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 The
Pitfalls of Seed Investing
by Thomas A. Shields
January 01, 2007
Seed investing has recently gained visibility in venture capital
circles with the formation of several seed-stage funds like First
Round Capital, and even formal programs within established VC firms,
like 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 business (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 mis-alignment 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 on this, see the blogs
mentioned at the end.)
Entrepreneurs may prefer angels
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 a 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 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 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 investment
is that it’s a small amount of money that is designed to both
prove a business model or technology is possible, and 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 number two above, that they may prefer
to take angel funding from true angels.
Some solutions
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 proper expectation setting 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 www.pehub.com/wordpress/?p=217.
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