I recently met an entrepreneur who was raising money for his startup. Six months prior, he had raised seed money (<$1M) from one of the increasingly popular seed programs big venture firms are offering (big venture firms = roughly $100M fund and larger). As a potential investor, the first question I asked him is “is the big venture firm following on?” The answer was no. What this means is the entrepreneur is going to have a *really* tough time raising any more money at all, because what all potential investors think is “if this top VC that has hundreds of millions of dollars and knows this company the best doesn’t want to invest, why would I?” What the entrepreneur didn’t realize is that when you take any money at all from a big VC in a seed round, you are effectively giving them an option on the next round, even though that option isn’t contractual. And, somewhat counterintuitively, the more well respected the VC is, the stronger the negative signal will be when they don’t follow on.
Even in the good scenario when the VC does wants to follow on, you are likely to get a lower valuation than you would have had you taken money from other sources of funding (angels, micro-VCs like Y-combinator). This isn’t obvious if you haven’t done follow on fundraising before, but I’ve observed it first hand many times. The reason is you won’t have the freedom to go out and get a true market valuation for your company. Suppose you have venture firm X as a seed investor and they offer you, say, a $6M pre money valuation for your follow on round (usually called the Series A). Suppose furthermore that if you were free to get a competitive process going that the “true valuation” for your company would be more like $10M pre. If you now go to another firm, Y, and pitch them, one of the first questions is going to be “Is X investing?” You say yes, X has made you an offer. Now what Y is thinking is either 1) “I should call up X and offer to co-invest at $6 pre,” thereby keeping you at an artificially low valuation, or 2) if that’s not an option (e.g. because you already have 2 VCs in the deal, because X doesn’t think Y is a high quality enough firm to co-invest with, etc) Y is going to hesitate to offer you a term sheet, for fear of being used as a stalking horse. This is industry lingo for when the entrepreneur uses firm Y to get a higher priced term sheet which X then matches and excludes Y. VCs really don’t like to be used as stalking horses. So what having a big VC in as a seed investor does is prevent you from getting a competitive dynamic going that gets you a true market valuation.
Why are big VCs doing this? If you have a, say, a $200M fund, spending, say, 5% of your fund to get options on 50 companies is a great investment. You could look at this from an options valuation perspective (seed stage startups have super high volatility – the key driver of options price in the Black-Scholes valuation model). More simply, just think of it as “lead gen” for venture capitalists. Basically big VCs are spending 5% of their budget generating captive leads for their real business: investing $10M into a companies at the post-seed stage.
These seed programs are relatively new so we are only starting to see the wreckage they will eventually cause. I predict in a few years, after enough entrepreneurs get burned, what I’ve said above will be conventional wisdom. Unfortunately there are a lot of good companies that will die along the way until that happens.
Disclosure: I sometimes compete with big VCs for investments, so I am not disinterested here.
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[...] via cdixon.org / The problem with taking seed money from big VCs. [...]
Good post, Chris. This is indeed an issue that entrepreneurs need to be careful about. One way to mitigate the risk is to only take seed money if there are clear, agreed-to milestones that would trigger the (often pre-negotiated) Series A. That’s how we try to set up our seeds at Flybridge to try to avoid the very issue you’re raising.
Another mitigating point would be – don’t take seed money from one VC. Insist on taking two. We recently came into the Series A on a deal that was seeded by two VC firms and one dropped out. We did our diligence, disagreed with the firm’s conclusions, and jumped into their shoes alongside the first VC. By having two VCs split, say, $500k and setting up milestones that would trigger a pre-negotiated Series A, you can possibly get the best of both worlds – VC-quality help with angel-level dilution and initial post-money bar.
Sitting on either side of the table, a milestone driven investment roadmap is the best model and it keeps the entire process open and honest so everyone understands what the definition of success really is as each milestone is achieved.
Chris, great thoughts.
If you haven’t already, take a peek at:
http://venturehacks.com/articles/options-open
If the VC isn’t interested you have bigger problems. If you have a great business model companies fall over themselves to give you money.
Good analysis.
But to be able to make a decision like this founders must ensure that they are in a very strong position and can afford to make choices – when it comes to taking money.
My rule of thumb is that once you start, don’t spend any time raising money, spend the first 12-18 months building value – product, traction, beta customers, feedback, more customers, monetization and take your venture cash-flow positive.
If you can walk into a VC and say we can continue to grow even without, but with your money we can scale it faster and bigger. You sure can make the choice of whom to take the money from. If not then chances are you may not a lot of choice when it comes to money.
Chris,
How would you ideally fund your startup?
Thanks for the great comments.
Jeff – Agree that 2 VCs make the situation a little bit better. You get some game theory working to your favor. I would add that it’s important that the VCs be of somewhat equal stature (and equal investment amounts, but they usually insist on that). If you have tier 2 firm co-investing with Sequoia and Sequoia doesn’t follow on, it’ll look bad.
In terms of pre-negotiating the Series A that is triggered with milestones, that sounds a lot like tranching, which I am against for a lot of reasons (it deserves a whole blog post…), but mainly at the early stages the direction often changes and so fixing the milestones can encourage the entrepreneur to manage to the investors instead of what’s best for the business.
That said, agree that every startup should have milestones, regardless of financing conditions – it’s just good business practice.
Sameer – I think there are some cases where you do in fact need capital at the very beginning. It’s true that many internet businesses today can be bootstrapped, but other kinds of startups including more tech heavy internet/software, or for sure hardware, biotech, etc might be better off taking some (non-VC) seed money.
Usually these types of deals are structured that you have to get _another_ VC to lead and price the A round, and the seed VC has the right of first refusal to 50% of the round, and converts their seed money at a 20% discount + interest towards that 50%. But overall I agree, only do this kind of deal with firms you have known for a long time and trust.
[...] cdixon.org / The problem with taking seed money from big VCs (tags: vc startup strategy) [...]
The whole VC concept and practice is debatable. I’ve personally seen three different businesses run into the ground and destroyed as a direct result of VC domination of the companies. As a result, I’m extremely nervous about borrowing *any* money for *any* business ideas at all; it’s a risky proposition. It’s refreshing to read Chris’ thoughts and insights.
@chris: I agree with your comment about taking money from non-VC sources. Which is self, friends, family and fools
Chris, there is a great comment thread happening on a TechStars’ forum re: your post. Unfortunately, it is not publicly available. Thus I have posted a slightly modified version of my original comment below:
I participated in TechStars in 2007. The first question afterward from nearly every investor was: “is Brad investing?” (Brad Feld is a VC and co-founder of TechStars) However, I also believe that this “negative signal” (or “Brad effect”) created by VCs’ involvement in seed stage mentor-driven investment programs (such as TechStars) is only half of the story.
Basil Peters, a member of the Bellingham Angel Group, wrote a great book titled Early Exits, Exit Strategies for Entrepreneurs & Angel Investors (But Maybe Not Venture Capitalists). I highly recommend that every startup founder READ THIS BOOK BEFORE TAKING A CENT OF FINANCING. Basil puts forth that the current VC model is broken. He cites shorter innovation cycles & the fact that tech startups do not require the intense amount of capital that they once did as two reasons that the old system is breaking down. Furthermore, Basil identifies an inherit conflict of interest between VCs and startup founders; stating that VCs have a tendency to block exits that would be completely acceptable to the founders & angel investors in the hopes of “hitting it out of the park”. Unfortunately, although this strategy works out in the end for the VC, several viable business are effectively bled to death in the process.
To a certain extent, it could be postulated that mentor-driven seed stage investment programs are the VC model’s adapted response to shorter innovation cycles & the requirement for less cash. Again, as a strategy, this makes very good business sense. However, there is perhaps an even more disingenuous conflict of interest that occurs within the adapted model when such a business is outwardly constructed as a mentorship. I say this, because the second you label it as such, it inherently possesses a grossly different mandate, which IMHO can’t socially afford the traditionally accepted “trail of blood”. In other words the culture needs to evolve with the model.
Having stated this, I would like to also say that my experience participating in TechStars was overwhelmingly positive.
Arron- very interesting. I’d never thought about the signaling value in seed programs. I guess that’s why Y-combinator is smart to invest equally in all of them. (Although now that Sequoia invested in Y-combinator will there be a “Sequoia effect” since presumably they’ll get first dibs on every company?).
I think VCs are generally a good thing for entrepreneurs and society at large, although there are certainly abuses (but those pale in comparison to other areas of finance such as later stage private equity and hedge funds). As an entrepreneur you just need to know what you are getting in for, including the fact that you now have to “swing for the fences.”
Chris – I agree that it is important to understand what you are signing up for first. I think that this was the biggest mistake for me during TechStars. In 2007 I came into the program viewing it primarily as a mentorship and educational opportunity. However, I emerged realizing that in certain respects it was a relatively cut-throat traditional business environment (which offered its own educational value). For example, we had individual “mentors” who would just as soon hire our team apart for their own VC backed projects as actually mentor our business.
Please Note: I would still recommend that anyone given the opportunity to participate in TechStars seriously consider doing so — just know what you are getting into.
Furthermore, as an entrepreneur, I think it is important to realize that there are several different investment strategies, which you can choose to align yourself with. For instance, the strategy that Basil discusses in his book is not about “swinging for the fences” so much as winning the game by consistently hitting singles and doubles. It all depends on your goal as an entrepreneur.
Also, I ultimately agree that VCs are generally a good thing for entrepreneurs and society at large. But again, culture needs (and will) evolve with the model — especially as business continues to become more transparent via social media.
Last but not least, I was mistaken, the TechStars forum is publicly viewable, you just have to be a member to post: http://startup.techstars.org/discussion/14/The-Problem-With-Taking-Seed-Money-From-Big-VCs
[...] The problem with taking seed money from big VCs. [Chris Dixon] [...]
[...] potential non-participation gives them option-like value. I discuss why I dislike these deals here. (This might be one point on which Fred and I [...]
The problem with taking seed money from big VCs- cdixon.org…
I recently met an entrepreneur who was raising money for his startup. Six months prior, he had raised seed money (…
[...] I was an early cynic. I told entrepreneurs that it was a bit of a Faustian bargain. If the large VC doesn’t agree to do your A round then you’re in a bit of trouble. Why? Because as a potential A round investor I’m thinking to myself, “if the large VC seed investor has been in the company for 9 months and isn’t leading the round then something must be wrong. Surely they have more information than I do.” And I think this line of thinking has started to become conventional wisdom as outlined in Chris Dixon’s excellent blog post saying that you need to be careful raising seed money from a large VC fund. [...]
[...] I was an early cynic. I told entrepreneurs that it was a bit of a Faustian bargain. If the large VC doesn’t agree to do your A round then you’re in a bit of trouble. Why? Because as a potential A round investor I’m thinking to myself, “if the large VC seed investor has been in the company for 9 months and isn’t leading the round then something must be wrong. Surely they have more information than I do.” And I think this line of thinking has started to become conventional wisdom as outlined in Chris Dixon’s excellent blog post saying that you need to be careful raising seed money from a large VC fund. [...]
[...] sponsor” problem. I didn’t realize the extent of it until I got emails responding to my earlier seed program posts from entrepreneurs who had been burned by [...]
[...] This post was mentioned on Twitter by Web Startup Group, wawanz and Brent Cappello, Ahad Bokhari. Ahad Bokhari said: The Problem With Taking Seed Money From Big VCs http://j.mp/2Mh9fn [...]
I respect your ability to turn hard to understand VC concepts into everyday speech
Chris,
Great post and truly admire your foundercollective.com, it was long-overdue. Some quick questions:
a) does a dedicated seed-fund charge management fees to its investors? if not, how does the fund cover opex? For example, in the VC model, GPS charge management fees to LPs and get paid carried interest;
b) How and when would “seed-lps” get paid?
c) What kind of support can you offer entrepreneurs, beyond coaching/advising/contacts?
d) What would the typical ownership stake be for a seed investor (I know that y-combinator takes a very small stake for a very^5 small investment); and
e) how many companies you need to invest in to start generating portfolio effects?
Would love to get your take on these, if you have time of course.
Thanks!
Enrique
617-780-5465
Hello, I agree Founder Collective sounds like a great thing BUT why don’t you answer emails? You do not have a number on your site so there is nowhere to call and I have emailed you regarding my business idea, and I have heard from friends who have emailed you – none of us have even received an answer. Come on, even if you do not like the business idea, isn’t it curteous to at least answer email?
After all – you do ASK people to contact you with their business ideas…
sorry, we will answer all the emails in time. just really behind right now.
[...] This post was mentioned on Twitter by Startup Atlanta, Lance LeMay. Lance LeMay said: Good post…just getting to it…The problem with taking seed money from big VCs cdixon.org – chris dixon's blog http://bit.ly/8uayOn [...]
Dear Chris,
Thanks for the great blog and the valuable information you provide to all the entrepreneurs without asking for anything back.
How can I find a mentor like you before starting to send my Business plan to all the VCs and BAs? If someone doesn’t have a friend with your kind of know how, and at the same time doesn’t feel ready to contact investors how can he or she fill that gap?
Thanks a lot!
Sebastian
[...] Don’t take seed money from big VCs – It doesn’t matter if the big VC invests under a different name or merely provides [...]
[...] Chris Dixon (abbreviated): – Don’t take seed money from big VCs – It doesn’t matter if the big VC invests under a different name or merely provides space and [...]
[...] Don’t take seed money from big VCs – It doesn’t matter if the big VC invests under a different name or merely provides [...]
[...] important point about fund size.” He’s specifically referring to his point of view that entrepreneurs shouldn’t take seed money from “big VC’s” (he defines them as > $100 million). It actually wasn’t the point of my post – my [...]
[...] Chris Dixon: The problem with taking seed money from big VCs [...]
[...] deals” – a statement that epitomizes the passive, extractor mindset. The problem with VC seed programs is they not only fail to enlarge the pie, they actually shrink it by making otherwise fundable [...]
[...] those deals” – a statement that epitomizes the passive, extractor mindset. The problem with VC seed programs is they not only fail to enlarge the pie, they actually shrink it by making otherwise fundable [...]
[...] – a statement that epitomizes the passive, extractor mindset. The problem with VC seed programs is they not only fail to enlarge the pie, they actually shrink it by making otherwise fundable [...]
[...] – a statement that epitomizes the passive, extractor mindset. The problem with VC seed programs is they not only fail to enlarge the pie, they actually shrink it by making otherwise fundable [...]
[...] think the issue was mostly framed initially by Chris Dixon in his article The Problem with Taking Seed Money from Big VCs. VentureHacks laid out the debate in a truly awesome interview & PowerPoint slides if you really [...]
[...] think the issue was mostly framed initially by Chris Dixon in his article The Problem with Taking Seed Money from Big VCs. VentureHacks laid out the debate in a truly awesome interview & PowerPoint slides if you [...]
[...] think the issue was mostly framed initially by Chris Dixon in his article The Problem with Taking Seed Money from Big VCs. VentureHacks laid out the debate in a truly awesome interview & PowerPoint slides if you [...]
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