There has been much discussion about VCs doing seed funding in the past year. I’ve written about it myself (Is VC Seed Funding Dead?) and (Is There Really a Signaling Problem with VC Seed Funding?).
Short summary of my posts:
1. There is a structural reason that VCs are investing at early stages,
2. Many (Union Square Ventures, Foundry Group, True Ventures, GRP Partners, Mike Hirshland at Polaris Ventures) do it the right way – we treat it as a normal investment and we don’t have a “options” strategy with our investment. I’ve done 4 seed investments in the past year and they are 100% referenceable.
3. Many firms do it in a way that can be more detrimental to entrepreneurs. They either do too many seed investments (for which they can spend no quality time with any) or they treat it as an option (“if you succeed come back and see us and we’ll match any term sheet you get”) – they view it as a sort of “right of first refusal.”
4. The signaling affect is overrated. Everything you do is a signal. Investors will look at which angels you chose, whether old bosses invested, whether you were an EIR somewhere and did they invest, etc. Future investors will also look at whether your angels “re-upped” if you hit a bump in the road. VCs are just one of many signals future investors at which future investors will look. If you don’t understand the concept of “signaling” please read the blog post I wrote on Understanding VC signaling.
5. There are positive benefits to the right VCs being involved early – especially if your company or the economy hits bumps in the road.
6. So the biggest issue for entrepreneurs IMO is not “to VC or not to VC” but rather “what chemistry do I have with my funding sources, how aligned to I feel we are on how to build a company, how much do they understand my specific opportunity and importantly what can I find out about them from referencing previous people with whom they’ve worked and do they have a well defined seed program strategy.
I think the issue was mostly framed initially by Chris Dixon in his article The Problem with Taking Seed Money from Big VCs. VentureHacks laid out the debate in a truly awesome interview & PowerPoint slides if you really want an in-depth understanding of the issue.
From the debate on VentureHacks, our offline chats and from our blog posts, I think that Chris Dixon and I are pretty much 98% aligned on the topic. It’s just that he’s a “super seed” investor in a firm, Founder Collective, that I really respect (and with whom I’ve done two deals and hope to do a third) and I’m a partner in a venture capital firm, GRP Partners. So we’re bound to frame the issue in slightly different terms. After all, when you’re a hammer everything looks like a nail.
Knowing What the Seed Funding Policy of your VC is
Nivi sent out a Tweet yesterday suggesting that you should consider taking seed funding from VC’s but only if they have clearly laid out their seed funding policy. I’ve been very public about my seed strategy but when I saw Nivi’s Tweet I realized that it is not laid out simply in one consolidated space. So here it is:
- We carved out a total of $7.5 million of our $200 million fund for seed funding. We have a limited amount of deals we will do. I treat each of these as a “normal” investment. The fact that I invest less just means the company is earlier stage and needed/wanted less or without a product/market fit we weren’t yet prepared to invest more heavily.
- The $7.5 million in split into $5 million of “primary” investment and $2.5 million is “follow on” seed investment. More on this later.
- I bucket each of these investments into three categories that drive my behavior around the next fund raising round – taking away any guessing about “signaling effects.” My A,B,C categories are below:
- I will stick me neck out for any seed deal I do regardless of how early or how much it struggles. If I’m in I’m “all in.” I have noticed that some investors distance themselves from companies that struggle. One thing I respected the most about my partner Yves is that in my darkest days at my first company he stood by me. I will never forget that.
A Deals: Deals that immediately and obviously successful. This can be on a subjective or objective basis but it’s basically a deal that we are strongly persuaded by the team, the product and/or the traction that they are heading in a direction that warrants more investment. In these cases we proactively offer to lead their next round of financing.
How this works:
- I try to set a price that feels like a fair balance between GRP and the company. We’ll probably end up paying more than we’d want to because we want to take the investment off the market and the entrepreneur will likely feel they should get a higher price if they shopped it broadly on the open market. This is the nature of compromise.
- If we can come to an agreement we will either lead the round ourselves or partner with other investors. Like Brad Feld I’m syndication agnostic but I have a slight preference toward working with others. The investor strategy is really determined by the management team.
- If we come to an agreement and fund the HUGE benefit to entrepreneurs is that they don’t have to trek up and down Sand Hill Road looking for money. The obvious positive is that there is a lot less time spent raising money and more time spent on building the business at a critical stage in the company’s development. The second less obvious benefit is this – the VC world is REALLY small and incestuous. Like it or not – news travels fast when you’re raising money. Not having to see 15-20 potential investors and share all of your plans can be a huge benefit if you don’t need to.
- If we can’t agree on price I tell entrepreneurs that they can raise money and say “GRP will speak for half of the round.” Done – the only signal is positive. Obviously this “half the round” offer has limits. If we invested at a $5 million post-money valuation and you find somebody to invest at $120 million pre-money then I reserve the right to say “no” to taking more than my prorata. But in all reasonable circumstances were in.
- If we invest the follow-on money comes from our non-seed fund (e.g. the $190 million).
We already have one example, which is Ad.ly. We loved the team (they hired a very experienced CEO (the founder’s recommendation to do so – not mine) and a great technology team, we loved the product category of in-stream advertising which I believe will continue to be a major trend and we were impressed with the quality of the product they were developing. So we led the first big institutional round and partnered with Greycroft Partners and Matt Coffin (founder of LowerMyBills).
I would expect 2-3 deals out of 10 to hit the A status.
C Deals: Deals where the team makes little to no progress – C deals are also pretty easy. No investor (angel, seed or somebody writing a $10 million check) will guarantee that they will make the next investment in your company. If the management team fails to deliver against even a modest set of expectations, doesn’t ship product, has internal conflict, demonstrates a lack of maturity or any other number of subjective judgment teams that your initial investment decision was wrong then the investor will not fund the next round.
Note that if you can convince outsiders to invest you are by default not a “C Deal” because almost any VC will at least do their prorata if you can find outside investors. But if you had a seed program that guaranteed the next round of investment it would be even more liberal than an A Round investment and there’s no reason for that. Anybody who “guarantees” your next round (other than by legal commitment) is not being truthful to you.
Having talked with our investors (known as LPs) I know that they feel that if we have a seed program we need to be willing to have C Deals – meaning that they want to be sure that we’re not committing to millions of investment in a company just because we seed funded them. That would run the risk of the “sunk cost fallacy that we all learned in basic economics (or if you didn’t make sure to read Fred Wilson’s primer on the topic
So let me assume 1-2 out of every 10 become C deals. Luckily I haven’t had one of these yet.
B Deals: Deals that are progressing but not obvious successes yet – So the real question for a VC who crafts a seed fund is what to do about those pesky “B Deals” because they probably will be the largest bucket of your investments. The reality is that despite all expectations going into a project, most companies take longer to get off the ground than the management team or investors would like. The product ships a bit more slowly, hiring takes a bit longer than anticipated, product/market fit isn’t achieved with the first product release, etc. Not everybody is an instant FourSquare or Quora and not every management team has credibility to get the next round of investment done before having proof of adoption.
So my biggest problem with VCs who do seed funding is when they strand or starve their B Deals. My strategy is to go to the B management teams and offer to do another seed round – perhaps even as large as the initial round. In an ideal world I wrote a $500k check and we got an additional $250-$500k from other investors. So we might collectively be talking about the company having an extra $1 million to get to a proof point.
Most likely this check comes in the form of “convertible debt” that is not priced but is converted into a future financing at a discount to the next round valuation. This is the most common form of “inside round” structure but it’s also possible you’d price it.
But this check is different than the first. It is delivered with the statement, “This MIGHT be your last round from us – so please act accordingly. If you hugely believe that you still have a $100 million idea then let’s go for it but please be prudent with how fast you spend your capital. If you’re less convinced that this is a huge opportunity now that you’ve been working on it for 18 months then perhaps you should find a “safe home” (read: sell your company) for your assets and we can all move on to our next opportunity.
Or perhaps you want to make your company “ramen profitable” so that you can run it a bit longer without needing capital and see whether you can build it to scale.
Or you find outside investors that become passionate about your project and we’d obviously be very supportive and do our prorata (at minimum) going forward to support you.
But please go into the next year to 18 months knowing that if there is no substantive progress we are unlikely to do a third seed investment.”
My hope is that 2-3 out of 5 would find the magic given an extra seed round and an extended period of time to work things out. The others would need to either sell, slim costs, find new lead investors or wind things down.
So when you’re talking with VCs about seed funding, I agree with Nivi. Ask their strategy. GRP Partners has set aside $5 million to do seed funding and has reserved 50% on top of this to to “follow on” investments for B Deals. We support our teams and feel this is a vital part of VC seed funding and that seed funding is a vital part of our broader investment strategy.
(Cross-posted @ Both Sides of the Table )