The startup ecosystem has a painful year ahead. Nearly half of Series C fundraising rounds were down or flat in 2016. Series B startups are next in line to feel the pain. [A] flat [round] is the new up [round]. If you really need another venture acronym, call it FITNU.

The market correction will not stop at Series B. If you’ve raised a Series A and need more capital in 2017, what I’m going to share might save your company. If you’re at the seed stage, this article might save you a lot of trouble.

Wait, what happened?

According to some investors, 2017 was supposed to be the turnaround year. Didn’t U.S. venture capital funds raise a record $42 billion in 2016? Didn’t we get past the notorious bubble?

Not quite. The bubble broke in 2015 when the tourist VCs driving unicorns in so-called private IPOs got spooked. They pulled back. This ratcheted down the VC food chain. The system couldn’t support the wild number of seed deals and high valuations. To protect itself, the system concentrated more money into fewer deals.

PitchBook found that the number of U.S. seed rounds declined 43 percent, from 1,537 deals in Q2 2015 to 872 in Q4 2016 — a four-year low. Early-stage financing (Series A and B) followed along. Deal volume tanked from 830 in Q2 2014 to 524 in Q4 2016.

Meanwhile, deal sizes swelled. Indeed, 42 percent of seed rounds were between $1 and $5 million in 2016, the highest proportion PitchBook has recorded over the past 10 years. Almost 50 percent of the early-stage money went into rounds worth $25 million or more in 2016.

Corroborating PitchBook, Redpoint Venture’s Tomasz Tunguz points out that the median seed round tripled, from $272,000 to $750,000 between 2010 and 2016. His analysis of Crunchbase data also shows that the median A round climbed from $3 million to $6.6 million over the same span, and the median B leapt from $10 million to $15 million.

So why the flat rounds?

In the bubble, more startups received seed funding because so many new seed venture firms entered the business. But the number of Series A firms didn’t grow much at all — they just raised bigger funds. Thus, Series A firms started writing bigger checks to meet the needs of their business.

Unfortunately, few seed startups qualify for $10 million to $20 million “Super-Sized” A rounds. As a result, the seed-to-A graduation rate plummeted. Series A follow-on investments dropped from roughly 25 percent in 2012 to less than 10 percent as of midway through 2016, says PitchBook. Over time, a lot of the seed-funded companies get extensions, so the graduation rate is probably closer to 20 percent. This is well below what it used to be, at 45-50 percent.

Plenty of companies took premature, massive A rounds and guzzled capital all the way to Series B. They became the source for all those flat and down C rounds. As I said, nearly half of C rounds were down or flat in Q3 2016.

Let me illustrate why. At the Series A, let’s say an investor buys 25 to 30 percent of a company and puts in $10 million. That defines the value as $33 million to $40 million post-money. B-round investors want to see at least a twofold increase from the post-money A to pre-money B. If not, they calculate they’re better off waiting for the C round.

In bubbly conditions, getting the 2x increase in valuation was easy. Startups hit their B. Then the market correction began, so they went flat or down at C. The flat and down rounds will sweep down from Series C to B to A to seed. In other words, winter isn’t over, Mark Suster.

Reseeding

In 2017, Series A companies will struggle to get their pre-money valuation high enough for the B round. If you take a flat or down round, it’s time to “reseed.” Effectively, you need to cut costs until your company resembles a post-seed startup.

Many founders think it’s “death” to take a flat or down round. They believe that partly because of equity dilution and partly because of signaling.

No company ever went bankrupt because of dilution. The real signal is what a company looks like after a flat or down round. Did it restructure to match the new reality? If so, it’s a more attractive company. The down round isn’t the problem as long as the company adopted a leaner, more sustainable model.

The capital structure is the hardest issue to solve because there can end up being too much preference from the Series A. Imagine you do a $2 million seed, and the investor has $2 million of preferred stock. Then you raise a $10 million Series A, and the A-round firm has $10 million in preference. You have a total $12 million in preference with a debt component that has to be paid back.

Sane investors don’t want $12 million in preference ahead of them at post-seed values. Even worse is getting the B round and having to reseed. You now have to deal with $25 million or more in preference. Take care of it. Do whatever it takes to reduce preferred stock in the capital structure when you reseed. That’s a harder problem to solve than your burn rate.

Next to bat

“Flat is the new up” is one way to describe the post-bubble correction. Star companies of 2014 and 2015 took flat or down rounds for their Series C. Startups that raised, say, a $1 million seed and $10 million Series A are now going through it at the Series B. Many will reduce employees and restructure their cap tables until they resemble post-seed companies. Reseeding is better than going down in flames. And, paradoxically perhaps, you might find that you grow faster with fewer employees and less internal contention. Maybe the premature Big A wasn’t such a good idea after all.

Seed startups, beware: FITNU is coming to you next.

Featured Image: Gary Waters/Getty Images



Source link