In this evolving world of seed investing, the re-evaluation of risk is significantly impacting early funding rounds, which are decreasing in number — and with fewer rounds, there is an increase in pro investor terms. This trend is driven by market dynamics and startup failures, which I believe is particularly true in the Birmingham market. An awareness of these market changes is essential for both investors and founders alike.
Capital markets, much like the tides of the ocean, rise and fall, affecting all boats in their path. Startups are akin to small boats that must be extra cautious not to get caught in an outgoing tide. However, their size also makes them nimbler and more adjustable, allowing them to navigate toward warmer seas and blue oceans. This adaptability is the very trait that investors seek, hope for as ecosystem participants, and aim to plan for whenever possible. Founders behoove themselves to make this argument more clearly. Smaller companies have the flexibility to more quickly adapt to the larger world, and for this reason, startups are a great source of innovation. This is why capital should come into startups, but founders need to more clearly state the advantage they have over their larger peers.
Many investors, from angels to institutional venture capitalists, are now scrutinizing their portfolio companies to assess risks they previously overlooked. In hindsight, it becomes clear that some risks were taken based on wishful thinking rather than market-driven data. Angels often relied heavily on the founders’ vision, only to realize that some projections were overly optimistic. Similarly, institutional VCs are recognizing that blindly following popular investment trends can lead to substantial losses.
Investors continually learn from their past deals, incorporating these lessons into their future investment strategies. Some investors, perhaps due to individual experiences or pressures from their limited partners (LPs), are opting to exit rather than quantify and manage risks effectively. While this conservative approach might stifle the growth of promising startups, it also opens opportunities for those willing to navigate and embrace the inherent risks in seed investing. The challenge remains to balance risk management with the potential for high rewards in nurturing innovative companies.
What this means for startups is that easy diligence is out. In today’s landscape, AI is transforming access to information and process automation, making comprehensive and thorough diligence more critical than ever. For investors, diligence is about delving deep into the core issues, continually asking probing questions to uncover the true risks involved. This shift means that superficial checks and balances are no longer sufficient; instead, a rigorous, detail-oriented approach is necessary to understand the complexities and potential pitfalls of a startup.
Effective diligence in the startup world involves several key strategies. First, leveraging AI and data analytics can provide deeper insights into market conditions, competitive landscapes, and operational efficiencies. First Avenue is working to use these tools to verify claims made by founders and to uncover any discrepancies or red flags as well as areas that will need work.
Second, engaging with industry experts and conducting extensive market research can help validate the startup’s value proposition and market potential. Lastly, founders should expect that investors will prioritize direct communication with the startup’s customers, suppliers, and partners to gain a holistic view of the company’s operations and its standing within the ecosystem. This thorough approach to diligence not only mitigates risks but also enhances the likelihood of investing in startups with genuine potential for growth and success.
From the founder’s perspective, helping investors in diligence obviously increases the chance for funding. I would encourage companies to realize the new risk perspective and proactively mitigating that risk. Typically, the major risk for any business is (1) market risk and (2) execution risk. I would also add a third to this list: financing risk. Knowing that these discussions about potential risk are important to the investor, startups should focus mitigating these three kinds of risk.
I think this is done best by continually questioning and pressure-testing business assumptions. I also think that, going forward, seed investing will involve a lot less money and a lot more questions. Ultimately, that will make a startup better, but it does require a bit of work for both the investors and the startup. As an investor, I always say that if you think my questions during diligence for the seed round are tough, wait until the larger institutional venture capitalist shows up at the next round. Seed/pre-seed level investors and founders would be well served to have a clear understanding of each of these risk elements:
- Financing Risk: What are the funding requirements to get to the next stage? When can the company self-sustain? If you are not going to be able to self-fund in 12-24 months, who explicitly is going to invest in you (i.e., can you name the VC)? What happens if they do not invest in you?
- Market Risk: How close are you to having a product that a customer will buy? What do you know — and what do you not know — about the type of company that will be your competition? What exactly is the next stage for you, your team, and your company? How de-risked are the next 12-24 months?
- Execution Risk: Why do you and your team have the experience necessary to execute this plan? What individuals can vouch for that credibility?
At the seed and pre-seed level, perfect answers cannot (and probably should not) be expected, but direct discussions will help both parties. Such discussions manage expectations, show areas of weakness, and proactively address challenges that will likely arise in the relationship. It is like pre-martial counseling for couples: it does not mean that the marriage will work, but it can certainly prevent going to the altar with the wrong person.