given my last startup ran out of cash in the middle of a pivot – I can relate to the reality of how ugly a situation that can be for the company. Needless to say that company – Lookery – never raised its next round.

  • Jon Callaghan

    You and I (and Fred) both lived through the last bubble and there are eerily similar signs, behaviors and (most importantly) those intuition bells ringing off like crazy. Rest assured, the innovation we are seeing now is real, fundamental and long term. Unfortunately, many of the decisions I’m witnessing are done for the shortest term gains, or without an understanding of the lifecycle of a company and of markets. We’re still investing in incredible people, but we’re also focused on True being in business for the next 10+ years, not just for this quarter.

    Thanks for a great post!

  • Shai Goldman

    The entrepreneur of 2000 and 2007 had the mindset that the next round of financing was owed to them. The entrepreneurs of 2008-2010 have learned or been educated to know that the Series A is not guaranteed and that the seed round would lead to four scenarios 1) a Series A round 2) cash flow positive and therefore don’t need a A round 3) sell the company 4) go under. This mindset an important distinction.

  • http://bothsidesofthetable.com msuster

    Thanks, Brad. Agreed. Totally.

    I did 4 seed deals in the past 18 months. I treated them all like “normal” deals. I led a major round on one with a co-investor at a major up round. I offered a major round for the second – they’re deciding if they even want to take money. I am leading a “seed follow on” on the third. And the fourth is new and launches its beta product in December.

    I can’t imagine what somebody with 50 of these personally would do. Or how the entrepreneurs would get the value.

    • frisbee3

      mark: to respond to your last sentence on “what someone with 50 of these would do”

      – we have a program and network of mentors to work with companies over the first 6-12 months
      – we expect most will ultimately fail, but that hopefully 1/3 will survive and/or thrive
      – regardless, many of the initial companies feel like the value is in both the initial check and in the set of services / mentoring / development we help them with — whether or not they succeed or survive, that value is still helpful.

      i think what brad and you are pointing out is that 1) there are a new group of angel investors who don’t understand the failure ratios, and that they will be surprised / challenged when many of their companies don’t get funding don’t survive. on the other hand, many of us who 2) are executing a larger, more quantitative strategy (& perhaps an incubator approach as well) do understand those ratios, and simply recognize that is how the system works.

      just because we don’t choose the same strategy as larger / later-stage investors doesn’t mean we don’t get it, or that we’re crazy — or even that we’re insensitive or uncaring to entrepreneurs. we simply have a different strategy, and one that may seem strange or hard to others who have more familiar and tested strategies.

      diff strokes for diff folks.

    • http://500startups.com/ Dave McClure

      test

      • http://500startups.com/ Dave McClure

        mark: to respond to your last sentence on “what someone with 50 of these would do”

        – we have a program and network of mentors to work with companies over the first 6-12 months
        – we expect most will ultimately fail, but that hopefully 1/3 will survive and/or thrive
        – regardless, many of the initial companies feel like the value is in both the initial check and in the set of services / mentoring / development we help them with — whether or not they succeed or survive, that value is still helpful.

        i think what brad and you are pointing out is that 1) there are a new group of angel investors who don’t understand the failure ratios, and that they will be surprised / challenged when many of their companies don’t get funding don’t survive. on the other hand, many of us who 2) are executing a larger, more quantitative strategy (& perhaps an incubator approach as well) do understand those ratios, and simply recognize that is how the system works.

        just because we don’t choose the same strategy as larger / later-stage investors doesn’t mean we don’t get it, or that we’re crazy — or even that we’re insensitive or uncaring to entrepreneurs. we simply have a different strategy, and one that may seem strange or hard to others who have more familiar and tested strategies.

        diff strokes for diff folks.

        • http://bothsidesofthetable.com msuster

          Dave,

          For one I do appreciate that you’re trying to innovate on the model. I’ve spoke with many of your portfolio companies. They talk positively about the mentorship approach, the in-house UX team, the intros they’re getting from your staff, etc. I get that you’re trying to do this a different way and that you’re applying resources to help you scale more effectively.

          What concerns me is a world in which one is expecting 2/3rd of companies to fail. It’s great if you’re in the 1/3, I guess? Maybe people taking money from you are self selecting that way in the sort of “take super small amounts of money and be willing to ‘fail fast'” kind of mentality. If so, then I guess they get what they signed up for and everybody is happy. On to the next one.

          But if any are expecting more active involvement when we hit tough times (as invariably we always do given economic cycles) I guess they’ll end up a bit disappointed. Or … maybe your strategy is to partner on each deal with somebody who is more active than you? That could work, too.

          I don’t wish you ill will (obviously, I consider you a friend). I mostly am out to be sure that entrepreneurs who are on their first cycle / first company have a very realistic perspective of what life looks like when the music stops playing. And there are less chairs. And it’s every man for himself.

          Mark

          • http://500startups.com/ Dave McClure

            agreed, we probably need to work together and our roles are more complementary than competitive.

            however, is it “better” to simply focus on a smaller set of companies that you think will succeed / spend more time with, or is it also ok to “let a thousand flowers bloom” and give more people a shot at the brass ring?

            personally I think ALL venture models assume a significant % of fail, not just mine… you may have ability to help more than the “average” succeed (which is why i want my comanies to work with you!), but I still think a majority of companies don’t survive much further than 1-2 years.

            that doesn’t mean we’re wrong or bad for funding them, just that we are practical in recognizing that FAIL HAPPENS and that we plan accordingly. and we build resources to help on development, design, usability, distribution, etc… and, if we’re smart, we develop relationships with larger downstream investors to help our companies that are progressing,

            see you on the playing field… we might even be playing for the same team. just different skills brother :)

          • http://www.twitter.com/biggiesu Mike Su

            Is a 2/3 fail rate for seed stage deals abnormally high? Fred Wilson has posted his expectation for his portfolio is 1/3 fail, 1/3 go sideways, and 1/3 are homeruns. If you’re just dealing in the earliest of stages, isn’t a 2/3 fail rate reasonable? By definition seed stage is higher risk, higher fail rate, and so it’s therefore less money, and lower valuations. The fundamental problem I’d imagine is actually just the higher valuations, because that then throws the risk/reward equation out of balance. But I don’t think a 2/3 fail rate is unreasonable for seed stages, and I think that has to have always been the case. It also seems like since the beginning the expectation has always been that angels can’t/won’t provide the kind of TLC that a VC can, simply because for the angel/high-risk model to work, you have to put more bets across a broader array of companies, which means you can’t possibly give the kind of love that a VC who just put $5mm in one company can. BUT, as valuations go up without the fundamental risk profile changing, then the stakes are higher.Would I love it if all VCs treated a $250k investment in a high risk early stage company the same as they would a $5mm investment in a later stage lower risk company? Sure! But that means that the VC can’t make as many seed investments because they don’t have the time to support it, and when you’re investing in fewer companies at the earliest stages, your risk increases. And of course, if the valuations are getting batshit crazy, then the risk gets even more out of whack.From an entrepreneur’s perspective, I think the big takeaway is as both you and Dave have pointed out at various points – high valuations are great unless you are unable to get traction or the economy goes kaput by your next raise (which means downround or shutdown). However, I think that’s independent of how many investments any given angel makes. After all, I hardly think Ron Conway has been able to give the kind of attention to each of his hundreds of companies the way, say, John Doerr has, and I bet Conway has a higher fail rate than John Doerr has, but they’re just at different points in the lifecycle, and both are doing pretty OK ;) BUT, valuations are the things that mess up the whole equation.

        • http://www.justanentrrepreneur.com Philip Sugar

          Hi Dave. Totally respect you have an upfront strategy, are clear about it and execute….you seem to be doing that. And if you want to get out on the Chesapeake Bay and bang around the Eastern Shore on a real crab boat….please reach out.Couple of non confrontational questions:1. Do you ever do deals where there is a co-investor?Because they can be really destructive when the get punched in the suck hole with a failure.2. If you decide not to follow do you just walk away?Because it really sucks to have baggage if you decide to slog it out.3. Do you just invest in consumer?Because you’d blow up a ton of careers (lives) if you ever invested in BtoB4. Do you plan for the 1 out of 3 failures (as we all know it always is worse than you expect) so consumers don’t become jaded?Because I personally don’t sign up for new stuff as much anymore because I personally have watched companies that fail do asset sales (with my custom email address for each signup) sell my ass?Best regards….

  • http://twitter.com/rodolfor Rodolfo Rosini

    True but companies with traction will be able to raise easily. Companies with seed funding and no traction, well maybe they should do something else.

    Question for you is: how many of the companies with a LOT of traction will skip the usual series A investors and go for larger rounds with B+ ones?

    My last company we raised an initial money from a VC and once we hit a certain valuation we kept raising money from more traditional sources. Might not be the next Google but it has the potential to generate enough returns to make the fund easily.

    Anyway while everyone is talking about a bubble, I am only seeing a lot of people who would like to be angels but that they are not really making a lot of investments since the funding of most startups comes from the usual suspects who were active way before VentureHacks.

    Anyway unless you hit inflection point in growth already or doing a me-too startup (badges? location? gameification?) raising funds is like delivering a baby. I’m sure the same is for you guys raising from LPs.

  • http://keithbnowak.com/ Keith B. Nowak

    Getting caught mid-pivot is a very tough position to be in. You know you need to make a change, know exactly where to move to, but cannot fund that transition. Raising money from existing investors is hard (either they cannot follow on or they don’t want to) and raising money from new investors is even harder since you have very little in way of traction with your new plan. This is exactly the position my company imercive ended up in – http://www.keithbnowak.com/imercive-postmortem/. I think this is a very common story and we may see many more as you point out.

    • http://www.justanentrrepreneur.com Philip Sugar

      What a good writeup……so many lessons learned….so many that I’ve learned the hard-way.

      How were your investors during this? Were they upset? Were they constantly calling? Or did they just accept what was going on?

      • http://keithbnowak.com/ Keith B. Nowak

        Thanks for taking the time to read my postmortem. Lessons learned the hard way definitely make a deeper impression.

        My investors were very supportive through this process. I made a point to be extremely transparent with everything that was going on. I was clear with what was working and what wasn’t so when we made the decision to pivot they were in support of it. They of course were not happy that things ultimately didn’t work out but they knew we gave it everything we had. When we were not able to raise another round the handwriting was on the wall so I think they knew what was going to happen. I also think though that they appreciated we kept at it as long as possible and didn’t just quit when we couldn’t raise the round.

  • http://www.betadvisor.com Jerome Camblain

    I guess we will next see an interesting 500 Mid-Pivot Distress Startups fund (a nice MPDS fund)…and then a fund of MPDS funds, and then a distress fund investing in selected FoF of MPDS…When interest rates are so low and no-one knows where to stick their cash, creativity that exists in the technology industry will gladly leak the the fund management one. This is what D McCure does already: a portfolio of riskier assets with a statistical potential (on paper) to perform…its reminds me the subprime securitization argument. It did work… for a while.
    If I mirror the investment industry to the VC one, I’d say that stock picking as W. Buffet (traditional VC) has brought more upside than statistical based securitized product (new large angel funds). I know a little bit about the stuff, I was a SMD at Bear Stearns…

  • http://khuyi.tumblr.com Kate Huyett

    I haven’t been in tech long, but from my time in finance, some of what I’m seeing and hearing around the early stage tech startup scene feel eerily similar to the way the stock market, private equity market and hedge fund market felt before Bear Stearns failed. One indicator in particular that’s caught my attention lately (one more storm cloud?) is HBS grads flocking to tech, which I wrote a bit more about here.