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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.
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.
Following is a post on super angels I wrote yesterday for PEHub.
In the beginning, there were angel investors. And it was good. As individual angel investors made more and more investments, they became super angels. One day a super angel woke up and thought to himself, “Gosh, I could do a lot more investments if I had a fund.” And so the super angels became micro-VCs (or “institutionalized super angels”). Everyone was excited and on the seventh day they did another deal instead of resting.
I’m a huge fan of the super angel movement. Some of my best friends are super angels and I’ve put my own money where my mouth is in funds like Chris Sacca’s, Dave McClure’s, Jeff Clavier’s, Roger Ehrenberg’s, and David Cohen’s. Not only am I an investor in these super angels, I love to have them on board with our investments at Foundry Group. And whenever they bring me something they’ve been working on, I always pay attention–as I know they know what I like to invest in.
But recently the super angel mantra of “traditional VCs suck” has reached a fevered pitch. What started out in Silicon Valley as a new wave of angel investors has evolved into a belief that “VCs are lousy seed investors” and “no one needs a VC–just raise your money from super angels and go to town.”
Fred Wilson from Union Square Ventures recently wrote an excellent blog post titled “The Expanding Birthrate of Web Startups.” As with many of Fred’s posts, the comment section was as useful as the post, and early-stage investors such as Mark Suster, Charlie O’Donnell, Roger Ehrenberg, and Anonymous Coward weighed in. The comments ranged from the now cliche-ish “VCs suck” to “What happens when super angel-backed companies need a new round” to “Companies will never need more capital. It’s a new world out there.” As I read through the comments, I kept pondering the same thought: “What happens in five years?”
Let’s consider a few situations. Take a typical super angel. Assume success. Investors (LPs and individuals like me) want to invest money with the super angel. The super angel probably creates a fund and raises a lot more money. Now the super angel is a micro-VC. Continue to assume success. More money is able to be raised. Now the micro-VC is a mini-VC. Does this keep scaling, or does the mini-VC succumb to the same challenges that $200 million funds ran into when they turned into $1 billion funds?
Now, take a super angel with a 20-company portfolio. The super angel is hyper-connected and works closely with the entrepreneurs he/she invests in. Suddenly he/she has 100 investments. Are the entrepreneurs getting the same attention from that angel–especially when they enter year three of their life, hit a bunch of speed bumps and need a lot of help? Or does this super angel just turn his/her back and say, “Well, that’s the breaks.”
Finally, take a super angel who is used to making $25,000 to $100,000 per investment. He/she becomes a micro-VC, raises a bigger fund, and now invests $500,000 per deal. Is there a difference in his/her behavior with regard to the $25,000 investments vs. the $500,000 investments?
I think the super angel movement is awesome, but the generalization that all VCs suck at seed investing doesn’t make sense to me. Correspondingly, the idea that entrepreneurs only need super angels doesn’t make sense either. There’s a renewed focus and interest in early-stage investing going on in the United States, and it’s being stimulated by a lot of factors. It’s a powerful thing that will continue to evolve, change and challenge all of the participants.
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.