Disrupting the Traditional VC Model: VC Adaptations for Seed Investments
Daniel Blomquist, Class 16
In 2011, NEA—a venture capital firm with a $2.5 billion fund—started to make investments from a dedicated seed program, writing checks as small as $100,000.1Why would the world’s largest VC firm want to invest amounts typically associated with angel investors?
As an early-stage venture capitalist based in Northern Europe, I wanted to understand what is driving traditional venture capitalists (VCs) to make seed investments, how they are going about it, and what the impact is for both VCs and entrepreneurs. As a result, I spent 12 months interviewing 20 venture funds, primarily in Europe but also in the United States.
In this article, I outline the reasons why traditional VCs are pursuing seed investments, and consider some of the problems associated with seed investments and how VCs are approaching these challenges. I close with recommendations for VCs seeking early-stage companies and for entrepreneurs seeking funding early on.
The VC Disconnect: Traditional VCs Lost Relevance for Many Startups
For many years, there was a strong trend that VCs raised larger and larger funds and tried to deploy more capital per investment professional. From 1995 to 2008, the average U.S. venture capital fund size increased 3.5x from around $100 to $350 million, and average capital per VC principal increased 4x from around $7 to $28 million.2
This approach led to increased focus on later-stage opportunities and an appetite for writing larger investment checks. However, today’s internet startups initially need less capital (figure 1) to get started thanks to open source, cloud solutions, and new distribution channels.
Figure 1. The shift in capital need for startups. Ironically, today’s internet startups initially require less capital.
Marc Andreessen describes one example of this shift in “Why Software Is Eating the World.”3 In 2000 when his partner Ben Horowitz was CEO of the first cloud computing company, Loudcloud, the cost of a customer running a basic internet application was approximately $150,000/month. Running that same application today in Amazon’s cloud would cost about $1,500/month—a 100x difference. Similarly, at Creandum the cost of our portfolio companies getting off the ground to offer web services has decreased 10-100x since the early days of the millennium.
At the same time, startups can get traction very fast. Many traditional VCs therefore face a problematic mismatch between their favored investment size and stage, and the capital needs of the startups.
The change in capital need for internet startups did not go unnoticed. New entrants including accelerators (pioneered by Y Combinator4 and Tech Stars5), super-angels,6 and dedicated micro/seed funds identified the possibility to provide smaller amounts of capital at attractive terms for the founders. On the other end of the spectrum, new entrants with massive available capital (pioneered by Digital Sky Technologies7) started to invest in category leaders at very high valuations. Traditional VCs started to get squeezed out and found it hard to get into the best companies.
The Empire Strikes Back: VCs Adapt to the New Competition
Increasingly, traditional VCs have started to make seed investments—and have even started dedicated seed programs—in order to become relevant to companies in the very early phases. In my interviews, all 20 traditional VCs indicated that the main driver for making seed investments is to increase their odds of being in on the big winners. That said, the possibility to make a better return by having invested at a lower entry valuation is also attractive but not essential. For example, NEA set up their seed program because many of their best investments historically had been seed investments and they wanted a faster and more systematic approach to continue to find and fund big winners from a very early stage.8
Some (5 of 20) specifically mentioned that they view seed investments as options rather than investments, meaning that they primarily make a small investment as a way to purchase information about the company’s progress. As competition is fierce for companies with strong traction, these VCs want to be on the inside and be able to make a “real” investment if the company’s business has taken off.
Another driver (mentioned by 5 participants) is for the VC to be relevant to the best entrepreneurs in all stages, specifically for serial entrepreneurs that the firm has worked with before or wants to get to know.
Different Approaches to Seed Investing
Having established some of the drivers for VCs doing seed investments, in this section I consider the different ways VCs have chosen to structure their seed investments.
I interviewed 20 VCs in the United States and Europe, all of whom focus on technology investments primarily in IT-related industries. They fall into three groups: seed-focused funds, VCs with a seed program, and VCs doing seed investments (see figure 2).
|Seed-focused funds (A)||1||5||6|
|VCs with a seed program (B)||2||2||4|
|VCs doing seed investments (C)||3||7||10|
Figure 2: Participant breakdown.
Seed-focused funds (A)
Many first-time venture capital funds focus on making seed investments. The reason is usually simple: first-time VCs often have small funds, and to be able to build an investment portfolio, these funds have no choice but to write small investment checks at an early stage.
Traditional VCs making seed investments (B+C)
Almost all VCs doing seed investments treat them as an unofficial carve-out within an existing fund. Therefore, there is no separate investment vehicle created for the LPs, nor are the funds allocated to seed investments really committed. This was the setup for 13 of 14 traditional VCs interviewed.
Only one VC had created a separate fund for seed investing; however, this setup came from LP requirements rather than from the VC itself. The VC mentioned that the setup created problems in terms of separate fund raises and potential conflicts of interest between internal resources, as well as between the LPs that were investors in one of the funds (seed vs. traditional early-stage) but not the other.
Some (4 of 20) VCs interviewed have created dedicated seed programs with dedicated resources, and often with a strong marketing message to attract interest from startups looking for seed investments. The investment decisions are very fast and require few General Partners’ approvals. These VCs typically see seed investments as options rather than “real investments.”
Attitude to seed investments: Real investment or option?
As mentioned above, 15 VCs mentioned optionality as the biggest reason for making seed investments. Typically, when VCs see the investment as an option, they allocate very small amounts of money relative to the fund size, and adopt a low-touch approach to the investments and do not take a board seat. As a result, they are typically open to having many investors on board and are not very concerned about ownership stakes at this stage—the main thing is to get in and have the possibility of leading the next round.
However, 15 of the VCs interviewed still viewed their seed investments as “real” investments. The investment process and terms are often simpler and the failure rate may be higher, but these VCs still commit significant time and resources to the investment. In these cases, higher initial ownership becomes more important to match the increased focus on the investment from the firm. The investment size is also often larger, providing the startup with a longer runway to prove itself.
In conclusion, the major driver for VCs making seed investments—independent of the approach—is to get a foot in the door before it becomes too difficult or too expensive to get into the best deals.
Challenges with Seed Investing and Possible Solutions
This section lists a number of challenges with seed investing identified in the interviews, as well as how VCs are approaching these.
There is always a trade-off between time- and resource-consumption on the one hand, and the potential payoff in terms of fund exit potential on the other. For most traditional VCs with large (or very large) funds, the problem is that small seed investments will not provide large enough deal-by-deal returns in absolute numbers to have a big enough impact on the total fund return—even when the exits are very successful.
One good example is when A16Z (Andreessen-Horowitz) made one of the most successful seed investments in history, with Instagram returning $78 million from a $250,000 seed investment.9 With a fund size of $650 million, though, A16Z would need more than eight such exits of $1 billion just to return the fund, something that has never happened in a single fund.
As such, VCs are counting on being able to deploy much more capital in subsequent rounds. They view the seed investment as an optionality allowing potential investment in the larger rounds from A-round and beyond.
Sourcing and investment selection can easily become a very time-consuming task when the number of opportunities also includes seed deals. VCs apply various methods to screen and select the right seed companies to invest in.
The team at Y Combinator (an accelerator) has created a reputation that allows them to cherry-pick among the top startup founders applying for their program. They have also built very strong connections to follow-on investors that use Y Combinator as a stamp-of-approval and even invest in the program itself (e.g., Sequoia10).
500 Startups (in the United States) and Seedcamp (in Europe) both run seed funds on top of their accelerator programs. Coupled with significant assistance from external mentors and advisors, these seed funds have allowed them to select investments in a more scalable manner.
Some VCs (e.g., Greylock, Founders Fund) focus their seed investments on founders they already know from prior investments. Others (e.g., Profounders) have an LP base with seasoned entrepreneurs who use their network to source and vet potential investments.
Another big challenge for VCs doing seed investments is how to handle the larger number of companies in the portfolio, both in terms of making more investments but also in terms of working with the companies as a value-adding, active investor.
Dedicated accelerators and seed funds often have designed their investment approach specifically to manage this issue. They leverage one-to-many interactions (e.g, events, forums, panels) and also add value by having external resources come into their programs. First Round Capital has been a pioneer in creating and investing in a platform for its portfolio companies, which are then able to connect with each other and provide assistance and help without necessarily involving First Round Capital’s partners.11
Some VCs deliberately avoid getting too involved and prefer to have a light-touch approach, even when they traditionally have an active involvement in their (normal-size) portfolio companies. These often rely on business angels or a co-investor to be more heavily involved with their seed companies.
A large number of VCs instead choose a less scalable model: they make fewer seed investments and instead work closely with them. This practice was more common among the interviewed European VCs than the U.S. VCs, and can mean taking a board seat.
Follow-On Investment Decisions
With more investments also comes the agony of more follow-on investment decisions. Successful VCs are generally very good at investing in the right companies but also at not continuing to invest in the wrong companies.
Good seed investors establish clear criteria and preferably have metrics and analytics in place, allowing them to evaluate companies and decide which companies should receive additional investments. They are also very disciplined in not investing further in companies that are going sideways or downhill.
One challenge repeatedly raised, especially from the entrepreneurial side (extensively covered by, e.g., Chris Dixon,12 previously an entrepreneur and now at A16Z), is the issue of signaling: what happens when a VC that made a seed investment no longer wants to invest in the company. This provides other potential external investors with a bad signal, as they wonder why the investor on the inside would decide not to invest.
VCs try to reduce this problem in several ways. As an example, Sequoia and others have even been offering angels (called scouts13) money on their behalf for investing in the startup, to reduce the expectation of the VC necessarily investing in the next round. Others sell back the shares to the founders or other shareholders before the next round of financing.14
Recommendations for VCs Doing Seed Investing
From my interview data, I have gathered a few recommendations for VCs making seed investments, highlighting some of the ways VCs are approaching the challenges with seed investments.
Select the Right Model Based on Market Conditions and Firm Capabilities
Less competitive markets usually offer better possibilities to evaluate startups and cherry-pick the most attractive seed investments. Alas, in such markets there may be less need for seed programs or for a “spray and pray” investment approach.
This is the case in the Nordics, for example, where I have spent the last six years investing. Here, many companies even in the seed phase have come further and can show more market proof before they receive seed investments, compared to Silicon Valley. We have repeatedly been able to make seed investments in companies with products in the market, strong growth in terms of usage, and even revenue and teams that have built the product and company for twelve months or more.
In any market, it is important that the firm’s culture and capabilities match the chosen seed strategy. A firm that is used to making follow-on investments in all its portfolio companies may find it hard to start adopting a very disciplined approach of killing off seed investments it has already made.
Be Disciplined and Design Clear Decision Processes for Follow-On Investments
Seed investing requires strong discipline and methods of evaluating which companies to continue to back. Many VCs testified to the lack of discipline in follow-on investing as the main reason for unsuccessful seed investing. It usually helps to have a strong sector focus, supported by metrics analytics to compare and evaluate companies.
Practice Transparency and Signaling
When a VC stops supporting a company, there is a big risk of bad-mouthing in the entrepreneurial community (especially smaller communities such as the Nordics). Also, if there are few active investors in the ecosystem, the issue of signaling becomes more profound. Usually, the best way to address this potential issue is to be very transparent about your approach, both to fellow VCs and entrepreneurs.
Scale Investment Resources
Building a large portfolio of seed investments is time- and resource-consuming, so finding ways to leverage the VC team is crucial. This can be achieved by exchanging ideas and experiences between the companies, or by utilizing angels and advisors and incentivizing them for being involved with portfolio companies. The latter can be accomplished, for example, through advisors (500 Startups has more than 50 mentors associated with the seed fund15) or Limited Partners (ProFounders’s investment partners are investors in the fund and available for its portfolio companies).
Ensure Senior Partner Involvement and Buy-In
For VCs that have specific seed initiatives and programs, it is imperative for General Partners to be actively involved in the design and execution of the seed program as well as the seed investments. Otherwise, there is a risk that the seed investments and the associated portfolio companies are perceived to be less important, both internally and externally.
Advice to Entrepreneurs Seeking Seed Financing
As an entrepreneur, it is often critical to understand the motivation and approach of the VC you select as an investor. My interviews with VCs generated the following recommendations for entrepreneurs selecting VCs for seed rounds.
Avoid Party Rounds
It is not unusual to see seed investments with several lead investors as well as a large number of smaller investors each getting very small ownership points. In this scenario, many entrepreneurs have experienced that instead of getting a vast pool of talent, resources, and investments for their company, no one really gets involved in supporting them if things don’t develop exceptionally well. As a result, I recommend having a clear lead investor in the seed investment stage to improve the chances of support both until and in the next fund raising.
Understand the Follow-On Investment Process
Finding out whether the VC is making the investment as an option or as a real investment can be very important, as this difference can strongly affect the possibility of getting additional financing. This can be done by, for example, asking the investor what the follow-on investment process looks like, checking their track record of how many (or few) companies they have provided with follow-on investing, and taking references from other seed-financed companies and asking them about their experiences with this investor.
Identify the Resources Available and Accessible
In a VC seed program, typically very few resources are provided on a one-on-one basis. For startups that know this and proactively address it, the seed program can offer great value—but for startups expecting to receive a lot of assistance, it may prove disappointing.
Try to evaluate the likely level of involvement from the VCs. Ask them how involved they are with their investments and in what form they are trying to add value. Again, check with portfolio companies and see what feedback they provide in terms of understanding how the VC operates and also how to best extract value from working with them.
Many VCs have found ways to provide value at scale, for example, in the form of theme-based sessions where portfolio companies meet each other as well as relevant external companies, or through platforms to connect and share. The main point is for the seed company to be aware of what to expect from the investor and to actively decide whether or not the investor provides a good fit.
Current State of Affairs
Recently, there has been much discussion about the Series A crunch.16 Seed funding has exploded (by angels, accelerators, and VCs) since 2007, but the number of possibilities for follow-on investment has remained fairly constant, so relatively fewer companies are getting follow-on investment.17 CB Insights has provided data showing that in 2009, there were almost the same number of seed deals and Series A deals, but in recent years seed funding has increased 3-4x while Series A deals have remained relatively flat.18<
One could argue that this will mean traditional VCs can comfortably remain focused on the A-round instead of doing seed investments. However, in competitive markets there is likely to still be pressure to get in early, especially for VCs whose brand does not set them apart or whose fund size does not allow them to pay up for the best deals.Therefore, it remains imperative to understand how VCs have adapted to making seed investments. By comprehending the drivers, methods, and best practices for making seed investments, VCs and entrepreneurs alike can optimize returns.
Daniel is a principal at Creandum, a leading Northern European venture capital firm based in Stockholm, Sweden. At Creandum Daniel primarily focuses on SaaS and games companies and is leading the firm’s seed investment approach. He works with a number of Creandum’s portfolio companies as a board director or observer, including Aito, itslearning, Nonstop Games, Wrapp, and iZettle. Daniel has a solid startup background from the software sector and significant international experience. Prior to Creandum, he was Vice President of Marketing at Ascade, a leading international telecom software company. Daniel holds an M.Sc. in Industrial Engineering and Management–International from Linköping Institute of Technology and EPFL in Lausanne, and an MBA from Stockholm School of Economics.
1 Patrick Chung, personal communication, November 2013; Alastair Goldfisher, “NEA Seeks Seed-Stage Deals,” Reuters Entrepreneurial, 2 June 2011, para. 3.
2 Basil Peters, “Venture Capital Firms Are Too Big,” AngelBlog 2013 post, graphs 1–3.
3 Marc Andreessen, “Why Software Is Eating the World,” The Wall Street Journal, 20 August 2011.
4 ycombinator.com/; for more information, see Tomio Geron, “Top Startup Incubators and Accelerators: Y Combinator Tops with $7.8 Billion in Value,” Forbes, 30 April 2012.
5 www.techstars.com/; for more information, see Geron, “Top Startup Incubators.”
6 E.g., Pui-Wing Tam and Spencer E. Ante, “‘Super Angels’ Alight: No Longer Flying Solo, Big Investors Attract Others to Juice Start-Ups,” The Wall Street Journal Finance, 16 August 2010.
7 For more information, see Bobbie Johnson, “Why Facebook and Silicon Valley Owe It All to Moscow,” Gigaom, 8 May 2012.
8 Patrick Chung, personal communication.
9 Ben Horowitz, “Instagram” (blog entry), A16Z, 22 April 2012.
10 Leena Rao, “Y Combinator Closes New $8.5 Million Fund, Sequoia Is Lead Investor,” TechCrunch, 21 May 2010.
11 Semil Shah, “’In the Studio,’ Kent Goldman Discusses First Round Capital’s Approach,” TechCrunch, 20 September 2012.
12 Chris Dixon, “The Importance of Investor Signaling in Venture Pricing” (blog post), 11 March 2010.
13 Colleen Taylor, “Sequoia Capital Is Raising a New Dedicated Fund for Its Stealthy ‘Scout’ Seed Investing Program,” TechCrunch, 19 February 2013.
14 Brad Feld, “Addressing the VC Seed Investor Signaling Problem,” FeldThoughts, 7 September 2010.
15 AngelList, “500 Startups,” n.d.
16 E.g., Sarah Lacy, “The Series A Crunch Is Hitting Now. Have We Even Noticed?” PandoDaily, 28 November 2012.
17 E.g., Sarah Lacy, “Finally, Actual Data: Series A Crunch Will Kill 1,000 Companies, $1B in Angel Money,” PandoDaily, 19 December 2012.