Product Market Fit (PMF) and Series A+ disconnected earlier this year

Normal market behavior is that seed companies are pre-PMF and Series A companies have PMF. You can see PMF metrics in this doc.

Overall about 20% of seed companies get to Series A but in my experience PMF is much more selective than that. About 5% of seed companies achieve PMF in my experience and about 25% of the series a companies I have reviewed have PMF, so about 4x more companies get funded even in normal times.

So why the 4x? In my experience there are two main reasons in normal markets for venture capitalists to fund pre-PMF companies. First, there are many times when a partner or firm has been looking hard for a solution to a specific market opportunity. Then, instead of holding companies to PMF standards, they will often fund the best of the companies going after that opportunity.

Second, the venture market is not nearly as sophisticated as its marketing. I regularly see funders with a lot of capital and very little discipline around evalutating PMF. There is still an assumption among many Series A+ funders that pre-PMF companies can execute their way to PMF. If a company is growing well, the fact that most of their growth is paid, or that their long-term retention isn’t anywhere near the 30%+ you need in consumer doesn’t phase some investors.

So even in sane markets, there is something like a 4x discrepancy. This is somewhat mitigated by the fact that the market doesn’t yet pay the proper price for product market fit. Given that 5% of companies achieve PMF from pre-seed, and that pre-seeds mostly get done around $5m valuations, a company which achieves PMF is worth 20x more or $100m. However, Series A has stayed stubbornly at $50m or less. If you look at it from the other direction and say that the average venture winner is a $200m outcome, eliminating market risk is at least half of the value creation that will happen in the company. Eliminating execution risk is where venture investors make their money.

We are not in normal times. Series A valuations have skyrocketed to as much as $200m, pushed by hedge funds and other tourists making bets on anything with traction. Even as these funds get washed out in the next downturn, I doubt Series A valuations will adjust below $100m. We live in a very efficient market with more and more capital lined up for PMF companies. Late stage capital will continue to put pressure on professional Series A, and founders are right in most cases to just take the money.

With the current market, Series A+ investors are using a couple of strategies which work to their favor but are not that great for founders. One strategy is to seed fund companies you like to give yourself an advantage if they do achieve PMF. The main problem with this for founders is that venture investors know nothing about finding PMF unless the specific partners was a serial founder or has an immense amount of seed experience. They also have no time to spend with their optionality bets. However, founders love the brands of these firms and will often allow them to crowd out seed investors who would be more helpful. This is seen regularly in YC demo days where venture investors will write checks to capture the optionality of promising companies. Only later do founders realize that there is nothing but cash and some brand value in these deals, the partners don’t have time or expertise for the dirty work and experimentation to find PMF.

That is one dysfunction for founders of the current market. This unfortunately combines with another trend to completely confuse first-time founders. For a long time, firms have paid attention to each other’s bets. Often when a firm wants a deal and doesn’t get it, it will turn around a couple of months later and fund the next round for that company at double or quadruple the previous valuation. For PMF companies, this makes a little sense because the market risk had been removed from the company and you could make a rational TAM and execution risk calculation to justify paying up.

However, what has happened in the last year is that the early seed deals triggered this momentum effect. So you see one firm do the seed for optionality and another firm turn around and do the Series A at 2–4x valuation three months later. And I’ve seen several series B’s now of pre-PMF companies where two momentum bets have happened. These are often perpetrated by junior partners at firms who see the momentum and want to jump on board and make their name. One might think this is all good for founders because now they may have $30m in the bank raised at a $200m valuation. What’s not to love?

The problem is that now you have a pre-PMF company with $30m in the bank and very high expectations. For serial founders who have seen this before, it’s no problem at all. They stick to that team of 6–15, experimenting furiously until they find PMF and telling their investors to come back in a year. But our industry is built on new founders. And now you combine inexperienced founders with inexperienced partners at firms hoping to build their reputation.

And the place this all comes together is the monthly board meeting. Board meetings are about accountability. Investors say ‘Tell us what you are going to do, and then exceed that’. The problem is that pre-PMF founders making promises around timing is ludicrous. The best a founder can do is to identify a key metric and experiment around it. This process is completely unpredictable, because almost all experiments fail (about 80%). So the best a founder can do is tell the board they are working on it and they may have results in a few months or never.

This kind of statement feels very very bad to venture partners who are used to PMF companies, because once a market is established, the founder has control of many more variables for success and the company turns into an execution play. The above statement from a founder sounds like they have low expectations for their company or are trying to shirk accountability. So inevitably the board pressures the founder into promising something. And then you spin the roulette wheel. If the founder does move that metric in the promised time, another promise needs to get made and the roulette wheel is spun again. As you can imagine, new founders in this situation are going to fail repeatedly, demoralizing them and their team.

This is what leads to the death blow. Since venture investors deploy capital and new founders don’t understand how hard management is, both sides will decide that adding headcount will help. You go get a great SEO person to work on that, or buy a great PM from Airbnb. You need more engineers so you can work harder and get more done. However as Fred Brooks famously wrote about engineering teams 50 years ago, the same is true for startups. Applying capital to early stage startups doesn’t work because finding PMF is an exercise for the founders. They have to hold the market in their head and develop enough of a map of their customer needs and emotions to experiment and continuously reposition what they do. This takes a ton of time. If you hire people, then you have to spend your time managing.

A two pizza team is the right pre-PMF trade off between managing and experimenting, because you need some talent diversity to try things quickly and build them well enough to get a real signal from your experiments. Once you exceed that team size, founders time gets eroded by management.

Is there a good solution to this? Probably not at a market level. I don’t expect Series A funders to understand PMF metrics, the nuances of a specific market, or avoid momentum investing. So the only solution is for founders to play the game on their own terms. That’s what serial founders do. They set expectations upfront about the process of finding PMF, the silliness of making promises before PMF, and why it is a death blow to over-hire early. I hope that this is useful to founders in this momentum funding situation. If you can stick to your guns, it can all work out and you will have plenty of cash in the bank to ride out the next downturn.

Co-founder and CEO NetGravity, Rocketship Education, Zeal Learning, Dunce Capital.