Some Complexities of Venture Capital Seed Investing

Mark Suster, a partner at GRP Partners, has an outstanding post up this morning titled VC Seed Funding is Dead, Long Live VC Seed Funding. Mark started blogging recently and has quickly turned into my second favorite VC blogger (after Fred Wilson) – if you don’t subscribe to his feed, you should.

Mark just did his first seed deal, a $500k investment in a company called, and his post is a long essay on how he’s thinking about seed investing these days.  He makes the appropriate warning (and differentiation) between VC investors who view seed investments as “options” on future rounds (e.g. they toss a little money in and then generally ignore the company until the next financing) and “active seed investors” (like First Round Capital, SoftTechVC, True Ventures, Union Square Ventures, and O’Reilly AlphaTech) who view the seed investment as their first round of several as they help get a company up and running.

I’ve been making seed investments since 1994.  I don’t know the actual number that I’ve done, but as a VC (starting in 1996) it’s probably more than 25.  In our most recent fund (Foundry Group) that we raised in 2007, we’ve made six seed investments (AdMeld, Gnip, Lijit, Next Big Sound, Standing Cloud, and Trada ) out of 17 investments in the fund to date and have one more that we expect to close this week.  Interestingly, we did only two of these by ourselves; the other four included co-investors such as First Round Capital, Spark, SoftTechVC, Boulder Ventures, and Alsop Louie.

In my world, there is no real difference between a seed investment and a “Series A investment.”  Ironically, when I started doing this, seed investments were the Series A investment; at some point in the last decade a bunch of VCs started saying “we only do Series A investments” so the seed investment became “less than the Series A” investment, although it never got relabeled so you see a lot of Series A (seed) and Series A-2 (the next round after the seed) investment rounds these days.  Regardless, in my world, a seed investment is the first round – when I make a seed investment I’m committed.

VC’s keep reinventing seed programs.  In 1994 when I was first making angel investments with my own money that I got from selling my first company I encountered several VC firms that had “seed programs.”  These firms had an accelerated way to invest $250k in an entrepreneur to help him get up and running quickly.  These investments were always convertible debt that converted into the Series A round at a discount.  The entrepreneur quickly got $250k, the VC got a seat (usually a controlling seat) at the table for the next round, and off they went.  I participated in a few of these – some that worked (e.g. a new VC came in and led the next round) and a few that didn’t (no new VC showed up, the entrepreneurs and the seed VC watched tensions escalate, and eventually there was an unhappy ending.)

Over time, I soured on the “convertible note seed funding” approach.  I’ve written about this in the past, but at the minimum I think it misaligns the entrepreneurs and the early stage VC.  More importantly, in my experience, it’s a signaling device – the seed VC isn’t as committed in a convertible note round as they are when they price a seed round and do it as a typical VC preferred financing, albeit with lighter terms.

One key thing for an entrepreneur to test with a potential seed round VC is whether or not the VC will invest in the next round by themselves.  The specific question is “Do I need an outside lead for the next round, or will you do it yourself?” While either case is fine, this sets the ground rules clearly for financings going forward.  In our case, we are perfectly happy to do the first few rounds of financing ourselves.  Some other great seed investors, especially those with smaller funds need a new investor to lead the next round.  Then there are traditional early stage VCs who have specialized seed programs where the rules of engagement are that there needs to be a new investor to lead the next round.  Knowing where you stand and what the ground rules are before you consummate the seed round is important.

With the emergence of pre-seed programs like TechStars I’ve had more visibility into VC seed investing activity from other VCs.  In Boulder, we just finished year three of TechStars and while plenty of the TechStars companies have their first round of financing include angel investors, I think six of the ten companies this year have (or will) close VC-led seed rounds.  I haven’t decided if there is actually more seed activity in 2009, or if VCs are focused on hunting for seed deals in more qualified places.  Regardless, being a great VC seed investor isn’t a no brainer and I encourage entrepreneurs to make sure they know how their VC investor is going to behave when it comes time to raise the next round.

  • Brad:

    One of the things I never understand is the distinctions people make as investors between seed investments, Series A, late stage etc…

    It always seemed that these distinctions were made because of larger and larger funds – and the need to create free options on the potential success of companies in the future.

    as far as I am concerned, the only reason you should invest in a start up is because you feel that the company has good future opportunity, and you really want to get involved and help the company out in the future.

    If you want to just be a passive investor – get yourself quickly to the public market space! Otherwise dig in and become partners with the founders.

    I fully understand the need to reserve in a fund for future rounds – but I never did understand the need for all sorts of distinctions.

  • While the distinction between seed and first round investors can be pretty nuanced, there is a huge difference between “early stage” and “late stage” investors.  Late stage investors typically don’t invest until a company has demonstrable momentum and usually invest post-revenue.  Some later stage investors won’t even invest until the company is clearly converging on being cash flow positive, while there’s even another category that only wants to invest after the company is cash flow positive.  This is very different than how a seed investor thinks about the world.

    While many of the larger VC firms have both early stage and late stage investors in the mix, most smaller firms have a clear strategy on one or the other.  There are, of course, exceptions, including those firms that claim to have a strategy but don’t really!

  • Solid post, Brad. As a corporate attorney representing entrepreneurs, I often push hard for convertible note seed financing because it is relatively quick, simple and inexpensive – and defers the valuation decision (all of which is discussed in “Mistake #5” here: Indeed, as Bill Reichert of Garage noted on The Frank Peters Show (see – starting at the 22:51 mark): “If you’re putting a few hundred thousand [dollars] in, it’s just not worth all the brain damage to price the round. . . . [and] it’s not worth spending too much on lawyers.” In short, I think entrepreneurs should understand that every deal is different, and there may be compelling reasons for using convertible notes in connection with seed financing. Many thanks, Scott

  • Thanks.  I agree that both the “price the round” and the “convertible note” approaches are totally valid.  There are just different implications and it’s important for the entrepreneurs to understand the differences, especially when dealing with a VC firm. 

  • great post brad.

    one thing i think does differentiate seed funds moreso than money (or size, or terms, or followon rounds) is the ability to provide relevant insight into deals based on operating experience. the other notable common trait with the seed funds you mention is that many of the partners / principals have been entrepreneurs and/or operators themselves.

    • I completely agree – many of the great seed fund investors (but not all!) had previously been entrepreneurs.

  • Feld. Put your money where your mouth is. Invest 100K into my round 1.

    • Do you have anything other than a single slide to look at?   

  • Brad, I can now understand why this is so easy for you and why some other VC's have problems with early stage activities (to do or not to do). Also I can say that there is no need to worry, entrepreneurs dont really see the issue at all – therefore the need to explain.

    I think the most important thing in any deal is for entrepreneurs to learn to know who they are dealing with. Ie. who are the people they are going to be working with. It's as simple as that. Those who have good reputation do work hard to maintain it. Those that dont have good reputation, why would those be in entrepreneurs list?

    I have been following this topic closely for a while related to both our for-profit & non-profit ventures. I think also this topic and specially the following conversation explains why there is a need for more "common language" about these things.

    Something that also new entrepreneurs could understand, developed jointly with Angels, VC's, Entrepreneurs & related experts. We must be able to remove big portion of the complexities involved in early stages. – there just is no way an entrepreneur can digest all of this while bootstrapping the the next great thing.

    • While I don’t worry, I’m not sure I agree that “entrepreneurs don’t really see the issue at all.”  I hear questions about this all the time from entrepreneurs – both first time and experienced.  I guess that’s part of why I write this blog.  I’m sure there will come a point where I’m wasting my time and I’ll stop.

      In the mean time, I definitely agree that there is a need for a more common language.  It’s awesome that we are at the point where we can even talk about this – when I started making investments the whole thing was a total mystery and there was no information anywhere about it (pre-web).  The few books that were available sucked – basically you had to talk to experienced people (if they’d talk to you) and get the info that way.  Today there is an amazing amount of information on the web which is an awesome starting point.  That said, it is becoming overwhelming.   

  • Thanks for the kind words, Brad. Funnily enough, I had already drafted a blog post to be released Monday that I had written 3 years ago citing your blog as my primary source of VC information and my inspiration for wanting to begin a VC blog.

    When I wrote the post I don't think I had fully realized the extent to which you do seed funding – it's good to know. I'll go back and read your "areas of investment" – would be great to find a deal to do together at some point.

    • I love how things come around in a good way!  Keep writing – you are awesome.

  • One terrific advantage of a convertible note is that it quickly brings operating capital into the company that allows you to begin executing on a business plan while bringing the right investors together for a priced round. We saw this at 1000 Markets. We were raising money during the Nuclear Winter and we were burning up a lot of opportunity cost pushing back on really wonky deal terms.

    Interestingly, w.r.t. to valuation and alignment, we didn't see any misalignment from our convertible note partner. It was from traditional Series X type VCs where we got downward price pressure on valuation and saw unfavorable founder terms. The seed funders we met are focused on getting the door with a fast-moving teams: Hence, 8 hour due diligence, 1 page term sheets. Fast balls down the middle.

    The old saw in venture capital, "We invest in the people," is actually something that works both ways. For entrepreneurs, we are just as invested in our seed stage VCs as our VCs are invested in us. So you better like them. Better trust them.

    In our case, we couldn't have found better investors to invest in, or have invest in us. Dave McClure of Founders Fund and Jon Callaghan of True Ventures.

    • Yup – you have great seed investors (Jon and Dave are two of the best).  And the way they do things is – at least in my opinion – the right way to do seed investing.

  • Great post Brad! While my experience is limited to the need of seed capital as it relates to future opportunities for angel investors, I agree with Matthew Trifiro. The seed money we at Napkin Labs have attained is a fantastic bridge to afford our company with time to fundraise for a series A round. Without it we’d lose traction and the ability to position ourselves as a strong and growing company that is worth the investment. Really that is the importance of a convertible note seed round, to get start-ups positioned for more mature and stronger valuations to appropriately attract and manage VCs or added value Angels who will want to lead the round with board related investments and attractive terms that begin to dilute the founders. I should add that added value investors are warmly accepted but I’m sure any will
    find that giving up even the smallest part of their baby is tenious. Convertible notes are to the founders benefit.

  • Brad – where do you see the misalignment piece in convertible debt financings? I read the earlier post on the topic and you seem to suggest both are fine.

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  • jackson

    Convertible notes create a misalignment because the investor is actually penalized for adding value because the note will convert into a smaller share of the company.

  • Brad and readers what do you think about this method?

    First Im a developer/ entrepreneur and not really super crafty with finance.

    Buy a 5-10 yr old shell company with good credit. Bring on an Investor with good credit and some convertible assets. Then using a combination of accounts receivables and the investors credit we obtain $1+ million credit line. Using our monthly receivables we pay the monthly loan payment.

    I realize the loan interest could grow steeply and add issues. I also understand if we hiccup wrong we can screw the pooch. The nice thing is with the growth funds we can hire the needed staff to pay off the loan and grow the company.

    We are running a private-beta "per task" (ticket system) development service for Open Source technologies and iPhone/Android App development. Currently we are booked solid for more than 3000+ hrs a month. We could take 10,000+ if we had the staff. We plan to officially launch in March 2010 after the Chinese New Year as most of our employees are based in China.

    We have had difficulty finding the right Investor because all of our staff is in China. We hire coders at around $500 – $1500 a month so our main overhead is the 30+ day training period where we cannot put the developers to work. Our goal is to grow to 200 developers by 2011 which would put our receivables at about 2 million a month.

    At the same time we are making regular income we are also building new internal startups that all have recurring monthly subscription income. A few even have patents. We started 5 this year. We are trying to grow 10 or more new startups per yr. Having a large development team we can quickly grow.

    I went on a spin-off tangent. My main question is do you think obtaining a loan is a viable method for growing a company? Or do you think it is too risky?

  • I don’t think I know enough about the situation to know whether or not you can obtain the $1m credit line (debt) you are talking about.  If you are cash flow positive, can show that you can pay down the note, and have assets to secure it, it’s certainly possible.

  • VCgate

    There is really no clear distinction between different investment stages due to the fact that the stages are defined by people with different views (you may consider an investment stage A while I can think of it as a seed investment).
    The real issue is that nowadays the situation is the same for all investment stages. You can no longer consider a certain stage more stable than the other, so there is no longer a difference as far as risks are concerned either.
    Check out how many entrepreneurs still get funds and create your own opinion regarding the stages that get most funds, if this is the case, here

  • To maybe help answer whether or not seed investing has increased in 2009, I've looked at a the data a couple times on my blog, most recently here:

    Clearly we're seeing a major VC focus shift to seed investing. Its driven by a lot of factors and in some cases VCs might even be forced to do seed stage deals because of the inability to continue later stage investing. But a lot of it is also the realization that seed investing can be more lucrative, especially if they follow the track of continuing on with later rounds of financing as you mentioned.

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  • thanks for share

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