Entrepreneurs, don’t fear the seed funding slowdown — it’s a market correction

A few years ago at an incubator demo day, I watched open jawed as a would-be seed investor made funding commitments based solely on 7-minute presentations – without speaking with the team or conducting any due diligence. Investor odds may have been better in Vegas.

Silicon Valley has been inundated in recent years with a new breed of euphoric “tourist” seed investors. Unlike the many thoughtful professional seed investors who engage in due diligence and offer strategic guidance, tourist investors offer little beyond money and false hope for many startups founded on tenuous ideas. Fortunately, things are changing – albeit slowly.

Some entrepreneurs may not be feeling it just yet, but early stage seed investments have dropped 40 percent since their 2015 peak. At least nine seed firms have closed, and even venture capital firm Kleiner Perkins recently shuttered its Edge-branded seed initiative.

Some industry observers fear the slowdown foreshadows an industry-wide downturn. On the contrary, as a Series A investor who evaluates seed-funded firms seeking their follow-on investment rounds, I view the drop in seed funding as a market correction, good both for the health of the ecosystem and for the entrepreneurs themselves.

As a former startup founder, I often tell aspiring entrepreneurs their time is worth far more than my funding. In other words, it’s better to be denied funding quickly than to waste years chasing a misdirected rainbow. It is heartbreaking to see entrepreneurs pour their souls into ideas that never should have been funded in the first place, months or years of effort utterly wasted. Now, due to the slowdown, more entrepreneurs will reclaim their time for more productive efforts.

In addition to prolonging the lives of startups based on weak ideas, the abundance of seed funding has also triggered the failure of numerous promising ideas. In the past, once entrepreneurs with compelling startup notions secured seed investments, other me-too entrepreneurs promptly took notice and copied the first company’s idea. Numerous players quickly overcrowded markets too immature to support multiple players. No one company could differentiate itself sufficiently, as each competed in a market that had barely developed. Luxe Valet, Carbon, and Zirx are examples of startups based on a promising idea (valet on demand) that wasn’t able to flourish due to a prematurely flooded competitive marketplace and the ensuing price wars. Fortunately, wiser company leaders knew when to pivot and have emerged stronger than ever.

As a result of both phenomena — the overfunding of weak concepts and the overabundance of competitors in undeveloped markets — few early stage startups grew to fundable Series A companies. This created the Series A crunch, in which 70 percent of seed-funded startups never secured additional funds. A healthier seed market will soften the Series-A crunch. Over the coming years, as fewer companies raise seed funding, we should see a higher percentage of (higher quality) seed-funded firms secure their Series A.

Here are some guiding principles for entrepreneurs seeking investments amid the softening seed environment:

1. Validate ideas with customers, not investors. Raising money is time-intensive. An entrepreneur’s first years are best spent developing concepts, testing out products and services, and gathering feedback early and frequently from target users, not investors. As Paul Graham stated in a series of tweets, “You can raise a seed round by pleasing investors, but to raise Series A you have to please customers. The reason customers are harder to fool than investors is not just that they know their needs better. They also have the option of waiting.”

2. An investment does not equal success. Just as it’s unwise for entrepreneurs to spend their time validating ideas with investors instead of customers, it’s just as unwise to spend time touting their fundraising instead of focusing fully on execution. Funding does not equal success — even if the press that can accompany big funding announcements makes it feel like it does. Long-term success comes from creating high-quality products and services that customers and users love. Plus, happy customers are often the best promoters – more authentic and longer lasting than any one-time article or advertisement.

3. Don’t raise too much money too soon. Not everyone can afford to bootstrap a business, but working as leanly as possible for as long as possible can enable entrepreneurs to get more money for less dilution when they fundraise and can make it easier to stay in stealth mode, unknown to potential competitors, longer. Delaying significant fundraising until product/market fit is achieved can also provide extra buffer for the course correction that may sometimes be needed with early-stage companies. Companies that have taken on large early investments based on high valuations can be tough to pivot.

4. Choose smart money over cheap money. There are exceptions to this rule, but in most cases, it’s wiser to bring on engaged, professional investors with entrepreneurial and operational experience, market insights, and customer and partner connections than it is to bring on tourist investors who have little to offer beyond money. Tourist investors stay out of the way, whether or not that’s in an entrepreneur’s best interest. The right investors know when to stay out of the way — and when and how to step in to provide guidance.

5. Skin in the game is better than a toe dipped in water. In many seed rounds, each investor is somewhat interested in spending time and energy with the company, but no single investor is highly incentivized to do so. Entrepreneurs may want to speak to seed firms willing to make more substantial investments, both in terms of money and in terms of strategic and operational support. This way at least one investor will have enough skin in the game to be a true partner in navigating the challenges of building a business.

Entrepreneurs who follow this advice and create solid, well-developed, differentiated offerings for promising markets have a decent chance of securing seed funding and beyond, despite the slowdown. As for those entrepreneurs who won’t land funding, they’ll be reclaiming their time, and that is worth more than investor money.

Ajay Chopra is a General Partner at Trinity Ventures.