The newest Cooley Venture Financing Report indicates that median Series A pre-money valuations were at an 8-year high in Q2 2012, leaving some seasoned venture capitalists scratching their heads. Michael Greely, a partner at Flybridge, put it succinctly in a recent post when he said “Series A round sizes have been coming down over the last few years as companies can get by with raising less capital … I expected valuations for Series A to be a fraction of the $11 million witnessed.”

Michael also did some back-of-the-envelope analysis using the common benchmark that “companies are raising ~$5 million in typical Series A rounds.” This $5m benchmark makes sense for VCs that invest in capital-intensive sectors like biotech. It also makes sense for the bigger VC funds, as data from the NVCA indicates that almost 80% of the $5.9B invested in VC funds in Q2 2012 went to the top five firms. That is an astounding concentration, and the nose-bleed VCs simply can’t write checks less than $5m-$6m and hope to deploy this capital effectively.

But where did this benchmark even come from? “Series A” used to just mean the first institutional funding to go into a company. For a very long time the fundraising pattern was pretty standard: launch on friends & family money, raise a seed round, then shoot for the Series A that will end up being around $5m. This pattern has caused the $5m benchmark to be conflated with what it means to be a “Series A.” Many VCs still attempt to force a $5m check on companies that would be better served by $1m-$2m, and many founders still aim for the $5m Series A even when it’s not appropriate for their businesses.

What we’re seeing with most modern internet companies is that this funding pattern has undergone significant changes over recent years. Thanks to inexpensive accessibility to a deep, open-source technology stack, it now costs significantly less to launch, iterate, and scale companies in the social-mobile-web sectors. Companies are frequently rejecting the $5m-$6m checks and instead turning to leaner, more efficient sources of follow-on capital. This isn’t a new concept – Paul Lee gets it, Dave McClure [censored] gets it, and Naval Ravikant of AngelList has suggested that we need to redefine these financing categories altogether. The new pattern looks more like this: launch from an incubator / accelerator (~$50k), get a boost from a micro-VC round ($300k-$500k), and then take a $1m-$2m “Bullpen” type round to hit your key proof-points.

So – if financing is getting leaner for the market sectors that bring in the most venture capital dollars per year, why are the analysts at Cooley seeing a spike in Series A valuations instead of a drop? I suspect this is happening for three reasons: (1) the capital-efficient Series A flies under the radar; (2) big VC firms are (still) over-funded; and (3) startups are reaching key milestones on less money.

The Capital Efficient Series A Flies Under the Radar

Call them what you want – bridge rounds, gap rounds, seed extensions – but leaner institutional financings are becoming increasingly common. Most analysts call these rounds “substitutes” to the Series A, but each one simply is a “Series A.” However, since these rounds don’t look like, smell like, or taste like the old standard $5m Series A, they don’t get analyzed as such. This removes the lowest end of Series A financing valuations from the data pool, and displays inflated valuations for the category as a whole.

Big VC Firms are (Still) Over-Funded

When huge amounts of capital are concentrated in the hands of very few VC funds, the challenge does not lie in negotiating deals at the lowest possible valuations, the challenge lies in deploying huge amounts of capital into a manageable number of companies. So, as Paul Lee has already pointed out, “At the end of the day, to the venture firm, the most important thing is ownership in the deal. If they have to pay a premium on the valuation, it’s not a big deal because they have a large fund that can absorb the extra money paid for the ‘hot’ company.” When a deal crosses over that $5m-$6m funding threshold and looks like a traditional Series A and, big VC will be ready to deploy capital even at higher valuations.

Startups are Reaching Key Milestones on Less Money

At Bullpen Capital, we are in a unique position to comment on an emerging part of the ecosystem. Our deal flow comes directly from the top Micro-VCs, and our value-proposition is that for every home-run company that can go raise a traditional $5m Series A right out of the gate, there’s a company that needs a little extra runway to pivot, find product-market fit, and hit its key milestones. What we’re seeing is that when these sorts of companies raise a “Bullpen” type round in the $1m-$2m range (after taking seed capital, but before a “traditional” Series A), they raise just the right amount of money to hit their key proof-points and show traction + scalability.

This creates one of two results – either the company goes straight to acquisition in the $50m-$100m range (and never even enters the data pool for Series A financings), or the company goes on to raise money at a quick 2x+ up-round from traditional VC funds at a higher valuation than they would have if they didn’t hit those proof-points. The Bullpen portfolio validates this theory: in our first six investments, we’ve seen two exits (5x, 9x), three up-rounds, and one quick pivot showing good traction.

Is there still a place for the “traditional” Series A? Absolutely, but the venture ecosystem is much more diverse than it used to be. At Bullpen, we’re seeing that when the right companies take a lean Series A, both founders and VCs are able to capture early inflection points and generate strong gains at the front end of the funnel before big VC shovels-in on the expansion rounds. Instead of throwing more money into the already-bloated top-five VC firms, LPs would do better to seek out more nimble funds that are capitalizing on this dynamic.

Keep in touch @jamesconlonvc and @bullpencap