Last night Amy and I had an awesome dinner at Perla with Fred Wilson, Joanne Wilson, Matt Blumberg, and Mariquita Blumberg. Fred and I have been involved in Return Path for a dozen years and this has become an annual tradition for us when Amy and I are in NYC. At 12 years of service, Return Path gives a six week sabbatical and a pair of red Addidas sneakers as a “get ready for your sabbatical” gift. Fred and I got the sneakers, but not the six week sabbatical.

I sat across from Joanne and since the restaurant was noisy our table ended up having two separate conversations going. Joanne is awesome – if you don’t read her blog, you should start right now, especially if you are interested in NY entrepreneurship, women entrepreneurs, food, and the thoughts of an amazing woman. I still remember meeting her for the first time around 1995 and thinking how dynamite she was.

Oh – and if you are a seed stage company in NYC looking to raise money, you are an idiot if you don’t immediately reach out to Joanne and try to get her involved. She is one of the most thoughtful angel investors I’ve ever met.

We talked a lot about seed stage investing during our part of the conversation. Joanne has done about 25 investments in the past few years and has a very clear strategy for what she invests in. She works incredibly hard for the companies she invests in, is deeply passionate about the products and the entrepreneurs, and clearly loves what she does.

During the conversation we had a moment where we were talking about feedback. I told her about my approach of saying no in less than 60 seconds. She told me a story about giving entrepreneurs blunt feedback in the first meeting, which I always try to do also. And then she said something that stuck with me.

Joanne will often start a meeting by saying something like I give you permission to hate my feedback. You can decide that you want to tell me ‘fuck you’ after the meeting. But I’m going to tell you what my direct and honest reaction is.

Now Joanne is a New Yorker through and through. Aggressive, direct, and clear. But never hostile. Ever. And a deeply loyal supporter. So this feedback, while direct, is incredibly powerful. It’s often extremely hard for someone to hear, especially if they are in “I’m trying to convince you to fund my company mode.”

I play the same way. At Foundry Group, one of our deeply held beliefs is that we always be intellectually honest, no matter how difficult it may be. At TechStars we pride ourselves on providing direct feedback, but always saying “this is only data”, letting the entrepreneur make their own decision about what to do.

These are versions of Joanne’s permission to “hate her feedback.” It’s a powerful way to frame any discussion. And I know I’ll be using the phrase “I give you permission to hate my feedback” many times in the future.

I received an email from an entrepreneur today asking me about something that made my stomach turn. It’s a first time entrepreneur who is raising a modest (< $750k) seed round). There are two founders and they’ve been talking to a VC they met several months ago. Recently, the VC told them he was leaving his firm and wanted to help them out. This was obviously appealing until he dropped the bomb that prompted their question to me.

This soon to be ex-VC said something to the effect of “I can easily raise you money with a couple of phone calls, but I want to be a co-founder of the company and have an equal share of the business.”

In my email exchange with the entrepreneur, I asked two questions. The first was “is he going to be full time with the company” and the other was “do you want him as a third full time partner.” The answer was no and no. More specifically, the VC was positioning himself as “the founder that would help raise the money.”

I dug a little deeper to find out who the person was in case it was just a random dude looking for gig flow. David Cohen, the CEO of TechStars, has written extensively about this in our book Do More Faster – for example, see the chapter Beware of Angel Investors Who Aren’t. I was shocked when I saw the name of the person and the firm he has been with (and is leaving) – it’s someone who has been in the VC business for a while and should know better.

I find this kind of behavior disgusting. If the person was offering to put in $25k – $100k in the round and then asking for an additional 1% or 2% as an “active advisor” (beyond whatever the investment bought) to help out with the company, I’d still be skeptical of the equity ask at this stage and encourage the founders to (a) vest it over time and (b) make sure there was a tangible commitment associated with it that was different from other investors. Instead, given the facts I was given, my feedback was to run far away, fast.

Entrepreneurs – beware. This is the kind of behavior that gives investors a bad name. Unfortunately, my impression of this particular person is that he’s not a constructive early stage investor but rather someone who is trying to prey on naive entrepreneurs. Whenever the markets heat up, this kind of thing starts happening. Just be careful out there.

There have been a number of thoughtful “early warning sign” posts in the past few days including one from Fred Wilson (Storm Clouds), one from Mark Suster (What Angel Investing & Florida Condos Have in Common), and Roger Ehrenberg (Investing in a frenzied market).

The seed investing phenomenon of 2010 has been awesome to watch and participate in.  The velocity of activity from individual angels, angel groups, seed VCs (the correct phrase for most of the “super angels” which have now raised actual funds), and even traditional VCs has been on a steep climb throughout the year.  When the numbers are tallied up at the end of the year (I’m sure someone will do it – and it won’t be me) I expect there will be all kinds of new records set.

But the warning signs from Fred, Mark, and Roger are worth reading and pondering carefully.  I have a few choice quotes to add to the mix that I’ve heard over the past thirty days.

• Prolific Seed VC: I only expect that 30% of the companies I funded this year will raise another round.
• Established VC With A New Seed Program: We are planning to make 30 seed investments out of our new fund.  We’ll do follow on investments in 10 of them.

In both cases, when I speculate on the next sentence they would have said if they were being direct and blunt, it would be something like “I expect the balance of them will go out of business after thrashing around for a while.”  The optimist would have a different view (e.g. that they would be quickly acquired or they would never need additional capital), but anyone that has been investing for a while knows this isn’t the likely outcome for any but a small number of these companies.

Mid-year I felt compelled to write a post titled Suggestions for Angel Investors. When I reflect on that post, my fear is that most seed investors aren’t implementing a “double down on the first round” strategy.  Some percentage of seed deals will quickly raise their next round (30% if you believe the two anecdotes above.)  Some percentage of seed deals will fizzle out.  But some percentage will get stuck in the middle.  They will be interesting ideas with solid teams that realize their first idea out of the gate needs a pivot.  Or they’ll be in the middle of a pivot when they run out of cash.  In the absence of the existing seed investors stepping up and writing another check (without any new / outside validation) it’s going to be hard for these companies to get to the place where they raise a next round financing.

While all entrepreneurs are optimistic on the day they raise their seed round that they’ll be one of the hot deals that easily raises a significant next round, it’s worth starting to plan from the beginning for the case where you “are interesting, but not unambiguously compelling.”  In these cases, you need more time and the only place you are likely to get it is from your existing investors.  If they are willing to keep investing on their own without a new outside lead, you’ll at least have a chance to get to the next level.  But if they aren’t, you could find yourself in a very uncomfortable situation.

I’ll end with Fred’s money quote:

“Anything that is unsustainable will eventually stop happening. And when it stops happening, there will be a dislocation event that will cause people to change their behavior. ,,, When will it stop? Who knows? But be prepared for it to end. And when it does, things will be different. And we should all be prepared for that time.”

Having worked alongside Fred for a long time in a number of companies through several cycles, I can assure you these words come from a place of wisdom, experience, and shared pain.

Earlier this week I did a one hour interview on “Meet the Angels” sponsored by Tech Coast Angels (one of the LA Angel groups.)  It was supposed to live but for some reason there were some problems getting into the webcast.  It’s now up on the web – if you were trying to watch it and couldn’t, it’s posted below.

Live video event with Brad Feld from TechCoastAngels on Vimeo.

I was thinking more about my post from yesterday titled Addressing The VC Seed Investor Signaling Problem.  There were a bunch of good comments that caused me to realize that I wrote the post from the perspective of a VC, not an entrepreneur.  As I mulled the comments over, I realized something very specific.

If a VC invests in a seed round but then doesn’t invest in the next round, there is a signaling problem, regardless of what the VC does with their investment.

When I read the post carefully, I realized that I implied that the VC firm’s strategy of selling back their seed investment might address part of the signaling problem.  In hindsight, it doesn’t address this at all.  It addresses a different problem – the free rider problem.

Most VC’s hate when other VC’s act as free riders.  A free rider is defined as someone who invests in an early round but then doesn’t participate in future rounds.  Note that I explicitly said “other VCs” and not angel investors.  Most VCs expect that angel investors will only invest in the first round or two, so they get exempted from free rider status.  I also exempt “super angels” / “seed-only VCs” from this – if you clearly define your role as an investor in the first round or two, and you never participate in later rounds, then you won’t end up being classified as a free rider.  But, once you start participating in later rounds, the expectation of your financial participation changes.

Early stage VCs are often expected to play at least pro-rata in following rounds.  When companies are successful, the early investors often (but not always) back off their pro-rata.  But, when companies go sideways or struggle, the early investors are often expected, by their co-investors – to continue to participate pro-rata until the company either succeeds or fails.  In many cases, the consequences for not participating are significant and you can get a taste for this from the post on the term Pay-to-Play that my partner Jason and I wrote in 2005.

The firm that I mentioned in the previous post addresses the free rider problem by saying “look, we’ll make it easy, we don’t support going forward so we’ll sell back our equity to the company, entrepreneurs, or angels and get out of the way for new VC investors.”  While this doesn’t address signaling, it does eliminate the free rider – in this case the VC that is not going to participate going forward.

When things are going great, none of this matters.  But when things aren’t, they matter a lot.  If I shift from the perspective of a VC to the perspective of an entrepreneur, I would only want VCs as seed investors who have a proven track record of consistently following their seed investments with future investments.  This will never happen 100% of the time – there are definitely seed investments that don’t make it. In addition, there are often cases where the entrepreneur doesn’t have choices and has to work with whoever shows up with a check.  But to hand wave over the issue is illogical.

Now, as a VC, I don’t want to co-invest with free riders.  I’m exempting angels, super angels, and “seed-only VCs” from this.  But if I co-invest with someone, I want to know that they are going to work with us to continue to fund the company, not walk away 50% of the time “because” – well – whatever “because” means.

The collision between signaling and free riders is what creates a lot of dissonance.  In the current wave of seed and angel investing activity, we haven’t hit a hard down cycle yet.  We will.  When we do, these two issues are going to pop to the forefront.  Anyone who participates in the early stage investment ecosystem (entrepreneurs, angels, and VCs) should make sure they spend some time thinking about this and incorporating it into their own strategy, before it is upon them.