Suddenly seed investing is cool again

For Kleiner Perkins, usually associated with high-return investments in Web giants, a six-figure stake in last year barely put a dent in its current fund.

Platial, which runs a website for making personalized maps, falls easily into the category of Web 2.0 startup. Like most of its ilk, Platial is relying on consumer adoption and advertising revenue. Its total funding: about $1.4 million.

Unlike rival Web 2.0 startups flooding VC offices with business plans, however, Platial’s founders say their ties to seed investors give the company an edge in finding distribution partners. “We have more credibility in their eyes because they know we’re going to be around,” says Di-Ann Eisnor, co-founder of the Portland, Ore.-based company.

Platial is one of a growing number of young companies being added to the stables of large venture fims that wouldn’t even give them a meeting, much less write them a check, a couple of years ago. Seed investing, like Internet entrepreneurs, is back in vogue.

The number of seed/startup deals rose from Q1 to Q2 and again in Q3 of 2006, according to the MoneyTree survey by PricewaterhouseCoopers, Thomson Financial and the NVCA. Venture firms made 90 such deals in the third quarter, up from 76 in the second quarter. As a percent of overall venture investments, seed/startup deals accounted for 11.3% of the total in Q3, recording their first double-digit percentage since the Q3 1999.

The amount of money being invested in seed/startup deals is also on the rise. VCs invested $329 million in seed/startup deals in Q3, up from $295 million in the prior quarter. Such deals accounted for 5.3% of the total dollar amount U.S. venture capitalists invested in Q3, the second highest percentage since Q4 1999.

Low, low prices

[Internet startups] don’t need $5 million right now. What they need is maybe $500,000. If VCs want to stay in the game, they’re going to have to find a way to play.”

Drew Clark, Director of Corporate Strategy, IBM Venture Capital Group

A key factor bolstering seed financing is recognition that the cost of starting businesses has declined, particularly for Internet startups. By relying on open source software, off-the-shelf components and virtually limitless cheap storage, companies can launch and grow to massive scale quickly and with minimal expense.

Internet startups “don’t need $5 million right now. What they need is maybe $500,000,” says Drew Clark, director of corporate strategy for the IBM Venture Capital Group. “If VCs want to stay in the game, they’re going to have to find a way to play.”

Some are taking a creative approach. Charles River Ventures augmented its seed initiatives in November with the launch of CRV QuickStart, a program that gives qualifying startups convertible loans of up to $250,000. The loans convert into equity if and when the company closes its next round of funding. According to CRV, QuickStart represents a broader commitment to seed funding. In the past year, roughly one-third of the projects CRV has backed have been seed stage.

CRV hopes the program will enable it to better compete with angels and Web 2.0 incubators. Easy access to funds may also convince a growing contingent of bootstrappers to stop running up their personal credit cards for working capital.

“Smaller is better” might seem like an apt mantra for VCs pursuing seed investments. The staid truth, however, could be simply that there are few late stage companies seeking funding at compelling valuations.

That’s the impression of Robert Ward, managing partner at seed fund Capybara Ventures, who views the uptick in early stage financing as a response to scarce supply of the types of large-stake investments VC firms favor. The sluggish U.S. market for public offerings makes for another disincentive to late-stage investing.

“Funds have kind of realized that the later stage opportunities aren’t just going to present themselves,” says Ward. “They are going to have to get their hands dirty and help make that happen themselves.”

It’s not just capital they need at that seed stage. They really need a lot of handholding.”

Jeffrey Sohl, Director, Center for Venture Research, University of New Hampshire

Mark your calendars

Moreover, the timing looks right. Today’s early stage investors should be perfectly set for when the IPO market recovers, says Gerry Langeler, a partner at OVP Venture Partners. He predicts a Nasdaq IPO recovery in 2009, if regulators take steps to reign in the costliest elements of Sarbanes Oxley. Companies funded today, Langeler says, will be in prime position to take advantage of a roaring IPO market in 2010.

In the meantime, with fewer quick exits on the horizon, some funds have been scaling back. Sevin Rosen Funds cited the weak IPO climate among its reasons for taking the unusual step of returning money to limited partners that committed to its newest fund.

“The difficulty is that VCs have raised funds through their limited partners with certain expectations of how that money is going be invested,” says IBM’s Clark. It’s hard to go from an expectation of putting in $2 million or more per deal to $200,000.

Some question whether large VCs should be in the seed game in the first place.

Jeffrey Sohl, director of the Center for Venture Research at the University of New Hampshire, doesn’t think it’s sensible for a $300 million fund to be doling out $500,000 investments. Beyond the logistical nightmare of managing due diligence for dozens of small investments, there’s the hassle of overseeing startups in their neediest phase.

“It’s not just capital they need at that seed stage,” Sohl says. “They really need a lot of handholding.”

Funds have kind of realized that the later stage opportunities aren’t just going to present themselves. They are going to have to get their hands dirty and help make that happen themselves.”

Robert Ward, Managing Partner, Capybara Ventures

Dissing dabblers

“You can dabble in [seed investing] and it might work on a one-off basis, but the likelihood of success is enhanced by having a consistent focus on the area,” says Stuart Davidson, a managing director at Labrador Ventures, which has focused solely on seed deals since 1989.

Typically, a seed investment takes as much time to oversee as a $5 million deal, says Greg Gottesman, managing director at Madrona Venture Group. That’s why he doesn’t expect much competition from large funds for the seed and series A deals in which his firm invests.

“It’s very difficult to do seed deals when you have to put significant amounts of money to work,” he says.

Sohl argues that very early stage investing is better suited for angels, who’ve been aggressively pumping money into startups. According to the Center for Venture Research, U.S. angel investments totaled $12.7 billion in the first half of the year, up 15% from the same period in 2005. Much of the increase comes from angels engaging in more mature companies, Sohl says.

So what’s a VC to do? Waiting a bit for a struggling startup to mature makes strategic sense in sectors where moving from concept to revenue generation takes several years. But investors don’t have that luxury with Internet services and consumer websites, which can launch and scale in a remarkably short time. It took just two years for social networking hub MySpace to grow into a Top 10 online destination and attract a $580 million buyout from News Corp. YouTube’s founders created the video sharing site in February 2005 and sold it to Google for $1.65 billion in stock just 19 months later.

Moreover, if entrepreneurs have the money to launch, they may not need subsequent rounds from VCs. Serial entrepreneur Joe Kraus, for example, spent just $100,000 to take his Wiki-based project collaboration tool JotSpot from concept to market before selling it to Google this fall for an undisclosed amount. A decade earlier, it cost Kraus $3 million to launch his first startup, search engine

You can dabble in [seed investing] and it might work on a one-off basis, but the likelihood of success is enhanced by having a consistent focus on the area.”

Stuart Davidson, Managing Director, Labrador Ventures

Breaking down barriers

Open source software has played a weighty role in lowering startup costs, says William Collins, CEO of Trellis Global, which is developing an online platform for managing Chinese exports. By using open source applications like Linux and MySQL in place of proprietary software, Collins believes he can cover his entire first-year IT budget for around $250,000—less than his previous startup paid for a single Oracle license six years ago.

Of course, low barriers to entry also mean more competition, and more startups that won’t survive.

Simon Birkett, CEO of HeadWest Software, a developer of open source-based project management tools, says most startups in his sector cannot succeed with the entrepreneur-working-out-of-a-garage model. Attracting paying customers requires marketing and public relations. While entrepreneurs may be bootstrapping today, they’ll need venture funding later.

Still, it’s a misconception to presume VCs are frantically seeking out the next YouTube. OVP’s Langeler says he prefers making seed investments in sectors with the highest barriers to entry. For example, OVP made early investments in bioinformatics startup Viral Logic Systems and nanotech outfit Nanostring. Practiced well, Langeler says, seed stage funding should be the most profitable part of startup investing. But too much money chasing too many look-a-like startups is a recipe for poor returns.

Even if the founders of YouTube had pitched their original business plan a year ago, Langeler doubts that he would have jumped to sign on. After all, for every site that becomes a household name, dozens of equally ambitious Internet ventures languish in obscurity.

“We’re scared to death of some of these consumer-facing deals,” Langeler says. “You’ll get the occasional hit record, but trying to predict that behavior as a venture capitalist is perilous.”