TechTalk: The Vanishing Early-Stage Fund –

You’d think with a $60 billion overhang that the venture capital industry would be flush with cash through and through. But, alas, this is no meritocracy. After years of declining returns, increased competition for good deals and mounting wariness among limited partners as to whether this was truly a dreamy asset class, capital has once again started flowing within the venture capital industry.

Yet, it’s flowing in one direction and one direction only: up! For seed-stage companies with big dreams and no money, that’s a problem.

Though large funds have reaped the rewards of a resurgence of committed capital, early stage venture capital-what we might more specifically define as seed-stage investing-has found itself left out in the cold. More simply put, if you’re a young private company with $2 million to $3 million in revenue looking to raise $8 million or more, the world is your oyster and billion dollar funds are your new best friend. Yet, if you’re an early stage company seeking a mere $1 million in startup venture capital at a $2 million pre-money valuation, you’ve got far fewer places to turn to turn.

The numbers prove the point. According to the MoneyTree Survey by PricewaterhouseCoopers, Thomson Venture Economics and the National Venture Capital Association, a three year downward trend in overall venture capital investments was finally reversed in 2004, though the rebound didn’t benefit everyone equally. Last year, VCs placed $20.9 billion into 2,876 deals, with an increase in overall funding for 2004 largely attributable to later-stage investments: Specifically, $7.2 billion was invested in later-stage deals as compared with $4.9 billion invested in later-stage companies in 2003. That’s the good news, sort of.

The bad news, at least for early stage companies, is that not only has the slide in money committed to seed-stage deals been in decline over the past decade (see chart), any uptick in overall VC investment in 2004 was largely missed by this first rung of entrepreneurs. In fact, the decline has nearly cut in half the amount of capital we place in our youngest companies and newest ideas each year. In 1995, 38% of total venture capital invested-that is, more than one-third of all VC dollars deployed-went to seed and early stage opportunities. Last year, that percentage share stood at a mere 20%, barely one-fifth of all VC invested capital.

Either we’ve all decided to go with more of a “sure thing” approach by betting on mid-to-late-stage companies, or we’re ignoring what, I suspect, is one of the more exciting and lucrative gaps in the venture industry.

“It’s a lonely time to be in true seed-stage/early stage financing right now, even though we kind of like it that way,” says Sean Foote, partner with Labrador Ventures, a seed-stage fund that has focused on the industry’s earliest stage deals for more than 15 years. Labrador, along with Onset Ventures, is a true early stage fund, the kind of firm that actively seeks out pre-revenue companies with half a dozen employees or less, where a prototype of the technology might exist but where VCs can also truly add value by wringing out technology risk, helping entrepreneurs validate a market and helping recruit top engineering and management talent.

“A large proportion of funds say they’re early stage right now-at least 30%-but they’re really not,” Foote says. “That number is far, far less. Either they are larger funds that are willing to look at all types of deals, or ones who used to do seed-stage deals but have grown a bit to larger with their successive funds.” That leaves just a handful of smaller true early stage firms, as well as a range of first-time funds, to fill in what is an expanding, if not a glaring, gap at the lower end of the spectrum.

There are a variety of reasons for this decline. Some chalk it up to the changing economics of venture capital, where the natural tendency is toward “bigger is better,” where VC partners in larger funds simply can’t monitor smaller investments relative to the amount of capital under management. Others argue that limited partners now demand reduced risk even if it means lower returns, while at the same time they offer larger chunks of money and, in turn, fatter management fees for VC partners. Some simply claim that partners can only look after so many deals at once, and thus it’s easier to monitor more established companies where more money is being put to work than a brood of younger companies requiring far more hand holding and parental supervision.

There are also structural mechanics within the industry that have changed how VCs and entrepreneurs look at how to start a business. First, it’s simply become more expensive to start certain types of companies-from infrastructure costs to talent to path-to-profitability. Second, because LPs often want to bump up the amount they invest in second, third or fourth funds, there’s an equivalent target creep in terms of the size of investments firms will make in companies. Some prefer to invest more of their dry powder simply because they have more dry powder to spare. And, third, even as the size of funds double and triple, the number of partners within a firm does not necessarily double or triple proportionately. Thus, partners not only get used to enjoying larger management fees, they feel they have to invest larger amounts in B, C and D rounds not only because they have it, but if they don’t, some other billion dollar fund absolutely will.

The interesting point here is that what might be bad news for young entrepreneurs seeking their first million is actually good news for those few-Foote seems to consider firms like Labrador the “lucky few”-who choose to specifically play in this narrowing seed-stage niche. It’s almost a “too good to be true” secret that seed-stage VCs would rather others not pay much attention to-and with good reason. The problems faced by large firms-fierce competition for quality deals, a lack of availability of such deals, and the lowered relative probability of 10X or greater returns-simply don’t surface within true seed-stage venture capital.

Labrador sees lots and lots of deals because early stage companies can literally come from anywhere. Legal counsel that might have just completed a startup’s paperwork will refer deals. Larger funds that see companies not yet ripe enough for larger investments, or that need some polishing prior to prime time, will refer deals. Former entrepreneurs and a range of board members will refer deals. And there’s clearly a track record of success. Labrador seeded software company Jareva with its first venture capital, helped nurture the company through a Hummer Winblad venture investment and reaped the rewards of a $65 million acquisition by Veritas. That might not sound like a lot of money to some partners at larger funds, but when your first pre-money valuation is $4.5 million or less, the multiples add up nicely.

And deals like Jarevea abound. A company such as EventGnosis, a software play specializing in event correlation (or what Foote calls “extracting information from all the data noise”) might just be the perfect example. It’s a true seed-stage startup seeking its first $1 million in a forest much thinned of capital sources.

EventGnosis is the brainchild of serial entrepreneur Lars Graf, the founder and former CEO of OpenService Inc., who developed the technology over the past several years and has already logged at least one revenue generating sale of the company’s first product, the Orion Development Platform. Without the platform, Graf says, it can take OEMs over one year and well over $1 million to create a single event management application. With the platform, time-to-revenue becomes as short as 90 days, he says.

Yet, aside from established firms like Labrador or Onset, or other smaller funds such as Rocket Ventures or Compass Technology Partners, EventGnosis would have to scour the angel investor landscape for its first seed capital, possibly delaying the company’s market penetration by months if not years.

Note that I am not making an argument that raising early money should ever be easy. Starting companies is a grind; it’s hard work and that’s clearly an essential part of the process-as well as a demonstrable gating factor for just how dedicated an entrepreneur might be.

This is, however, an argument for either existing funds, new funds-or even LPs seeking to deploy more capital within our industry-to no longer ignore the essential and fundamental benefits of true seed-stage and early stage investing.

Not only are valuations more attractive, not only is deal flow more robust, not only is there less competition for entrepreneurs to accept term sheets, but investing earlier cuts to the very notion of why most VCs do what they do. To create and add value within organizations where bandwidth and talent is sorely needed. To take risk in the hope of creating sustainable businesses where quality output, increased hiring, and contributing to the overall health of the economy all go hand in hand. To prime and polish even more companies in order to create an ever better and more efficient channel of mid-to-late-stage startups for further follow-on investing by larger funds.

Thus, to add talent, resources and capital at the earliest stages of company formation essentially adds all of that, and more, to the entire food chain of startups within our industry. For these reasons we should start filling the gaps at the earliest stages of venture capital, helping seed-stage companies keep pace with the money being raised by mid-stage and late-stage companies, allowing startups of all sizes to participate in the much awaited and well-deserved rebound in our industry.

Ravi Chiruvolu is a general partner of Charter Ventures, an early stage venture firm based in Palo Alto, Calif. He specializes in enterprise software, software infrastructure, e-business and wireless. He can be reached at