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Ep. 355: Despite the global pandemic, seed investing remains hyperactive amongst VCs. Satya Patel of Homebrew shares his expert advice on how to raise seed capital in 2020.
This episode is sponsored by Lightmatter.
SaaStr’s Founder’s Favorites Series features one of SaaStr’s best of the best sessions that you might have missed.
This episode is an excerpt from Satya’s session at SaaStr Summit: The New New in Venture. You can see the full video here, and read the podcast transcript below.
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The transcript for this episode is below:
I’m here to talk to you today about raising capital in today’s environment, particularly at the seed stage, so we’ll touch on the Series A stage as well.
I wanted to start by just talking a little bit about something that all of you have been hearing about, which is PPP loans, the SBA program for getting capital to companies in need. The reality is is that if you’re a startup just getting off the ground, PPP isn’t a legitimate option for you. So, I’m here to tell you exactly what you need, what PPP really means for you, and the difference between raising money in today’s environment versus not being able to do it. So, with that, let’s jump right in.
The world has certainly changed, there’s no question about that. Sheltering-in-place is just the most obvious impact; how people interact with each other, when and if customers buy, whether the rebound is a V-shape or a W-shape or a loop-de-loop, there’s definitely a lot of change in today’s world, and that’s the only thing that we know for certain.
The other thing that we know is that there’s a ton of confusion about what’s going on and how long this is going to persist. We don’t know very much about the virus, we don’t know the right way to approach fighting it, and we certainly don’t know how the economy is going to perform over the coming months. So, don’t count on anyone, I mean anyone, to give you the answers.
And you certainly shouldn’t expect answers from The Midas List or VCs that you know and respect. We’re just living in unprecedented times. Anyone who pretends to know how this is going to play out is doing just that, they’re pretending. As much as VCs spend time evaluating the markets, evaluating businesses, trying to predict the future, we don’t know any more than any of you in relation to what’s going to happen here over the next 12, 18, 24 months.
So, for you, as founders and entrepreneurs, the key is to focus on the things you can control, and one of the things you can control is how you tell your story to VCs. But, to do that effectively, you need to get in their heads, no matter how scary a place that might be. So, what are VCs busy doing right now? That’s a good place to start, to understand the actual landscape in which you are trying to raise capital.
First, they’re focused on their current portfolios. Which companies are in a world of hurt? Which companies are benefiting from accelerating trends and new dynamics? Which just need to bide their time? Any VC worth his or her salt is focused on helping the founders and CEOs that they work with take care of the physical and mental wellbeing of their teams, stabilizing their businesses, and planning for the uncertainty over the next 18-24 months. So, getting their attention right now for anything new is really tough and that’s something that you should just accept and know, going into any potential fundraising process.
The other thing that VCs are doing is one very important part of their jobs, and that’s meeting companies and studying markets to figure out where they might want to invest eventually. You’ve all probably gotten a cold email from a VC associate or partner asking about your business or wanting to understand your market. Expect more of those because VCs trade on data and they all have the time available to them right now to spend hours talking to folks like you about what’s going on in the world and collecting that data. But that’s only the beginning for them, collecting data is the thing that they can do right now. Unfortunately, the reality is most of them are just waiting and sitting on their hands.
The thing that most people don’t realize about venture capital is that VCs are always thinking about capacity, and most venture partners at Series A and later firms only make one to two investments per year, and so the opportunity cost of making an investment now, versus thinking about an investment later, is a real cost to them because it’s a cost of their time, not to mention what might be happening from a broader market perspective.
And, from that standpoint, there’s a huge disconnect between the public markets, unemployment rates, and what startups are experiencing on the ground right now with customers. Until there’s more stability in those areas, you can expect that most VCs will be waiting for a time where they have more comfort with valuations, with customer behavior, and with knowing that there’s going to be another set of VCs down the road who are going to be willing to write a check to support their companies on an ongoing basis. So, most investors, no matter what they say, are taking a wait-and-see approach. If an investor is telling you that they’re active or open for business, they probably are, in the sense that they’re busy collecting data, but that doesn’t necessarily mean they’re in a position to write checks.
The good news for all of you is that seed is very different. I don’t want to be a complete downer, so this is hopefully a bright spot. There is a ton of capital committed to the seed asset class, and because we’re investing at the earliest stages of the market, there’s only so much price compression that investors can expect. As a result, what’s happening in the public markets isn’t necessarily impacting the very early stage of the private markets.
The other thing that’s important is that there are many types of investors at the seed stage. There are angel investors, super angels, pre-seed funds, microfunds, institutional microfunds. The reality of their businesses, our business, is that we can’t afford to miss the next great company. We only get one bite at the apple, we are seed-stage investors. Unlike firms that are later, Series A and later, oftentimes those funds will invest at Series A and Series B, or Series B and Series C, so they have the opportunity to revisit companies that they may have missed. Not the case to the seed stage.
And, as a result, seed-stage investors are active in the market at this very moment. The other thing is that most seed investors tend to do more volume of investing than investors at the later stage, so the opportunity cost of investing in something right now isn’t the same as it might be for a later-stage investor. And so, for all of those reasons, seed right now is a very different beast than Series A and later-stage investing.
It’s definitely an active market at the seed stage. Homebrew is only one data point, but we’ve made five investments since shelter-in-place started, and every one of those investments was a competitive situation, so there are many firms that are trying to write checks into some of the best companies, hopefully. We’ve spoken to many of our peer funds and most of them have made at least one, and mostly more than one, investment during shelter-in-place. And probably the even better news for all of you, is that, given competition, valuations at the seed stage haven’t declined dramatically, maybe 10-20% at the seed stage, and maybe up to 20 or 30% at the pre-seed stage, but given the world we live in, there are some realities about seed-stage investing and the amount of capital that’s being committed to the asset class. That means that the amount of activity and the opportunity for you to go tell your story and raise capital is as strong as ever.
That said, there are some differences about the world we’re living in now. Obviously, as we’re seeing now, the most important one and probably the biggest difference is you’re going to be pitching over Zoom. And no matter what a VC says, they prefer to meet people in-person. So, it remains true that lots of VCs still haven’t figured out if they can get comfortable making investments without having met someone in person. For you, the thing to do is ask the question: are they willing to and have they made an investment over Zoom? And then determine whether you want to continue the conversation.
It’s going to be tough to be the first investment that a partner at any VC firm makes without having met you in person. There’s so much subtle communication that gets lost over video, you need to make it up with energy. You might feel like you’re exaggerating your expression or tone, but it’s going to be more effective. You really need to put your best foot forward and exude that passion and energy that maybe you take a step back from when you’re in the room, but over a video, there’s nothing more important than convincing people and demonstrating to them that you have the energy and the commitment to whatever idea that you’re pursuing.
A very tactical piece of advice: invest in good lighting. Do it now, before you pitch. Both subconsciously and consciously, it has an effect on whoever’s going to watch you. Ideally, another piece of advice is that you’re setting the camera on the video at eye level. No one’s going to get a sense for who you are by looking at your chin or the top of your head, certainly if you’re going to have a glare off the top of your head, like I do, in many cases. So, invest in good lighting, set up your camera well, and exude energy if you’re going to be pitching over Zoom, which is the reality of how the next 12-18 months is likely to look like for founders and entrepreneurs who are trying to meet with VCs.
Another major difference is that you can expect that investors are going to want to do many more references than they might have in the past, both customer references and professional references. Have those ready. Prep anyone you’ve asked to be a reference with the things that you want them to highlight, and make sure that they have the two or three questions in mind that they’re likely to be asked by any potential investors. Definitely have at least one person that you’ve worked with, recently, on the list. Nothing’s more frustrating for a potential investor than getting a set of references where the most recent reference is from two jobs ago.
And if you don’t have any mutual contacts with the investor, where they can do backchannel referencing on you, you’re going to need to go the extra mile in terms of that communication style that we talked about over video, and also the proof of your commitment to what you’re building, and maybe even evidence of product market fit. But, backchannel referencing and on-sheet referencing are critical at this moment, and being prepared to handle those requests well is going to be the difference between success and failure in your fundraising process.
Expect that investors are going to want more time with you. Because you’re not getting those soft cues that you get from meeting people in person, investors are going to want to have more time over Zoom with you and your team, and you should want that, too; after all, you’re choosing an investor and making a commitment for the life of your company, and so take the time to get to know those investors over Zoom cocktails or virtual working sessions or whatever is going to give you a better sense of what it might be like to work with them and give them a better sense of what it might be to work with you. Deal processes may take more time overall, but if you make yourself available, and you probably have some time, you’ll help speed things along. But know that there’s going to be a greater time commitment, more meetings, more conversations, to get over the bar and over the hump for closing your seed financing, or any financing in this environment.
So, despite some of these changes, which are subtle in some ways, fundraising is mostly the same at the seed stage. Seed investors are betting on a market that’s two to four years from now, and sometimes even longer, so they can’t afford to take a wait-and-see approach and wait until the economy straightens itself out or the government gives better advice around how we’re going to deal with all of this, they have to be investing now for the future. And given the number of investors and the amount of capital that’s in the market, remember that it only takes one yes, that’s all you’re trying to get to, and that one yes will automatically create scarcity for you and get others to say yes, so put your best foot forward and try to get to that one yes.
So, how do you do that? My point of view would be there’s still only one way to get to yes at the seed stage. You’ve got to make them believe. Investing at the seed stage is an irrational act. There’s no amount of data that is available about your company and about you, at the seed stage, that’s going to convince somebody based on cold, hard facts. Think about it: all there is is a few people and an idea, and that idea has all the odds in the world stacked against it, yet investors have to decide to give you hundreds of thousands or millions of dollars, despite all of that. And that’s why your goal is not to win the argument with data, it’s to generate emotional resonance so that the investor irrationally believes in what it is that you’re pursuing and in you. And that’s where we get to what we believe PPP really means in today’s environment and in any environment when you’re raising capital at the seed stage.
This PPP doesn’t come from the SBA or any government entity, this PPP comes from the story that you weave when you deliver your pitch. It starts with you and the other people on your team. VCs want to surround themselves with people who they can learn from and who they want to enjoy spending time with and working with. They want to support founders who deeply believe in something that should exist in the world, in founders who they feel deserve tremendous success, and who they want to see succeed.
Belief might spring from any number of things related to your team, any number of characteristics, including the founding story, the chemistry of your team, the unique insights that you have into the problem that you’re solving, but it’s important that you get across something special about your team. Because this is an emotional decision more than a rational one, it’s very true when VCs say that they invest in people first. It’s the emotional connection to those people that leads to the investment because no rational thinking leads to saying yes at the seed stage when it’s an idea and a team and not much more. So, focus on the people and communicating what’s special about you and your team.
The second way of building an emotional connection is about the potential of your business. The potential of your business might be captured by the mission or the market or the product, but somehow you need to leave the VC feeling that he or she absolutely wants the problem that you have identified to be solved, and the thing that you’re building to exist in the world, and that what you’re building is going to be enormous in scale and scope. This is why VCs have a hard time investing in things that aren’t targeted towards them; if something’s not relatable, it’s hard to see the potential of it, but your job is to communicate the potential of it, whether it’s through the market opportunity or the product or the mission of the business. It’s the promise of the early-stage startup that can make VCs take that emotional leap and ignore the difficult reality of what it means to start a company that’s most likely to fail.
And the final P in the PPP that really matters is proof. Unfortunately, accept that you don’t have it at the seed stage. Most companies don’t end up where they start and, if that’s the case, then the early signs of what you see as product market fit aren’t real, for the most part, because the use case you’re addressing probably isn’t consistent across all the customers you have, the customers who are adopting don’t share enough common characteristics for you to have identified a singular customer type, long-term engagement isn’t proven, early customer acquisition costs are misleading, so there’s a bunch of reasons that the proof you think you have is probably not proof in the investor’s mind. So, the thing to remember about that last P, proof, is that you can’t count on it at the seed stage. Nothing kills a good story like data. For most VCs, it’s easier to bet on the promise then the reality, especially at the seed stage, so you’re better off playing on emotion, and, again, people and potential are the emotional keys that you want to cue off of and drive your story around.
So, now that you know the keys to raising seed capital with PPP, it’s time to think about the A, and while the seed is all about emotion, the A is completely different, it’s about risk, and so we’re going to talk a little bit about how to think about risk in the context of your seed-stage company that’s in pursuit of a Series A.
The dirty little secret of investing, of a business which is predicated on people who take risks, is that VCs actually don’t like risk very much, they’re afraid of it, and that’s why the bar for Series A rounds and later keeps rising, and investors are generally willing to overpay for clear momentum as opposed to take early risk when they could be getting a better price because, at the end of the day, most VCs don’t want to take dramatic risk. And they’re only willing to take risk when they know that the risk that they’re taking is less than what the prior investors took and, hence, the higher price. And so that’s the thing to keep in mind is you’re always being evaluated from a risk perspective, and VCs are trying to evaluate very specific areas of risk when it comes to your business.
We categorize the types of risks that investors are looking at into five buckets. The first is product, and that includes everything from technical risk, timing risk, those kinds of things related to establishing product market fit. The second major risk is team risk. Are you missing some key skillsets that are going to be critical to execute the plan that you have or to deliver against the mission that you’re pursuing? Sometimes, that could be somebody from a sales perspective, somebody from a design perspective. Many founding teams have people who can build products, but they’re missing some other key areas that could be critical to reducing the perceived risk or executing against the potential of the company.
The third risk is market risk, which includes everything from size of the market, regulatory risk, geopolitical risk, all those kinds of risk that fall under the category of market. The fourth major risk that investors are evaluating is go-to-market risk. Is there a clear definition of an ideal customer? Is there a repeatable, scalable sales model? Is there somebody beyond the founder who’s been able to sell on a repeatable basis? Those are the types of questions that are asking in the category of go-to-market risk. And then, finally, fifth is financial risk. Can the capital be managed until the next financing? Can the company manage cash until the key milestones have been achieved or the risks have been addressed? And will the business be attractive to future financers and future investors based on what it’s able to accomplish? So, those are the five risks that you need to think about because these are the risks that are in the heads of any investors that you’re going to be talking to.
Your job with seed capital is to reduce or eliminate those risks, but it’s unrealistic to tackle of five of them. Pick the three that are the most significant and focus on those, and then tell the Series A investor why you chose those, what have you done to mitigate those risks, and why should they bet on you being able to eliminate the other risks in the business? Oftentimes, at the seed stage, the most common risk to focus on are product risk, market risk, and go-to-market risk, but it’s going to really depend on the investor that you’re talking to and, more importantly, on your specific business. So, with your seed investors, get on the same page in terms of what are the most critical risks to address, and then pick the three that you’re going to try to tackle during that seed phase of your company.
Finally, in addition to addressing the risks, you need to achieve some level of scale. The Series A investor is trying to bet on less risk, but also there’s clear scale to demonstrate that this can be a large and viable company. Whether it’s customers or revenue or some reasonable trajectory of growth, or some absolute level of customer attraction or revenue traction, you’re going to have a hard time demonstrating that you’ve eliminated or reduced risks if you haven’t achieved some level of scale. And so combine reducing three risks with scale and you can unlock your Series A.
So, if you’re going to remember three things from today, start with the very first, which is don’t fear the world that we’re living in. Things have certainly changed, but more is the same than is different in the world of venture financing, especially at the seed stage. Second, the only PPP you need to keep in mind are the ones that will help you make them believe: people, potential, and proof. Importantly, people and potential are the ones that you can control, proof is unlikely to amount to much, but it’s important for you to know that as you’re going into your seed fundraise process. And then, finally, after your seed, pick the three risks to tackle and you’ll be set up for a successful Series A.
Published on July 24, 2020