VC Seed Funding is Dead, Long Live VC Seed Funding!

This is part of my ongoing series about Raising Venture Capital. This posting was inspired by an email from Rajat Suri who wrote me an email in response to Chris Dixon’s blog post (link below) from August, which recently re-ran on Business Insider and has generated much Twitter chatter.

A few years ago it became fashionable for large VC’s to do seed funding.  With open source software (LAMP stack) and cloud computing infrastructure it just wasn’t that expensive to get your company going and founders just wanted to raise less money.  Some larger VCs felt they were being “scooped” by some younger, nimbler and smaller VCs.  So they set up seed programs that allowed for rapid decisions for $500k or less, often done as convertible debt for both speed and cost reasons.  There are multiple firms that did this.

I was an early cynic.  I told entrepreneurs that it was a bit of a Faustian bargain.  If the large VC doesn’t agree to do your A round then you’re in a bit of trouble.  Why?  Because as a potential A round investor I’m thinking to myself, “if the large VC seed investor has been in the company for 9 months and isn’t leading the round then something must be wrong.  Surely they have more information than I do.”  And I think this line of thinking has started to become conventional wisdom as outlined in Chris Dixon’s excellent blog post saying that you need to be careful raising seed money from a large VC fund.

But I’m no longer an entrepreneur – I’m a VC at a $200 million fund called GRP Ventures, the largest active fund in Southern California.  And I’ve just completed my first seed deal of Ad.ly ($500k) with another exciting deal I hope to announce within 30 days.  What gives?  Am I a hypocrite?

Actually, I’ve changed my views slightly on the issue.  I still believe you need to be careful taking seed money from a large VC, but I believe the arguments for/against are more nuanced than I had previously thought (and times have changed).  Arguments for/against after the jump …

1. I do think you need to be careful with funds that have done 20-30 seeds deals in fairly rapid succession.  Talk to companies that have taken this money and see if they’ve gotten support.  I have spoken at length to one such entrepreneur who tells me that he hardly hears from his VC.  He was told informally that they view him as an “option” whereby they can wait and see if another VC makes an offer.  If a VC term sheet comes in they begin their due diligence process.  I recommend you do your own due diligence before deciding whether to take this money.

2.  The contra is also true.  Many VCs who do lots of seed stage deals are very supportive and active.  Look at Josh Kopelman over at First Round Capital.  I think they definitely qualify as a VC and not a seed fund.  They do many early-stage deals.  Yet talk to virtually any FRC company and they’ll tell you that these guys are some of the most active board members and offer some of the best advice in the industry.  I sit on a board with Howard Morgan of FRC and I can tell you this guy works harder than most and has a punishing travel schedule.  I would say the same thing about True Ventures.  I haven’t met a single founder has hasn’t raved about their experience working with Jon Callaghan, Phil Black or Tony Conrad.  They have a large-ish fund.  But they do small, seed like investments when they like the entrepreneurs.  They’re active, helpful and wise.  And how about Andreessen Horowitz?  I know the jury is still out since they’re so new but I know many entrepreneurs eager to work with them.

3. What exactly is seed funding anymore?  Entrepreneurs want less cash because they want to control dilution and preserve exit options at lower prices.  One of the hotter companies lately in the mobile social networking is FourSquare, which raised $1.35 million from Albert Wenger and Fred Wilson at Union Square Ventures and O’Reilly AlphaTech Ventures.  Is an average of $675k each a seed deal?  Anyone doubt that Union Square and Bryce Roberts will be active?

4. You also need to ask yourself the reverse question.  Are there inherent risks in taking angel money?  If you have a VC that’s bought into you and your business then it’s far easier to put together a bridge round with a VC if you need that $1-2 million to get to your next milestone.  I know raising new VC in the past year has sucked.  But if you already had a VC chances are they tried to find a way to help you preserve your business in the down market.

Many angels were forced to fold given their tremendous losses in real estate and the stock market.  I’m a big fan of having angel investors, don’t get me wrong.  In SoCal we have great operators like Klaus Schauser, John Greathouse, Matt Coffin, Kamran Pourzanjani and others.  In NorCal there are legends like Ron Conway, Jeff Clavier, Mike Maples and the Energizer Bunny, Dave McClure (and I’m CERTAINLY never going to say anything bad about my friend Dave after reading this awesome blog post)-

I think having the right angels involved at an early stage is critical.  I prefer to see deals that have great people around the table before they come to me both as validation and because I know that the company will be more focused once it’s worked with these teams (not to mention having cash so they’re further along).  But unless you get top-tier angels who have deep pockets don’t assume that angels are necessarily a better option than VCs.  Might be, but not a given.

5. I’d also say that I’m not quite as negative about funding someone else’s seed deal anymore.  I now know that the mega funds that did too many seed deals aren’t paying enough attention to them.  So I’m not put off by the fact that I’ll be used as a stalking horse or that there is something wrong with the company provided I’ve spent quality time with management and can make my own assessment about the team and business.

6. Chris talks in his blog post about your A round pricing being lower if you have a VC seed investor.  His argument is that when you find a new VC to invest there will be some kind of collusion between the A round investor and the inside seed investor.  I could definitely see that happening.  But I’m not really sure it is necessarily so. Pricing a new round is always a function of how competitive the deal is so just because a VC seeded the deal doesn’t drive down price if 3 VCs are competing for the deal.

I told Sean Rad at Ad.ly when I invested that I’d like to do his next round but as a VC I can never guarantee that I will (nor would an angel).  I told him he’s free to shop around the deal and see what price the market will pay.  I also said we’d like to co-lead the next round if an external investor is so inclined.  I can’t see how Sean is any worse off with me than he would be with angels?  In many ways I feel he’s better off.  As a decent size fund we’ve validated the team and concept.  And if he’s performing well (he is) and wants to do a quick round to avoid a lengthy funding raising process he has the option of talking with us about doing his A.  As I always tell entrepreneurs – it’s far easier to talk with VCs when they’re already partially pregnant.

So how can I justify doing seed investments?

Simple.  I plan to do a few but not so many I can’t manage them.  I have 3 total companies I’ve invested in this year (2 A’s, 1 seed) – soon to be four.  All of these are referenceable.  I think all of the founders would tell you that I’m active, supportive and engaged in their businesses, customer interactions and talking about future fund raising requirements.  If you talk with the founders of the 3 businesses where I wrote personal angel checks for I think they’ll tell you that I’ve actively helped with their fund raising processes.

When we funded our two seed deals we used the Y Combinator Open Source Term Sheet and were highly entrepreneur friendly.  I offered a WAY cleaner term sheet than any angel “club” deal that I’ve seen in SoCal or even from the seed fund investors themselves.

See, I don’t think it’s a question of To VC Seed or Not to VC Seed, I think it’s the age old question of who you’re working with and how well they reference.  I’m surprised at how little referencing some founders do on their VCs.  I’ll save that for another post.

You’re never going to have a gaurantee with ANY investor that they’ll commit to the next round.  But great companies who choose great investors invariably have an easier time.