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VCs in seed rounds: signaling theory

One of the economic theories that I learned during my studies at the University of Leuven and that has always sticked with me is the signaling theory. It’s the bedrock of behavioral economics and it’s the theory that explains a big chunk of all human behavior. In fact, you don’t need a degree in Economics to be confronted with this theory on a daily basis. I still remember, when we were on holidays at the Dalmatian coast with the family, our mother would insist we would dine in the most crowded restaurant. Bonus points if it was crowded with locals. Of course, from a pure rational economic point of view this didn’t make sense at all. All other variables remaining constant, you can expect longer waiting times, slower service and more restrictions on the menu; Yet, this strategy proved to be very successful very fast (and obviously the other variables were no constants). It’s a fair assumption that people -and especially locals- would prefer the best restaurant and thus the most crowded restaurant would be the best one.

Signaling theory wasn’t only useful for our family to find the best Croatian goulash, but is also used by VCs to find the best investment opportunities in the startup landscape. The signal they follow is the investors that covered the seed round and their behavior when the new funding round is announced. Signaling theory is useful in cases where participants in a market have asymmetric information. The theory assumes that when there is asymmetric information, the behavior of the market participants will reflect what they know. When you’re playing poker and your opponent suddenly goes all-in, you know it reflects very favorable odds from his side. You might not be able to see his cards, everything he does will reflect his position.

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When you raise your seed round with angel investors, you are largely protected from signaling risk. After all, these investors are not expected to (or able to) lead or even join in on the A-round. It’s a smart move since you keep all options open, however it can also be beneficial to have an investor from the beginning that can lead the A-round as well (signaling can work in your favor too). When a VC looks at a startup, they know that -even with thorough due diligence- they will never have perfect information. The investor that invested in the seed round has worked extensively with the founding team, knows about all the roadblocks and how they handled disappointments early on. He knows the story behind the numbers and knows the vision behind the strategic decisions that have been made. Consequently, when the founders start raising the A-round, every VC will look at the seed investor.

When the seed investor is a VC that is also active in post-seed/A-rounds, whether or not they lead the follow-on round is very important. After all they have the most complete information and can best assess the opportunity. Additionally, how fast you complete raising the round matters as well. The word spreads fast once you start talking with investors. When a house is for sale and it’s not sold after a year, people will get suspicious and assume there are a lot of hidden problems. The same happens with startups. Once you publicly start raising, you better close the round fast. Convincing the seed investor to lead the follow-on round enables you to almost close the round before the fact that you’re raising becomes public knowledge.

The numbers seem to confirm the signaling theory. Research by CBInsights suggests that startups that raise a seed round have a 35% chance of raising an A-round as well. When the seed investor is considered ‘smart money’ (VC) and this investor follows in the A-round, the chance increases to 51%. If this VC doesn’t lead the follow-on round the chance of an A-round drops to 27%.

The reason I decided to write this article is that I meet a lot of founders that don’t really realize the consequences of their decision which investor to work with in the seed stage. With Micro-VC funds popping up left, right and center (more than 200 VC funds have raised > $4bn to be deployed in early stage startups), this has become more relevant than ever. I suspect that with seed-focussed VCs booming and A-round VCs remaining the same, startups not being able to secure a follow-on round from their seed investor will become more common.