The Need for a Seed Lead

Over the past several months the issue of signaling risk in seed investments has gotten a fair bit of attention. Here’s a break-down of the concern:

  • Because of the “deflationary” economics around running a startup, (i) seed rounds have gotten smaller such that investment amounts are below what would normally move the needle for an early-stage VC, and (ii) the number of startups has increased as a result.
  • VCs can manage only a fixed number of investments if they’re to avoid letting their attention be stretched too thin, lest they become a mere commoditized source of cash with no value-add.
  • Normally when a VC invests in a company, they’ve done their diligence, reserved a fixed amount of their dry powder for follow-on investments, and someone’s reputation is on the line for the success of that investment.
  • Some early-stage VC funds, in order to stay in on the action, have purportedly turned to a “spray and pray” investment strategy, through which they make lots of tiny investments with minimal diligence at the seed stage; so many in fact that there’s no way they could do follow-on investments for all of them.
  • But with tons of small investments, the claim is that these companies are viewed merely as options, not as portfolio companies that a VC would be more committed to, and the VC is therefore much less likely to participate in the next round.
  • Problem: Because later-stage investors will see this early-stage VC on the Company’s cap table and know that they have the cash to make a follow-on investment (not necessarily the case for an angel), they will understandably become suspicious of why that VC isn’t continuing to invest. This is the negative signal.
  • Theoretical Nutshell: Taking on real VC money at the early-stage is therefore risky because that VC may (i) just view you as an option, (ii) therefore really isn’t all that into you, and (iii) if he/she decides to end the relationship early, could make it a lot harder to find a dance partner for the Series A.

To be honest, I don’t have a dog in this fight. I can’t really because I’m too young and haven’t seen enough deal flow to say whether this happens or not.  I do know that some very well respected people are of the mindset that it does happen, and other well-respected people (and here) think it’s just hot air.  The takeaway that I’ve gotten from a lot of the discussion is that, most likely, some early-stage VCs really do screw entrepreneurs in this way.  But others are sensitive to the signaling issue and are committed to their seed investments. So do your homework.

I recently came across a very interesting post by Roger Ehrenberg over at IA Ventures that talks about the trend of what he calls “party rounds” in which founders, out of a fear of losing control early on, deliberately structure their seed round so that nobody is really a lead investor – lots of small checks.  The crux of his concern is as follows:

What if things don’t happen according to plan?… Isn’t this the time that the deal lead steps up to lead a bridge round assuming management is executing well but simply needs more time? Yes. But wait, we have no deal lead. We don’t have an investor with enough skin in the game to care…. By not having a lead, a partner who takes the long view and has the resources to back it up, the founders have placed themselves in a very risky situation.

What’s fascinating about his point is how, rather than early-stage VCs treating seed investments as options out of some reckless plan to keep their hands in lots of cookie jars, founders are, out of a bit of paranoia, turning themselves into options by not letting anyone write a large enough check.  This is an extremely important perspective to add to the whole signaling debate: there are huge advantages to bringing in a committed high roller at the seed stage.

The worst-case scenario would be to let institutional money into your seed round, but not let them put in real money.  Then you’ve loaded up on signaling risk, while making it virtually costless for them to write you off.

Assuming you’ve found a reputable early-stage VC who is sensitive to signaling issues and willing to take the reins (of the funding, not your company) and grab a large chunk of your seed round, realize that their deep pockets could be a potential lifeline when you hit some road bumps along the way.  And a lot of us know that the Series A is where you’re likely to find road bumps.  There are of course other benefits, like having the VC’s network opened up to you early on.  Regardless of how often founders get screwed by signaling, Roger’s advice is tangible enough to bypass theoretical debate.  Keep it in mind if you’re in the (fortunate) situation of having to choose whom to take seed money from.

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