AGILEVC My idle thoughts on tech startups

August 9, 2010

Much virtual ink has been spilled on the pros and cons of taking seed stage investment from larger VC funds.  Chris Dixon and Fred Wilson have their viewpoints, more recently Mark Suster and Brad Feld added their perspectives and helpfully laid out their firms’ specific approach to seed investing in a clear and public manner.  Fred Destin also had a good post which categorized various type of seed investor, and also highlighted the fact that at the end of the day alignment, mutual respect, and cultural fit are most critical regardless of what type of seed investor you’re talking about.  And Chris Douvos, an investor in both traditional and micro VC funds, weighed in with some LP perspective [NB - PEHub paywalls after 7 days].

The changing startup landscape, at least for internet / software enabled companies, has forced nearly all large VCs to evaluate their approach to seed investing whether they’ve been active in the seed space historically or not.  The general pros and cons of large VCs as seed investors have been thoroughly discussed.

But given the continuing evolution of many VC’s philosophy towards seed investments, I thought it would be helpful to lay out the different approaches I’ve seen large VCs take towards seed investments.

1) Seed Investment No Different - These firms will make investments at a seed stage, but treat them no differently than any other early-stage investment (e.g. Ser A or B).  A GP that wants to pursue a seed investment has to allocate one of their deal “slots” to it, must convince the full partnership of the merits, and the firm treats it like every other portfolio company.  These firms typically do a relatively small number of seed deals per year, most often with repeat entrepreneurs with whom they have a relationship.

ENTREPRENEUR PROS – If these firms invest you typically get full firm buy-in and help, have much higher confidence VC firm will follow-on.

ENTREPRENEUR CONS – Process often takes a long time, must convince firm that concept has a high probability of being “venture” scale and team is capable of executing at that scale, optionality for funding and exit post seed round may be constrained.

2) Seed Program as a Basket of Options – These firms have a specific program for seed investments, which will often entail a process and investment team staffing that’s different from “full-scale” investments.  Whether expressed publicly or not, the firm’s expectation is that only a small number of seed investments will ultimately be suitable for full-scale investments.  But the option value to the VC firm of the few that do outweighs the capital expenditure in the ones that don’t.  These firms often do a very large number of seed investments per year.

ENTREPRENEUR PROS – Often easier to obtain seed investment from these groups, may have standardized process and terms.

ENTREPRENEUR CONS – Negative signaling issue is incredibly acute given firm’s low follow-on rate.  Only the chosen few companies that graduate to full-scale investments receive the firm’s full backing, both in financial and human capital.

3) Seed Program as a Mini-Fund – These groups specifically carve out a portion of the large fund, but manage it to a very different set of expectations than the large fund (e.g. deliver good seed returns on this “separate” pool of capital).  Staffing and investment process may be different or at least a subset of the entire firm.  Theoretically this “fund within a fund” is benchmarked essentially on it’s own, by the agreement of both the GPs and LPs.

ENTREPRENEUR PROS – Done right it has the potential of the best of both worlds, in having the perceived support of a large VC fund but with the expectations and support of a dedicated seed fund.  May be easier to get seed investment from these groups than VC firms practicing model #1.

ENTREPRENEUR CONS – Could be a wolf in sheep’s clothing, either in reality or by perception.  If other investors believe the “mini-fund” VC is in fact taking approach #2 this could create many issues.  There are also very few precedents for this approach and internal support within large VC firms for this type of program may change over time.

4) GP Angel Investments as Seed Program - A number of partners at large VC firms invest as angels at a seed stage.  Typically, though not always, these firms do little or no seed stage investing from their funds.  A very small number of groups have “formalized” the angel investing efforts of their GPs for the benefit of their funds.

ENTREPRENEUR PROS – May provide opportunity to work with helpful investors earlier than they typically invest.

ENTREPRENEUR CONS – May still have perceived signaling issues regarding follow-on.  Potential conflicts of interest may arise, between the individual GP who invests and his or her partners and between the GPs and the fund LPs.  This potential conflict is why Brad Feld stopped making angel investments when Foundry was formed, and an example of this issue came to light a few years back with angel investment by some partners at Insight Ventures in Photobucket.

5) VC Fund as Investor in Seed Investment Programs - Some large VC funds have invested capital in various seed investment programs (incubators, accelerators, seed funds, etc).  They do so generally to gain privileged access, whether explicit or implicit, to promising startups that they can invest in beyond the seed stage.  Some publicly announced examples include investment in Betaworks by RRE Ventures and others or Sequoia\’s investment in Y-Combinator, but there are plenty of other examples that are kept quiet.

ENTREPRENEUR PROS – If you take investment from one of these seed programs, you may get better access to the large VCs who invested.

ENTREPRENEUR CONS – These relationships may not be transparent when you speak with these seed programs.

 

As many of you know I’m a seed-stage focused investor thru NextView.  For the record, we’ve co-invested with all types of seed investors from angels to micro VCs / seed funds to large traditional VCs.  At the end of the day, entrepreneurs seeking capital have the primary goal of getting their vision funded which I can certainly empathize with.  But I tend to be uncomfortable with any situation where a VC views a seed investment as an option.

In truth though, there is no “right” type of seed investor for every situation… what’s far more important is for entrepreneurs to have a frank conversation with whoever they take seed investment from to understand the investor’s objectives, approach, and values.  Index Ventures, which has a long history of seed investment, talks about a strong preference to invest at the seed stage with like-minded “fellow travelers” regardless of what type of investor they might be.  This means investors that truly understand the risk profile of a very early stage startup, are willing & able to roll-up their sleeves and constructively help, and is seeking success on that seed investment rather than some hypothetical future investment round.  This is a sentiment I tend to share.