Seed Stage Firm Takes Different Approach

Fifteen years ago, Gady Nemirovsky and Robert Fanini were seated together in a stretch limo as it glided around San Francisco, both guests at a friend’s bachelor party. They were strangers at the time, but their bachelor friend knew that both had started their own companies.

Nemirovsky was the founder and CEO of Sonnet Financial, a foreign exchange services company, and Adzaar, an online ad startup. Fanini had been involved in the founding of four companies, including Foglight Software. Fanini was talking with the same VCs that sat on the board of one of Nemirovsky’s companies.

Eventually, “Robert asked me what they [the VCs] were like to work with, and that started a very long conversation about raising money,” says Nemirovsky with a laugh. “I’ve had great guys and not-so-great guys” on the board, he says.

Given their similar backgrounds, the friends decided to start their own seed stage venture fund, Inspiration Ventures, a few years ago. The Burlingame, Calif.-based firm raised about $10 million, mostly from GPs at other venture firms.

Because the fund has flown under the radar for so long—and because the fund’s strategy involves cashing out almost exclusively in Series A rounds—VCJ Senior Editor Constance Loizos asked Nemirovsky to talk about Inspiration’s unique approach.

Q: You were both operational guys. Why start a small fund that can’t be paying you much to manage?

A: Because we know firsthand how hard it can be for entrepreneurs. You’re a star to your venture investors one week, when you’ve generated some buzz or had some great results, but if you don’t hit your milestones or your market falls out of vogue, then suddenly, nobody wants to know you anymore. It’s not as extreme as it was in the late ‘90s, but the VC process is still a difficult one for founders. So we partly wanted to do a better job of it, while making money.

Also, personally, I’d started a few companies and discovered that the stage I most love is when there are four or five people and you feel like you’re going to change the world in some small way. You can do that every three or four years as an entrepreneur, but if you run a small fund, you might be involved in three or four early stage companies a year.

Q: Are you backing three to four startups a year?

A: It doesn’t always work out that way. It’s the first fund for both of us where we’re investing other people’s money. In good times, you can invest quickly, and in not-such-good times, not so quickly.

Q: Are you referring to frothy seed stage valuations right now?

A: When Robert and I started doing research into [the fund], which was 2006/2007, funds had grown really large. Twenty years ago, the average venture fund size was $75 million. Now it’s north of $300 million. We knew that those funds needed to invest bigger chunks of money than $500,000 to move the needle. At the same time, it was already getting a lot cheaper to prove out a concept. So we saw a lot of demand and not a lot of supply at that point. Now, of course, seed stage investing has grown very fashionable.

Q: I understand that you differentiate yourselves by almost always selling to secondary buyers, rather than hanging on to your positions. Why?

A: Right, we make early stage investments in the hundreds of thousands of dollars, but not as a prelude to piling more money into a company. We think of it as proof-of-concept capital. When the Series A materializes, we sell half our position at a significant multiple of what we invested. It’s good for us. It gives us good liquidity. It’s also good for founders. VCs typically have minimum ownership requirements, so they typically cram down more money down the throats of entrepreneurs than they want or need. Selling some of our position lets them do that without forcing the founders to sell their shares.

We also think it puts us more squarely on the founders’ side of the table. [Once involved in a startup], the investors face a conflict at the next round. They pay one price at Series A, and while they want the Series B price to go up, the investors don’t want the price to go up too much because they don’t want to pay too high a price. It puts them in a tricky situation.

Q: So I take it you won’t do a deal that involves convertible notes?

A: We typically do not do convertible notes. The limited benefit we’d receive as a note holder if and when these notes convert—which is usually around a 20% discount to the Series A—doesn’t fit in well with our strategy. Also, a couple of advantages often mentioned of using convertible notes is the speed with which the round can close, and the low legal cost. But we’ve been able to get financings done with very low legal bills, and the last couple of investments we made took six weeks from the time we first met the founders until the day the funds were wired into their account.

Convertible notes can be a bit of a Faustian bargain, too. If the note holder is an investor like a venture fund that would typically invest in follow-on rounds, and that investor chooses not to invest in the company’s next round, it makes it extremely difficult for the startup to get financing anywhere else.

Q: How much do you typically invest and in what types of companies?

A: We’ve invested as little as $250,000, but our sweet spot is around $500,000. One of our most successful companies, and one that exemplifies what we look for, is the usability testing site UserTesting.com, to which we wrote a check in January 2009. Big and small companies turn to the site to see if people are using their [web]sites the way they think they are. It’s founded by good guys who are defining a big market, and it’s very capital efficient. They don’t need a lot of money to get where they are going.

Q: What about exits?

A: [We exited from] Handipoints, an online kids’ virtual world that was acquired by Slide, which was acquired by Google.

Q: Had you hung on to your position or sold some of it?

A: We held it. If we sell our stake, the Series A has to be a certain size. If a company just wants a little additional capital, for example, it doesn’t make sense for us to exit. And Handipoints fell into the latter category. (Note: Handipoints raised $250,000 in seed funding from Charles River Ventures in 2007, then a $550,000 round from Inspiration and angels Aydin Senkut, Keith Rabois and others in 2008.)

Q: Great, did that return your fund then?

A: Not quite, but close.

Q: What’s your newest investment?

A: Textingly, which is launching this month. It’s kind of like a Constant Contact, but for texts [allowing businesses to interact with their customers via texts]. Mobile is hot, but it seems like venture is ignoring texting, which is huge and not going [away].

Q: How many companies have you funded so far, and when do you raise your next fund?

A: We’ve made less than 10 investments, though we’re likely to do a couple more in the next few months. A lot of seed funds spread around a lot of capital for a lot of deals, and that certainly works, including for Ron Conway and Y Combinator. It’s not like we take one deal and work it really hard, but we want to invest in good teams and strong markets.

As for a new fund, for us [our current fund] was a proof of concept. So far, it’s been going pretty well. It just depends how well we finish it off, which is a function of markets and deal flow.

Q: Do you think all the social media is making it hard to shop? It seems to me to be exacerbating the frothiness.

A: Maybe. It’s a balancing act for me. I read what’s out there, but you have to avoid the temptation to be sucked into the swirling vortex. You don’t want to get pulled into crazy bidding wars because you feel like you have to do something. And though we don’t see nearly as many deals as a [Kleiner Perkins] or Sequoia or even a Dave McClure, who knows everyone, we’re already seeing more good deals than we know what to do with.