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Hi, I’m Brad Feld, a managing director at the Foundry Group who lives in Boulder, Colorado. I invest in software and Internet companies around the US, run marathons and read a lot.

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Entrepreneurs Dislike Signaling; VCs Dislike Free Riders

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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.

Addressing The VC Seed Investor Signaling Problem

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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.

VC Seed Funding Example: Trada

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My partner Seth Levine has a detailed post up today titled Trada – from the beginning that describes the creation and financing of Trada. Foundry Group is the seed investor in Trada and Seth’s post describes one example of what I think is effective VC seed investing.

The meat of the funding story follows:

“Of course coming up with the idea is the easy part. Executing against that idea is another matter. In this case neither Niel (nor I) had any interest in creating a traditional syndicate to fund the company. Instead we quickly put our heads together about a financing (we like to say it was over beers, but the truth is more mundane – we hammered out the details in a 10 minute conversation in the conference room of the Foundry office). We decided that we wanted to bring in some experts to help us with the business and together flew around pitching the business to a small handful of strategic angel investors to pull together a small syndicate that became the initial Trada investor base. Niel and I hammered out a second financing in similar fashion (again around the Foundry conference table, this time without the need for an angel roadshow). It’s a great example of how we like to work with entrepreneurs – especially those that we have a long history with. We like to be involved early (in this case before an idea for a business even existed) and we think of our angel investments as a down payment on a subsequent investment in the business (we’ realize that we need to give early businesses some time to develop).”

The short version is that the seed round was figured out in ten minutes – this was the “Series A”.  A few strategic angels were added to this round.  We did a second financing by ourselves at an increased valuation – this was the “Series B”.  Recently Google Ventures led the a $5.75m “Series C” round.

The terms on the Series A and B were straightforward as Niel Robertson, the founder/CEO of Trada is a sophisticated entrepreneur (Trada is his third company) so he had no patience (nor did we) for silly, complex early stage terms.  More importantly, the two key aspects of any deal – price and control – we able to be negotiated quickly between Seth and Niel, partly because of their long history working together which was built on mutual respect and trust.

When we funded the Series A (the seed round) of Trada, we fully expected we were at the beginning of a multi-round journey.  Seth does a great job of explaining how it got started – I encourage you to read his post for an example of one of the financing cases where I think a VC can be an excellent seed investor.

Now That’s How You Do An Angel Pitch Event

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I attended the second Open Angel Forum in Boulder tonight.  Simply put, it was dynamite.

This is an intense week for seed stage stuff in Boulder as TechStars Demo Day is tomorrow where 11 new companies are having their coming out party. The Boulder New Tech Meetup had a special double header (Tuesday and Wednesday) where six teams practiced their pitches to a room of 300+ people on Tuesday followed up by the other five on Wednesday.  The streets are crawling with angel and early stage investors – local and from other parts of the country – and the vibe feels great as tomorrow is the big day.

I had high expectations for Open Angel Forum after the first one in Boulder in the spring.  Jason Calacanis came up with a great format when he created Open Angel Forum and David Cohen has done an awesome job of hosting and coordinating the two Boulder events.

The format is ideal.  20 qualified angel investors – to qualify you must be active making angel investments (at least three in the past year).  Six companies all raising seed rounds ($1m or less).  Dinner and drinks paid for by sponsors.  No fee to either the entrepreneurs or the angels.  Casual setting (we did it in the TechStars Bunker) – some mingling before it got started, followed by five minute pitches + five minutes of Q&A for each company.  The whole thing took an hour – just the right amount of time.

All six companies – Pavlov Games, Rapid.io, Adapt.ly, Awesomebox, PlaceIQ, and BrowseAndPay did excellent jobs.  They were each high quality and totally fundable and I heard several commitments happen during the evening.  I left about 45 minutes after the pitches ended – the event was still in high gear and with Jason leading a table full of angels and entrepreneurs in a game of Texas Hold’em while the beer drinking and discussions continued.

The thing that is so cool to me about this is that it’s a super high signal to noise ratio – all the companies had clear, tight, and relevant pitches and the entire audience was accessible angel investors.  No BS, no posturing, no fees for anything – just entrepreneurs and angels doing their thing.

Over two days, 17 early stage software / Internet companies are having high quality exposure to angel and seed investors in Boulder.  And on Saturday, we have TEDx Boulder.  It’s good to be back in town.

The Buzz on Angel and Seed Investing Continues

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Ah – well – another day passed and there was once again a ton of chatter around angel investing.  A lot of it was prompted by AngelConf 2010 which you can watch recordings of on Justin.tv (AngelConf 2010 Part 1 and AngelConf 2010 Part 2).  While there continues to be plenty of negative VC tone and “disruptive change is here” (ala traditional VC is over), there were also some great nuggets, including my favorite line from Joshua Schachter of typical VC behavior of SHITS (Show High Interest Then Stall).

But I think the two best posts to come out of yesterday are Lead Investors, Dipshit Companies, and Funding Every Entrepreneur by Fred Wilson and MoneyBall for Startups by Dave McClure.  While they come at things from very different angles, they are both very insightful and important.  Importantly, they are willing to use words in their posts that Goldman Sachs has apparently banned in email as of yesterday.

We are packing up the Homer house today and I’m looking forward to diving back into the fray next week in Boulder.

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