Seed investors are getting creative to survive the Series A crunch

By Michael Carney , written on February 8, 2013

From The News Desk

There’s been plenty of talk about the Series A crunch and how it affects Seed stage companies looking to raise follow-on funding in 2013. Less talked about is how it affects companies trying to get out of the gates and raise their initial Seed round, as well as those investors considering backing them.

To get an idea of how the Los Angeles ecosystem is looking at this issue, I’ve spoken to a handful of accelerator directors, Seed stage VCs, and angel investors about what, if anything, they’re doing differently this year to avoid getting crunched.

Here are tips they shared:

1. The general theme across the community today is “capital efficiency.” This isn’t measured in terms of the speed at which companies spend capital. Rather, it is in how much can be accomplished with each dollar. Investors are looking for companies that can take the $500,000 to $2 million they raise in Seed capital and make enough progress in terms of either revenue generation or user engagement to make them irresistible to Series A investors.

This was always the case, but the emphasis has been ratcheted up to 11. There’s a lot less forgiveness, or partial credit than there was in years past.

2. Don’t run out of money in the fourth quarter – whatever you do. Investors are advising companies to consider the timing of each investment and what it means for when a company will need to fundraise next. Particularly with checks being written now, in the first half of the year, investors are concerned with backing companies that will be running out of cash and looking for new backers in fourth quarter of this year or first quarter of 2014.

Many believe the end of the year will mark the depths of the capital crunch, only to be further impacted by the typical holiday slow down. I’ve heard from several VCs and accelerator investors alike that companies need to raise enough early to give them a runway to mid 2014. By then, the worst of the crunch will be behind us.

3. Take any guarantee you can get. Several accelerators in town have been changing their model, at least in part, as a response to market conditions. Santa Monica’s Launchpad LA announced recently that it would guarantee up to $100,000 to each company it accepted, offering its standard $50,000 in cash for approximately 6 percent equity, plus an optional $50,000 capped convertible note available to founders should they want it.

Down the beach in Venice, Amplify has taken a similar, although less formal, approach. The group has been investing $50,000 to $150,000 in several of its companies prior to their raising a larger Seed round, making decisions to do so on a case by case basis. The idea for both groups is to remove the fundraising pressure typically associated with a 90-day accelerator sprint, and allow companies to focus on the company building benefits of such programs.

“Originally we planned to do 20 deals per year,” Solomon says, “but it's probably more like 15 per year now, which frees up more cash to invest more [in follow ons] when needed.”

Given their investment velocity, accelerators offer a good barometer for the overall seed stage market. That two of the leading LA accelerators are so publicly changing their model suggests that the capital crunch is real, and it’s impacting the strategy of early stage companies and investors.

It could also be a referendum on the LA ecosystem, which still lacks local capital, despite recent improvements in that regard. Nonetheless, you don’t see Y-Combinator (YC) adjusting its funding model of $11,000 per company, plus $3,000 per founder for 2 to 10 percent common equity. Given its pedigree, YC may be immune from the worst of the Series A crunch. Or, the LA accelerators could be a canary in the coal mine, hinting at tough times for others further up the food chain.

4. Those who can’t raise, tranche. We saw tranches become popular in the wake of the dot com bust, and in some corners of the LA ecosystem they are back. Tranches are essentially a way to earn your way to a full Series A, by proving milestones to unlock capital along the way.

One example of this is ClubW, which yesterday announced a $3.1 million Series A (its first round since exiting Amplify). “This deal was one that raised money in tranches which helped ratchet up valuation and build confidence metrics,” Amplify’s Solomon says. “This is the way we approach raising money in this market $50,000, $150,000, $300,000, $750,000, etc. It’s hard to just go out there and raise a $3 million Series A.”

Tranched rounds aren’t ideal. Fundraising is always a distraction, and dragging it out in this way only makes it more so. These rounds can present signaling challenges as well, sending the message to outside observers that no one was willing to take a big bet on the company. But for companies that must choose between raising cash to fight another day, and not, the decision is clear. And for those who hit their milestones and win the validation among investors may end up being higher.

5. Don’t count on a best case scenario playing out. Ask for what you need, no matter the dilution. A lot of Seed funds are digging deeper to do follow on Seed rounds to help keep their companies alive. But don’t count on this to save you. They’re not doing it for everyone and some firms frown on it completely. Last night, Josh Kopelman said Seed extensions are a rare exception for First Round Capital. His firm believes that it gives companies all the capital needed at the outset of its rounds, and that they need to make it work.

Like so many others, Kopelman also warned of taking Seed money from VCs. Even if every company they back is amazing, VCs will only do a Series A with a small percentage of them. That’s just the restrictions of the industry. The risk of the negative signal if you’re not one of the winners can be devastating. “Ok, so XYZ big name bulge bracket Sand Hill road firm is an investor," Kopelman says investors ask themselves. "'Do I think I’m smarter than them or not?' And that’s a hard spot to start a discussion.”

But again, money is money. If a VC is the one who wants to give you a seed investment, at least raise enough from them to get to meaningful traction and give yourself the best shot of getting the A.

The best companies will continue to get funded, regardless of the environment. But now more than ever, part of being a “best company” is knowing your funding needs, understanding the market conditions, and planning accordingly. Because 2013 will not be like 2012.

[Illustration by Hallie Bateman]