Addressing The VC Seed Investor Signaling Problem

One of the most common criticisms of VC investors making seed investments is something that has become known as “the signaling problem.”  The explanation of this problem is that VCs create a “negative perception” about a company if they make a seed investment but then don’t follow through and make a next round investment.  Another way to say this is that a VC creates a “signaling situation” with their seed investment – if they don’t follow on in the next round they are “sending a signal” that something is wrong with the company (hence the label “signaling problem.”)

Last week I spoke with a partner at a large VC firm whose firm has been around for a long time.  They have a new seed program (as of a few years ago) after eschewing seed investments from 2002 to 2008.  The partner that I talked to told me that they are doing 30 seed investments out of their newest fund.

I was surprised on two levels – the first is that they have a very visible anti-seed reputation.  I pointed out that their market reputation was that they didn’t do seed investments nor did they do many Series A investments.  He said “we changed that a few years ago.”  I suggested that their web site didn’t talk about their seed program; he responded “yeah, we need to work on our web site.”

The second, more important thing, was that I couldn’t make the math work on their fund.  I asked them how many of the seed investments they expected to follow with regular first round investments.  He said “half of them”.  So – 15 of their investments in the fund would come from their seed program.  I asked how many other investments they’d have in the fund.  He said 30.  So they’ll end up with 45 active investments in the fund (high for their fund size) of which 33% came from seed investments.

I then asked how they were going to deal with the “signaling problem” for seed investments they didn’t follow on with.  Here he said something that made me pause: “We’ll sell them back to the founders, the company, or the angels at somewhere between $1 and our cost.”  I probed on this (as in “seriously, can you give me some examples?”)  Without naming names he explained three situations in the past two years where they’ve done this.  And, in each case, his firm had decided not to follow on, took themselves out of the cap table, and the three companies were able to raise additional financing (in one case from a different VC firm.)

I thought this was a pretty clever way to deal with this issue.  While it doesn’t eliminate the problem created by the signaling issue, it addresses part of it.  I don’t know if this firm will follow through on unwinding their positions in 15 of the 30 seed investments they make. I also don’t know how they’ll feel when one of the 15 they decided not to follow goes on to be massively successful and their seed piece, if they had kept it, would have returned a meaningful amount of money to them.  But if they do take this approach it seems like they should shout it from the rooftops as part of their VC / seed positioning statement.

I’m not a fan of this “spray and pray” seed investing strategy for VCs.  Instead, when we make a seed investment, we don’t treat it any differently than our non-seed investments.  Rather than repeat our approach here, take a look at the post How I Think About Seed Investing As A VC that I wrote a month ago.  That said, I found the approach of selling back the seed investment at $1 to be an interesting way to address part of the signaling problem.

  • Roger

    Can you say what firm is doing this?

    • I'll leave it to them to publicize themselves. I'm not sure whether or not they are comfortable with their name being public.

  • How does this address the problem? It makes it look like the VC values their investment at zero – which surely makes the signally problem even bigger.

    My understanding of the signalling problem is it's not about valuation but whether someone should invest in a company at all due to inside information that investor has about the company. This approach is only changing the potential valuation (or dilution) so does not affect the core issue – does the VC know something bad about the company that I, as a potential investor, does not.

    • davidlukas

      I agree, or rather, I have the same question. I can understand how, if the original investors are out of the cap table, then mgmt doesn't have to send new prospective investors to talk to the original seed guys. So, one awkward conversation avoided. But the share buyback has to be disclosed to new investors… Brad, would you find it at all disconcerting that the last investors were so convinced there was no upside that they relinquished their position for a return of somwhere between -100% and zero?

      • I wouldn't be troubled by this, but I understand why many VCs would be.

  • I am not sure how this addresses the signaling problem unless the company never admits that ABC VC invested in the company, but sold out for $1 (or more). That would seem to be almost worse if disclosed and somewhat deceitful if not.

    • You are correct – it's an important point. If the company was an investor but isn't in the cap table anymore because of a stock buy back, one would still expect the company to disclose the previous relationship.

  • It strikes me that the VC you reference is their own worst enemy – a changed strategy that is two years old and not communicated; no attention to their web presence or (apparent) concern over how they appear in the community. They come off like they care less how they fit/look/act into the ecosystem inhabited by entrepreneurs.

    The style of communications and general opacity to Entrepreneurs is what is causing me (and legions of other) entrepreneurs to bias towards new money, in whatever label it takes. I'll take a tougher term sheet any day from a sincere, open and respectful investor that wants to roll up their sleeves and create value together.

    • Well said Perry – I completely agree.

  • I've said this a few times before, but I think the signaling issue is blown way out of proportion. In theory, it sounds bad, but in practice this is a complete non-issue. I was terrified after we raised our angel round from a big VC and then read all the blog posts about how it would signal the end of the world.

    When we went out to raise our next round, our original VC did not participate. Not a single new investor (out of 30) had any issues with it. A few asked, but most simply did not care. In fact, for most, it was a sign of social proof that the established VC was still active (even though they werent putting in more money). We even did a couple of investor pitches at our old VC's office! So all in all, it was a huge benefit to us to have taken that money.

    I personally know two other entrepreneurs who had the exact same experience. So from my experience (albeit limited), I would have to tell other entrepreneurs to stop worrying about this and just go out and raise money from whoever you think is the best fit. There are too many other real problems to worry about when starting a company to lose sleep over this supposed signaling that likely won't affect you in practice.

  • Personally i dont see it as that big a deal. I mean you dont care if Friends and Family dont re-up for the Series A round (for me personally most of my FAF investors couldn't afford the next round even if they loved the company and knew it was on track).

    Make your own decisions as a Series A invesor instead of relying on other people to do your homework.

    • I behave this way, but as davidlukas says above, many VCs don't. While it's nice in theory, most VCs will focus too much energy on "why aren't my other VC cohorts continuing to support the company.

  • I'm skeptical on two fronts. As you say, they don't really address the signaling problem – their investment will be known or otherwise disclosed even if they aren't on the cap table any more. The second issue is more subtle and all companies seeking early stage investment need to understand it – you touch upon it. What are the economics of such investments in terms of the VC's structure and goals. Such investments made by larger venture capital firms are often primarily marketing ploys to attract deals that they might not otherwise be exposed to or to plant hooks for later rounds. This is reasonable, of course, but the actions need to be understood in order for everyone involved to be able to make informed choices.

  • It would be one of the best policies to invest in the areas(themes) VCs know well, and throughly follow through. But even though this kind of "Focus and Grow Strategy" is adopted, all the investments can't be perfectly successful. The most important thing is not to lose good opportunities owing to a short-sighted view. There is no royal road to successfully investing except by having a keen insight into uncertain future.

    When I as a entrepreneur meet VCs, I can make judgements about whether or not they have such ability to do that. If they don't have such ability to that, it must be true not to get along with them from the beginning.

  • Great post, another indication to why you should pick you investors that match the company ecosystem and vision…since there is no break up 🙂


    • PhilSugar

      Actually in this case the VC is willing to do the breakup.

      That in my mind is a really good thing.

      Everybody knows that many deals just aren't going to work out.

      What really sucks is when you don't do a break-up. I'll continue with the marriage example. Its like living with someone where there is no sex (money) and they hate your guts to boot (you aren't going to be their 10xer)

      There is nothing worse than having an investor on your board flailing….month after month year after year. Look you have to take responsibility for the situation as well. You didn't sell the investor on this outcome.

  • PhilSugar

    I think that’s a great way to handle it.

    There are two “options” that VC’s sometimes take that Entrepreneurs hate, they both revolve around not having the cojones to say I don’t like the company and really stand behind that.

    The first is not saying no to a deal but keeping the door open with an ton of bs phrases…

    The second is when you’ve decided its not going to be a breakout deal to just get out of the deal. You don’t like it fine get out.

    Don’t worry about: “when one of the 15 decided not to follow goes on to be massively successful and their seed piece, if they had kept it, would have returned a meaningful amount of money to them”

    You’ve decided its not going to be massively successful have the cojones to stand behind that decision and get out.

  • A fascinating approach indeed. A couple of thoughts/questions:

    1) The startup still has to be able to show how much money it raised to get this far. If I ask the startup about their prior financing and they don’t answer honestly, that to me is an even worse signal — one that I cannot trust the integrity of the founders. If they do answer honestly, then we’re back at the signaling problem, and in fact it’s even worse than before since the VCs pretty much liquidated their position for no value.

    2) When the VCs sell their stake back to the company for $1, what tax implications does that create for the company?

    • Also, since it's a valuation event, how does that affect the strike price of any options issued around that time to new employees? (IANAL)

      • If anything, it'll provide justification for a lower strike price for the stock which is a good thing for an early stage company.

    • 1. Totally agree.

      2. Probably none – it's a realized loss for the VCs but probably just a treasury stock buy back for the company that won't have any tax impact.

  • How does anyone even let them in their deals?

    "We'd like you invest in your company, but there's a good chance we won't be supportive. If that's the case, we'll disavow any knowledge of your existence and cut all ties… which also means we won't publicize our investment in you either."

    Sounds like a great deal. :

  • Mark Solon

    Hey pal, good to be back. I've read the bulk of your summer posts over the last week or two and you covered a lot of ground my friend…

    While it's noble of them to buy the stock back, it really doesn't solve the signaling issue at all Brad. Everyone knows everything these days, period. You can't burn the docs, they'll come up in due diligence. Also, would you back any entrepreneur who didn't talk about it up front? Of course not. It is what it is. There are many obstacles to raising capital, having a VC back out after a seed investment is just another of many. It shouldn't stop a worthy company from raising. Hell, depending on the VC, it might even help.

    • After reading through the comments and thinking about this some more, I agree that this doesn't do anything to address the signaling issue. What is does is eliminate a non-supportive investor from the cap table early on, eliminating the "free rider problem." More in a separate blog post.

  • Nelson Bostrom

    What if small VC funds or angels announce to the world that they're only really interested in being part of an angel round and that they want out when the series A comes in. Would this further eliminate the signaling problem? I don't fully know the mechanics and valuations from angel rounds to Series A, and I am not sure if this would make sense on a portfolio theory basis. It may then make sense for angels to sell their shares directly to the new investors? (If I could make 50% in 9 months as an angel consistently, I'd be in good shape. – Just tossing numbers out there)

    I wonder when the secondary markets will come into the picture – that way, after a series A, an angel could sell out on the secondary market without signaling anything……..Just an idea….

    • I think this is a very tough approach for angels. You would be taking all of the risk but limiting your upside. You won't be successful with an angel portfolio long term with 2x on your winners – there are going to be too many losers to compensate.

  • vengo

    Hi Brad,

    Nice article.

    Would be interesting to understand their premise as to why they want to follow-on investment in only 15 of their seed invested companies.

    Is it the bandwidth issue of the said VC firm ?


    Vengo Ventures

    • This was their stated strategy – do a lot of seed investments and expect to not go further with 50% because they don't work out.