Breaking bad money pile
Courtesy of AMC
Commentary

Free-flowing seed capital is giving startup founders a false sense of confidence

Mar 11, 2015

There has never been a better time to be an entrepreneur. The number of seed-funded companies has quadrupled over the last four years. More than 200 micro venture-capital firms have recently raised more than $4 billion to invest in startups at the earliest of stages. AngelList and FundersClub are growing in popularity. This all adds up to an awesome environment for entrepreneurs to get started. It used to take weeks or months to raise a seed round. Now we’re now seeing some rounds get raised in a matter of days. Incubators and accelerators are pushing out larger numbers of companies, many receiving term sheets within hours of walking off the demo-day stage.

There's a problem, though. I believe this current environment—call it the "Seed Surge"—is unintentionally exacerbating what comes next. (Call it the "Series A Crunch.") The current free-flowing seed stage capital is giving lots of founders a false sense of confidence as they head into their Series A funding round. As Y Combinator president Sam Altman recently tweeted: “Seed money is so easy to raise in the current environment that founders assume they can just raise more money whenever they want."

I recently worked with a team of talented, young founders who had raised their seed financing without breaking a sweat. They had their choice of investors—I’m thankful they chose my firm, First Round Capital—and their seed round was oversubscribed twice over. They set out to raise their Series A round six months later. Guess what happened? A rude awakening. They ended up raising money, but not as much as they hoped for. It was much harder than they expected. It took months to cross the finish line. In the CEO's words: "Our seed round was super fast and hyper-competitive, and then we went into the [Series] A and started getting interrogated about our data. It was like graduating from elementary school straight into college."

This experience mirrors that of many founders and startups I've seen. I believe, across our industry, the unprecedented amounts of seed funding available to startups early on is setting them up for a tough reality check at Series A. Call it a crunch; call it whatever you'd like. But it is significantly impacting startup companies' long-term success. The key is to stay lean and thoughtful after the first money hits the bank.

The seed misleads

Seed funding is more plentiful and easier to raise today than I've ever seen. It sets an expectation among founders—especially for the young, first-time variety—that something they expected to be challenging is relatively easy. That, in turn, sets strong expectations for the next time they do it. The problem? The number of Series A rounds hasn't changed. The amount of Series A capital has not increased. If you have four times the number of companies with seed funding, that's four times the players competing for the same money—making it four times harder to raise a Series A round than it was five years ago.

More often than not, founders tell me they were shocked by how hard it was to get a term sheet, how long the process took, and how much more complex the conversations got. One CEO told me: "Seed funding is all about your idea and team. Series A is all about the numbers. We weren't tracking cohorts or anything at all. I didn't know about LTV or CAC"—the acronyms for "lifetime value of a customer" and "cost to acquire a customer"—"or how to answer questions about the economics of scale. We walked into an interrogation that we weren't prepared for.”

One reason this happens is that founders mistake casual conversations with VCs for serious interest. In venture capital, partners and associates are paid to get out there and build relationships with promising young companies, but there's no commitment. Series A investors are always looking to catch a company before they run an official process, as it's almost always in their best interest to pre-empt a competitive funding situation. That means that they're aggressive in trying to get early meetings.

First-time founders see their inboxes fill with email from venture capitalists. They often assume that the volume and intensity of that interest will translate into an easy funding round. They feel like they have to start their fundraising process immediately or miss out. What they don't realize: They're not ready.

Show me the metrics

The danger with a too-early pitch is that a startup likely hasn't hit the right milestones and hasn't had the time to establish a fundraising strategy. After raising a seed round, startups must get smart about the inflection points they need to pass (such as growth in users or revenue) to demonstrate the customer traction they need to land a Series A. This is critical: Series A investors have more choices than ever.

Furthermore, once a company has taken more than a handful of meetings, it can be viewed as a “shopped deal.” Information travels quickly in the startup community, and containing information is a huge advantage for founders. Great fundraising processes are run tightly. If a VC knows that 20 of her peers have already had a look and passed, that's some serious negative signaling. How many people eat at a restaurant after 20 of their friends tell them it stinks?

There are some investors who avoid the herd mentality, of course—but even among them, a founder is likely to start from behind. As a founder, that doesn't mean you won't be able to raise funds in the future; it just means you're setting yourself up for a much bigger challenge. Once a deal is shopped, founders often need to demonstrate more traction by focusing on solid execution for nine to 12 months before they can take another swing.

A new normal

What's more, startups are seeking ever-larger Series A rounds. It's pretty clear that the market can't accommodate it, yet we keep seeing companies setting out to raise $15 to $20 million Series A rounds just a few months after they've raised their seed round. To invest $15 million, an investor needs to have three times the conviction that that they have for a $5 million investment.

There are a few factors driving this desire to raise $15 million or more at the Series A stage. Founders see a handful of data points and believe that a new normal exists. For example, a founder watches her peer raise a large Series A round and reads a few news articles about large Series A rounds and feels that she can do it, too. It might be possible. But it's far from typical.

I also hear a lot of later-stage investors giving early-stage founders bad advice. Say a founder takes a first meeting on Sand Hill Road and mentions a large target-round size. When the investor doesn't blink, the founder now thinks it's within reach. It may not be. (Founders, take note: It's much easier to increase a round size than to decrease it.)

The most successful founders wait to raise additional funds. They wait to demonstrate traction. They wait to hit proof-points that represent real step-change for their companies. When they finally do raise, they ask for a lower range. You never want to call an investor back and say, “Hey, I know I told you last month that I was raising $15 million, but now I'm going to raise $6 million.” It will raise red flags about you and your company. Better: “So I was going after six to eight million, but it looks like we're going to be able to do $12 million, given strong investor interest.”

Founders don't have to fall into the Series A trap. In fact, they can capitalize on these trends and use them to their advantage.

Some of the smartest founders I work with are taking advantage of the seed-funding boom to raise larger early rounds, buying themselves more time to get more done and hit more of those critical inflection points. Their thinking: If you're only new and shiny once, get as much out of it as you can.

Smart founders are also pausing to map things out carefully. It always surprises me how many startups fail to plan realistically around their spending. Young companies say: "We have 12 months' worth of cash. Let's launch in 11 months." This isn't a good plan. Founders must have a clear picture of the traction and proof points they'll need to show investors when they eventually do raise their Series A. Keeping your burn rate low until you have product-market fit will give you the best chance at building a big company.

And when smart founders do launch, they define success by what happens in the months that come after it, not before. Let's say you're an e-commerce company. You know the winter holidays will represent 40% of your revenue to date. You don’t want to be in a position where you have to raise in November; you're going to want to make sure you have enough cash on hand to raise in February after the milestone.

Finally, a smart Series A pitch should be much more polished and rehearsed than the average founder probably thinks. The Series A pitch is a make-or-break proposition. Founders need to be able to demonstrate mastery of their numbers in conversation. That know-it-cold approach takes no less than four weeks of preparation.

And the last thing? Don't panic. Adversity is not necessarily a bad thing. As Walt Disney once said: "All the adversity I’ve had in life, all my troubles and obstacles, have strengthened me . . . You may not realize it when it happens, but a kick in the teeth may be the best thing in the world for you." Starting a company is not easy. It's hard to build an awesome product, to hire talented people, and to raise capital. Don’t let the Seed Surge fool you into thinking that future financings won’t be a struggle.

Josh Kopelman is a founding partner of First Round Capital, a seed-stage venture capital firm. A version of this article was first published on its website.

All products and services featured are based solely on editorial selection. FORTUNE may receive compensation for some links to products and services on this website.

Quotes delayed at least 15 minutes. Market data provided by Interactive Data. ETF and Mutual Fund data provided by Morningstar, Inc. Dow Jones Terms & Conditions: http://www.djindexes.com/mdsidx/html/tandc/indexestandcs.html. S&P Index data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. Terms & Conditions. Powered and implemented by Interactive Data Managed Solutions