Rounds in venture investing
For an investor, rounds, and startups are a bit like poker. It pays to know when to push and when to fold
Rounds are certainly one of the fundamentals of venture capital investing. For a long time, we avoided the topic because it seemed too obvious and well-worn. However, rounds hide several things not so well known to newcomers, which prompted us to write this material. This short article will discuss the different types of rounds and what each tells the investor about the startup.
What is a round?
A round is the moment when a startup attracts new capital. Nearly all companies go through this stage, except those that die too soon. An experienced investor can draw a picture of a startup and capture the essence of the conversation in a few minutes at the mere mention of this or that round.
Raising capital is a fairly rare and always important phenomenon. The startup team decides when to announce a new round, depending on success and some other factors. Usually, the event takes place when the company is developing and moving to a higher level, but not always. The more developed the startup, the higher its valuation, the more money it will need in each subsequent round.
It is necessary to remember that a startup cannot raise new funding every month. There are only so many tries, just like life in a video game, so you should use each of them wisely. The influx of new money is not only a new opportunity but also a tricky side effect – a conversation about the shares of the participants in the deal. If you can do without the new investment, do it. It will be easier for both the startup and the current investors.
It is worth noting that in most cases, the companies that are doing well attract a new round of investment. But if a startup suddenly goes bad, investors can simply write off the asset and not give any more money. No one wants to be involved in a company that is knowingly losing ground. There can be exceptions. Sometimes so much effort and resources are invested in a startup that the company will be saved by any means necessary. In other words, too big to fall.
Rounds can be divided into two groups: progressive and special. You have probably heard of progressive ones: Seed, Series A, and others. That is, they repeat the names of the stages. During the progressive rounds, the startup raises money to move to the next stage of development. At the same time, the company's valuation systematically increases.
But not everyone has heard of special rounds. These include flat rounds, bridge rounds, and down rounds. Many investors may never encounter them in their lifetimes, because these rounds are optional and do not always occur. First, let's review some characteristics of the progressive rounds that club members invest in.
Classics. Pre-seed, Seed, and Series A Rounds
In the theory of venture investments, one often comes across the thesis that pre-seed and seed rounds take place without the participation of venture capital itself. Young companies, it is said, get by with only FFF, grants, and angels. This is far from the truth. In fact, there are no restrictions on participation in the rounds of venture capitalists, who are free to invest at any time.
The pre-seed round refers to the earliest stage of a company's capital raising. The deal size is around $200,000. This stage is so early that textbooks don't always refer to it as a round per se. Each venture fund interprets the list of requirements for startups during a particular round independently. It all boils down to the approach of the individual investor. However, there are universal qualities that everyone is looking for.
One characteristic of pre-seed rounds is maximum risk. However, this disadvantage is compensated by relatively low capital requirements. Today, early stages, including pre-seed, are the real trend. Investors love to invest in such startups because a small injection of capital can more than pay off in the future.
Here, the most important asset of a startup is the team, so look at them first and foremost. In addition, spend a lot of time on hypotheses and evidence in their favor. Usually, the startup does not have a product yet, but it is certain that such a product is needed and that there will be a demand for it.
The seed round is a logical continuation of the previous phase. The availability of a finished product is mandatory, and all attention is paid to the traction, not to hypotheses. In other words, the startup must have a customer base and real sales. It is important for the startup to demonstrate product-market fit. This is when the product turns out to be in demand by consumers and solves a real problem in the market. This is a difficult stage and not everyone makes it. The average deal size is around $2 million.
The last progressive round to mention is the Series A round. This is where the real business is supposed to start (whatever that means). The key is scalability. The startup is already on its feet, the product is a joy to behold. Now capital investment is needed to enter new markets, expand production, and significantly grow the customer base. The round can be $15 million or more.
The specifics of the rounds are not set in stone. For example, you may come across a pre-seed startup with traction that would be the envy of its seed-stage neighbors. That same startup may or may not have an MVP. Also, remember that startups don't have to grow and raise money all the time. Money comes when it's really needed.
The purpose of capital is to allow the startup to reach self-sufficiency and the prospect of exits. A company can stop at a stage and round where it feels comfortable. Don't think that Series A startups are good and everyone else is flawed.
A Test of Faith. Flat Round and Bridge Round
Now we come to an overview of the special rounds. I would also call them additional or in-between rounds. These rounds are optional, they are not tied to any particular stage of the startup, and they can happen at any time.
The first one will be a flat round. During such a round, the startup raises new investments, but the valuation of the company remains unchanged. And the startup does not move to the next stage of development.
A flat round is usually caused by one of two reasons: the startup has not yet achieved the desired metrics, or external factors suddenly and unexpectedly have changed for the worse.
The flat round itself does not indicate a deep crisis. In this case, the company remains stable, while the inflow of new capital will help fortify the current situation and wait out adverse circumstances. The startup may be experiencing growth difficulties right now, but after a few quarters, things may get better.
With a flat round, current investors can increase their stake in the company or get more preferential terms in the next priced round. For new investors, such a round is a very interesting option because it allows them to get involved in a promising company at a moderate valuation. In the future, such a move can be justified because the company will show results sooner rather than later.
The bridge round is similar to the previous one. The company still needs capital, but not to maintain the status quo, but to expand. If the nature of the flat round is more passive, the bridge round is the opposite. In most cases, the need for a bridge round arises from rapid growth that the startup cannot keep up with. The company has a clear path to the next stage. It is just a matter of getting the money for the final push.
In general, the essence of the flat round and the bridge round can be summed up in two words – the business requires money. But why? You need to understand that on the spot. As a rule, such rounds are not part of the plans of investors or startups. They emerge spontaneously and can be caused by force majeure or by real management problems within the company. In the end, the startup may simply fail.
Don't take such decisions of your portfolio companies lightly. Just find out what is going on in the company and what caused the need for another round of investment. It is foolish to give up on a company that has “only” completed 80% of its roadmap.
Crisis of Trust. Down Round
In the case of a down round, there is little reason to be optimistic. The startup attracts new investments at a lower valuation than before. There is a clear negative connotation here, which speaks of concerns within the company: loss of part of the market, decrease in profitability, departure of key employees, or something else. As a result, the startup requires money, announces a new round of investment, and there are no willing participants. This is a brutal blow to the heart. The last option left is to devalue, or in other words, to lower the valuation of the company.
During the down round, the founders of the startup are faced with a choice: sacrifice an even larger share of the company and their independence, or close the business. The interesting thing is that the down round is not necessarily the end. What if the startup simply overestimated itself and is still a good company? But the event carries a significant reputational risk that would scare away investors of its mere appearance.
However, a down round opens the door for new investors to participate in a company that was previously overvalued. It does not matter whether the valuation was justified or not. Sometimes an adjustment in a company's assessment leads to an influx of new investors who literally pull a startup out of the grave. The startup team may have failed, but the intervention of investors who recognize problems and solutions can revive a promising company.
I called this part of the article a crisis of confidence for a reason. The down round can be the result of indifference and mistrust of investors during the flat and bridge rounds. As a consequence, the startup gets stuck in a loop where every next decision only makes things worse. In general, be more farsighted and don't jump to conclusions without full context and data.
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