According to CB Insights, the number of seed stage funding deals in the U.S. declined for the fourth straight year in 2018, continuing a trend that has seen the number of deals steadily drop, while the average size of deals increase. It’s safe to say this is the new normal. Yet, there continues to be a huge surplus of available capital and there are more funds out there than ever before.
For new entrepreneurs, as well as repeat founders of early stage startups, these changing conditions are having a dramatic impact on how, where, and from whom they raise early capital. In years past, raising a seed round often boiled down to finding a local VC or angels that would invest a few hundred thousand dollars on just an idea for a company. It was more about who you knew and where you were located, rather than actual traction or feedback from the target market.
But as competition for the best deals has ramped up, legacy investors in Silicon Valley are now beginning to seek out investments in startups all over the world, due in large part to the proliferation of elite tech talent. While that may seem like a potential goldmine to entrepreneurs operating outside Silicon Valley, founders need to understand how investors think about investing in startups, particularly outside their home markets.
Here are three things entrepreneurs must remember when investors come calling from abroad:
Distributed teams are no longer a liability, but proximity to market is still a must
The prevailing school of thought historically, was that in order for startups to have a legitimate shot at making it, they all have to be located in Silicon Valley or in another top US tech hub. After all, the US is where all the investors and best talent are. However today, that isn’t necessarily the case anymore. Yes, it is still crucial to have a foothold in the US, mostly on the business side of the company, since this is where so many potential customers are, but having a distributed team is no longer viewed as a red flag to many investors
Other markets, like Israel, have proven track records of churning out elite tech talent. We have seen a number of successful startups that set up the company headquarters and at least one founder (usually the CEO) in the US to be near customers and investors, while the rest of the engineering team remains in Israel.
Prudent investors will still require the CEOs of their companies to be in the US market, but that doesn’t mean the R&D team can’t stay in the home market. This means that, the other founder/CTO staying back with the R&D team must have the leadership skills necessary to keep everything on track, while the CEO establishes the business headquarters in the U.S.
Investors are hunting for value, often relying on local co-investors
Much has been made over the past few years about the soaring valuations of Silicon Valley startups. Every day it seems like a new company announces a $50 million plus round of fresh funding, along with a new sky high valuation. The frenzy created around all that activity has a profound impact not just on those companies themselves, but on all the smaller startups in the broader ecosystem as well. The overwhelming competition for capital in Silicon Valley is forcing many seed investors to mitigate the inflated valuations in their portfolios, by looking for more undervalued and underappreciated opportunities in other markets.
Valuations for startups outside of the US are typically lower, and represent prime opportunities for investors that are being squeezed from the biggest VC funds that are writing checks earlier in the pipeline and driving those massive valuations up. Typically, late stage investors would be the ones taking a “gamble” on outside opportunities like those in Israel or Europe, but competition is forcing seed investors to look for early stage opportunities outside of their immediate geography.
As a result, seed funds are now becoming more open to co-investing with foreign funds. As mentioned above, investors are sourcing deals outside their home markets, but funds are still not comprising much of their portfolio beyond the US. These select deals are happening on the edges. In order to find the best deals in a foreign market, US funds often seek out local VCs to collaborate with, someone they have maybe done a deal with before that knows the local startup scene inside and out. They are still looking for a process of familiarity, even if it is overseas.
Not all investors add value
As a founder, who you take money from matters a lot. Is it a benefit or to your detriment to take money from investors who are not local to you? How involved will they be?
Startup founders need to think long and hard about the non-monetary value that investors provide. If they are removed from the day to day operations of the company and unaware of challenges the company faces, then what is the point in having them there?
Lately, there has been a rush of large funds to invest at the seed level, offering piles of cash but without any guarantee of long term value and support. With this new “spray and pray” approach, billion dollar funds just don’t have the bandwidth and attention to support their small investments the same way that they do the larger, more capital-heavy investments.
The best investors are not necessarily the biggest. Instead, the best are the ones constantly adding value to actually help the business grow, whose core focus is to invest at the pre-seed and seed stages of a company. Are they making introductions to potential customers and partners, opening doors to new markets, etc.? Who are the investors that are going to actually help you work through problems? Who will be a partner to you?
Seed investing, like all venture capital, is changing in a meaningful way. What used to be a local, almost neighborhood-oriented process, is now a global business — at least in terms of deal sourcing. Yet, most investors still require physical proximity to the founder/CEO and the company HQ to ensure they can truly help the company execute on its vision.ᐧ