💸 The revenue myth decoded

Raising money for your startup is a hard thing to do, and a CEO knows that she will be periodically on the market to ask investors to trust her company vision. The fundraising process is part of the journey each founder faces; it’s the time when she learns how to create a big company starting from a small one. Time is the most pressing issue, but this journey is a marathon🚶🏾‍♂️, not a sprint 🏃🏼‍♀️that spawns tangible results over an average period of 10 years.

Good founders share a typical pattern. In the early years, they have to demonstrate that their company is on something that matches user’s needs. With almost no marketing budget, they have to use word of mouth techniques to enlarge the user base. When and if the company shows signs of 📈 growth, they start drawing people's interest. In this context, the Seed phase can be considered just a first glimpse into the company's ability to climb the market, but Series A is when things get serious, and growth needs structure.

The A round is commonly the first time the company’s equity is sold, and it’s very different than any previous financing phase. Term sheets and potential lead investors come into play, and venture capitalists might approach you with hundreds of million dollars in their pockets.

What actually differentiates a company that can raise a Series A round from one that can’t is its ability to prove that the product reached Product-Market fit. That translates into: “what the startup offers can be sold, and users keep using and paying for it.” Attaining that phase of development in the company life cycle is a significant milestone.

Most of the startups that can attract capital in the Seed phase with few months or even weeks of data will never get to close a Series A round because of a lack of Product-Market fit. When we talk about software-driven companies in the enterprise market, Product-Market fit involves revenue, and most of the time, recurring revenue. But getting income is just the tip of the iceberg for a company. What you are actually looking for is to prove substantial customer retention and take-off of customer acquisition. A company in the Seed phase, with a limited amount of capital, can work on the former but can barely approach the latter. That is due to a simple fact:

In the startup business, 🌱 Seed money is meant to be used to make a lot of experiments 🧪 on customer acquisition and get through retention.

Still, Seed financing changed a lot in Silicon Valley during the last decade. Sometimes we use to say that the 2010 Series A is today’s Seed round. And it’s true. For example, very few companies showed revenue ten-fifteen years ago when facing an A Round—just 15%, according to a recent study by Wing VC.

In 2020 things work differently.

Nowadays, 82% of startups, which raise an A Round, have good revenues.

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To move from an investment round to the next, all startups need to reach milestones, and milestones can differ from area to area. B2B and B2C have different milestones. And again, within B2B, SaaS products, eHealth solutions, and biotech companies must fulfill different investor expectations. The Seed and A round depend on one another, and to successfully close a Series A financing, it is essential to understand Seed stage dynamics before you decide that you want to create a startup. This is true everywhere in the world, but especially in those areas where an A round means “big checks.”

🏄🏽‍♂️ How the Seed stage transformed

First off, today, Seed is a phase, not a single round. On average, a founder raises more than one time before the Series A financing—Wing VC report talks about 1.2 rounds on average. In my experience, a founder closes at least two rounds. Ten years ago, the Seed round was a single event, and companies ended up raising a few hundred thousand dollars from angel investors, but today is different. Y Combinator remodeled its fundraising documentation—SAFE, Simple Agreement for Future Equity— a few years ago to reflect this change:

(In 2013) startups were raising smaller amounts of money in advance of raising a priced round of financing (typically, a Series A Preferred Stock round).

Today companies are consuming more Seed capital before going out for an A Round because, at this stage, investors expectations are broader:

In 2019, the median company had raised a total of $3.3M prior to raising a Series A, up from $3.0M in 2018 and 5.5x more than the $600K of 2010.

This is more than 5 times the capital that was required ten years ago. Truth is not that the market became tougher or more crowded, but the up-shift in Series A rounds is the result of an increase in the average VC fund size.

According to Crunchbase data, roughly 84 percent of the capital raised by U.S. venture investors went into funds raising $250 million or more.

Source Crunchbase March 2019

Much more capital to deploy on the market and few partners to manage the process moved startup milestones upward.

The check size increased, and expectations followed as well. That’s also why valuations outside Silicon Valley are much lower and sometimes confused. VCs have less capital in their funds, but they still keep calling a 2-3 million financing a Series A Preferred Stock round. Unfortunately, the difference in round size between top ecosystems and all the others confused many startup founders around the world. Especially when they don’t live Silicon Valley dynamics day-by-day. Probably in many countries, the fundraising dynamics are more or less the same San Francisco used to have in 2010. In 2011 Kong Inc—formerly known as Mashape Inc.—Seed was $1.5 million. For Sysdig in 2013, we closed a Series Seed round for $2.3 million. All Seed rounds, not Series A.

So be careful, the name of a financing round is important and geography dependent. Because the Bay Area leads the worldwide startup scene, it develops more rapidly and set the current standard—at least in unicorn-chasing markets.

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🥇 Seed financing: few things well done

In my experience, Seed capital flows into the company bank account in two or even three fundraising events. Each of them might bring better valuations increasingly, generally starting from $3M up to $15M. It’s a broad range, but it depends on what stage of product development the company reached.

Angel Round, Pre-Seed, Seed, and, in pandemic times like today, plenty of Seed extensions. Those are just the most common names used in Seed financing. The essential thing here is not the round name, but that, round after round, Seed financing gets the company ready for a significant Series A.

Let’s consider, as an example, a typical SaaS company. To close an A round nowadays, the company needs at least $1.5M—maybe $2M—in revenue. This means that the $3.3M raised on average during the early years must be very capital efficient. Each dollar spent should generate $0.5 in revenue before you can raise again. That’s why you see most of the SaaS startup today approaching a Seed round with income. And sometimes, you see companies raising a Seed extension to grow their revenue before approaching a Series A.

Most people confuse a startup’s revenue for a savvy approach—like in an ordinary company—but it’s not. You are not trying to become self-sustainable in your Seed phase, you’re learning how to scale a business. When we talk about startups, most of the time, you have first-time entrepreneurs in front of you. The startup system developed a straightforward method to train those people: work on customer acquisition and product experiments to consolidate customer retention. All that training is focused on building a company that grows step by step, allowing the founder to raise the next round to expand.

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The market changed as well

The secret 🤫 to winning at this game is to start building the easiest product possible. Fewer features in the first release, and listen to your users to understand what’s next.

When people tell me that there’s no way to leave something out of a product release, 99% of the time, it’s not true. Forcing themselves and their team to stay in a ”garage” for 12-18 months before launching the product, it’s a big 🐛 mistake, and the most probable result will be that nobody will use what you created.

If you can’t get users to join your product, and you can’t raise money from investors, your vision is likely too broad—i.e., weak and confused—for a startup. “Think big” means “Thing big and listen to your users” in this case.

Elon Musk, the founder of PayPal, Testa, and SpaceX, teaches us valuable lessons about this fact. Paypal was created to become a comprehensive financial platform, but people were not interested in that vision. E-mail payments ended up to be what drew interest in users and investors—a smaller and focused promise with a vast market on the horizon.

Becoming a thoughtful observer of how Silicon Valley evolves over time is one of the most important things to learn. Ten years ago, a lot of capital filled the pockets of consumer companies. Now the enterprise market 🏭 moves most of the business in the area.

Eric Feng, the co-founder of Packagd, a former partner at Kleiner Perkins, wrote an excellent piece at the end of 2019. He analyzed all YC data and found out that:

In the early years of YC, there were far more consumer companies being selected for each batch, hitting as high as 80% of all companies. But that ratio has steadily declined such that now the enterprise companies clearly outnumber the consumer companies.

Eric’s analysis also demonstrated that the trend highlighted by YC data analysis is also representative of the rest of the Seed market. Today most of the Seed financing is in enterprise-focused companies and in that space revenues matter.

In this case, “Think big” means “Thing big and listen to the market.”

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🤔 Conclusions

When you raise capital in the Seed phase, always remember what are the market expectations not just for the stage you are in today but look at the next milestone in your fundraising process. At the very beginning, don’t waste time searching for a lead investor or an equity-priced round. Instead, move fast and raise what you need for a small talented team in the next 18-24 months. Make the process smooth using a Y Combinator SAFE—always capped. Build a product in 12-18 weeks and listen to your users. Look for customers since day one and make them pay. You don’t need to be focused on scaling your customer acquisition strategy, but instead, you need to make customers happy. Experiment a lot and talk to people. Then iterate until you’re suitable for the next phase.

This morning I read a Twitter flow by Michael Seibel, CEO at Y Combinator, which perfectly fit my point here:

Michael Seibel @mwseibel

A lot of startups ask me for feedback on their startup idea. Most of the time I am not an expert in their field nor a potential user.

Michael Seibel @mwseibel

I believe founders do this because they think that investors are the gatekeepers of the startup world and they want me to "like their idea" and accept them into YC.

Michael Seibel @mwseibel

So if you want investment, don't ask for product feedback - share your numbers and ask for money. If you want product feedback, try cold emailing potential users and founders who have tried and failed to solve a similar problem in the past.

PS: If your company metrics look great, and you are in Silicon Valley, come talk to us 😉. We have great Italian 🇮🇹 coffee ☕️.

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