Seed is the new Series A

Whilst the amount invested by VCs into European companies continues to break records, deal count is dropping alarmingly and is now back to 2013 levels. Average deal sizes continue upward as VCs seek more mature opportunities. This relentless squeeze at early stage is forcing startups to rethink their funding plans. What is going on and how should founders react?

What is the data telling us?

A review of the latest market reports from major analysts including Pitchbook, Beauhurst, and Dealroom is a huge reality check for young companies.

Whilst the headlines are all about record investment levels, the real story is the relentless decline in the number of early stage investment deals. This makes sobering reading for businesses that may think that access to capital is getting easier. It’s not.

Pitchbook’s European Venture Report 2Q 2019 provided stark insights at the mid-year point confirming we are truly in a new era:

• €8.1 billion invested across 1,089 rounds; the highest quarterly deal value on record
• Deal count down 12.5% QoQ; the lowest quarterly figure since 3Q 2013
• Angel & Seed stage had the lowest quarterly deal volume since 4Q 2012
• First-time financings declined rapidly in 2Q to only 245 transactions; the lowest quarterly figure since 3Q 2010
• Early stage VC deals (Series A & B) by number were at their lowest point since 3Q 2015
• Late stage (Series C onwards) deals soaked up around 60% of all € invested to the ‘detriment’ of earlier stages

Seed is the new Series A

For those Seed stage companies aiming for their first scale up round, Series A, the picture is particularly challenging. The number of early stage VC deals in Q2 was at the lowest point since 3Q 2015, declining over 17% from 1Q19. The data shows that capital is being invested in fewer but more mature startups.

Dealroom’s recent analysis, The Series A Landscape in Europe, took a deep dive into transaction sizes. One of the conclusions was that rounds at this stage have mushroomed in size over recent years. Series A deals of 3-4 years ago, ‘Old Series A’, were typically in the $4-$7M range. In the new era, ‘New Series A’ is now categorised as being in the $7-15M range. In fact, it extends beyond that with some of the larger deals attracting a new label, ‘Mega Series A’, being anything above $15M.  

At the same time investment criteria have shifted up with deal size. As we commented in our earlier article on this subject, “Seed is the new Series A”. For founders now seeking Series A finance, that bar is continuing to move upwards. The result is that some late Seed stage rounds have all the characteristics of a Series A round of 4 years ago. In turn, Series A rounds now look more like Series B of that era.

Latest Q3 reports confirm that the trend continues

The latest market report from Dealroom shows $8.7B of investment into European startups ($9.8B including Israel) in Q3 2019. Year to date, €28B has been invested in Europe & Israel, up from €21B a year ago. However, deal count continues its downward trend, as can be seen from the graphs below:

A breakdown by round size is highly illuminating. This confirms all the growth is being driven by larger rounds.

Rounds below €10M are simply not growing anymore.

In fact they are down in value by 17% YTD compared to the first 3 quarters of 2018.

What about the UK?

Beauhurst’s analysis of the third quarter 2019 confirmed that the trend we are seeing at the European level is mirrored in the UK. Whilst 2019 has been the best year of equity funding since the record set in 2017, “Q3 was the lowest quarter for deal numbers in 5 years.”

Beauhurst noted that deal numbers have declined across all stages. Venture stage has seen the most marked change with a 24% decline in deal numbers compared to Q2, yet the amount of capital invested grew by a huge 56%.

Henry Whorwood comments; “A decline in deal numbers is always a troubling sign, as it suggests investors are becoming less tolerant to risk and opting instead for a more selective portfolio. The most innovative startups need equity to fuel their growth, and these high-potential, fledgling ventures will be left in the lurch if investors choose to be more cautious with their capital.”

What is driving this shift?

If we look at European investment sources over the past decade, we see an increasing concentration of capital in fewer funds. A continued and dramatic decline in new VC fund count since 2011 combined with a sharp increase in capital intake since 2015, has put substantially more cash into fewer VC channels.

This trend does seem to show the first signs of slowing in 2019 as the number of new funds is starting to indicate a small recovery. However, the fundamentals of the current funding environment aren’t going to change any time soon.

The biggest concern for Seed stage businesses is the decline in smaller funds (sub €50M), which have been in absolute freefall since 2012. Pitchbook recorded 72 new ‘micro-funds’ in 2012 and only 13 in 2018. The good news is that we have seen this trend start to slow. At the mid-year point 11 new funds in this category have been launched in Europe.

Other than this small chink of light, the big picture isn’t really changing. The reason for the huge increase in overall capital intake is that the VC asset class has become more and more attractive. Valuations of rising star companies have been trending up for some time and new Unicorns are pulling up others.

Companies are staying private for longer. Whilst 2018 was an exceptional year for exits in Europe at €52B across 460 liquidity events, we have seen a return to more sober levels in 2019. Just €3.6B has been returned over 214 transactions so far this year.

As a result, those successful companies that are staying private, especially through Growth stage, are sucking up huge volumes of capital. The VC ecosystem is ballooning as the more mature businesses seeking expansion capital are steering away from more volatile IPO markets.

It could be argued that this huge increase of capital is really just money that used to be invested post-IPO, so more value is being captured by VCs who traditionally sold post-IPO.

How should founders react?

Firstly, we must come to terms with this new reality. The data is unequivocal. The trends are clear. Fewer and fewer early stage companies are receiving the funding they need to prosper and grow. Many will simply not make it.

Sadly, many early stage businesses have not yet woken up to this current reality.

Talking to dozens of startups as we do every month through the course of our advisory work, its alarming how many seem to be operating in a state of denial. We are watching too many slow-motion car crashes.

Founders are simply not adjusting their plans early enough to position themselves for funding success.

The warning signs - Red flags we are now seeing with too much regularity:

• Lots of small rounds with no clear plan to scale.
• Current investors insisting the company start exploring an early exit (to the frustration of the founders).
• Waiting until there is only 6-9 months of cash runway remaining before thinking about the next funding round.
• Little understanding of what evidence will be required to satisfy new investor criteria.

But for those with the strongest investment propositions who are switched on to the needs of investors and are coming forward at the right time, the rewards are there. In spades.

So, what must founders do to increase their chances of funding success? Here we make 3 key observations that we believe are universally true no matter what type of business you are creating:

1. Your funding plan must be part of your business plan, not an afterthought.

Remember you are trying to fulfil 2 sets of needs at the same time: the needs of your customers and the needs of your investors. If you forget either one you are in big trouble. If you don't truly understand the needs of your target investors at each stage of investment, then you MUST find out well in advance.

That means that unless you are using an advisor to assist, you will need to roll your sleeves up and do some solid research:

Who are the ideal investors to support the business through Seed, Venture and Growth stages? I mean by investor type and name. You must be specific and base your decisions on their track record, not just the fact that you happen to know someone there. Create a list and write down what is needed. Keep this under regular review.

Without this information you are shooting blind:

You will not be able to determine how to optimise your investment proposition.

Your funding strategy will likely not survive first investor contact.

You will waste lots of time and energy talking to the wrong people.

You will run out of time.

2. Seed is no longer a round, it's a stage - with multiple phases and funding points

Map out the key milestones for the business through all stages as early as possible. Link these to ideal funding events. In particular, partition Seed stage into phases where you will have solid evidence of progress. These will be moments where you can demonstrate to investors that you are clearly transitioning though the gears towards having a scalable business.

Plan this in advance and communicate with the whole team and your current investors:

Set clear expectations and review progress regularly. Be heavily objective driven.

Keep the focus narrow so you do not get distracted with activities that are not an absolute priority i.e not customer related.

Make yourself accountable for delivering the evidence needed.

3. Your current investors will almost certainly have to support you for longer, so love them to death

Choose your early Seed stage investors wisely – Angels, Angel Groups, specialist commercialisation companies, small VC funds and the like. Alignment of interests is paramount. If you have a small VC fund involved be careful. If they are investing towards the end of their investment period, you may come under pressure to sell just when you are planning to scale up! Not what you want.

Keep all your investors appraised of your plans and progress:

Plan regular face to face updates with the most influential and deep pocketed.

Publish a regular (monthly) investor update – see our recent article on this.

Don't be shy about asking for help; seek advice and referrals to other investors.

Make them feel part of your journey and foster a strong emotional connection to you and your vision.

In summary:

Whilst VC investment is at a record high, deal count is down dramatically to 2013 levels.

Average deal sizes have risen significantly in line with tougher investment criteria: Seed is the new Series A.

The number of small VC funds have been in absolute freefall since 2012. There is more cash available than ever before but from fewer sources.

Your funding plan is your satnav to funding success. Make it part of your business plan and nail it down well before you contemplate the investor pitch.

Seed is no longer a round, it's a stage - with multiple phases and funding points. Know yours.

Love your investors to death and make them feel part of your journey. They will be more important to you than ever before.

About the author: John Hall is CEO and co-founder of Duet Partners. His 30-year tech career began with major US semiconductor and software companies, and was based in Silicon Valley during the '90's. Before Duet he was CEO of a VC-backed consumer electronics company, sold in 2009 following several rounds of capital raising. In the past 10 years since starting Duet he has advised dozens of founders on the startup to scaleup journey and is a retained Board advisor to a number of UK technology companies.