The Big Reset in Seed to Series A Graduation Rates is Real and Permanent

We are in the middle of a big reset where the percentage of Seed stage companies that graduate to Series A rounds will drop dramatically, with implications for founders and VCs.

I wrote this memo for the investing team at Precursor earlier this quarter, as I wanted to distill a bunch of my thoughts and share them with our team. I decided to publish it to a larger audience with a few minor edits - I hope people find it helpful.

A Fundamental Shift in the Series A Venture Landscape

For the past ten years, the near-term goal for most seed-stage companies has been to raise a Series A round of investment. Good venture capital firms saw 50-75% of their seed investments graduate to Series A rounds during this time. The ability to get successful seed-stage companies financed at the Series A stage was taken as a given by most seed-stage firms and their limited partners. In many ways, graduation rates became a key part of the marketing story around seed-stage firm performance.

For the past 18 months, the Series A market has been very quiet. Outside of AI-related investments, it feels like deal volume is off 75%. The Series A investors I know don’t feel any pressure to make investments and don’t really seem that excited or interested in much these days. Unfortunately for seed-stage companies, the Series A market can remain on strike longer than most seed-stage companies can remain solvent.

Part of the premise for the rise of seed VC funds in the late 2000s was that cloud computing, other technical innovations, and lean startup thinking meant that startups could get to validation points earlier. Many articles were written about how we would see a generation of capital-efficient startups that would do more with less as a result. This capital-efficient ethos never really took root as it happened to coincide with an unprecedented explosion in the venture ecosystem's access to capital and historically low interest rates. There was no need to be capital-efficient in an era of capital abundance.

With the era of capital abundance coming to an end, the stage might finally be set for the era of the capital-efficient seed stage company. Seed-stage startups are likely to confront a world in which raising Series A rounds of investment remains difficult for quite some time. There will be a premium on execution and doing more with less capital. The necessary pieces might finally be in place to push companies back toward the hoped-for levels of capital efficiency.

There is a natural tendency to assume the current depressed level of Series A funding is just a blip, and things will return back to previous levels. While that is possible, we are far more likely in a protracted era where Series A financing will remain challenging. The level of activity that we saw in 2020 and 2021 was an anomaly, and we are unlikely to see a return to those levels anytime soon (with the exception of investing in AI). To the degree that the Series A market comes back, it will be far more muted than it was at the peak. If not for the bridges and extensions done in 2022, we would already have more data on the tightening Series A market as more companies would have likely tried and failed to raise.

There is value in thinking about what life looks like from the vantage point of a Series A investor in today’s market. From their vantage point, things look challenging:

1. Many Series A and multi-stage funds are managing the largest funds they’ve ever raised. Many firms are still finding a way to deploy the largest funds they’ve ever raised, and it feels like there is some level of indigestion in the ecosystem. There is a lot of pressure to find companies that will produce big enough outcomes to impact their fund returns. The chart below (courtesy of Pitchbook) highlights this; it shows the amount of money raised by all US VCs, including the growth in the number of funds that were raised:

1. Lower public market revenue multiples means companies have to do more to go public. The public markets care about financial performance, and becoming a public company requires at least $200 million in ARR to be taken seriously. The multiple contraction in public markets impacts the way VCs think about the value of their private holdings and what those companies need to achieve to be IPO-ready.

2. Exits need to be $5 billion or more to matter - Related to the fund size comment above, there is no way to make the math work for large funds without big outcomes. If you own 20% of a $1 billion company, it only returns $200 million. That just doesn’t matter for a $1 billion or larger venture fund. I suspect that much of the enthusiasm for AI investing is driven by a desire to chase what feels like a really big market opportunity in the making.

3. Series B through pre-IPO rounds are very hard to get done - The people who do the follow-on investments for Series A investors are also not doing a ton of deals. Like seed investors, Series A investors can only be the point person on so many investments; they also need people who can finance the next round and help them manage their portfolio support load.

4. Series A firms do their own seed investing and are not relying on seed and pre-seed companies to show them deals - Most multi-stage firms have created their own dedicated seed funds or seed programs to do early-stage deals; they are not wholly reliant on seed funds and others in the ecosystem to bring them deals. This in-house pipeline of deals will compete with opportunities that we and other seed firms bring them.

With that backdrop, here’s what we will see in the remainder of 2023 and through 2024 and possibly beyond:

1. Decline in Graduation Rate from Seed to Series A - Historically, we've seen a strong pipeline of companies moving from seed to Series A. Recent numbers, however, indicate a significant decline in this graduation rate. Measured graduation rates will continue to fall for several quarters as companies go out for and fail to raise Series A rounds. Graduation rates from seed to Series A could drop to 25%, or one-third or one-half of what they were at the peak.

2. Reduced Series A Deal Volume - The decline in graduation rates will be accompanied by a decrease in overall Series A deal volume. This is already happening, and the Series A market (outside of AI) will remain sluggish for at least a few quarters.

3. Fewer Extensions and Bridges, More Harsh Judgment - One other byproduct of lower Series A deal volume and lower graduation rates will be less bridging and extending by seed funds. As previously bridged companies fail to get to Series A, the calculus on when to bridge or extend and why will change, and firms will become more cautious in providing more capital to companies that haven’t broken out. Fewer bridges and extensions will also increase the percentage of companies failing to get to Series A.

What does this mean for us?

1. We must stay focused on backing the highest quality founders - The bar on founder quality needs to remain extremely high. This is not about focusing on resume, pedigree, or traction to date; we need to identify founders who we believe can turn investor capital into demonstrable progress and find product-market fit. As many of you have heard me say, I have moved the bar up myself, and there are many founders I would have considered in the past who do not clear today’s bar.

2. Do not assume that there will be a Series A investor interested in funding the company - I have always said that it’s hard to predict what Series A investors will want to see because not even they know what they want to see until they see it. We need to consider fundraising risk for companies that need a Series A to achieve their mission. Not every seed company needs a Series A round to succeed; more will have to succeed without additional capital.

3. Get alignment with the founders on the financing path forward - This is the most important change we need to keep in mind. There will be money for our very best companies. However, this change opens space for us to look at companies where a seed and pre-seed round will give the company the money it needs to become a high-growth company with minimal go-forward external capital needs. This is not about finding small, break-even companies that don’t build to scale. This is really about making sure we find companies where we are aligned with the founders on the long-term capital needs of the business. Those who have joined me on pitch calls of late have probably heard me ask this question of the founders who pitch us. We have a few companies in the portfolio that have built capital-efficient businesses while continuing to grow quickly.

4. We will need to be good at advising companies on which fundraising paths are available to them. Many founders we back assume that there will be a next round. This year, I’ve had some hard conversations with our portfolio company founders in cases where I don’t believe that the next round is a real option. Sometimes, that’s because the market is small; in other cases, I have concerns about capital efficiency and how well the previously invested capital has been invested. It is imperative that we get good at giving founders honest and accurate information about their fundraising journey and what options are on the table for them.

5. Dilution is our enemy, too. We are aligned with founders on capital efficiency because dilution is our enemy, too. We will make the majority of our financial returns from our first check investment decisions, so minimizing dilution will amplify the return on those investments.