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This morning my partners at Foundry Group and I announced that we are going to make 50 seed investments of $50,000 each on AngelList between now and the end of 2014. We’ll be doing this via AngelList’s new Syndicate approach through an entity called FG Angel where we will create a syndicate of up to $500,000, allowing others to invest $450,000 alongside anything we do. For now, we are using my AngelList account (bfeld) which I’ve renamed Brad Feld (FG Angel). We are working with Naval and team at AngelList to get this set up correctly so that a firm (e.g. Foundry Group) can create the syndicate in the future, at which point we’ll move the activity over to there.
For years, we have had people ask if they can invest alongside us at Foundry Group at the seed level. We’ve never had an entrepreneurs fund, or a side fund, so we’ve encouraged people to invest in Techstars and other seed funds that we are investors in. As of today, we have a new way for people to invest alongside of us – via AngelList’s syndicate. The minimum investment is $1,000 per deal, so if you make a $1,000 commitment to our syndicate, you are committing to investing $50,000 alongside of us between now and the end of 2014 in the best seed investments we can find on AngelList. Simply go to Brad Feld (FG Angels) and click the big blue “Back” button. Special bonus hugs to anyone who backs FG Angels today (as I write this, the first backer has come in – from Paul Sethi – thanks Paul – awesome to be investing with you.)
This is an experiment. If you know us, we love to experiment with stuff, rather than theorize about things. We are huge believes in seed and early stage investing and through a variety of vehicles, including Techstars and our personal investments in other early stage VC funds, have well over 1,000 seed investments that are active. This has created an incredible network that adds to our Foundry Group portfolio. With FG Angel, we are taking this to another level as we begin a set of activities to amplify this network dramatically.
So there is no ambiguity, the investments come from our Foundry Group fund. All economics, including the syndicate carry, go to our fund. We are calling this FG Angel because we are approaching this the same way we do with any angel investment. I’ve written extensively about my own angel investing strategy in the past – you’ll see this reflected in what we are doing here. Over the years my angel strategy has been very successful financially and our goal with FG Angel mirrors that.
We expect we’ll learn a lot about this between now and the end of the year. When we learn, we’ll share what we learn. We believe deeply that the best way to learn about new stuff is to participate. So – off we go. We hope you join us – both in the syndicate and the ensuing network.
On Friday, I saw a tweet from Chris Sacca about super pro-rata rights that said “Seeing a lot of VCs cram super-prorata terms into deals. Feels uncool to me. Any good arguments for why it’s helpful to entrepreneurs?” I quickly responded to Chris on Twitter with “@sacca just say no to super prorata” and then opened up a WordPress window and scribbled some thoughts for a draft post on that that I was planning to put up Monday morning (now).
On Sunday, I saw a phenomenal post from Mark Suster titled Why Super Pro-rata Rights are Not a Good Deal for Entrepreneurs. In it, he covers many of the reasons I was planning to cover. He also does a great job of setting up how pro-rata and super pro-rata rights work. It’s a must read post for any entrepreneur doing a seed or early stage financing.
Mark talks about why super pro-rata rights are suddenly appearing regularly, but I think he’s being too nice about it. He says:
“Often it’s when a larger fund (e.g. non seed / micro VC fund) wants to put in $500k (less than their typical investment) but wants to have a marker on your company if you end up being super hot. In my mind, it’s almost like a dog pissing on its territory. Read: it’s an option for that investor and a super expensive one to you, the entrepreneur.”
This behavior is not limited to large funds. I’ve had two investments over the past year where smaller funds tried to argue for super pro-rata rights in the seed round. In one case they argued that they were going to do more work than the other two investors (which included me); in the other case they stuck with the 20% argument but said “we have to have 20% after the next round in order for us to want to work on this investment.” In both cases the entrepreneurs ultimately decided not to include the firm insisting on super pro-rata rights in the round.
I’ve also starting seeing this ask all over the place with the “new” seed programs that large funds have. This is a subset of the case Mark is referring to, but it’s actually more annoying than Mark makes it out to be. In the last two years, many large established VC firms have created “new” seed programs. These are firms that have historically positioned themselves as early stage investors, but in some cases explicitly stopped doing seed rounds while in others simply drifted away from them. Suddenly, they are back, with seed programs aimed at making high velocity investments in brand new companies.
I applaud these firms, but only if they are doing their seed investing in a way that is consistent with how they position the activity as “entrepreneur friendly.” Specifically, if you are entrepreneur friendly and you do a seed investment, you do not need or even want a super pro-rata right. Instead, you should earn the right to invest above your pro-rata in the next round through early engagement with the company, hard work, and active help for the company. This behavior is “entrepreneur friendly” and is the spirit of how many firms are talking about their seed programs (e.g. we make decisions quickly, we treat you like any other company we invest in, and we help as much as we can.)
Now for firms that insist on super pro-rata rights, they should call it how it is. Which is “we are tossing a tiny amount of money in you now but we want to reserve the option to own a lot more if you are successful.” Mark calls this dynamic out specifically in his post, but doesn’t put it on the VCs. It doesn’t actually bother me that a VC might want to take this approach; I just don’t think an entrepreneur should ever accept it if he has any other choices.
In many cases, I’ve seen the VC request for super pro-rata rights collapse in the context of a hot seed investment. The entrepreneur holds all of the cards in this case and should use them, as it gives the entrepreneur many more options in the next round. If the VC insists on the super pro-rata right, make sure you really understand what is going on, as this negotiating posture (and philosophy) on the part of the VC will likely surface again in the future.
To all my VC friends – take a page from the super angel playbook. If you want to do seed investments, or have a formal seed investment program, model it after the super angels, especially the ones who have raised small VC funds. These guys make small investments, bust their asses for the companies they invest in, and often get opportunities to invest more in the next round. In a lot of cases, they don’t have the capacity to do anywhere near what you could do, but in all cases I’ve been involved in, the entrepreneurs have fought for these seed investors and as someone who doesn’t feel the need to be the first money in a company, I’ve always tried to accomodate the request for more than pro-rata in the context of the new financing I’m leading.
And yes Chris – it’s definitely uncool.
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.
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.
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.