Fertile Soil?

Let’s face it. Seed stage investing is no easy task, what with the risk that comes from readying the technology and business model of a young company. It’s no wonder that seed stage investing is far from the most coveted area for venture capitalists.

In fact, as an investment category, seed stage activity is at an historically low level. In the first quarter of this year, VCs invested just $169 million in 47 seed deals. That’s way down from the median of $202.9 million invested in 82 deals per quarter over the past 20 years, according to the MoneyTree Report from PricewaterhouseCoopers and the National Venture Capital Association. (The report is based on data from Thomson Reuters, publisher of VCJ.)

“VCs have grown larger, and now smaller investors are hard to come by,” says David Cremin, managing director of DFJ Frontier, a West Coast-based firm that focuses on seed and early stage deals.

Sensing an opportunity, some VCs are experimenting with outsourcing their seed investing. The idea is to boost their number of seed deals without adding the time-intensive resources that startups normally require.

For example, Sequoia Capital recently teamed up with some angel investors to put $2 million into Y Combinator to help the seed stage incubator grow the number of startups it funds from about 40 to 60 per year. The investment by Sequoia comes as it has moved aggressively into growth stage investments in recent years and has thrown its weight behind Chinese and Indian affiliate funds that are less likely to make early stage deals. Sequoia currently invests about 15% of its capital in seed and early stage deals, down from about 45% 15 years ago, according to Thomson Reuters.

VCs have grown larger, and now smaller investors are hard to come by.”

David Cremin

Y Combinator is more than happy to deploy the extra capital. “We wanted to expand aggressively in the recession,” says Paul Graham, a Y Combinator partner. “This is a good time to launch a new tech company.”

Another firm tapping outside resources to boost its seed investment is the Founders Fund. The firm, which is currently investing from a $220 million second fund it raised two years ago, plans to award 12 fellows $25,000 each to invest on its behalf. The arrangement theoretically allows the firm to increase its seed activity without a commensurate increase in the time-intensive resources that seed deals traditionally require.

Partners for Sequoia and the Founders Fund declined to comment on their new programs.

Other seed and early stage investors had generally positive comments about the efforts. Larry Kubal, co-founder and managing director of seed stage firm Labrador Ventures, says it makes sense for early stage investors to outsource their seed investing. “The major impediment of implementing an in-house program is that it consumes investment professional time,” he says. “Success requires the leveraging of trusted, proven external resources.”

Kubal predicts Sequoia will at least break even on its Y Combinator investment. Plus, it will receive “increased options in terms of pre-qualified, emerging seed stage deal flow,” he notes. “But the key point is no added expense to partner time.”

Seed investors play a signficant role. The more the better, as far as I’m concerned.”

Alan Patricof

Y Combinator operates an online application process for young startups looking for funding. Graham says the $20,000 that Y Combinator invests in a company is typically what a startup entrepreneur raises from friends or family members.

Once the Y Combinator team reviews the online applications, it whittles the applicants down for the next round of evaluation. It sets up 10-minute meetings with each of the 60 prospective startups over the course of a weekend. If a startup looks promising, an investment is made.

Graham says that most of the capital goes to pay for the founders’ living expenses. In return for its investment of $20,000, Y Combinator receives anywhere from 2% to 10% in stock of the startup, with 6% being the average, Graham says.

Y Combinator has supported several early stage startups that have since been acquired, including Anywhere.FM and Omnisio, according to Thomson Reuters. Y Combinator also invested in Reddit, which was sold to Condé Nast Publications, and Loopt, a startup that subsequently raised funding from Sequoia and New Enterprise Associates.

“What we learned from doing this over the past few years is our model actually works,” Graham says.

Venture funds need to outsource their seed activities. The major impediment of implementing an in-house program is that it consumes investment professional time.”

Larry Kubal

Like Sequoia, the Founders Fund is also experimenting with outsourcing its seed investing, but it’s trying something radically different. It has set aside at least $600,000, which will be doled out in chunks of $50,000. The firm will give at least 12 designated “fellows” $25,000 each to invest in a startup of his or her choice, then the firm will put in an additional $25,000 in each company.

If any of the startups raise a subsequent round, the Founders Fund has the option to invest another $250,000 in each. Among the all-star fellows participating in the program are Michael Arrington, founder of tech news site TechCrunch; Esther Dyson, head of EDventure; Reid Hoffman, co-founder of social networking site LinkedIn; Terry Semel, former CEO of Yahoo; and Mark Zuckerberg, CEO of social networking site Facebook.

While the Founders Fund and Sequoia are focusing on outsourcing seed deals, more firms are keeping the function in-house. For example, Charles River Ventures (CRV) launched an in-house seed program in 2006 that offers as much as $250,000 in the form of a loan. Its QuickStart Seed Funding Program focuses on opportunities in the communications and technology, software and services, and new media sectors.

CRV’s program provides select entrepreneurs with a loan in the form of a convertible note to fund the work needed to build out the idea, product or service. In doing so, CRV says it’s providing the capital to fuel ideas without painful seed stage dilution.

In a similar move, Spark Capital launched an in-house seed program called Start@Spark four months ago. The Boston-based venture firm invests in what it describes as the conflux of the media, entertainment and technology industries. The firm raised $260 million for its first fund in 2005 and more than $360 million for its second fund in late 2007.

What we learned from doing this over the past few years is our model actually works.”

Paul Graham

Spark Senior Associate Rob Go says the firm’s capital under management gives it an edge over so-called “micro-seed” efforts, such as Y Combinator’s. “Most companies need more gas [than $20,000] to get a product built or do business development and deals,” Go says, noting that Spark puts up to $250,000 in its seed deals.

“Where we’re different from a Y Combinator is we invest in the full value from infrastructure to concept,” Go adds. “We also commit to a fast due diligence of a few weeks. And we invest in a seed round with a $250,000 convertible note. On the subsequent round of funding, the note gets converted.”

The jury is still out as to whether it makes more sense to do seed investing in-house or outsource it. The efforts by Sequoia and The Founders Fund should help answer that question. For now, most VCs are happy to see any effort being put into seed deals.

Seed investors “play a significant role,” says Alan Patricof, founder of early stage firm Greycroft Partners. “The more the better, as far as I’m concerned.”