November 29, 2020
COVID has changed the world in so many ways, some positive and some negative. But I don't hear anyone talking about how most secondary- and tertiary-market seed funds will fail post-COVID. The world of fundraising will forever change as a result of COVID, and that will be most true at the earliest stages of pre-seed and seed.
To understand why I think these funds will fail, let's start with what's wrong with these funds. It's quite simple, really: At their core, many (most?) early-stage funds outside the capital centers of the Bay Area and NYC are location arbitrage opportunities. The GPs at these funds believe they can get better deals in companies solely because of their location.
What's wrong with regional seed funds today: "That's not market"
Raising money early-on in a company's life has traditionally been a location-dependent endeavor. It's been too hard and costly to fly to SF/NYC to raise $1m-2m. And with small funds (and plentiful deal flow in SF/NYC) investors aren't coming to you, either. That has meant that regional funds — of which there tend to be few per region — have a monopoly on deal flow.
One of the oddest, but most common, examples of how this plays out is a phrase I hear frequently in Michigan: "That's not market." When a startup wants to raise money and is hoping for a low-to-reasonable valuation for SF/NYC, the local investor will respond, "That's not market, it's much too high for this area."
I have no idea what that phrase actually means. The average deal price gets you an average deal. Do the investors only want average deals? Personally, I only want to invest in the best companies, and I'm willing to pay up for them. The upside more than makes up for it.
Any talk of what "market" is devalues the specific startup in question. Imagine if Elon Musk came to these investors and said, "I'm starting a new company in Michigan and am looking for capital, but I want a $100m valuation pre-revenue." Would they balk at the valuation, or write the check because he's one of the greatest entrepreneurs of our time who only works on humanity's existential issues?
In the last 20 years many states have attempted economic development policies that included setting aside money for venture capital. Foundations have provided even more capital. The goal is to have pseudo-economic development funds drive technology startup growth in their state.
So when you hear regional firms play a game that begins and ends with cramming founders on valuation, you wonder how the backers (the state and the foundations) think about their actions vis-a-vis the goal of bringing more startups to their state. After all, if a founder can choose between starting a company in, say, Michigan and taking 30-40% dilution or starting a company in SF and taking 10-20% dilution, which do you think they're going to take?
What happens next: Location arbitrage is a losing strategy post-COVID
More to the point, though, is that playing the location arbitrage game is a losing strategy post-COVID.
The reason you don't see more regional growth funds is that it's much easier to travel at those stages. If you're raising $20-50m or more, your company is at a point where there's no problem buying a plane ticket and a hotel and going to SF for a week followed by NYC for a week. And the investors' funds are big enough, chasing so few great deals, that they're willing to get on a plane and visit you, too.
Thus, there's no meaningful location arbitrage in the later stages. You don't need the local capital and the capital doesn't need to be local, so everyone travels to make the best deals, regardless of location. That means the best companies, the best investors, and the best terms.
The same tectonic shift is about to happen in regional seed funds: in the last 9 months since COVID took over our lives, we have all become extremely comfortable doing deals over Zoom. Even if it's not the #1 choice for some people, it's reality for everyone now.
For a founder, then, the choice will be very simple: start your business wherever you want and raise from the best investors on the best terms, regardless of their location. Zoom has become the cheap flight to SF/NYC that we've never had before.
The losers of this shift, of course, are the regional seed funds who no longer have a location arbitrage opportunity.
Ironically, for many of the pseudo-economic development funds, the goal of their backers may actually come true now. The exodus from SF is real, and secondary- and tertiary-markets are lighting up with founders. At Assembler Labs, we're seeing plenty of potential founders come back to the Midwest from the coasts. They saw COVID as their opportunity to start a company in a cheaper area, be closer to family, find better housing, etc. And they knew they could fundraise from the best funds as well as recruit the best people, regardless of location.
While the states and foundations put their money behind funds that will lose, they may accidentally achieve their goal of more startups in the area.
How can regional funds win?
What's a regional seed fund to do? It's a question we've been asking ourselves at Assembler Labs. While we are not strictly a fund (we are a startup studio that works with founders to create companies from scratch), we have been regionally focused for the last two years. We've been rethinking our strategy, ensuring we can capitalize on a post-COVID world. It's still an open question, but here's how we're thinking about it right now:
1. Build a great product for founders
First and foremost, funds must think of themselves as having a product. If they think their product is just capital, they're probably going to lose. This already happened over the last decade by the biggest and best funds (see: a16z), but few seed funds, specifically regional seed funds, rarely think this way. a16z really pioneered this, with their platform for entrepreneurs: back office help, strong network, recruiters on staff, etc. There's a reason why a16z has almost 200 employees today.
I believe platforms like a16z will work their way down to the seed level. It won't happen in the same way, but it will happen. The best seed investors will prime their companies for success in a way other firms simply can't.
2. Fish in a smaller, stocked pond
Another way for regional funds to win is to become experts in verticals, or otherwise become thesis-driven investors. This allows investors to dive really deep, provide lots of value, and send a strong signal to future investors and customers that a company which has been vetted and invested in by this firm is going to be one of the best in this industry.
That specialization also leads to highly-targeted deal flow. As a GP, removing the location constraint can end up meaning wandering in a vast expanse not knowing where or how to find the best deals. It's analogous to fishing a new lake, having no idea where the best holes are.
By specializing in an industry or thesis, they can focus on building an extremely strong network and target specific companies about to break out. It allows the fund to move from passive (deals come to them by virtue of the fact that there are only a few funds in their region) to active (seeking out the best deals, narrowed by thesis). In other words, they can fish in a small, stocked pond.
Meanwhile, for founders, the wall is coming down
While much of the above has been focused on the fund and the fund manager, I don't want to dismiss the fact that this tectonic shift is a huge gain for founders everywhere.
"Talent is evenly distributed, but opportunity is not" has been a favorite phrase of mine for a while now. From remote work to new collaboration software, COVID has provided many cracks in the metaphorical Berlin Wall that stops opportunity from reaching everyone. The downfall of predatory regional funds will be one more crack in the wall.
The next 20 years of startup funding in secondary- and tertiary-markets will be some of the most exciting to watch.