Is Europe Going to Seed?

The news just keeps getting better for European startups. Following the recent emergence of entrepreneur-backed venture funds focused on seed deals, Index Ventures, one of the region’s most successful venture firms, is rolling out a new seed fund that promises to invest in about 10 garage startups per year.

The new fund, called Index Seed, will be carved out of Index’s latest fund, $441 million Index Ventures V. Index did not disclose the size of the seed vehicle, but industry watchers believe it will be somewhere between $20 million and $40 million. Index says the fund’s deals will range in size from $50,000 to $1 million per company.

This is a significant development for a European venture market that has been steadily drifting toward the safety of later stage and growth investments. Last year, growth deals alone accounted for more than half of all venture investments, compared to just 28% in 2007, according to data compiled by the European Venture Capital Association. For the most part, established funds are seeking to put larger chunks of money to work in more mature companies that have a realistic chance of exit—a strategy that has left little room for riskier investments in seed and early stage companies.

“To a certain extent, Index is making a statement about being counter cyclical to what the rest of the industry is doing,” says Fred Destin, a partner at Atlas Venture who is based in London. “They are saying there is a real lack of attention here, so, by definition, there will also be some great opportunities.”

A key question related to Index’s effort is whether the creation of its seed fund represents a significant change in the European venture market. Will Europe’s leading venture firms follow Index’s lead and steer more money into seed deals?

Sonali De Rycker, an investment partner at Accel Partners in London, isn’t so sure. “My view is that seed funding in Europe still has lots to prove as an independent and comprehensive strategy,” she says. One problem she sees is that Europe lacks the infrastructure to support these deals. The United States, by contrast, has seen the rise of so-called “super angels” who have funded a series of blockbuster companies ranging from Twitter to LinkedIn to Mint. But these same super angels are few and far between in Europe.

We will happily split a $200,000 deal three or four ways, rather than saying this is already way below our minimum so we need the whole thing.”

Neil Rimer

What’s more, the United States market boasts tech giants like eBay, Google and Yahoo, which can pick off startups very early in their lifecycle, sometimes for as much as $100 million. This in itself can make seed investing worthwhile, even for a larger fund. “But that doesn’t really happen in Europe, mostly because the eBays and Googles are not looking to buy tiny companies here,” De Rycker says.

What also doesn’t work in Europe, says Destin of Atlas, is the Ron Conway strategy of investing in almost every halfway decent seed deal in town in the hopes of corralling a future Google or two. “Unfortunately, we don’t have any Googles here, so you can’t run a fund that way,” he says.

So what does Index see that other European VCs don’t? Firm co-founder Neil Rimer says European companies are being created with little capital and hitting milestones faster than ever before thanks to out-of-the-box technology platforms like cloud computing, open source and Facebook. “We needed a way to respond to this,” he says.

Index does not want to miss out on the best new startups, especially since they now have the potential to become massive businesses in the blink of an eye. “Just take a look at a company like Groupon,” Rimer says, referring to the deal-of-the-day shopping site that amassed a $1.35 billion valuation in just over a year. “That was an idea that took off because they put together the right type of offer with an innovative business model. And there are a lot more deals like that.”

It probably also didn’t hurt that one of the Index’s most visible partners, Saul Klein, is a seed-stage junkie. Separate from his duties at Index, he founded SeedCamp, a popular program created to jumpstart and finance the entrepreneurial community in Europe. Klein will now commit the bulk of his time to Index Seed.

Klein said in an interview with Reuters that venture firms need to get involved earlier with amounts as small as $50,000, or risk being too late to help entrepreneurs shape their strategy. “When I helped to start a business in Boston in ‘95, to buy a Web server was $1 million,” Klein said. “Nowadays you can rent server capacity from Amazon for 50 pounds ($77) a month.”

My view is that seed funding in Europe still has lots to prove as an independent and comprehensive strategy.

Sonali De Rycker

Klein will be joined on a part-time basis by his father, Robin Klein, an active angel investor and the founder of The Accelerator Group (TAG). In addition to the two Kleins and Neil Rimer, the Index Seed team will include Index Partners Danny Rimer and Mike Volpi.

Index has not yet disclosed any investments from its new fund, but it is no stranger to the seed game. The firm has made about 40 seed investments in its 15-year history, including startups like Lovefilm, Moo, Moshi Monsters and Stardoll. Increasing the frequency of seed deals to at least 10 a year will be a significant commitment for the firm. “We don’t want to pass on what could be very interesting companies that may not need to come back for money,” Rimer says.

And if the seed-funded companies do come back for money, Index believes it will be in a good position to take a leadership position in the Series A or B rounds.

Simon Cook, CEO of DFJ Esprit in London, says most venture firms in Europe have an agreement with their limited partners that allows them to invest up to 5% of their fund in seed deals. But whether they tap the full amount is another question. He says the seed provision enables larger funds like his to quickly invest in a serial entrepreneur they have backed before or capitalize on a truly amazing opportunity. But Cook is quick to emphasize that deals like that don’t come around every day.

“Larger funds have to put money to work and produce significant returns, so it’s a tradeoff of time vs. seeing a cool deal,” says Cook. “Making a huge number of little bets is not a great business model for VCs.”

Perhaps most striking about Index Seed is that the fund says it will invest alongside other angels and try not to crowd them out, which is typically the case with institutional money. “We will happily split a $200,000 deal three or four ways, rather than saying this is already way below our minimum so we need the whole thing,” says Rimer. “We’re willing to do that because that’s the spirit of these types of deals.” He believes this is a totally new approach to seed investing.

Larger funds have to put money to work and produce significant returns, so it’s a tradeoff of time vs. seeing a cool deal. Making a huge number of little bets is not a great business model for VCs.”

Simon Cook

By contrast, a firm like Accel prefers the more traditional method of incubating deals on its own. It will seed companies by backing known entrepreneurs in spaces it understands well. Most recently, for example, the firm seeded an open source risk management company called OpenGamma, as well as a customer experience startup called Causata.

“We get in very early, help hire the first few people and set up the business from scratch,” says De Rycker. “This is the way we’ve done it and hope to continue doing it.”

In nothing else, the formation of Index Seed could prove a savvy bit of marketing for Index. After all, there are a number of new seed and early stage players entering the European venture scene, including upstart firms like Atomico Capital, Notion Capital, ProFounders Capital and Team Europe Ventures. (See “Startup Stars Aim to Fill Early Stage Void,” page 36, April VCJ.) Index may be trying to send a not-too-subtle message to entrepreneurs that it is the real player in this market—the one entrepreneurs should speak with first. “This is clearly a move by Index to brand this initiative more aggressively,” says Destin of Atlas.

For his part, DFJ’s Cook sees Index Seed as more than a marketing ploy. He believes the real message being sent by Index is that the firm plans to become a one-stop shop for startups, from conception to exit. Indeed, the formation of Index Seed comes just two years after the firm launched a $400 million growth fund to invest large sums in mature technology companies.

“I think the venture industry is consolidating into fewer bigger players that are able to offer a wide range of products,” Cook notes. “There is no point starting up thousands of companies in Europe if no one is there for the next round. So, in that sense, this is a good thing.”

Additional reporting by Georgina Prodhan, Reuters