The most important question to ask before taking seed money

There is a certain well respected venture capital firm (VC) that has a program for fledgling entrepreneurs. The teams that are selected get a desk, a small stipend, and advice for a few months from experienced VCs. I could imagine back when I was starting my first company thinking this was a great opportunity – especially the advice part.

Here’s the problem. A few years into the program, approximately 25 teams have gone through it. The sponsoring VC funded one team and passed on the other 24. None of those other 24 have gotten financing from anyone else. Why? Because once you go through the program and don’t get funded by the sponsoring VC, you are perceived by the rest of the investor community as damaged goods.

Most early stage investors are bombarded with new deals. There is no way they could meet with all of them, or even spend time seriously reading their investor materials. In order to filter through it all, they rely heavily on signals. The person referring you to them is a very big signal. Your team’s bios is a very big signal. And if you were in the seed program of a VC who has a multi-hundred million dollar fund and who decided to pass, that is a huge signal.

Meanwhile, the unsuspecting entrepreneurs think: “I was at a prestigious VC this summer – this will look great on our bios and company deck.” The truth is exactly the opposite: the better the VC, the stronger the negative signal when they pass.

Thus, the most important question to ask before taking seed money is: How many companies that the sponsor passed on went on to raise money from other sources?

The best programs don’t have sponsors who are even capable of further funding the company. Y Combinator simply doesn’t do follow ons, so there is no way they can positively or negatively signal by their follow on actions. (Although now that they have taken money from Sequoia people are worried that Sequoia passing could be seen as a negative signal. I just invested in a Y Combinator company and was reassured to see Sequoia co-investing). Other seed programs lie somewhere in between — they aren’t officially run by big VCs but they do have big VCs associated with them so there is some signaling effect. (I would call this the “hidden 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 it).

The most dangerous programs are the ones run by large VCs. I would love for someone to prove me wrong, but from my (admittedly anecdotal) knowledge, no companies that have been in large VC seed programs where the VC then stopped supporting the company went on to raise more money from other sources.

As has been widely noted, startups – especially internet-related ones – require far less capital today than they did a decade ago. The VC industry has responded by keeping their funds huge but trying to get options on startups via seed programs. Ultimately the VC industry will be forced to adapt by shrinking their funds, so they can invest in seed deals with the intention of actually making money on those investments, instead of just looking for options on companies in which they can invest “real money.” In the meantime, however, a lot of young entrepreneurs are getting an unpleasant introduction to the rough-and-tumble world of venture capital.

Disclosure: I am biased because as an early stage investor I sometimes compete with these programs.

http://MeetInnovators.com Adrian Bye

please do continue posting this kind of stuff; very interesting
http://reecepacheco.com reecepacheco

Such a great point, Chris. It's easy to get excited with early-stage interest from a popular VC, but like you say, it's really just them buying an option on you. We went through this and while it was tempting to really pursue it, I'm glad it didn't work out.

I think Fred's post today on avc.com re: 'slow capital' relates to this. If the VC's in question really took their time with the companies – before and after accepting/investing – these numbers might be very different.

I'm curious – do you think this effect exists at all among angel investors? I know some investors have big names that others may follow, but are there other investors out there who would scare you away?

http://www.cdixon.org chris dixon

Angel investors: no one expects angels to lead follow ons. If they
are really wealthy/prominent people might expect them to do pro rata,
but even then signalling value is vastly lower than with VCs, whose
sole purpose is to put 10m into companies.

http://reecepacheco.com reecepacheco

Makes sense. Thanks Chris.
bkcookiemonster

If you're a typical VC fund trying get in on seed deals, is it possible to fix the situation by doing the 2 following things:

1) Having a policy such that once invested in a seed round, the VC will make a strict policy to not re-invest/re-up.

2) Assigning each seed deal an official venture partners (who maybe is required to co-invest?) so that the seed guys get some attention and mentorship even though they represent a very small portion of the fund's asset allocation. Maybe the venture partner could be a seed/angel fund as well.

This way, there are no “mixed signals” as to how interested the VC fund is in the given team post investment. The price of losing the option shouldn't be *so* bad since they're already in at a time when valuation is lowest.

What does everyone think?

http://www.cdixon.org chris dixon

But the big VCs don't really care about the seed investment itself – the whole point is to get an option on putting in a lot more money later on. Hence #1 would undermine this goal.

bkcookiemonster

That makes sense, the seed investment itself will get the fund very small % ownership to begin with if you hold Y combinator/Tech Stars/etc. avg valuations as comparable examples. No fun without the option.

Wish there was a way to solve this problem.

charlottekim

Yes! I completely agree. This past spring/summer I looked into several of these programs and spoke to a LOT of people, I came to the same conclusion and didn't apply. I operate on the premise that when approaching the venture community (probably even more so in NYC than Silicon Valley), it's a very tight community and people talk. Don't want to go out too early, don't want to go out to too many. Definitely need to be cognizant of what people are saying, thinking or reading about you (esp before you have results to show) because first impressions only happen once. I'm biding my time.

http://www.cdixon.org chris dixon

VCs definitely talk to each other a lot, on both coasts. Outsiders
don't realize how much.

Sam

Chris – Great post to help those just starting out. I'm in the process of drafting a business plan, and have been struggling to find good resources. The best article I came across was one you actually referenced in an older post – http://whohastimeforthis.blogspot.com/2005/11/h…
I realize this is slightly off topic, but do you have any recommendations for good business plan outlines to use for a seed fund pitch?

http://twitter.com/cdixon chris dixon

Sequioa used to have a nice page, but I think they got rid of it since the redid their website. Cowan's thing is the best thing I know of online.

http://www.replicatorinc.com Joseph Flaherty

Great article Chris. Is this the Sequoia page you are thinking of? I used it while business planning and found it to be extremely useful:

http://www.sequoiacap.com/ideas

http://twitter.com/cdixon chris dixon

yeah that's it
Sam

Thanks! This is great.

http://jared.tumblr.com jaredhecht

Out of those 25 companies, can the lack of follow-on financing simply be attributed to an uninspired product? Is this a case of correlation vs. causation? I'd think that if a respected VC firm had a seed program, it would immediately generate interest for outside VCs.

http://twitter.com/cdixon chris dixon

Those companies were over a couple of years where allegedly there was a rigorous selection process among many entrants. So in theory the VC already filtered the uninspired products out.

As an active participant in this world, I would say it is definitely a case of causation.

Brad

Jason Fried's easy solution, and the best advice anyone can give you: don't take seed funding, make money first (taken from mark bao's notes http://j.mp/19TtN7):

# the bootstrapped company starts off thinking: we need to make money.
# the funded company starts of thinking: we need to spend money. these investors have given us x million dollars—we should spend it!
# the funded company detracts away from doing final execution of the product and making revenues.
# start as early as you can. you don’t become fantastic at piano by starting at 20 or 25. you do become fantastic at piano if you started at age 5.
# price forces you to be good and better than the rest. the pressure of price is very, very good.
# pricing your product will give an avenue for the people buying your software to give you feedback on it.
# if a product is free, you don’t get that feedback.
# if a product is free, it’s just “good enough.” people will take it and say it’s just “good enough” to use for free.
# the most intimate transaction between people: money. I’m giving you this money earned by hard work because you offer something that I want.
# funding is like crack. it’s an addiction with names like Series C. Don’t keep going back for more and more funding; it’ll make your addiction worse.
# planning is GUESSING. figure out stuff as you go, because you never really know. plan some, but improvise a lot.
# I promise you’ll still be using post-it notes in 20 years. Usefulness trumps innovativeness; usefulness stays while coolness deteriorates over time.
# all the art in the world in one room won’t make a museum. the fact that it rejects 99% of art makes it a museum. apply this to software features.
# 37signals’ byproducts include Getting Real, the job board, and more. they have generated 37signals more than $1M in revenue. the job board itself has made $1.5 million.
# “we apologize for any inconvenience we may have caused you” is the worst way to say “I’m sorry”
# the best are everywhere, even outside Silicon Valley, don’t think you HAVE to be here. 37signals is based in Chicago.
# sorry, failure is not a rite of passage. you don’t have to fail. failing once doesn’t prevent another. Fried thinks the idea of “you have to fail once” and having to “learn about failure” is ridiculous.
# learning a lesson from failure is learning what not to do. learning what to do is a lot better than learning what not to do.
# other peoples’ failures are other peoples’ failures. don’t worry about them.
# anyone know how to sell things for free? you can’t. you can only sell things for money.

http://www.rescuetime.com webwright

“Jason Fried's easy solution, and the best advice anyone can give you: don't take seed funding, make money first”

So who fills the financial gap between idea and first customer? Some people can bootstrap that, but not many. If you've got a complex/big product idea, you're sunk (not everything can get to v1 in a month or two). More importantly, who fills the gap betwen first customer and substantive revenue? 37s (with a hugely popular blog and smash-hit-noteriety of Rails) took 12 months before they punted their (established/successful) consulting business to focus on their product. Said a different way– they needed 12 months of growth to get to/near breakeven EVEN WITH THE HUGE FOLLOWING THE HAD.

Bootstrapping a services business is pretty easy. Bootstrapping a product business is really hard unless you support it with an existing consulting business. Quitting your job and trying to bootstrap BOTH (start a solo consulting practice that's going to support product efforts) is nigh impossible. It's do-able, but I'd rather sell a small slice of my company to get the ability to focus.

http://shanacarp.com/essays ShanaC

There are certain business that fall in between. Those scare me the most…

http://www.cdixon.org chris dixon

There are certain businesses that simply require big up front investments – e.g. a search engine, biotech, etc – where VC financing makes sense. If you are making lightweight web products like 37signals, VC financing might not make sense. I think there is definitely a place for VC financing and there is also a good case to be made for bootstrapping a lot of companies that raise VC today.

srevzin

Great post Chris. VCs see the value of deal sourcing at an earlier stage than their fund normally calls for, so these seed programs might be around for some time.

But like you said in your earlier post, as the problems in this model become “conventional wisdom” for entrepreneurs, VCs will start seeing less quality deal flow from these programs as smart entrepreneurs turn away.

A better model would be to build relationships with entrepreneurs more organically and provide advice without seed funding in a less formal way. That way VCs still get exposed to good companies and can gauge the quality of the team without the risk of sending a negative signal by not choosing to invest.
http://codingrelic.geekhold.com DGentry

I guess its similar to the signal when early VCs decline to participate in subsequent rounds, though there the bloodlust of crushing early investors sometimes makes a new round happen anyway.
danielgackle

I really like these posts, but am confused on one point. How does the seed stage differ from later stages? It must, because if you remove the word “seed” from “Beware taking seed money from VCs because you are giving them an option on your future and will be in trouble if they pass later” (paraphrased), it would follow that taking *any* VC money is a bad idea. But that doesn't seem to be your point.

Would you please explain the difference? Isn't one always giving a VC such an option when taking money from them? Is it a matter of the degree of commitment? i.e. with seed they can put a little money in for 6 months and not do very much, just to wait and see, whereas with “real” money they're actually in the game now and behave accordingly?

Brad

Haha, in my book you're right on target Dan. Taking VC is borderline insane for most (I emphasize most, not all) businesses; refer to Jason Fried's points above in my comment.

danielgackle

No, that's not what I meant at all. The topic here is not “problems with VC in general”, but rather the problem with *seed* VC. What I want is a clearer understanding of the difference between seed VC and later VC: why does one lead to the dynamic Chris describes while the other, presumably, does not. What Jason Fried et. al. have to say on the topic of VCs in general is well-known and not to the point here.

http://www.cdixon.org chris dixon

Dan – Good question. It comes down to the amount of money and % ownership the VC has. Big VCs are in the business of trying to get for themselves, say, $50M from winning investments. That means the exit needs to be, say, $300M, and they need to own 15-20%. Seed rounds are just options to put more money in, where there is no way (except in very extreme outlier cases) that they could get such a return without putting in more money, because they don't own that much and the company and will own even less as the company gets further financing from others.

What this boils down to is if you roughly: if you are taking less than <$1M from a >$300M fund, it's a seed round. They care more about the option than the actual money invested.

Does that make sense?

http://walkercorporatelaw.com Scott Edward Walker

Chris – This is outstanding, insightful advice. Indeed, as a corporate lawyer for 15+ years, the most common mistake I have seen entrepreneurs make in dealmaking is the failure to diligence the guys on the other side of the table (which I discuss in detail in “Mistake #1″ here: http://bit.ly/10eiiN). In the seed-financing context, you have identified one of the key diligence issues – and one that few entrepreneurs understand. I tip my hat off to you for continuously providing important advice to entrepreneurs. Cheers, Scott
http://www.facebook.com/people/Nabeel-Hyatt/639480676 Nabeel Hyatt

Great post. I'm glad that periodically these articles crop up reminding young entrepreneurs of this issue. Fred W, Josh K, and even little old me have tried to warn folks about the tradeoffs of “going VC” too early (my post was catalyzed by the CRV Quickstart program, but generally the same message: http://nabeel.typepad.com/brinking/2006/11/vcs_…)

One thing folks don't talk much about is that EIR programs can sometimes run the same risk, although not quite as much.
http://twitter.com/betterlabs Vaibhav Domkundwar

Chris, couldn't agree more. But with VC requirements of a startup shrinking, its also becoming important that you raise seed money from the “right” set of angels/incubators, who I believe are increasing serving as “screeners” for larger VCs, who don't/can't spend time looking at all early stage deals. So a bootstrapped startup that is ramen profitable on its own, suffers from a disadvantage of not being able to potentially get in front of large VCs because they are not “screened” by the prominent angels/incubators.
jessicamah

Hey Chris,

My company took some grant money from Lightspeed Venture Partners over the summer, and I thought about how this would affect raising money in the future. What happens to the companies that don't ultimately get money from Lightspeed?

The thing is, very few of them even pitch the firm after the summer. Lightspeed typically invests $3M+ into companies, and never is a company ready to raise that much money after 2 months of building a product. That just doesn't make sense.

I asked John Vrionis, one of the partners at Lightspeed what his thoughts on this were. Exactly the same — every company that passed through the program was comprised of college-age students, which meant many of them were still in school. Not to mention, as I mentioned earlier, 2 months isn't much time to build a company worthy of $3M+ of venture financing.

So they do something similar to what YCombinator does: bring in the early VC firms, like Baseline and Maples. Companies that live past the summer often need $250-$1M to continue, and a large VC firm simply isn't interested in the smaller deals.

http://www.cdixon.org chris dixon

Hmmm… If it's not to find deals, what's Lightspeed's motive for
running the summer program?

jessicamah

Haha – I asked them the same question, and John Vrionis' response was “because we want to build relationships.” It's their way of having fun with a group of college students, and it might lead to an investment down the road. But I felt that they were very genuine, and that they weren't doing this to bring in more deal flow.

It's the VC firms that don't give grants that are more problematic… the VCs that have the right to invest in future rounds, but Lightspeed wrote us a check without any legal parameters. I doubt that many VCs would do this.

http://www.cdixon.org chris dixon

I guess the cynical view would be they have a good cover story to protect
their startups from negative signaling. The optimistic view says they are
just good people (which, incidentally, I've found the Lightspeed team to
be).
…………………………………………………………………………………………………………………………………………………………………..
Chris Dixon | hunch.com | Cell: 1-917-282-0854 | 54 W 21st St #1001,
NY NY | cdixon.org | @cdixon

john_vrionis

Hi Chris – this is John Vrionis from Lightspeed. I think this is a great discussion topic, thanks for posting. I appreciate your views and frankly agree with a number of the posts. There is certainly risk in seed funding from a VC and a possible stigma if that VC doesn’t want to continue investing in the next round. For the purposes of this thread I want to briefly explain our motivation behind our summer program. I look at it this way, at Lightspeed we’re in the business of fostering entrepreneurship. I started the program in 2006 because we had the resources and desire to provide students the platform they need to dedicate 100% of their time during the summer to their startup ideas. As a grad student, I (like most of my entrepreneurial classmates!) had to take jobs to pay the bills and therefore startup time was left to nights and weekends. When I joined Lightspeed and saw there was willingness to offer something better, we decided to give it a try.

We don’t ask for equity or a right to invest. We never intended it be an incubator or a seed program. We honestly feel it is a privilege to work with such bright, energetic people at this stage in their careers and enjoy building the relationship. Of course if an investment opportunity is created (post summer experience or at some point down the road), we'd be thrilled, but that’s not the primary goal. We’ve enjoyed working with dozens of teams since the program began and are always tinkering with the format based on input from the students.

jessicamah

Hey Chris,

My company took some grant money from Lightspeed Venture Partners over the summer, and I thought about how this would affect raising money in the future. What happens to the companies that don't ultimately get money from Lightspeed?

The thing is, very few of them even pitch the firm after the summer. Lightspeed typically invests $3M+ into companies, and never is a company ready to raise that much money after 2 months of building a product. That just doesn't make sense.

I asked John Vrionis, one of the partners at Lightspeed what his thoughts on this were. Exactly the same — every company that passed through the program was comprised of college-age students, which meant many of them were still in school. Not to mention, as I mentioned earlier, 2 months isn't much time to build a company worthy of $3M+ of venture financing.

So they do something similar to what YCombinator does: bring in the early VC firms, like Baseline and Maples. Companies that live past the summer often need $250-$1M to continue, and a large VC firm simply isn't interested in the smaller deals.
http://twitter.com/jonathanjoseph jonathanjoseph

I have a slightly different take on this. The problem is not in the seed programs per se (unless they are tied to a fund that is $100M>), the problem still lies in the VC business itself.

Of course a large venture fund isn't going to be comfortable enough to know that there is a $100M+ exit after only a few months.

Once there are enough funds (and there will be) that are in the <$50M less range that will be fine with $5-$25M exits there will be far more options for entrepreneurs coming out of these programs.

This “problem” should be seen as part of the lingering VC shakeout and not an indictment of seed programs like YC/Techstars etc, which are playing a very, very valuable role.

http://www.cdixon.org chris dixon

I am talking almost exclusively about seed programs / incubators / summer programs run by big VCs ($300M plus funds), not techstars and Y combinator etc which I think are playing a very valuable, positive role.

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joseggonzalez

Thank you very much !!
-www.google.com/profiles/matrix2007
Connect, tag & stalk me !!
Jg
http://500hats.typepad.com davemc500hats

>> Y Combinator simply doesn’t do follow ons, so there is no way they can positively or negatively signal by their follow on actions.

hmm, i don't believe that's correct. at the very least, i'm pretty sure PG & PB have done follow-in investments in a number of YC companies. you might want to ask Paul or Jessica to confirm.

—

personally i don't think there's anything wrong in setting up funds to do follow-on, but most large VCs don't have the capacity to do very much of it… thus the bad signal you speak of. in our case, we have 2 seed vehicles: fbFund (an incubator program that's a joint venture with Founders Fund, Accel, & Facebook), and FF Angel (an associated seed fund i manage that focuses on ~$100K investments).

when we planned out fbFund for 2009, we specifically made the point that neither Founders Fund nor Accel would likely be leading subsequent rounds, and for Founders Fund we would mostly be doing any follow-on via my FF Angel program.

of the 22 companies we invested in for the incubator program, 6 have currently received financing, and it appears likely at least another 4 more will receive financing by Q4/09 or Q1/10. (note: ~4-5 other startups are profitable or close to break-even and may choose not to raise capital, but i'm guessing most of them will).

to date FF Angel has invested in 1 of the fbfund 2009 startups (Thread.com), and we're likely to do 2-3 more. however, we aren't leading on any of those rounds, and there are simply just too many potential opportunities for us to invest in all of them — in fact, i missed investing in one of them because other investors moved more quickly

in summary: our “success” rate for follow-in financing and/or break-even looks like it will be above 40%. that exceeded my expectations of 25%, but perhaps we just got lucky this year. we will likely do follow-on financing in 15-20% of the companies, which i would also consider to be higher than my initial expectations.

so while i don't disagree with your general observations, i think there are a few structures that can be successful. by explicitly not leading in follow-in rounds, but still participating, it forces other VCs to make their own decisions.

the above aside, it's still early and we're still learning how all of this works best. as we advise our startups, we'll watch, measure, and iterate on our approach.
http://500hats.typepad.com davemc500hats

(btw chris: love your stuff & generally agree with your observations above, but given your investing role you might want to make that disclosure at the top, rather than bottom, of your post

http://www.cdixon.org chris dixon

sure, didn't occur to me, but good advice, thanks.

Doug Coyle

Chris, good dig at Charles River (awful fund) but pardon me … you don't do seed either.

http://www.cdixon.org chris dixon

not sure what you mean I don't do seed?

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empresario1

Good post…I came across your post by looking for commentary/insight on whether or not it makes sense to take money from a “seed fund” that is really part of a larger VC. Our situation is slightly unique in that we have commitments from friends, family and angels to account for just over half of what we are trying to raise. The “seed fund” wants the rest of it, but wants an option to invest at a discount in the subsequent round. Initially, we thought it made a bunch of sense to be associated with this “brand name” VC, but the more we think about it and see commentary like your post, we are thinking we don't take their money? Any advice would be appreciated…
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http://www.victusspiritus.com/ Mark Essel

First popular post read, I mark it 7/10 Chris. An absolute must read if your concept needs funding from the start. And generally good advice for startups that pursue funding later.

Many startups aren't even looking for funding. It's much better to focus on business and revenue building, and seeking out outside money only when absolutely necessary.

How about splitting your startup to two external seed investors? Is that only applicable in selling one's
soul
http://www.victusspiritus.com/ Mark Essel

First popular post read, I mark it 7/10 Chris. An absolute must read if your concept needs funding from the start. And generally good advice for startups that pursue funding later.

Many startups aren't even looking for funding. It's much better to focus on business and revenue building, and seeking out outside money only when absolutely necessary.

How about splitting your startup to two external seed investors? Is that only applicable in selling one's
soul
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