Hello and welcome back to our regular morning look at private companies, public markets and the gray space in between.
Today we’re digging into seed-stage companies, the vanguard of the venture market. In particular, we’re trying to understand why the ratio of seed deals now favor enterprise startups over their consumer-focused brethren. The fact that seed investors recently inverted their preferences, cutting more checks to enterprise (B2B) startups in 2019 than consumer-oriented companies (B2C) was news.
We wrote about the trend here, as regular readers will recall.
To better understand what’s going on, I spoke with a number of early-stage venture investors who recently dropped by Equity, came highly recommended by peers, and several I know personally. The goal was to get a handful of inputs from different firms to get under the skin of the trend.
What in the hell is going on in seed? Let’s find out.
Why are enterprise seed deals on top?
This morning we’ll hear from Jenny Lefcourt at Freestyle Capital, Jomayra Herrera of Cowboy Ventures, Hunter Walk from Homebrew, Iris Choi of Floodgate, Sarah Guo from Greylock and Ajay Agarwal of Bain Capital Ventures. As you can see, we picked a list of investors form firms of different sizes, theses and focus. However, each investing group either focuses on early-stage investments that include seed deals or dabbles in them.
Here’s what we want to know: why did the the majority of seed deals swap from consumer-focused startups to enterprise-focused deals?
Our investing group detailed a number of explanations, a handful of which echoed each other. To best convey their thinking, we’ll quote each investor at moderate length. If you are in a hurry, the most common point made against consumer-focused seed deals is go-to-market difficulty in the current market.
Other reasons include price, secular changes to the technology landscape, and the changing experience profile of the investing class themselves. (Minor edits made to select responses for clarity.)
Freestyle’s Jenny Lefcourt said via email that consumers are an increasingly difficult cohort to sell to, because they “became fickle with the proliferation of VC-backed, consumer-focused startups over the past few years.” As a result, consumers became “harder and more expensive to acquire and even harder to retain,” meaning higher customer acquisition costs (CAC) and lower lifetime value (LTV).
That’s a bitter combination for a startup looking to generate investor interest over other, possible deals. Lefcourt also said that some investors are moving to later-stage consumer-focused investing, as “consumer [deals are] harder to know at seed stage and many VCs would rather pay-up for more data [and/or] traction.”
Cowboy Ventures’ Jomayra Herrera made technology points and market-based arguments regarding the changing ratio of seed deals. Regarding technology itself, she noted that there’s a “lot of opportunity to innovate [in] industries that haven’t been touched by tech.” This is the argument in favor of vertical SaaS investing. She also cited changes in how people work, creating “opportunities for new enterprise startups to emerge” that are investable.
Turning away from tech and towards business issues, Herrera cited go-to-market issues with consumer-focused startups, saying that due to “over-reliance on Facebook and Google to reach consumers, it’s hard for consumer startups to cost-effectively break out” today.
Herrera also said something that we all know to be true, but don’t hear often: “enterprise tends to be a little less risky.”
Floodgate’s Iris Choi cited price as a possible reason for the change, saying that her firm has “observed over the last few years that valuations were getting frothy in consumer companies that were showing early signs of traction.” This led to “valuations [that] were too steep for the kind of seed deals we consider our core product.”
Choi continued, saying that despite a “fairly evenly split between consumer and enterprise portfolio companies,” her firm has noticed that it is frequently “easier to see a path to building a capital efficient business in enterprise than in consumer.” That would make enterprise deals more attractive; capital efficiency means less investment is needed to reach a lucrative exit, leaving early shareholders with a larger slice of the eventual pie.
Homebrew’s Hunter Walk made an interesting argument regarding the changing makeup of seed deals. In Walk’s view, “the nature of the people doing the investing” is critical to understand the current venture landscape. There’s “a wave of new VCs from operating backgrounds” according to Walk, who worked in “the first generation of cloud-SaaS-enterprise companies and are thus investing in what” they know best.
Walk also said that many current seed investors are investing in tools “that seek to solve the problems they experienced day-to-day as operators.” He noted that it was premature to know if this “familiarity bias” will wind up proving lucrative or not.
Greylock’s Sarah Guo made two key points in answer to our question regarding comparative seed deal volume. First, that getting to investing “conviction” in early-stage deals “has always been more natural on the business-to-business side, because you see unsolved pains from talking to customers and portfolio companies.” That makes good sense.
Guo also noted via email that while there’s “still a lot that’s interesting in consumer” seed investing, “the FAANG vice-grip on distribution in core consumer social and e-commerce has made it tougher for new consumer companies to break through.”
Pausing before our final entrant, it’s pretty fascinating how many of our small investor group have seen go-to-market challenges for consumer-oriented seed deals; I wonder if this is partially due to later-stage startups raising huge sums and then stuffing channels, leaving little room for smaller companies to buy attention? Regardless, let’s get to our final investor on our first question.
Bain Capital Ventures’s Ajay Agarwal offers a top-down look at the change, citing exit patterns as the reason for changing intake investments (seed), saying that the “sheer volume of successful public enterprise companies and their relative performance post IPO has driven the volume and interest in enterprise companies.”
This especially makes sense in light of the 2019 IPO class, in which Zoom and CrowdStrike stood out (enterprise) and Uber, Lyft, Pinterest, SmileDirectClub and others struggled (consumer). Agarwal also told TechCrunch that this “is not a new phenomenon” with “five times more enterprise exits north of $1 billion than there were consumer exits” in the decade ending in 2017.
There’s a lot to chew on in there, admittedly. My read is that there are any number of reasons that currently push seed investors towards enterprise deals over very early-stage consumer-focused investments. Boiling down as much as we can, it seems that the group argue that it’s easier and more efficient to grow enterprise businesses at the moment (GTM) and that there are interesting and compelling technology solutions to existing market problems on the enterprise side that make for attractive bets.
Pricing impacts
What impact does all the above have on price? Is the rising preference for enterprise deal volume driving prices up? Maybe, seems to be the answer.
Our half-dozen investors mostly cited a generally rising price climate for seed deals (all deals getting more expensive) over enterprise-focused deals becoming more expensive on their own, when asked about price impacts of rising enterprise seed volume.
Agarwal said “seed valuations have increased dramatically,” but that his firm has “seen this rise in valuations happen across the board.” Herrera made a similar point, saying “valuations are rising for seed deals overall, regardless of whether they are enterprise or consumer.”
Something is going on, though. Choi made an interesting point, arguing that what counts as a seed deal is blurring, that “it’s less about the valuations being too steep and more a question of whether the companies that are raising at a higher valuation are really raising rounds that historically would have been considered Series A deals.” Seed deals have certainly become larger in recent years, helping give rise to Pre-seed deals as their own category.
Enterprise deals can get expensive if the startup in question is showing attractive traction, Guo said. According to the investor, while “the early stage ecosystem has been impacted the least by the inflated valuations of the past few years,” there still change afoot. Guo told TechCrunch that “there’s recently been a more dramatic step-up in enterprise valuations once you have signs something is beginning to work,” leading her firm to place bets on a “thesis and entrepreneur” pairing, or when Greylock sees “the first glimmers of magic.”
So enterprise seed deals are often expensive, but seed is getting more expensive as valuations rise in general; there’s lots of capital chasing big exits and that means quite a lot of clogged phone lines when something looks ready to break out. Seed, it’s just like late-stage!
More to come.