Understanding the Risks of VC Signaling

Posted on Apr 3, 2010 | 92 comments


CatcherThis is part of my ongoing series on Understanding Venture Capital.

I recently wrote a blog post on understanding how the size and age of a venture capital fund might affect you when you’re raising money.  Because it is a “series” I plan to get into some of the deeper complexities of funds such as “cross over funds” and “why VC’s hate to price their own deals” at a later stage. The last post was a high-level primer.  I know many super experienced entrepreneurs who don’t understand the basics of how fund size and age can affect them so I thought it was worth establishing a baseline.

Chris Dixon provided some commentary on Twitter that he believes my last post missed “the most important point about fund size.”  He’s specifically referring to his point of view that entrepreneurs shouldn’t take seed money from “big VC’s” (he defines them as > $100 million).  It actually wasn’t the point of my post – my point was just to get people thinking about the issues of size and age in the first place.

But I understand Chris’s sentiment and in certain situations I agree.  But while he’s directionally right that there are risks, he’s wrong to rule out all VC’s who do seed investing.  Yes, I’m a VC who does seed investing so I have a bias.  But Chris is a seed investor who competes for deals with VCs so the bias runs both ways.  I bet if we discussed the issue live we’d probably end up agreeing more than disagreeing.

Let me elaborate:

1. The problem with VC Seed Funding – Chris is right to raise the issue with entrepreneurs because there have been instances where large VC funds have set up seed programs where the investments have been used as “options.”  There are many problems with this.  First, if the VC does 15-20 of these under one partner then it is certain he can’t spend any time with these investments.  And they don’t.  I believe these VC funds have suffered some amount of reputation fall out.  In a world of The Funded, VentureHacks and entrepreneur blogs this kind of information spreads like wildfire.

Second, more damning is the “signaling problem.”  This means that if a VC invests in your seed round and does not participate in a future round the next round investor will think to himself, “well, if Big VC Co. invested in the seed round they have more inside knowledge than I do.  If they’re not willing to fund the next round then something must be wrong with this company.”  This is true and does happen.

Third, he notes that even if they do invest they’re likely to do so at a lower price because you can’t truly get an independent valuation.  He says that if somebody new looks at the deal they’re likely to call the seed investor and collude on a price that is artificially low.  I’m sure this happens, too.  But I’m also sure it doesn’t happen all of the time.  As always it comes down to competition.  If you have several new investors looking at your company you’re likely to get  higher price.

2. Why are VC’s really doing seed deals? There are several reasons why VCs are doing seed investments.  One of them is simply that more entrepreneurs don’t require as much money to get through their first milestones.  When I was first starting companies in the late nineties it took $3 million just to get version one of our product out the door.  We had to buy expensive Sun servers, Oracle databases, Unix licenses and build complex software.  Bandwidth and hosting charges were expensive.  These days solid entrepreneurs can get their companies through the first 12-18 months for $500-$750k.  So if a VC wants to work with really talented early-stage entrepreneurs there are times where they have to be willing to seed fund them in order to be in the deal.

This was the exact case on my first two seed deals (and as a $200 million fund I fall into Chris’s “big” status – although I certainly don’t feel that way ;-) ).  My very first seed deal was a company that told me flat out that they didn’t want to raise more than $500k.  We offered them more : $750k-1 million.  They said that they didn’t want the extra money or dilution.  We took the $500k.  We used the Y Combinator open source term sheet.  We signed the term sheet within 48 hours and had funded in under 2 weeks.

How did it go so quickly?  I knew the team for 2 years and had tracked their company through to pre-launch.  We funded it just before they took the wrappers off of the company.  They were grateful for the extra money as their launch was overwhelmingly successful and they had to rapidly hire staff to support customer demand.

It’s true that some VCs view seed deals as options.  I do not. I’m not the only VC who feels this way.  The deal I described has gotten just as much attention from me as the A round investments I’ve done because I haven’t done 15-20 seed deals – I’ve done three.  The seed nature to me are just the size, price and risk factors – not a pure “option” to see what happens.

3. Signaling problems always exist - What Chris doesn’t make clear is that signaling problems exist with nearly EVERY investor.  If you raise angel money that’s another story.  But if you raise from any fund and unless the fund has a 100% consistent policy that they will absolutely never do a follow on investment then a signaling problem exists.

Let me give you an example.  A very well known early stage fund used to have a rule that they didn’t do “follow on” investments.  Life seemed easy as they told all investors that their model was to lead the first round and not to follow on.  The problem is that all investors speak with each other.  And I learned through the grapevine that they had done a very small number of follow-ons for their most promising investments.  They didn’t announce that – it just happened.  So once I knew this my obvious question on the deals that I looked at was, “ok, are you investing?”  You can’t avoid it – signals always exist unless a fund is 100% absolute in its rules.

Or … you raised your $500k from angels and now are ready for a VC “A” round.  You’re trying to raise $3 million at a $6-7 million pre-money (e.g. “A” investors will own 30-33% of your company).  Well, if you raise that VC money you’ll have the signaling problem if they fall out of love with your company in the future because you’re not performing well.  The reality of raising venture capital is that you’ll always have some signaling risk- frankly, there’s almost no way around it.  It’s an occupational hazard.  Your best antidote to the signaling effect, I’m afraid, is to perform reasonably well.

Let me give you another example.  Let’s say you’re an EIR (entrepreneur in residence) at a VC firm.  You were there for 9 months and then you left and created a company 15 months after you left.  If that VC doesn’t invest people will ask why.  That’s signaling.  You’ll have your reasons and some VCs will get beyond that.  But it’s a signal nonetheless.

Different scenario:  You’re on your second company.  A prominent VC funded your first company but isn’t currently investing in this company.  Think that’s not a signal?  Think again.

Or you’ve never done a startup but your last boss from Google, Facebook or Yahoo! is now a VC.  Many are.  They didn’t invest in your company?  Signal, signal, signal.

OK, so your boss didn’t become a VC.  You were a VP at a startup company that sold for $100-200 million making the founder very wealthy.  You’re startup raised angel money and is now looking for VC.  That founder wasn’t one of your angels.  Think that the VCs looking at your deal won’t wonder why?  Think they won’t call him?  Signal.

It’s very hard to completely get around the signaling problem.  It always exists.  I agree with Chris that it is more prominent when a big VC invests in the seed round of your current company and doesn’t follow the investment.  But if you raise money from a small seed fund and they don’t want to follow (and you’re not able to immediately raise new money) you’re equally screwed.

3. The problem isn’t whether or not to take seed money from a big VC, it’s which VC you are working with – I’ve written about good VC seed investors before in this post about taking seed funding from VCs (if you’re very interested in the topic it’s worth a read even though it’s similar to this post).  Fred Wilson of USV invests in seed deals including in Foursquare where they split a $1.35 million investment with O’Reilly Alphatech Ventures (OATV).  I think Fred qualify as both an active investor and one in which you’d be delighted to have on your team.  He’s also an investor who isn’t shy about following on at deals in which a new VC does not come into the next round.  And he works at a “big” VC.

Brad Feld at Foundry Group also invests in seed deals (this is a great post worth reading on Brad’s views of seed deals).  In fact, 7 out of Foundry’s first 16 investments were seed deals.  Foundry is both stage agnostic and syndication agnostic.  They don’t mind being the lead investor on deals that they seeded.  How many entrepreneurs wouldn’t kill to have Brad and/or Foundry in general involved with their company.

First Round Capital meets Chris’s definition of a “big fund” and they do seed and A round investments.  They also do follow ons so Chris’s point about signaling exists with FRC as it does with most investors.  I’ve never met a FRC CEO has has anything but positive things to say about the fund and their involvement with portfolio companies.  Sometimes they’re “over the top” effusive about FRC!  FRC is the most innovative VC out there now.  They’ve found a way to get leverage for their high volume of investments by running CEO Summits and special industry events beyond what many VCs provide with their lower volume of investments.

Same with True Ventures.  Their entrepreneurs are evangelical about how great it is to be part of True’s portfolio.  Big fund.  Great reputation.  Seeds deals.  Would you not take money from them?  I would.  In fact, I nearly did at my second company but we were bought by Salesforce before we raised our round.  True was my top pick to work with in Silicon Valley.  They seemed to have a different way of working than most VCs, which I found appealing.  And I know that True has done some very small seed deals as well as some larger A round deals.  They seem to be managing fine with both models.

And then there is my firm, GRP Partners.  I’ve made 3 seed investments out 5 total investments over the past year.  Two of the three were at the founders’ request.  In one of the three instances the company is now raising more money.  I proactively offered the CEO to fund the company without any other investors having to come into the deal to lead it.  I gave him what I consider a very fair price.  I then told him, verbatim, “I feel this is a fair price.  You’re more than welcome to shop around on Sand Hill Road for as long as you want.  I’ll take the whole round, half of the round or my prorata.  If you shop it be aware of a few things: 1) your information will be widespread in Silicon Valley including amongst your competitors (this is just a reality) and 2) it’s likely to take 6-8 weeks to get through the process if you’re doing well.  If you accept my terms you’re done.  Cash in bank in 30 days.  Your choice.”

It wasn’t an easy decision for the team.  It was sincere in my offer.  They elected to sign my term sheet.  Chris might say that they could have gotten a higher price had they shopped it.  He might be right – we’ll never know.  But the highest price possible is not always the best outcome for the company.  I gave them a “high” price by Chris’s definition in his post on not taking seed money from VC, but I didn’t give them a “Foursquare Price.”  But importantly, there was no signaling effect.  By offering to take half the round or my prorata I fully enabled the company to do whatever they needed to do.

Entrepreneurs – please take note.  I know you’ve all read Chris’s post because so many of you have told me so.  He makes many great points so if you haven’t read it you should.  But the reality is that in life it’s far more important to look at the whole picture.  Make sure you know the reputation of the people you’ll be working with.  I’ve covered that topic in this post on how to reference check your VC.   If they blog make sure to read what they think because they make much of it known in writing.  I’ve made my entrepreneur thesis clear.

It’s not black-and-white.  It’s more important to pick wisely with whom you work at an early stage.  Whom you work with is more important in my opinion than it is whether they’re a seed fund or a VC fund.

4. The plus side of good VC’s doing your seed round - I just want to hit one last topic that is worth noting.  There is one point that Chris leaves out of his post.  There can actually be a positive side of a “good VC” doing your seed round.  I like to talk about seed investments with entrepreneurs in these terms:

a – if your company sucks wind don’t think that you’re guaranteed to get a follow on from me or from anyone else.  if you completely miss the target you’re dead no matter whom you raise the money from.  So a good VC fund or seed fund or angels in this case is all neutral.  You’re forked either way.

b – if your business is “killing it” (e.g. doing really well) then it also won’t matter.  Do you think companies like FourSquare or Gowalla would ever struggle to raise follow on rounds if their early stage VC’s don’t follow?  Or for that matter can you imagine their VC’s not following?  If you’re doing well you’ll have demand

c – so for me the most telling case is when you’re doing “ok” but you haven’t hit major proof points yet.  This is actually what happens the majority of the time at startups so if it’s you, you’re in the norm.

In the “c” case (50%+ of outcomes) let me point out the following.  It’s far easier to get an extra $500k out of a $200 million VC fund to get to your next milestone than it is to squeeze $500k out of 5 angels if they’re not sure you’re performing well.  They often judge your performance on whether VCs show interest.  How’s that for a dilemma?

And more to the point – if you hit a major economic down cycle (like September 2008) you’ll have tough times with all investors.  But it will be much easier to get a small bridge from a VC than one from angels.  Why?  Because angels will have their money in real estate, the stock market, etc. and a VC’s fund has one purpose – startups.

And the final argument I hear is, “I’ll just do angel money now so I can shop my next round to a big VC at a high price.”  Um … that’s fine in scenario “b” above.  In scenario “c” – good luck.  I’d much rather have the fund on the inside and on my team with the ability to bridge me than on the outside.

I am a fan of raising angel money and often tell entrepreneurs to do so.  What I like most is that if your company has an opportunity for an early exit most angels would be delighted.  I’ve written about the fact that I feel most businesses should never raise VC.

But if you plan to try and build a big company then involving good VC’s early can be a benefit.  I think you’ll be just fine taking their money in your seed round and if it’s a small round I don’t believe most good VCs would block an early exit.

And for reference, most “good VC’s” will work with seed funds and angels in seed deals.  In my first deal we took angel money in the seed round (from 2 angels) and an early-stage co-investor in the A round.  In my second seed deal I did the whole round for expediency.  In my third seed deal we co-invested with a seed fund and then syndicated the rest to strategic angels.

And if I ever got the chance to work with Chris Dixon’s fund I’d be delighted.  I like the way he thinks.

  • http://blog.cahootsapp.com/ Brian Sierakowski

    Seems to me a lot of signaling resembles “damned if you do, damned if you don't”.

    The CEO gets funding and buys a new car, is he trying to waste our money? The same CEO gets funding but does not buy a new car, is he too afraid to spend the money? Is he too cautious?

    By this logic, everything you do is going to send a signal, be it good or bad. I think a lot of being an entrepreneur is doing what you think is best for your company at the time, and then owning the consequences if there are any. Worrying about what signal putting on the right leg of your pants first vs the left leg is going to send you into paralysis.

  • http://venturehacks.com nivi

    I want to throw something into the mix. The % ownership a VC takes in a seed round will affect most of the analysis you did here.

  • http://bothsidesofthetable.com msuster

    Brian, I agree. I think “signaling” can be overstated. That said, it's important for entrepreneurs to understand. With regard to VC's who invest and then lose interest … the signaling problem is real and is dangerous.

  • http://bothsidesofthetable.com msuster

    How so?

  • http://venturehacks.com nivi

    For example, if a VC is taking a small % in the seed round (say 5%), they're just buying an option no matter what they say. I don't think they'll be very likely to bridge you in case 4 (c) “you’re doing “ok””. They're going to be working against your valuation in the next round. You have less signaling problems if you can convince next round investors that the seed VC did 15 seed deals and couldn't really pay attention to them.

  • http://bothsidesofthetable.com msuster

    re: very small percentage with 15-20 deals – yes, easier to explain away
    re: VC's who are already investors in your company working against your valuation – that's entrepreneur mythology. I'm not saying it doesn't happen but I've seldom seen it myself. If you do a high valuation they can at least point to their partners and LPs and show how much “value” has been created.

  • http://www.vumedi.com Roman Giverts

    Chris' bar at 100mil may the problem. I think what he really means is funds over 500mil. Union Sq is a 125mil fund with 3 partners, in your case 200mil with 4 partners…. these are all pretty small firms. Purely by his logic, an 80mil fund with 2 partners is ok, but these aren't?

    The point is, you need to analyze your VC a bit more, as you described. If Marc Andreesen wants to invest 500k in your company, are you going to turn him down bc his fund is 300mil with 2 people? Having Marc Andreesen involved might just outweigh the “risks.”

    Also agree that signaling is everywhere, and trying to avoid bad signals is futile. However the rhetoric that a VC can better help with a bridge round is also kind of lame. Quite frankly, picking an investor on the assumption that things might not go great and you will have trouble raising money later is terrible. What kind of insecure entrepreneur thinks like that? Well…. the kind that sells companies for 20-30 million. But the most successful entrepreneurs I know always have no doubt that their company will be incredibly successful and their company will be the next four sq. They're not people who hedge and think, “lets pick an the best investor in the event that we're mediocre.”

    In the end, I think the most important factor is which investor that gives you the best chance of being a large successful business. If that investor is in a 300 million fund and you know that if you turn out to be mediocre he wont give you much attention, well then that's life. Dont be mediocre.

  • http://www.vumedi.com Roman Giverts

    One other thing, I would like to see this debate between a couple ex entrepreneurs who are NOT now investors.
    Let's remember that Mark and Chris are incredibly biased. The purpose of their blogs is not solely to “help” entrepreneurs …. Don't forget that all of this “advice for entrepreneurs” is actually self serving.

    (This is a by far the best blog out there btw, but I'm just saying…..)

  • http://bothsidesofthetable.com msuster

    Hey, Roman. I accept your point that you shouldn't choose your investor based on what happens when you aren't doing well. I'm just saying that I've been in a number of conversations with entrepreneurs who literally have told me, “I want to save you for the next round so I can shop it at a higher price.” Imagine how that sounds to an investor ready to write a check? I'm just pointing out what I've told tons of entrepreneurs when they were talking to other VCs (e.g. not me) about how I would think about it in their shoes. I always say, “in for a penny, in for a pound.” When a VC invests in you and thing go in a normal fashion (e.g. not 4sq) then having easier access to capital is a good thing.

  • http://bothsidesofthetable.com msuster

    Thanks, I think? ;-)

    I know that I have a bias and I stated it up front in the post. I don't write for PURELY altruistic reasons. But much for altruistic than you might think. I enjoy writing. Almost everything I've ever written I've had in 1-on-1 discussions hundreds of times with entrepreneurs so I thought I'd just put it out there in a public and written format. And as scores of entrepreneurs will tell you, I've taken a ton of private calls with entrepreneurs to help them with questions when I had zero vested interest. Not being too defensive – just pointing that out ;-)

  • http://www.stefanobernardi.com/ stefanobernardi

    He actually talks a lot of the valuation he is willing to give, and that is what directly impacts the % he's gonna own. Can't see the point on your comment nivi..

  • http://www.vumedi.com Roman Giverts

    Yeah I know… I wasn't trying to be an ass. just felt like someone
    had to say it, so as not to get too carried away with this debate.

    Roman
    925-548-2640

  • http://www.vumedi.com Roman Giverts

    I understand. all things being equal, then i guess it's good a thing.
    My point is that you don't want to do pick a lower quality investor bc
    you might have easier access to capital later. If fact if you pick a
    lower quality investor, you will most likely need that easier access
    to capital :)

    Roman
    925-548-2640

  • http://bothsidesofthetable.com msuster

    I don't think you were being an ass. You're right to point it out. And it's why I stated it up front. Thanks, again.

  • http://blog.cahootsapp.com/ Brian Sierakowski

    Seems to me a lot of signaling resembles “damned if you do, damned if you don't”.

    The CEO gets funding and buys a new car, is he trying to waste our money? The same CEO gets funding but does not buy a new car, is he too afraid to spend the money? Is he too cautious?

    By this logic, everything you do is going to send a signal, be it good or bad. I think a lot of being an entrepreneur is doing what you think is best for your company at the time, and then owning the consequences if there are any. Worrying about what signal putting on the right leg of your pants first vs the left leg is going to send you into paralysis.

  • http://venturehacks.com nivi

    I want to throw something into the mix: the % ownership a VC takes in a seed round will affect most of the analysis you did here.

  • http://bothsidesofthetable.com msuster

    Brian, I agree. I think “signaling” can be overstated. That said, it's important for entrepreneurs to understand. With regard to VC's who invest and then lose interest … the signaling problem is real and is dangerous.

  • http://bothsidesofthetable.com msuster

    How so?

  • http://venturehacks.com nivi

    For example, if a VC is taking a small % in the seed round (say 5%), they're just buying an option no matter what they say. I don't think they'll be very likely to bridge you in case 4 (c) “you’re doing “ok””. They're going to be working against your valuation in the next round. You have less signaling problems if you can convince next round investors that the seed VC did 15 seed deals and couldn't really pay attention to them.

  • http://bothsidesofthetable.com msuster

    re: very small percentage with 15-20 deals – yes, easier to explain away
    re: VC's who are already investors in your company working against your valuation – that's entrepreneur mythology. I'm not saying it doesn't happen but I've seldom seen it myself. If you do a high valuation they can at least point to their partners and LPs and show how much “value” has been created.

  • Roman Giverts

    Chris' bar at 100mil may the problem. I think what he really means is funds over 500mil. Union Sq is a 125mil fund with 3 partners, in your case 200mil with 4 partners…. these are all pretty small firms. Purely by his logic, an 80mil fund with 2 partners is ok, but these aren't?

    The point is, you need to analyze your VC a bit more, as you described. If Marc Andreesen wants to invest 500k in your company, are you going to turn him down bc his fund is 300mil with 2 people? Having Marc Andreesen involved might just outweigh the “risks.”

    Also agree that signaling is everywhere, and trying to avoid bad signals is futile. However the rhetoric that a VC can better help with a bridge round is also kind of lame. Quite frankly, picking an investor on the assumption that things might not go great and you will have trouble raising money later is terrible. What kind of insecure entrepreneur thinks like that? Well…. the kind that sells companies for 20-30 million. But the most successful entrepreneurs I know always have no doubt that their company will be incredibly successful and their company will be the next four sq. They're not people who hedge and think, “lets pick an the best investor in the event that we're mediocre.”

    In the end, I think the most important factor is which investor that gives you the best chance of being a large successful business. If that investor is in a 300 million fund and you know that if you turn out to be mediocre he wont give you much attention, well then that's life. Dont be mediocre.

  • Roman Giverts

    One other thing, I would like to see this debate between a couple ex entrepreneurs who are NOT now investors.
    Let's remember that Mark and Chris are incredibly biased. The purpose of their blogs is not solely to “help” entrepreneurs …. Don't forget that all of this “advice for entrepreneurs” is actually self serving.

    (This is a by far the best blog out there btw, but I'm just saying…..)

  • http://bothsidesofthetable.com msuster

    Hey, Roman. I accept your point that you shouldn't choose your investor based on what happens when you aren't doing well. I'm just saying that I've been in a number of conversations with entrepreneurs who literally have told me, “I want to save you for the next round so I can shop it at a higher price.” Imagine how that sounds to an investor ready to write a check? I'm just pointing out what I've told tons of entrepreneurs when they were talking to other VCs (e.g. not me) about how I would think about it in their shoes. I always say, “in for a penny, in for a pound.” When a VC invests in you and thing go in a normal fashion (e.g. not 4sq) then having easier access to capital is a good thing.

  • http://bothsidesofthetable.com msuster

    Thanks, I think? ;-)

    I know that I have a bias and I stated it up front in the post. I don't write for PURELY altruistic reasons. But much for altruistic than you might think. I enjoy writing. Almost everything I've ever written I've had in 1-on-1 discussions hundreds of times with entrepreneurs so I thought I'd just put it out there in a public and written format. And as scores of entrepreneurs will tell you, I've taken a ton of private calls with entrepreneurs to help them with questions when I had zero vested interest. Not being too defensive – just pointing that out ;-)

  • http://www.stefanobernardi.com/ stefanobernardi

    He actually talks a lot of the valuation he is willing to give, and that is what directly impacts the % he's gonna own. Can't see the point on your comment nivi..

  • Roman Giverts

    Yeah I know… I wasn't trying to be an ass. just felt like someone
    had to say it, so as not to get too carried away with this debate.

    Roman

  • Roman Giverts

    I understand. all things being equal, then i guess it's good a thing.
    My point is that you don't want to do pick a lower quality investor bc
    you might have easier access to capital later. If fact if you pick a
    lower quality investor, you will most likely need that easier access
    to capital :)

    Roman

  • http://bothsidesofthetable.com msuster

    I don't think you were being an ass. You're right to point it out. And it's why I stated it up front. Thanks, again.

  • http://how2startup.com/ Roy Rodenstein

    - Agree w/all your signaling examples, quite right. Chris is right as well, but I took VC seed after doing DD on them and got the followons just fine.

    - I think you'll get to this later in the series but I too caution entrepreneurs sometimes against “I'll do some Angel now and save VC for a higher valuation later.” You can actually *easily* end up diluting yourself *more* by doing that, unless you go supernova hot.
    The advice I give is that Angel is usually appropriate first money as you're usually still finding Product-Market Fit. The choice of funding should fit your stage, but trying to get clever with it to shave a couple of points off of dilution is usually a bad idea.

    (For any Boston folks I'll be doing a talk on these topics at BarCamp in a couple of weeks)

  • http://www.cdixon.org chris dixon

    Hey Mark – Great post. As you suspect, I do generally agree with you. What I am mainly arguing against is what you describe here:

    – Chris is right to raise the issue with entrepreneurs because there have been instances where large VC funds have set up seed programs where the investments have been used as “options.”

    I think this might be more widespread than you think. A lot of big VCs you and I both work with are doing a lot of this in my view. I'll say explicitly that the firms you mention (GRP, USV, FRC) are NOT the firms I'm thinking of here as being guilty of this, and I do agree taking seed money from them is generally fine.

    I think there is some truth to:
    -What Chris doesn’t make clear is that signaling problems exist with nearly EVERY investor.

    But I do think the signaling is a lot less with “true seed investors” since the bulk of our money is already in the seed round and the follow on money is often a small portion of that and we will often do pro rata or something like that just to be good guys and support the company since its not really a needle mover. A huge difference economically from a VC who put $50K in the seed and is now contemplating whether to put in $5M…

  • http://bothsidesofthetable.com msuster

    Yeah, fair points. And I'm aware it's widespread, which is why I'm glad your wrote your post. I had been warning people about this for 3 years.

  • http://www.linkedin.com/in/rajatsuri rajatsuri

    Chris would you really counsel an entrepreneur who is offered a seed round with a large VC to refuse it? It's a bit difficult to do so. Sure we have to be aware of the risks before making a decision, but most founders will probably (rightly or wrongly) back themselves to blow away the seed milestones set.

  • http://how2startup.com/ Roy Rodenstein

    - Agree w/all your signaling examples, quite right. Chris is right as well, but I took VC seed after doing DD on them and got the followons just fine.

    - I think you'll get to this later in the series but I too caution entrepreneurs sometimes against “I'll do some Angel now and save VC for a higher valuation later.” You can actually *easily* end up diluting yourself *more* by doing that, unless you go supernova hot.
    The advice I give is that Angel is usually appropriate first money as you're usually still finding Product-Market Fit. The choice of funding should fit your stage, but trying to get clever with it to shave a couple of points off of dilution is usually a bad idea.

    (For any Boston folks I'll be doing a talk on these topics at BarCamp in a couple of weeks)

  • http://www.cdixon.org chris dixon

    Hey Mark – Great post. As you suspect, I do generally agree with you. What I am mainly arguing against is what you describe here:

    – Chris is right to raise the issue with entrepreneurs because there have been instances where large VC funds have set up seed programs where the investments have been used as “options.”

    I think this might be more widespread than you think. A lot of big VCs you and I both work with are doing a lot of this in my view. I'll say explicitly that the firms you mention (GRP, USV, FRC) are NOT the firms I'm thinking of here as being guilty of this, and I do agree taking seed money from them is generally fine.

    I think there is some truth to:
    -What Chris doesn’t make clear is that signaling problems exist with nearly EVERY investor.

    But I do think the signaling is a lot less with “true seed investors” since the bulk of our money is already in the seed round and the follow on money is often a small portion of that and we will often do pro rata or something like that just to be good guys and support the company since its not really a needle mover. A huge difference economically from a VC who put $50K in the seed and is now contemplating whether to put in $5M…

  • http://bothsidesofthetable.com msuster

    Yeah, fair points. And I'm aware it's widespread, which is why I'm glad your wrote your post. I had been warning people about this for 3 years.

  • http://www.linkedin.com/in/rajatsuri rajatsuri

    Chris would you really counsel an entrepreneur who is offered a seed round with a large VC to refuse it? It's a bit difficult to do so. Sure we have to be aware of the risks before making a decision, but most founders will probably (rightly or wrongly) back themselves to blow away the seed milestones set.

  • http://www.cdixon.org chris dixon

    If thats's your only option then of course you should probably take it.

    I have seen situations recently where the round is oversubscribed with high quality angel interest yet the founders make room for a VC who is clearly just looking for a foot in the door option. In most cases the founders regretted this later.

  • http://www.cdixon.org chris dixon

    If thats's your only option then of course you should probably take it.

    I have seen situations recently where the round is oversubscribed with high quality angel interest yet the founders make room for a VC who is clearly just looking for a foot in the door option. In most cases the founders regretted this later.

  • http://avc.com fredwilson

    such a great post Mark

    charles river ventures invested in Odeo, sold it back to Evan Williams when Twitter had already launched. i begged CRV to take a big piece of the first round we did in Twitter. but they weren't sold on the deal and were soured from the Odeo experience (rightly so). we went ahead with them doing a nominal amount. they signaled and i ignored it. i'm glad i did.

    the key thing about signaling is who is doing it

  • http://avc.com fredwilson

    that's not true Nivi. we are 10% holders in a company we seeded last fall but have not announced. they could go out and raise a follow-on round and they might. i want to own more so i offered them a pre-emptive offer that is likely higher than market. i can afford it because we already own 10% of the business. our average price will be lower than any new investor.

  • http://avc.com fredwilson

    totally entrepreneur mythology. VCs are bad guys too.

  • http://avc.com fredwilson

    it's a lot like a marriage. many end in divorce. so pick your partner wisely

  • http://avc.com fredwilson

    enlightened self service

  • http://avc.com fredwilson

    this is a great discussion chris. we solve the problem by doing the next round in almost every situation (every one to date btw). we sometimes have to hold our nose and write the check. and we signal by the amount of the check. but if you get one round from us, you are almost certain to get another round. it might be a bridge or two or it might be a small insider round, but you'll likely get another round.

    we do that as an investment in our reputation. we know the money is not likely to generate our target return but its an investment in our franchise. treating entrepreneurs like options is a good way to self select yourself out of the best deals, so its a smart investment in my opinion

  • http://avc.com fredwilson

    we've asked into several angel rounds, etsy is the one i can talk about but you are aware of another chris. i am pretty sure the entrepreneur has not regretted it in any of these situations. so i think this discussion is really about the quality of the firm you do business with not signaling.

  • http://www.vumedi.com Roman Giverts

    Good story! I've never understood the herd mentality of VCs. Of all the people in this world, you would think VCs, especially former entrepreneurs, would be the opposite.

  • http://avc.com fredwilson

    sadly most VCs are herd followers. but not the best ones. sequoia, benchmark, etc can make up their own minds, and do

  • http://www.vumedi.com Roman Giverts

    Yep that's why they're in such high demand. As an entrepreneur I'm
    thinking how do I innovate and not follow the herd! How can a bunch of
    herd followers be the ones who are suppsosed to fund innovation. Just
    doesn't make sense

  • http://www.cdixon.org chris dixon

    I agree. You are doing fairly large seed rounds (500-1M i think?) with the intention of increasing % ownership in most cases versus other firms who are putting in $50K for a pure option. Some of those are thought to be high quality firms. I don't think they are high quality but I it's a combination of firm quality and just how good the investor's intentions are.

  • http://avc.com fredwilson

    such a great post Mark

    charles river ventures invested in Odeo, sold it back to Evan Williams when Twitter had already launched. i begged CRV to take a big piece of the first round we did in Twitter. but they weren't sold on the deal and were soured from the Odeo experience (rightly so). we went ahead with them doing a nominal amount. they signaled and i ignored it. i'm glad i did.

    the key thing about signaling is who is doing it