Rotten seeds

Indigestion in the venture market, yet to reach the earliest stages

In another life, I was involved in a business that irradiated seeds in order to kill off pathogens. The germination rates for seeds in a commercial context usually ranges from 70-80%. Given the size of arable farms, and how many seeds they must plant, a percentage point increase in healthy germination can make a massive difference in both top-line (how many plants grow and can be sold) and bottom line (with better germination rates, you can buy fewer seeds and decrease input costs).

(Strained sequitur) In a venture capital context, seed germination rate is equivalent to those startups having raised a seed round going on to further success. That success, for better or worse, is usually defined by raising another round of venture capital: a Seed+, a Series A, etc. Unfortunately it looks as though there’s a sharp reckoning coming for those seed stage businesses.

Our friends at WSGR, a San Francisco based law firm, put out a quarterly report “The Entrepreneurs Report: Private Company Financing Trends” which summaries the terms of all the deals that they’ve closed in the prior quarter. WSGR are the primus inter pares of tech law firms so the deals that they work on is a great proxy for full market data. Q3’s version contained the odd picture, above.

For every stage of venture capital, early to public/private crossover, valuations indicate a much depressed market versus 2022….apart from seed. Indeed seed valuations this year look as though they will exceed last year.

Of course, this could be justifiable. The most common justification that you hear is that that seed is so early that it’s insulated from the sharp end of things and goings on in the public markets. This explanation is understandable in a sense. In another sense it’s rather unrealistic when considering that as interest rates exist and will continue to do so for the foreseeable, this insulation will not remain true for an entire economic cycle.

Another justification points to some of the AI megarounds done for pre-seed AI businesses. Good recent examples include $14m for Mythos and €105m for MistralAI at pre-product stage. While these outliers will no doubt have an effect, they would have to be very neatly distributed across the three 2023 quarters in the data above. That’s very unlikely. In addition to this they are outliers, the exception rather than the norm, so it is also unlikely that there are enough of them to skew the overall picture.

In our experience it is a better idea to pay close attention to the data picture rather than trying to find anecdotal reasons for its potential irrelevance. What the picture tells us is that demand is way down in ventureland. That’s certainly true for Series B and beyond. Series A seems to be just about grappling with this new reality. Meanwhile, seed continues up-and-to-the-right ?? as if interest rates never really happened.

Just like the demand-and-supply graphs that we all cut our teeth on in school: falling prices (deal valuations) are a reflection of falling demand. That mechanic seems to be working its way through every stage of venture capital and it appears as though seed is the remaining port of call. Notwithstanding the return of ZIRP.

Indeed the only explanation of this seed valuation bonanza can be understood in terms of increased demand. Many multi-stage funds have been cramming into seed deals in recent times. It’s easier for a big fund to write a small cheque in this environment: more palatable for LPs + keeps everyone busy. This dynamic is well explained in Sam Lessin’s State of VC 2023, highly recommended.

There is good news in all of this. There exists a great opportunity in Growth stage (Series B+) investing and beyond. There is some magic in the slow cycle of venture. There will be a glut of seed stage companies coming through the Series needing to compete for smaller amounts of venture capital. Many will fail to raise. However those that do survive may well be stellar companies - which burn less cash, by design - that investors will get access to at more reasonable valuations than the last few years. Going back to our demand-and-supply analogy, this is the journey back to equilibrium.

Tikto

At Tikto, we purchase stakes in EBITDA profitable businesses and tech businesses with challenged business models and follow that up with incremental growth capital. We bring our network of experienced operators to help execute a business plan for the next phase of our portfolio companies’ growth.

Get in touch: [email protected]