Seed investing has recently gained visibility in venture capital circles with the formation of several funds, such as First Round Capital, and even formal programs within established VC firms, such as Charles River Ventures’ QuickStart program. However, despite the perception that seed investing has been the sole purview of angels, most early stage VC firms have historically engaged in selective seed investing. At Woodside Fund, for example, about 20% of our portfolio companies were seeded with less than $1 million, and most of those were founded with our help.
Given that entrepreneurs have become smarter about taking too much money, and that starting certain kinds of businesses (notably in Web 2.0) requires much less capital, moving earlier stage and placing less money makes sense for most early stage VCs. However, seed investing differs from traditional early stage, not just in the size of the investment, but in structure and expectations. Here are three pitfalls that investors need to watch out for:
• The often-used bridge loan as a seed investment structure can create misalignment of incentives between investors and entrepreneurs.
• High quality entrepreneurs may prefer seed investment from angels instead of VCs, because it’s easier to raise the next round.
• If a fund is doing many seed deals, the success of the seed program for the VC depends on a fairly high attrition rate.
To bridge or not to bridge
Bridge loans are the most common form of seed investment, and there are good reasons why they work. They are quick and convenient to structure. They avoid messy discussions around valuation and ownership percentages. The capital structure is simpler, with fewer classes of stock. And by not setting a valuation, the company doesn’t get “anchored” for a Series A valuation discussion.
Bridge loans can also create alignment problems, however. When the Series A comes along, the bridge holders have a financial incentive to convert at as low a valuation as possible, which may put them at odds with the entrepreneurs. Sometimes the new Series A investors object to the amount of discount or warrant coverage that the seed investors have negotiated. And seed investors may insist on equity-like terms for the bridge, which makes them nearly as complicated as equity rounds. (For more detailed discussion of this issue, see the blogs mentioned at the end of this article.)
Entrepreneurs may prefer angels
When the Series A comes along, the bridge holders have a financial incentive to convert at as low a valuation as possible, which may put them at odds with the entrepreneurs.
Tom Shields, Managing Director, Woodside Fund
An experienced entrepreneur considering seed investment from a firm that would be traditionally considered a Series A investor will ask himself what happens if the VC chooses not to go forward. A traditional angel is not expected to participate in or lead the Series A, but with a traditional VC, as Jon Callaghan says, “if the insiders won’t support it, why should we?” Of course, this could be an issue in any round of financing, but it is particularly acute at the seed stage. At Woodside Fund, we have had one case where we did a Series A investment after a seed investor declined the option, but it definitely made it harder, and that entrepreneur is much less likely to take seed from a traditional VC next time.
More time, not less
Just because a company takes a small amount of money does not mean it takes less time. Most early stage VCs claim to add quite a bit of value to their entrepreneurs, helping with recruiting, strategy, resources, customers, etc. Seed stage companies usually require more of this than more mature Series A companies. And yet, this kind of program contemplates investing in an increased number of companies given their small investment size. Where will the time come from?
The investment thesis most VCs have for doing lots of seed deals is that it’s a small amount of money that is designed to prove that a business model or technology is possible and/or preserve option value. In many cases, the business model or technology will not prove to be quite as fantastic as the entrepreneur predicted, and the option will be declined. In fact, the dictates of portfolio theory (and investor time) almost require that most of the options be declined. Experienced entrepreneurs understand this as well, and this comes back to point No. 2 above, that they may prefer to take funding from true angels.
At Woodside Fund, the way we address the above issues is through complete transparency. As with any investment, we work with our entrepreneurs to clearly define which early milestones are necessary proof points to the ultimate success to the business. Defining these milestones brings clarity to the appropriate amount of capital to be raised (always remembering that it will cost more and take longer), be it a small seed round or a large Series C. If the milestones are met, everyone is happy with a nice up-round. If things do not work out as expected, it is better to find out earlier so that both the time and money of entrepreneurs and investors is kept to a minimum. We find that transparency and setting realistic expectations go a long way to preserve our relationships with our founders, even when things go wrong.
To date, we have found that taking the time to work closely with our investments generates better outcomes than just doing more deals. We look for areas where we can add value, and make returns for our investors. But we also remember when we were entrepreneurs, and we work very hard to make every investment successful both for us and our company teams.
Tom Shields is a Managing Director with Woodside Fund, an early stage venture capital firm in Silicon Valley. This article was adapted from a post on his blog at www.oxyfish.com. He would like to give credit for some of the ideas explored here to the blogs of Josh Kopelman, a managing director at First Round Capital who blogs at redeye.firstround.com; Fred Wilson, a partner at Union Square Ventures who blogs at avc.blogs.com; and Jon Callaghan, a co-founding general partner of True Ventures who wrote a blog about seed investing at pehub.lndo.site/wordpress/?p=217