Why Later Round Investor Funding For Startups Is Declining

Interest rates, economic uncertainty, disappointing markets are all contributing to the decline in later round financing for startups by venture investors and others. 

But it may also be that at this now lengthy inflection point in the equity markets for startups, especially in tech - and perhaps because of some concerns about a bubble in generative AI - , venture capital firms and other investors are insisting on better performance and more stringent milestones indicating future success before they commit more funds. JL
 

Angus Loten reports in the Wall Street Journal:

The share of startups making it to a Series A or a later round is declining. Economic uncertainties, market fluctuations and higher interest rates are prompting more caution among investors. Half the startups that raised $1 million in seed funding in 2018 had gone on to a Series A. For the 2021 cohort, the share is at 24%, and 6% for 2022. An entrenched downturn has more startups unable to raise Series A rounds. The median time between seed and Series A rounds has stretched to 25 months, compared with 21 months in 2022. Series A rounds mark when a startup advances into a viable enterprise, attracting additional investors and higher-priced shares, instilling confidence that a startup’s business prospects provide momentum for the future.

When the startup market began souring last year, many investors shifted to small-dollar bets on ventures in their earliest stages. Now, an entrenched downturn has more of these startups unable or unwilling to raise follow-up Series A rounds.

“The graduation rate to Series A is way below historical norms,” said Avlok Kohli, chief executive of AngelList, an online network of startups and investors. “There’s just not that many people writing those bigger checks.”

The funding wall is a big shift from the past year, when venture investors regarded seed startups as a haven. They poured record amounts of cash into fledgling companies with cheaper shares and lower private-market valuations.

Named after the preferred stock sold to investors, Series A rounds typically mark when a startup advances from an idea into a viable enterprise, attracting additional investors and, importantly, higher-priced equity shares. Closing a Series A round can instill investor confidence that a startup’s business plan and prospects for growth withstood greater scrutiny, providing momentum for future funding rounds.  

Ravi Sandepudi, co-founder and chief executive at Effectiv.

PHOTO: EFFECTIV

Ravi Sandepudi, co-founder and chief executive at Effectiv, said he chose to raise a second seed round this year, rather than proceed to a Series A, to give his San Francisco fintech startup more time to build its business.

“Given the VC market getting tougher, and even broader volatility in financial markets, having an even longer runway was good for us,” Sandepudi said.

Effectiv, which is developing a real-time fraud and risk-management platform for banks and other financial institutions, in July announced a $4.5 million seed round, led by Better Tomorrow Ventures. The funding followed an initial $4 million raise, announced as a seed round in March 2022, which Sandepudi now considers a pre-seed round.

“This gives us the opportunity to raise a Series A round from a strong position down the line,” Sandepudi said.

For U.S. startups with at least $1 million in seed funding, the median time between seed and Series A rounds this year has stretched to 25 months, compared with 21 months in 2022 and 14 months roughly a decade ago, market analytics firm Crunchbase estimates.

During the pandemic-era boom, the number of startups that raised at least $1 million in seed funding surged. Crunchbase found that in 2021, almost 3,000 startups in the U.S. raised initial seed funding of at least $1 million, compared with about 1,700 in 2018.

The share of these startups making it to a Series A or a later round is declining, although some companies might be avoiding raising money given the weak venture market. As of this month, half of the startups that raised at least $1 million in seed funding in 2018 had gone on to a Series A or post-seed round, according to Crunchbase. For the 2021 cohort, the share is at 24%, and at 6% for the class of 2022.

Economic uncertainties, market fluctuations and higher interest rates are prompting a more cautious approach among investors, said Matt Cohen, founder and managing partner at early-stage venture firm Ripple Ventures.

“Investors are becoming increasingly discerning about their investment choices, scrutinizing startups’ business models, traction and potential for growth more intensely,” Cohen said.

The market for seed-stage companies wasn’t always this bleak. As later-stage startups last year faced sagging private-market valuations, the median seed-stage valuation climbed 17% from 2021 to $10.5 million, according to researcher PitchBook Data.  

Though spurred by deteriorating market conditions for more mature startups, last year’s surge in seed funding followed a number of veteran investors raising dedicated seed funds, including Greylock Partners and Andreessen Horowitz. 

“Mid- and late-stage investors increasingly sought to participate in Series A in search of lower valuations,” said Peter Wagner, founding partner at early-stage investor Wing Venture Capital. They included many nontraditional investors new to the venture market, he said.

On top of larger investors, more than 1,000 new microfunds—with $50 million or less in capital—also began backing seed-stage startups over the past three years, according to PitchBook.

 

The resulting surge in capital changed the nature of a Series A round, making it an almost mid-stage financing, Wagner said. But once the market turned, he said, most of these new investors disappeared, reducing available Series A capital. 

“Things trickle down from the top, starting with the IPO market, which has been frozen for well over a year,” said Steven Rosenblatt, co-founder of seed investing firm Oceans. “That made the Series B and C slower, which is now cooling off Series A.”

Though painful for founders of nascent companies, the correction will ultimately help the market find a more sustainable balance, Rosenblatt said. “This is a healthy cleansing of the ecosystem, although there are still some frothy valuations in small pockets, such as generative AI,” he said. “This is necessary so we can get back to building the next great companies.”