The Rise of the “Sapling Round” in Technology Startups

I was in the valley last week meeting with over 23 investors (primarily seed and series A stage). From Andreessen-Horowitz and Accel to Sigma ventures and True ventures, we had a chance to talk to partners who are looking at over 2000+ deals every year to invest in less than 10 (in the case of older funds) to over 50 (in the case of a16z).

While there’s lots of talk in the valley about the series A crunch and its impact on startups, I wanted to bring to attention a new (to me at least) trend that is consistent among all valley technology startups.

It is the rise of the “sapling round” of funding.

The sapling round is when a company raises between $250K to $2.5 Million, syndicated among  5-15 investors, and is largely (over 75% in the valley) a convertible round.

It is a round that is raised between the seed and the series A round.

The reason why this round is becoming more prevalent is a combination of the rise of startup incubators and accelerators and the constant “raising of the bar” among series A venture investors.

Typically the incubator puts in the first “seed” round of about $25K and provides access to another (in some cases) a $75K through its partners. In case the startup does not go through an incubator, they raise a seed round from angel list or friends and family to the tune of about $250K or less.

Then the startup goes through a 3-4 month program and before or at their demo day looks to raise another $250K to $1.5 Million in a convertible note.

Why?

1. Series A investors have raised their bar for what constitutes their round. All of the investors I spoke with would put $2M to $5M in the series A.

Sean of Emergence Capital, whose firm focuses only on SaaS companies, said he has seen in the last 11 months little over 150+ companies in SaaS with over $1 Million in revenue and they have only funded 2. Another early stage consumer Internet VC mentioned they looked at over 50+ companies with between 2.5 Million to 10 Million active users (not yet making revenue) and invested in none yet.

One of the larger firms that does Cloud infrastructure investments and Big data only has seen over 20+ companies with a complete management team, over 20+ paying customers and great market traction to invest in 1.

2. Companies are realizing that “traction” alone is insufficient (in most cases) to get money from the series A investor. While product + traction will still get you a seed round, the later stage investors are looking for revenue and growth in revenue as the primary metric. There are exceptions, but they are rare.

3. Startups are realizing that its taking 12-18+ months to get to that series A, so they are raising more convertible rounds and bridge rounds until they hit those series A milestones. Even in the valley getting to $1+ Million in revenue in less than 18 months for a product startup is rare.

What does this mean for startup entrepreneurs?

1. Most entrepreneurs are in “forever raising” mode until their series A. One even called it “passively always raising” or PAR for the course. They are looking to gain one investor at a time, in chunks of $25K or looking for micro VC or super angels to put in $100K+

2. The teams are lean for longer. According to Ali at Azure Capital, most of them were at 5-10 employees shacking out of a co-working space even at $1Million in revenue.

3. There’s a big push towards breaking even with the sapling round funding, so there’s a constant battle in the entrepreneur’s mind between growth and profitability. One is considered a “safer option”, while another (growth) is what the sapling investors and series A are looking for.

What trends do I see going forward in 2013?

1. The rise of the “priced” sapling round. While most seed round are priced (6%-10% for $25K from the accelerator), and series A rounds are priced as well, the sapling investors are stuck in the middle with a convertible note. That’s definitely going to change next year as they also try to maximize their earnings.

This has major implications on startup funding. If the sapling round does get priced, then it is officially, series A. Which means the current series A investors will become series B. This is consistent with the theme that its taking less money to get to start a company and even less money to get to $1 Million in revenue, than before, so seed rounds and series A rounds will be smaller than they were 3-5 years ago.

2. Early stage VC’s will continue to raise the bar higher, forcing most startups to go for the safer option (breaking even faster, profitability) in 2013, which will lead to the “lifestyle” business discussion popping up, all over again.

3. Many convertibles will convert, without a series A, as sapling investors will try hard to look for buyers of their portfolio company among mid-sized companies in their attempt to get an exit.

P.S. The term “sapling round” was coined by one of the founders in the accelerator, Bhaskar who was at our lunch discussion yesterday when we were reviewing the implications of this trend on our startups.