The Gap

//David Hirsch//

2014 was a very active year for us at Metamorphic Ventures. From the time we closed our fund to January 1st,, we were extremely active; leading and participating in a number of early stage rounds and backing some pretty amazing founders. We invested in more companies, at a faster velocity than ever before, and had several notable exits along the way.

One of the things we noticed in the market was a big sea that has opened up a pretty big opportunity for Metamorphic Ventures and other funds of our size. We’ve been calling this opportunity “the gap”.

The gap exists between the seed and Series A rounds. It’s a direct result of the infamous Series A crunch, which has occurred because of the growing number of angel investors (especially in the valley). This is due to so many experiencing extreme wealth and liquidity from companies like Google, Facebook, Twitter, LinkedIn, Pinterest, Palantir, Uber, Salesforce, etc. We also saw the rise of micro vc funds (~$25 million). These funds could write checks for several hundred thousand to a million dollars, but aren’t known for following on with their investments unless it’s a real breakout success (and even then they rarely follow on with size).

At the same time, the cost of building a product has become basically free. In an industry that funds innovation, there actually hasn’t been tremendous innovation until recently. This is changing as entrepreneurs have more choices than ever before with solutions like Y Combinator, AngelList, Indiegogo and Kickstarter to fund their company. Like content creators who can choose from YouTube, MCN’s, Netflix, Amazon, HBO etc. rather than the traditional networks; entrepreneurs have more choices than every before away from traditional big VC firms to fund their companies in the early stages.

The combined changes in the market meant that a lot of companies were being started and seeded, yet have much less flexibility and a lack of funding options in the Series A rounds and beyond. Josh Kopelman did a great job writing about this in detail this week and how entrepreneurs can prepare for it.

The truth is I think the series A crunch is BS. The companies that should scale and raise more money typically do (there are always outliers) and the ones that don’t either haven’t found product-market fit or don’t have a clear vision that investors see (this doesn’t mean investors are right). I think we need to be more concerned with the IPO crunch than the Series A crunch.

Access to capital in the later stages has also changed. Earlier I mentioned the IPO crunch. Due to companies choosing to wait longer to go public, there is a real blur between publics and privates. Large traditional public market investors including private equity firms, hedge funds, mutual funds, and family offices are moving downstream as well and investing in later stage deals. With the strongest companies staying private longer, technology investors need to be thinking in a away that is liquidity and stage agnostic. Tiger Global is investing in companies like Warby Parker, Flipkart, Survey Monkey, Harry’s, Thumbtack and others. TPG is investing in companies like Uber, Airbnb, Box, etc. Fidelity is investing in companies like Pinterest, Uber, and Taboola as well.

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Source: Mark Suster (http://www.bothsidesofthetable.com/2014/07/22/the-changing-structure-of-the-vc-industry/)

This is actually similar to what happened in advertising from 1991-2001. Before we launched Adsense, marketers were buying keywords on Google’s search page. Most of these marketers weren’t big brands as the big brands were still heavily invested in traditional media. These advertisers were actually small direct response marketers. These marketers were buying niche keywords like “diabetes” for lead gen and content models like WebMD and making the math work (at these earlier stages). As Google became a more mainstream advertising solution, bigger companies like Pfizer, Astrazeneca, and Merck came in and didn’t need the math ROI. It was all about branding and access. The small guys couldn’t bid up on keywords and if they did pay up, their CPA went up as well which cannibalized their net return on investment. This sounds what’s happening right now with smaller investors (our fund size included). Many of which are investing in uncapped notes or paying up on priced rounds. With this, the exit burden increases and it becomes hard to make the fund math work unless everything goes exactly according to plan (which it rarely does in venture). The same can be said for entrepreneurs whereas the best-laid plans are almost certain to go astray.

Due to this market shift, we saw a lot of the bigger traditional venture firms moving downstream. Firms like Kleiner Perkins and Accel began to invest earlier and earlier in order to find the best deals. Don’t get me wrong, there are some amazing investors on Sand Hill Road, but the trickle down effect is real and entrepreneurs have more choices than ever before. A rounds have become the size of what was a B round just a few years ago.

Many of the larger firms aren’t worried about valuations and making the ownership math work (like the smaller funds are). It’s about access to the best deals and branding, hence “the gap” in the market.

Optimizing for valuation and amount of capital isn’t as obvious a choice for founders as it may seem. Sometimes it’s better to take less money and prove out metrics in order to set the company up to win appropriately in the long run. Oftentimes, taking in too much capital too quickly can change the company’s culture for the worst, create unrealistic expectations, and distracting press coverage. It’s harder than it appears to grow into the wrong valuation.

The gap in the market exists between the smaller seed (or even friends and family) rounds and the larger series A rounds which have become commonplace. Because a fund of our size ($70 million) is both bigger than small (micro vc’s and angels) and smaller than big (under $200 million), we have the unique ability to invest in seed extensions, or what we’re calling “superseed” rounds (which are really pre A and post seed rounds). The truth is, two of our last “gap” investments started as these “superseed” rounds and ended with us leading the series A (the naming conventions around the venture round stack is confusing anyways. None of it makes sense anymore and is being rewritten in real time).

While it’s never been easier/cheaper to start a company, it’s still extremely hard to scale a company and oftentimes it takes longer than planned. Nobody talks about the fact that the cliché metaphor of the hockey stick growth curve still starts with the blade of the stick (the elongated part at the bottom used to hit the puck). Because of this gap, we’ve found an opportunity to invest in companies that, unlike pure seed opportunities by definition, are further along and there are real metrics we can point to. For example, a marketplace may have a few thousand paying customers and therefore we know that there’s vetted demand for the product. This also really helps us and our seed investments learn and grow together quicker.

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Image via Airbnb

As funding sources become bifurcated (really big funds and others that are somewhat small), this seemingly helpful in between stage allows entrepreneurs to play offense as they can continue to prove out the math around their metrics and optimize for a more suitable valuation later on. In this scenario, founders can extend their runway and make some key hires while not having to worry about a certain valuation in the market or starting a months long process of raising money. This gives founders the ability to play offense and continue to build their company in the short term while setting them up to succeed over the long term.

This also allows us to take an active role in helping companies during a pivotal time. One of the reasons we’ve put together such a diverse group of advisors/investors is to help companies in these situations. The extra runway allows them to hit more of their metrics and raise a real A round (which we’ll typically lead or participate in as well as help raise). A lot of our investors and partners are also active investors in venture and therefore we have the ability to bring them around the table to help our portfolio companies raise money. Through this investor base we have the financial resources within our LP base to invest directly into later stage deals. If founders choose, we can help them directly through to the public markts. We may not always be the correct partner for the later stages, but it was important for us to give founders that choice if need be.

In 2014 and the beginning of 2015 we’ve made several investments in this “gap” stage and will continue to do so throughout the year. While we’re still investing in the best teams, with great product vision in large markets at the seed and series A stages, this new “gap” opportunity has been an interesting edge for our firm.