Seed-Stage Activity Fumbles Amidst Increases In Late-Stage Dealmaking

Seed investing – which has long attracted the least capital of any startup funding stage – is getting proportionately smaller.

The total number of investment rounds for U.S. seed-stage startups hit the smallest projected quarterly total in five calendar years in Q3 2017, according to Crunchbase data. Investors have also put fewer dollars into seed deals this year compared to the prior two. And all of this is happening at a time when late stage dealmaking, and the vaunted unicorn space, is still heating up.

Follow Crunchbase News on Twitter & Facebook

So what’s going on?

Is this just the normal and healthy cyclical reaction to escalating valuations? Or should we be getting nervous?

To get some perspective, Crunchbase News talked to Jeff Sohl, director of the Center for Venture Research at the University of New Hampshire, which focuses on angel, seed, and early-stage investing research. We combined his insights with internal research and number-crunching to get a clear idea of where we are in the seed funding cycle and what trends we should note.

Here are some of the topics we touched on.

To what extent does seed investment follow market cycles, and does the recent pullback signal bearish times ahead?

The seed and angel investment market does have cycles, but they don’t necessarily coincide with cycles in the public markets or even the venture industry, Sohl explained to Crunchbase News. Historically, upticks and downturns for seed coincide with the amount of capital sloshing around at that stage.

Basically, it’s like any other investment space: People want a good deal. If money going into seed rounds spikes, and valuations rise, that tends to lead to a pullback as investors get startup sticker shock. Then, when valuations fall and deal competition subsides, seed investors start looking for something to back.

Sohl stated he started seeing valuations climb to historically high levels about four years ago. That means we’ve probably been due for a pullback for some time. Crunchbase data reflects this. Seed funding investment and round counts began trending noticeably lower in Q4 of 2016. Since then, we haven’t seen steep declines, but there’s been no big upswing either.

Below, we’ve put together charts for total projected U.S. seed investment and round counts for the past five calendar years:

Why might seed-stage investing shrink at the same time that later stage grows?

As venture funds get bigger, it’s just not economically or logistically feasible for partners to do much seed investing, according to Sohl.

A fund of a couple hundred million dollars typically has just a few managing partners responsible for allocating capital. They’re looking to put millions of dollars to work in a funding round, much more than a seed-stage company requires.

Even among seed-stage investors, startups seeking initial funding rounds of a few hundred thousand or less often struggle to attract attention.  Many funds and individual angels now prefer bigger rounds, commonly $1 million to $3 million, for seed-stage companies that are a bit more mature, have a lower perceived risk of failure, and will likely produce an exit faster than a brand new startup.

Investors complain about high valuations in Silicon Valley. To what extent are they seeking out other locations where capital is scarcer?

The valuation spikes of the past few years have been most pronounced in the largest venture ecosystems, further explained Sohl. This includes Silicon Valley, but also to some extent other big venture hubs like New York, Los Angeles, and Boston.

The prospect of backing compelling startups at lower valuations is driving investors to look at some of the more underserved startup ecosystems, particularly the Midwest. Chicago, in particular, seems like it should be a bigger hub for seed investment, Sohl believes, given its large talent pool. Minnesota startups also seem to  receive scant funding relative to their potential, he stated.

Can a strong job market put a damper on startup founding activity, as talented people in hot industries take jobs with existing companies rather than start their own?

Data tends to support the idea that recessions motivate people to start companies, especially because they can hire talent cheaply and easily. So sometimes down economies do produce good startup activity.

However, if you talk to people in the 25 and under crowd, there’s still a huge allure in being part of a startup, even in a strong job market. For younger workers without mortgages and retirement funds to worry about, the risk of a startup failing isn’t catastrophic. Moreover, young workers may be even more willing to take a risk on a startup in a strong economy, since if things don’t work out they’re confident they can still get a regular job.

iStockPhoto / tuk69tuk