Buying Options at Seed
We’ve done a handful of deals with multi-stage $1B+ venture funds in hyper-competitive seed rounds. As a predominantly pre-seed fund, these investments are not core to our model, but we make the occasional small supporting investment in our network.
The price of these rounds is often astounding. We’ve seen newly formed companies raise $5M+ at $30M+ valuations with nothing more than a slide deck.
When we expressed our amazement at the willingness to pay such prices at such a high-risk stage, one of the investors from the big fund commented:
It's not really about price, it's really about ownership.
My first reaction was that this was a stupid justification. How far could the “ownership” priority be taken? Would you be willing to invest $20M at $100M valuation for a brand new startup just because you got your ownership target?
When you consider the model for a $1B fund however, the model starts to make more sense. Series A rounds (in 2020, this is defined as $10M+ for 15%+ of the company) are often the most competitive because they offer the best risk adjusted returns on capital. Series A deals are about “winning”.
So then a $1B+ multi-stage firm is really just buying an option during the seed round. When their funds were smaller, they accomplished this via scout funds, but I think scout funds have proliferated to the point where there are so many scout investments the signal to noise ratio is low, and many hot deals often have scouts from multiple large funds so information arbitrage is no longer a viable advantage.
“Buying out” a company with notable operators or past successful founders then becomes a viable strategy precisely because you’re positioning the fund to be able to best preempt the Series A. Additionally, the fund then ends up often with more than 30%+ ownership after the 2 rounds, which also can significantly reduce the possible exit scenarios for the company that can return the fund.
Is “buying out” a good strategy for the $1B+ multi-stage firms? I’m not sure. It all depends on the failure rate from seed fundraise to Series A.
Founders Dilemma
I think a lot of founders completely ignore the potential negative scenarios that the large seed can introduce for them down the road as well.
Everyone knows the seed investor overpaid just to have an option for the Series A. If you aren’t able to materialize the type of growth expected for a $15M+ Series A, then you’re going to raise a downround and you’ll end up in a worse scenario than if you had raised a traditional $1-2M seed.
More often than not, as a founder you’ll end up in the “gray area” where you’re not a breakout hit, but you might warrant another round of financing. In this scenario the multi-stage firm that led your seed is probably going to pass, which introduces significant negative signal to the market. If you had raised at a $8M valuation previously, you’ll likely be able to raise another round at $12-15M. But if you raised your seed at $20M+, you’re likely going to have a downround.
I think as a founder you need to ask yourself, “Do I really need the extra money?” It can be exciting to raise $4-5M fresh out of the gate, but realistically you shouldn’t be paying yourself more than you need to live, and hiring too many early employees before you really know where you’re headed is a recipe for disaster.
A lot of founders I talk to proudly say “Well we have 60 months of runway now!” — and they’re right that often times, success can take many years. But the sad reality is that the founding team and investors at the $1B+ firm aren’t going to care about much about the company 4+ years down the road when there hasn’t been any material growth.
Overall, I don’t think the massive seed rounds are positive for the ecosystem - founders and investors alike. But in such a competitive Series A environment, I understand why firms need to get creative about buying their options and it does seem like a viable strategy if you’re good at identifying the massive winners.