US Seed-Stage Investing Boomed During Pandemic

When the United States initially implemented COVID-19 lockdowns, many in the startup community anticipated a significant shift in the landscape. However, the predicted downturn for rapidly growing startups that relied on substantial venture capital funding did not materialize.

Quite the contrary occurred.

While workforce reductions occurred quickly and extensively in the initial phase of the pandemic, venture capital activity rebounded by the middle of the second quarter. Deal-making in the third quarter was notably fast-paced and highly competitive, with some investors characterizing it as exceptionally strong.

Often overshadowed by the attention given to large funding rounds and prominent initial public offerings were the seed-stage startups. These early-stage companies are crucial as they form the foundation for future industry leaders.

TechCrunch investigated seed-stage investing to understand what developments were overlooked during the heightened activity in later-stage startups. An analysis of PitchBook data, combined with insights from venture capitalists, revealed several key trends.

Firstly, the trend of increasing seed funding amounts, observed in previous years, persisted even with the challenging economic conditions. Secondly, the increase in the size and value of seed deals wasn't solely due to an abundance of capital in the private markets. Instead, the pandemic altered the types of startups that investors found appealing, and this shift didn't necessarily lead to a greater volume of deals.

Let's examine the data to gain insights into this unusual year. We will also feature perspectives from Nihal Mehta of Eniac Ventures, Jenny Lefcourt of Freestyle, Mar Hershenson of Pear VC, and Eric Tarczynski of Contrary Capital, who share their observations from 2020 as active investors during this period.

The American seed market in 2020

In 2020, the seed funding landscape often went unnoticed amidst the attention given to larger, later-stage investment rounds. These substantial deals tended to capture most of the media coverage, making it challenging for smaller startups to gain visibility. The sheer volume of late-stage activity – approximately 90 rounds of $100 million or more in the third quarter, for instance – overshadowed smaller investment activity.

However, despite operating somewhat under the radar, the amount of capital invested in early-stage startups across the United States experienced a dynamic year with notable fluctuations:

The total dollar volume of seed investments decreased as the first quarter progressed, reaching its lowest point in April, at the beginning of the second quarter. However, with the arrival of May, the rate at which investors allocated funds to seed-stage companies began to increase, returning to January levels – effectively, pre-pandemic levels – by June. Therefore, the initial downturn in seed funding due to COVID-19 proved to be relatively short-lived.

Investment momentum continued throughout the summer months. Subsequently, an exceptionally strong September resulted in a surge of seed funding, making the third quarter significantly more active compared to the two quarters that preceded it.

U.S.-based seed-stage companies secured $1.58 billion in funding during the first quarter. This figure slightly decreased to $1.53 billion in the second quarter, with the period’s late-quarter recovery falling just short of the first quarter’s initial total. The third quarter of 2020 then witnessed $2.23 billion in total capital invested into domestic seed-stage startups, representing a substantial increase of nearly 46% from the previous quarter.

This considerable growth represents a boom that investors will likely discuss in the near future.

Before shifting our focus from data to analysis, let’s consider the fourth quarter. Seed funding data is often delayed, so caution should be exercised when interpreting the limited November figures. Furthermore, as we are still in December, complete data for the month is currently unavailable. However, October, the first month of the fourth quarter, achieved a performance comparable to the second-highest month of the year in terms of seed dollars invested.

The final quarter began positively. A more comprehensive understanding will require the release of the remaining data.

The seed funding data itself is noteworthy, but the underlying reasons for the dramatic shift from the poor results of April to the substantial capital influx of September are even more compelling. This represents a story of how the COVID-19 pandemic reshaped the entire startup ecosystem, altering priorities and impacting various companies.

We will begin by addressing exceptional cases, which can sometimes dominate discussions but may not accurately reflect the broader trends. Nevertheless, even these outliers aligned with the changing dynamics of 2020.

Outliers

The typical initial investment in seed funding during 2020 began in January at $2 million, but this amount decreased to $1.7 million by April before increasing again to $2.97 million in October. As might be expected, the average deal size during the year was connected to the amount of capital being invested in early-stage companies.

The increase in the average seed investment amount was affected by a few exceptional funding rounds that featured remarkably high valuations.

For example, Clubhouse secured $10 million in funding at a $100 million valuation while still in its testing phase, and Pave, a company participating in the Y Combinator program, received a $75 million post-money valuation prior to its Demo Day presentation. It is worth noting that both of these rounds were spearheaded by Andreessen Horowitz, a prominent Silicon Valley venture capital firm that also secured substantial funding itself during the year.

However, beyond these exceptional cases and their influence on the overall figures, a sufficient number of seed deals were completed each month that these very large investments likely had only a limited effect. Instead, investors interviewed indicated that the largest seed investments they made in 2020 were generally between $4.5 million and $5 million. These investments were often associated with valuations approaching $15 to $20 million on a post-money basis.

This data presents a more moderate picture than the valuations seen in deals led by Andreessen Horowitz, but the increasing median deal size does highlight a dynamic and competitive seed funding environment.

Let's focus our attention on understanding why so many deals increased in size during 2020. According to the investors we consulted for this report, the combination of readily available, low-cost capital and a worldwide health crisis that dramatically altered lifestyles and work patterns was more than sufficient to trigger a surge in seed funding activity, leaving venture capitalists working to keep pace.

The New Landscape

Jenny Lefcourt from Freestyle explained that investors began to prioritize businesses demonstrating success during the COVID-19 pandemic or poised for growth in the subsequent environment. Consequently, Freestyle experienced a clear increase in both the typical investment amount and company valuations, as she communicated to TechCrunch.

However, identifying a startup favorably positioned for 2020 and beyond wasn’t the sole factor. Intense competition among venture capital firms to invest in companies performing well before and throughout the pandemic—including those undergoing significant positive transformations—also played a crucial role.

“I believe seed funding prices are being inflated by larger [venture] firms entering the market earlier and wanting to avoid missing out on the next company like DoorDash,” Lefcourt stated. “These larger firms have substantial capital available and believe it’s preferable to allocate some [funds] at the seed stage for the potential of significantly increasing their investment in successful [startups] as they grow.”

Eric Tarczynski, founder and managing partner of Contrary Capital, echoed the sentiment of abundant capital pursuing a limited number of promising startups. “The same amount of institutional capital is now focused on a much smaller group of companies [and] sectors considered winners due to COVID,” he observed.

This investor perspective highlights how the pandemic effectively eliminated the market for startups in certain industries, like hospitality, travel, and restaurants, while simultaneously fueling growth in areas such as digital health, fintech, and edtech. This created a bottleneck, elevating successful companies while hindering those that struggled, and potentially reducing the number of startups considered viable for further funding.

“In many respects [the evolving startup market] has streamlined the process for seed-stage founders seeking capital. Conversely, [the seed investing environment following COVID-19] has made securing funding exceptionally challenging for companies facing difficulties or operating outside of favored sectors,” Tarczynski shared with TechCrunch.

Mar Hershenson, co-founder of Pear VC, anticipates a future trend of “seed death,” where numerous early-stage startups fail, alongside the emergence of exceptional successes—companies propelled forward by the pandemic.

Hershenson’s assessment aligns with the general understanding that most startups ultimately fail, serving as a reminder that the current surge in seed investing will take years to translate into definitive outcomes.

However, a shift towards greater conservatism is already impacting seed investing. Early-stage investors are reducing their risk tolerance in their investment strategies. This explains the current boom in seed funding for the startup categories accelerated by COVID-19—investors are prioritizing current, demonstrable success over potentially groundbreaking technologies still in development.

This return to seed investing conservatism is also influencing who gains access to capital.

Nihal Mehta, a founding partner of Eniac Ventures, noted that “more capital is being directed towards deals perceived as high quality based on conventional metrics, [such as] experienced or successful entrepreneurs launching a company in a related field.”

“This trend was further amplified by the inability to meet in person, leading investors to feel more secure investing in ‘proven’ entrepreneurs with existing connections within their networks,” Mehta added.

The consequences of this reversion to traditional investing patterns are not insignificant. Venture capital’s established networks often lack diversity, and as Mehta pointed out, this is “likely detrimental” to the diversity of perspectives within funded startups.

The data supports this claim. After years of incremental progress, the diversity of fundraising in 2020 declined, potentially leading to lasting repercussions. We will now examine this further.

Hurdles and the future

Information from PitchBook reveals that companies led by women secured $13.75 billion in funding across 1,702 investment rounds this year, which accounts for 23.3% of all venture capital financing. This figure represents a decrease from the 23.8% recorded during the previous year, marking the initial decline observed in over ten years.

PitchBook’s analysis also indicates that the amount of funding received by female founders experienced a 31% reduction during the first three quarters of 2020, when contrasted with the corresponding period in the prior year.

In the early stages of the pandemic, both investors and founders anticipated a reduction in funding for underrepresented demographics, including women, due to a decreased appetite for risk. This prediction has proven accurate. Gradual systemic changes, widespread gender biases, and the demands of childcare also negatively impacted funding amounts and the motivation to seek investment.

The strong rebound seen in seed funding makes the downturn in funding for female founders particularly concerning.

Venture capital has demonstrated its resilience throughout the challenges presented by the pandemic. All investors surveyed are currently considering or actively planning to raise additional capital within the next year to meet the ongoing demand for seed-stage investments (or chose not to respond for legitimate reasons). While we anticipate increased deal flow and investment volume throughout the remainder of the decade, it is crucial that these funds are directed towards a more inclusive range of startups.

There is still reason for optimism. Positive developments regarding vaccines could shift investor preferences towards different sectors, potentially benefiting some while restoring funding to those previously impacted by the pandemic. A return to in-person meetings could also create greater opportunities to invest in a more diverse group of founders. The ongoing trend towards greater accessibility in venture capital suggests that more funds could reach a wider range of entrepreneurs, creating a positive ripple effect that supports underrepresented groups.

The year 2020 was unprecedented, and the same may hold true for the year ahead. Moving forward and looking to the future.