Winter has descended on the Series A ecosystem. Apart from the recent surge in AI-related deals, the market has cooled significantly, with Seed graduation rates plummeting over the past two years. According to Carta, 30.6% of startups that raised Seed funding in the first quarter of 2018 reached a Series A round within two years. In stark contrast, only about 15% of startups from the 2022 cohort have achieved the same milestone.
This steep decline has resulted in a record number of Seed-stage company closures, with shutdowns spiking by 102% year-over-year in the first quarter of 2024 — compared to a 58% increase across the broader startup ecosystem. Adding to the pressure, the timeline to Series A has also elongated, forcing startups to balance stretching their cash reserves while achieving increasingly difficult growth benchmarks.
Yet despite the cold front blanketing the Series A market, the Seed landscape remains notably frothy — raising a Seed round has, at least on paper, never been easier. Here, we explore these market dynamics, discussing the importance of the graduation rate for Seed-stage investors, the factors driving the squeeze at Series A, and the implications for fund managers and investors.
Seed-stage venture is one of the riskiest yet most rewarding corners of the private markets. While “power law” returns occur across venture, they are most pronounced in this niche of the asset class, which boasts the highest mean return across VC at a staggering IRR of 50%. Investors with huge outliers can sometimes reap 50-100x their initial investment — a level of return simply much harder to reach in growth and late-stage VC investing.
However, hitting that coveted benchmark is anything but a walk in the park. Seed investors face a high bar for success: they need to spot and back multiple unicorns to drive fund outperformance. A Seed-to-unicorn graduation rate of just 3% highlights how easily fund managers and, in turn, their LPs can slip into Seed investing’s 7% median return.
Where does the Seed-to-Series A graduation rate come into play? It’s a crucial milestone for startups aspiring to become unicorns. Historically, 20-30% of Seed-funded companies have successfully made the leap to Series A, with top VC funds boasting rates as high as 50-75%. In contrast, graduation rates are much higher in later stages — 60% of Series A companies make it to Series B, and the same goes for Series B to C and C to D.
This underscores just how crucial it is for Seed companies to reach Series A — it significantly boosts their chances of becoming a standout in the portfolio. With the Seed graduation rate now dropping to around 15%, it highlights the tougher challenge Seed investors face in reaching this critical threshold.
The excesses of the ZIRP era are an easy target for explaining the current turbulence in the Series A market. During these boom years, an influx of capital fueled the rise of new Seed funds. Emerging managers secured significant funding, while established Seed managers raised considerably larger funds. Additionally, during the 2022 market reset, Seed-stage investments were seen as a stronghold for multi-stage investors, further flooding the space with cash.
This flood of capital has sparked several ripple effects in today’s Series A landscape. For one, as more money flowed into the system, the number of Seed-stage companies exploded. In the SaaS sector alone, the number of startups that received Seed funding in 2021 and 2022 nearly doubled from 2020. This has created a supply-demand imbalance. Fewer Series A dollars are available relative to Seed companies hunting for capital, with Seed deals currently outpacing Series A deals by a 3:1 ratio.
Increased capital inflows have also driven historically high Seed valuations, setting the stage for heightened expectations when companies re-enter the market for capital. For example, most Series A investors typically seek to double a company’s Seed valuation. When these startups are valued at $25 million, this entails much more ambitious targets around ARR, customer growth, and more to justify a $50 million Series A valuation.
Series A investors’ heightened expectations are also shaped by a vastly different macro environment than when their funds were raised. In 2021, a thriving exit market and a steady flow of multi-billion dollar public listings fueled greater confidence in underwriting risk. Today, these outsized exit opportunities have dwindled. Public market revenue multiples have dropped, and companies must achieve more to go public. Further, the M&A environment is still largely stalled, with the upcoming election casting uncertainty on when it might revive.
As these investors manage some of their largest-ever funds, they face growing pressure to back only those startups capable of delivering outsized returns to move the needle on overall fund performance. This has slowed the pace of dealmaking as investors hold out for “goldilocks” companies that balance growth, profitability, strong margins, and low burn rates.
For example, many Series A investors today want to see companies running at solid gross margins before scaling, hitting more than the traditional 1 million in ARR, and driving a 3x or better annual revenue growth multiple. This flight to quality is evidenced by the rising valuations for Series A deals, even amid a broader slowdown in deal activity. Investors are zeroing in on higher-quality businesses that can command stronger valuations.
However, while median Series A valuations have remained resilient, the step-up multiples between Seed and Series A have compressed, indicating a relative decline in price. Nnamdi Iregbulem, a Partner at Lightspeed Venture Partners, cited these step-up multiple dynamics to challenge the narrative that higher investor expectations alone are the sole driver of the Series A crunch. He argues that if only the best companies were getting funded, they should command a higher premium. Instead, their relative price has dropped.
Iregbulem attributes this decline to a shift in investor sentiment. Traditionally, Series A has represented a strong signal of product-market fit (PMF). In the run-up to 2022, high premiums for Series A largely reflected investors’ confidence that the business was derisked. Today, amid ongoing uncertainty, Iregbulem suggests that investors have grown more skeptical of PMF at this stage — they expect more but believe less.
With Series A expected to remain a difficult hurdle for early-stage startups, a lower Seed graduation rate holds significant implications for stakeholders in the high-risk, high-reward land of Seed investing. For one, achieving more with less will likely continue to define the venture landscape, making capital efficiency critical for startups aiming to progress through funding stages. Yet simultaneously, they need to balance burn rates while meeting higher revenue growth benchmarks.
Many VCs have highlighted the struggles Seed companies backed by multi-stage funds will face in this environment. Critics argue that the check sizes and ownership stakes are often too small for these fund managers to commit significant time and resources. Seed investing, they contend, has become more of a call option for these funds rather than a focused strategy. As startups grapple with tougher standards, the ecosystem may increasingly favor fund managers who take a more hands-on approach, actively supporting their portfolio companies through the pipeline to improve graduation rates.
Further, among all stages of VC, Seed managers and LPs embark on the longest journey together. Given the long road from Seed to exit, graduation rates have long been a crucial metric for fund managers to share with LPs as a critical indicator of success. With graduation rates dropping, fund managers may need to increase communication and transparency with LPs about portfolio performance. Without this, LPs’ appetite for Seed-stage funds could diminish, complicating an already challenging fundraising environment for the asset class.
Venture capital returns become even more bifurcated following market corrections, like the one unfolding in the post-ZIRP era. As the number of successful exits declines, a select group of fund managers who back the rare outliers will significantly outperform their peers. For LPs playing in the Seed-stage ecosystem, success hinges on exposure to this small pool of breakout companies.
As graduation rates drop, the importance of manager selection has become more focused. This landscape will continue to favor fund managers who identify and back the highest-caliber founders and startups that can turn investor capital into demonstrable progress and find product-market fit.
Equally crucial for LPs is exploring the best approach to Seed-stage portfolio construction in this environment. Seed stage venture is an incredible asset class in aggregate but comes with a high degree of volatility. In theory, high-volume Seed investing mitigates risk by increasing the ‘shots on goal’ a fund manager has at getting exposure to one of these outliers and, in turn, the overall probability of achieving a consistently attractive return profile.
Yet, as hinted above, a colder Series A environment could favor a more concentrated approach to investing in which investors can take on a more operator-adjacent role in proactively helping their companies get to that Series A. This strategy, though, introduces greater risk and volatility, as it requires a higher success rate from fewer investments.
When building out a portfolio of Seed-stage fund managers or allocating to an early-stage fund of funds, allocators need to be mindful of the risk they’re willing to take to achieve their venture returns while also considering which managers will find success amid current market dynamics.
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