It’s not that seed investors are smarter – it’s that entrepreneurs are

Paul Kedrosky recently speculated that there might be seed fund “crash” looming. Liz Gannes followed up by suggesting seed investors are a fad akin to reality-TV celebrities:

In many ways, what [prominent seed funds] are saying is that they’re just smarter, and as such will outlast all the copycat and wannabe seed funders as well as the stale VCs with a fresh coat of paint. But then — Kim Kardashian is the only one who can make a living tweeting. At some point it will be quite obvious whether the super angels’ investments and strategy succeed or fail.

Here’s the key point these analyses overlook: It’s not the seed investors who are smarter – it’s the entrepreneurs. Consider the case of the last company I co-founded, SiteAdvisor. We raised our first round of $2.6M at a $2.5M pre-money valuation. After the first round of funding, investors owned 56% of the company. Moreover, the $2.6M came in 3 tranches: $500K, another $500K, and then $1.6K. To get the 2nd and 3rd tranches we had to hit predefined milestones and re-pitch the VC partnerships. Had we instead raised the first $1M from seed funds, we would have been free to raise the remaining money at a higher valuation. In fact, after we spent less than $1M building the product, we raised more money at a $16M pre-money valuation. We never even touched the $1.6M third tranche even though it caused us to take significant dilution. This was a very common occurrence before the rise of seed funds, due to VCs pressuring entrepreneurs to raise more money than they needed so the VCs could “put more money to work.” When SiteAdvisor was eventually acquired, we had spent less than a third of the money we raised. Compare the dilution we actually took to what we could have taken had we raised seed before VC:

Professional seed funds barely existed back then, especially on the East Coast. And even if they did, I’m not sure I would have been savvy enough to opt for them over VCs. I thought the brands of the big VCs would help me and didn’t really understand the dynamics of fund raising.* Today, entrepreneurs are much savvier, thanks to the proliferation of good advice on blogs, via mentorship programs, and a generally more active and connected entrepreneur community. For example, Founder Collective recently backed two Y-Combinator startups who decided to raise money exclusively from seed investors despite having top-tier VCs throwing money at them at higher valuations. These were “hot” companies who had plenty of options but realized they’d take less start-to-exit dilution by raising money from helpful seed investors first and VCs later.

Will there be there a seed fund crash? Seed fund returns are highly correlated with VC returns which are highly correlated with public markets and the overall economy. I have no idea what the state of the overall economy will be over the next few years. Perhaps it will crash and take VCs and seed funds down with it. But I do have strong evidence that prominent seed funds will outperform top-tier VC funds, because I know the details of their investments, and that their portfolios contain the same companies as top-tier VCs except the they invested in earlier rounds at significantly lower valuations. So unless these prominent seed funds were incredibly unlucky picking companies (and since they are extremely diversified I highly doubt that), their returns will significantly beat top-tier VC returns.

* Note that we have nothing but gratitude toward the SiteAdvisor VCs – Rob Stavis at Bessemer and Hemant Taneja at General Catalyst. They offered what was considered a market deal at the time and supported us when (almost) no one else would.

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http://twitter.com/L1AD LIAD

were you committed to taking the 2nd & 3rd tranches if you hit the mandated benchmarks? I had something similar where investors effectively got free options on the business – definitely didn't feel that interests were aligned.

(p.s. whats a man to do to get a deck in front of you? I'm still waiting for you to google yourself)

http://reecepacheco.com reecepacheco

haha… well played.
peter12

given that you're founder of two startups you're probably not serious (yet)

focus

http://www.bijansabet.com bijan

Great perspective and thanks for sharing that.

but that isn't how we do things so I would hate to lump all VCs together

for example, consider the seeds that we led OMGPOP or Tumblr or other seeds of $1M or less. The second rounds were all significant up rounds and not traunch based. Sometimes the insiders lead a big step up (so the founder diluted less and didn't waste time on a fund raising process), and sometimes the founders received an up round from a new investor.

but I don't remember us ever doing a financing where we (entire VC syndicate) owned more than 50% of the company for $2.5MM and two rounds of financing. And I don't see myself ever doing that.

http://www.cdixon.org chris dixon

I agree but think you, USV, and True and probably a few other firms are exceptions to the rule.

http://www.metamorphblog.com Matt Mireles

Kleiner Perkins did this same traunch-style investment with Cooliris. Irked me then too.

Thanks for sharing the specifics. So incredibly helpful for us n00bs.

http://www.cdixon.org chris dixon

sure- felt like it was finally long ago enough I could share specifics.
http://www.victusspiritus.com/ Mark Essel

Right on Matt. This is the type of info you don't know or even consider, when hustling to secure funding for a first startup. Props to Chris.

http://avc.com fredwilson

we have never offered a traunch based deal either. so maybe there is a third category Chris. seed investors, new school VCs, and old school VCs

http://www.cdixon.org chris dixon

agree – you know I always exempt USV (and a few others) from my “big vc” diatribes

http://kickpost.com/ calebelston

The ironic thing about the so called “seed fund bubble” is that less capital is actually being put to work then might normally be dispensed if the same companies were going for VC.

This is almost certainly good. As you mention, many of the best companies also have the opportunity for traditional VC, which means they weighed their options and chose a path that is simply putting off VC for a while until they can get even better terms, or exit before needing many millions.

It's hard to argue credibly that there is a bubble when less capital is flowing into a system and at lower valuations.
http://hdemott.wordpress.com Harry DeMott

Yes, same portfolio, lower cost base = higher returns. The only way that doesn't work is if the company continues to need financing and the seed investors do not – or cannot participate in the subsequent rounds.

The truth is that having higher quality seed investors should only leads to better outcomes. Not only will companies be far better prepared when they go for their first VC rounds – but VC's will end up putting less money to work in companies – and so their successes will be more capital efficient and their failures less costly.

Given a consistent market – returns should improve all around – but VC's will be disrupted by not being able to put as much capital to work.

Based on your own experience, I could imagine a situation where you see more tranched deals – but where the tranches are more widely spaced – and the option for the capital draw down lies with the company – and not with the VC.
http://informationarbitrage.com/ infoarbitrage

chris, interesting post. as you know i am a big supporter of micro-vc and think the math you have laid out is both true and compelling.

i do feel, however, that there are a few issues facing micro-vcs that haven't yet been tested: (1) willingness and ability to fund into later rounds; and (2) correlation of returns among consumer, app-oriented micro funds.

i, like usv, true, spark and first round, deeply believe in the value of a “life cycle approach to investing,” e.g., leaning hard into winners, not throwing good money after bad, cutting losers short. a lot of money is left on the table by angels (or funds who act like most angels) who are unwilling or unable to push in more chips when the odds are stacked in their favor. whether more micro vcs choose following on as a key part of their investment discipline remains to be seen, but i suspect will have a marked impact on investment returns.

i do worry about how much diversification is really happening among micro vcs, particularly those based in and around the Valley. my sense is that so many consumer plays and apps are being funded by a relatively concentrated set of players, that i wonder if this won't eventually lead to a lot of tears among these funds and their lps if this focus area and investment thesis doesn't pan out. it reminds me a little of the heavily trafficked strategies among quant funds in late 2007-early 2008, where a set of common models and market disruption led to sharp liquidity problems that drove massive sector losses. these strategies were seemingly uncorrelated – until they weren't. i'm not calling for a problem but am merely raising the issue.

roger

http://www.cdixon.org chris dixon

“my sense is that so many consumer plays and apps are being funded by a relatively concentrated set of players”
I think this is partly true, but also partly a distortion due to the fact that B2C companies get a lot more coverage on TechCrunch etc. I haven't done the analysis, but I think at least half of Founder Collective startups are B2B.

http://shanacarp.com/essays ShanaC

Is there a way to kill some of the distortion?

http://informationarbitrage.com/ infoarbitrage

chris, interesting post. as you know i am a big supporter of micro-vc and think the math you have laid out is both true and compelling.

i do feel, however, that there are a few issues facing micro-vcs that haven't yet been tested: (1) willingness and ability to fund into later rounds; and (2) correlation of returns among consumer, app-oriented micro funds.

i, like usv, true, spark and first round, deeply believe in the value of a “life cycle approach to investing,” e.g., leaning hard into winners, not throwing good money after bad, cutting losers short. a lot of money is left on the table by angels (or funds who act like most angels) who are unwilling or unable to push in more chips when the odds are stacked in their favor. whether more micro vcs choose following on as a key part of their investment discipline remains to be seen, but i suspect will have a marked impact on investment returns.

i do worry about how much diversification is really happening among micro vcs, particularly those based in and around the Valley. my sense is that so many consumer plays and apps are being funded by a relatively concentrated set of players, that i wonder if this won't eventually lead to a lot of tears among these funds and their lps if this focus area and investment thesis doesn't pan out. it reminds me a little of the heavily trafficked strategies among quant funds in late 2007-early 2008, where a set of common models and market disruption led to sharp liquidity problems that drove massive sector losses. these strategies were seemingly uncorrelated – until they weren't. i'm not calling for a problem but am merely raising the issue.

roger
Zarooba Rozruba

It takes balls to post a screenshot with a spelling error. A spelling error that is already underlined with red as such.

valution
http://www.adrianscott.org/ Adrian Scott

Great analysis, and thanks for sharing the numbers. It's going to be very interesting to see how the second round makeup evolves over time. VC's seem to want % of company, whereas seed investors are not focussed on that, and that should be very tempting to founders over time… VC's: hemmed in by seed investors on one side, and DST on the other? …
http://uniquevisitor.net Jeff Pester

I like the correlation reference; Seed Funds to VC Funds to Public Markets. The only true test will be relative performance over at least one market cycle.
http://avc.com fredwilson

that last line is not exactly true Chris. we were too slow to offer you a financing at Site Advisor and Bessemer and GC beat us to the opportunity. but we were very interested and i suspect we would have gotten there pretty quickly.

also, i will take the bet on seed funds vs VC funds. i'll stake our 2004 fund against any seed investor out there.

http://www.cdixon.org chris dixon

someone recently said to me your 2004 fund will be “epic” which I suspect will be true.
http://www.cdixon.org chris dixon

updated last line

http://avc.com fredwilson

i like how you did that. i am going to copy that move when doing comment driven updates

http://www.victusspiritus.com/ Mark Essel

It's the pro social adaptive blogging move. Tip of the hat to Chris for the rapid update

http://thegongshow.tumblr.com andrewparker

The USV blog used to feature on it's front page (before a redesign last year) a 10 minute interview with Fred, Brad and Charlie. Unfortunately the podcast is lost to the Internet ether because it was done by Businessweek, and the permalinks were ravaged in their collapse. In that interview the USV team is asked which deal they feel like they missed over the years. Siteadvisor is the only example the team cited.

http://shanacarp.com/essays ShanaC

Check if the TimeMachine has it, it sometimes stores files. If you know the file name (or the approximate file name) you can search the time machine for a link to the file name, and download it. It's worked for me in the past!

It's probably still there too since that website was around for such a long time.

Rick

Great post … It shows that growing (especially East Coast based) seed partners are filling a huge need in the market especially at the earlier stage when entrepreneurs benefit most (from a dilution perspective) from achieving milestones. With additional financing sources you are also taking less of a financing risk. Today – you may have less dilution than our analysis
http://discourseandnotes.com/ Dan

Can't help feeling that this debate needs to be updated to reflect recent market realities. The S&P is down about 18% (and counting) since two months ago, and economic signals are pointing to a global slow-down again. Exits, LPs, opportunities, could be heading into an environment that reflects the turmoil… which, one would think, will impact valuations, follow-on rounds, liquidity, risk-appetite, and many of the subjects of this article. Maybe the super-seed vs. VC debate should now be one about which group will do more to reduce the future funding risk for the entrepreneur. Despite the larger size of VC funds, I don't think the answer is obvious.
http://vinodgopinath.wordpress.com/ Vinod Gopinath

What is also working in favour of seed investments, is the fact that consumer internet apps can be developed and deployed with a million dollars or less compared to traditional software development in the pre-MVP era.
- Fast feedback loops
- Availability of better frameworks that speed development & deployment
- Smaller and more agile teams
Coming from a system software & kernel development background, this sure was a learning experience for me. I suspect some VCs are still going thru this learning curve.
Guest

“Had we instead raised the first $1M from seed funds, we would have been free to raise the remaining money at a higher valuation.”

Pardon my naivete, I'm curious as to which seed funds will give a startup that kind of money.

Y Combinator will give you around $20k for around 5%, which means you'd have to sell your entire company 2.5 times in order to raise a million dollars.

Further, if you're saying entrepreneurs are savvier, and using SiteAdvisor as an example of how you could have done things better, what seed funds back in 2005 would have given you a million dollars?

From your footnote, apparently none, so where's the evidence founders are smarter? There are simply more options now, because you can do more with less money as technology advances, as always.

Can you list any examples of companies that have been able to raise over a million dollars while giving up single-digit percentages of equity, like the 9% in your fabricated example?

This sounds like fantasyland to me, but you have far more knowledge in this area.

http://www.cdixon.org chris dixon

Seed funds like Founder Collective are part of syndicates that routinely
rounds between 300-1M total. In my example the seed investors got 29% of
the company for their 1M, not 9%. That's roughly what we are seeing in the
market now.

http://www.homethinking.com nikiscevak

I think it's also important to look at the perspective of the super-angels. It's fine if they are investing their own money but once they setup $10m funds like what's happening now it just seems like minor-league baseball. If they are successful they'll either raise a lot more money and look like a 'new model VC' or they'll just simply become a VC after demonstrating success (Reid Hoffman).

Point being, that managed super angel funds offer a worse economic incentive to the partners and so they'll either start just managing their own capital/close off to outside investors (100% of gain instead of 20%) or they'll become/join a VC (20% gains on $100-200m fund).

p.s. agree whole-heartedly on the entrepreneur dynamic but feel like your USV, True etc. exception list will grow ever larger and this whole debate will end up in semantics.

http://www.cdixon.org chris dixon

re fund creep (funds getting bigger and bigger): i think you can fix it with
new carry structures. why should a 5B buyout fund and a 10m seed fund have
the same fee structure?

Beth

Hi Chris, I like your flexibility in thinking about new deal structures. Are you starting to see something akin to “start-up creep” where some start-ups may bootstrap their way through what would traditionally be considered a seed round and/or even an early stage round before seeking investor financing? (perhaps even indicia of a Series A round if product/market fit and first sale are considered). Here, the indicia of the start-up seem to become a bit misaligned with seed funds in some respects and VCs in other respects. Can you share any advice for this situation?
Thanks,
Beth
http://twitter.com/janthonymez J. Anthony Miguez

I agree on the fund fee structures needing to change. The rise of sophisticated seed investing has driven long overdue innovation on the funding side. As a VC in 2000 it was clear the shift was on to start-ups building companies for VC funding (big market, big burn, put lots of money to work). Now the investors have to build a funding mechanism for the company. Seed and syndicated angels are a great start to filling a need. The only bubble I see is a group of “me-too” VC's coming off of their investment period trying to put as much money to work as possible and therefore inflating certain valuations. Not good for investors and not good for companies. Seed and “New VC's” keep it all aligned. There was a reason King Arthur had a round table.

chrissheehan

Having run a micro cap fund ($10M) since 2005, I very much agree with Chris analysis. Our strategy as angels and small fund investors is to work with entrepreneurs that want to raise the “right” amount of money – typically $500k – $2M, in order to test a set of assumptions around the opportunity. They take less dilution than if they raised $5 – 7M in a traditional A round, and preserve more options regarding funding, growth rates, and risk profile for their company. This works for many opportunities in the IT industry (not all, but many).

And I agree with Roger's comments. For us, we have managed to build a diversified portfolio across the IT stack – infrastructure, B2B, SMB, and B2C. We also encourage all our angel investors to reserve for follows on and maintain that discipline in our fund.

Great post Chris.
http://twitter.com/WaltFrench Walt French

I don't doubt that entrepreneurs are “smarter” in some sense but am amazed that my scan of the article + comments found not one mention of a firm's business prospects.

Some former co-workers — extremely smart software types with a real vision, I thought — ran a startup for years, during which they spent almost all their time raising funds. Care with the cash was not enough to ever accumulate critical mass on the product side. The effort chewed through several hundreds of millions without a single sale. The startup guys were philosophical, but some resented having their opportunities hijacked by funding. The VCs just saw this as business as usual. They never had a very good idea of the real business they were investing in.

No wonder Buffet is famous for saying that he only invests in firms that an idiot can run, because someday, one will. The entrepreneurs had better be twice as smart as your average firm's leadership, because they have more challenges, more difficult challenges, and almost no margin for error.

http://www.cdixon.org chris dixon

I talk about those kinds of issues ad nauseum on my blog – just not in this post.

http://www.pakman.com dpakman

Good post, Chris. At Venrock, it is extremely rare to do a tranche-based deal, particularly in IT. I have seen it done in healthcare and that is usually done because the company will need $30M – $40M more capital to reach its next fundable milestone (i.e., drug approval) but there are a bunch of additional fact-based milestones before that occurs. In the IT world, I haven't seen a tranche-based deal done in the last 18 months I have been here. I do think smaller funds investing smaller amounts makes tons of sense, provided the funds have enough capacity to defend their ownership should the company choose to raise a bunch of additional capital. Many of the more successful tech companies start small but eventually raise a lot of capital (facebook, twitter, zynga, etc.) and that can put pressure on smaller funds' returns unless you can maintain ownership. On topic, we just closed a smaller fund today…
http://www.victusspiritus.com/ Mark Essel

Gracias. Startup info gold for those actively seeking or positioning themselves to seek funding later. I heard briefly of tranches before and was a little bewildered by the “bridge” like nature of them. Mark Suster wrote a great post against bridges.

“prominent seed funds will outperform top-tier VC funds”.
I can't wait to see how this plays out!
http://sheynkman.tumblr.com Kirill Sheynkman

Like your math, Chris. But I would find it difficult to find a VC that would do a Round A (or a round B, if you call it that) where the percentage of the company being sold is only 9%. If your pre-money is $16M, you still need to sell a significant chunk for $6-8M at least. I have always faced the same “need to make it interesting for us” arguments in a Round B as I did in a Round A. 9% stake is just not interesting enough. Again, your experiences may differ, but at least that's the schooling I've had.

http://www.cdixon.org chris dixon

I agree. I was just simplifying a bit. I suspect you agree with my main point – that it's good that startups have a new option where they can raise less seed money.

http://sheynkman.tumblr.com Kirill Sheynkman

I absolutely agree that there are new ways to fund something and hitting Sand Hill Road should not be the first, knee-jerk move. However, the VC math is still the VC math. Just two things really bother me…
1. A startup that wants to raise $1M on a $15M pre-money (saw a couple asking for that). I usually tell them to have a bank or a friend loan them the money .
2. A seed or a VC who asks for draconian terms ($500K for 60% of the company). I have seen a few of those and I usually tell the entrepreneur to run immediately. Actually, seed funds tend to do this more often. I think they are preying on ignorance.
A good funding deal should be a win-win (to overuse a cliche).

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http://how2startup.com/ Roy Rodenstein

Great post and mostly agree, esp. as an angel myself. In the interest of full information for entrepreneurs, I do think it's fair to mention:
- if you have a good/great company, you could easily raise an A round upfront at much higher valuations. We had offers at an $8-10M pre-money and if you can swing a single firm, you could get $4M with founder+employee equity of 70%
- going the angel/seed route first definitely buys you time, but that can also backfire. If you're *not* progressing as fast as VCs “think you should”, or if you do the angel round at a low enough valuation, you could well end up selling off more of the company via seed+A than straight A

As usual, these scenarios vary on a lot of factors, but all are possible and common for first-time entrepreneurs especially.
http://www.trueventures.com Jon Callaghan

Great post, Chris.

At True we take it one step further and strive for Founders to own control through 2 rounds. It doesn't always work out that way, but if you structure the A round properly there is a shot that it works. We like our mainstream Seed/A rounds to max out at 25% dilution, and seek less in our seed and super-seed deals. We lobby for option pools on the smaller side of market are incredibly transparent with Founders about our average ownerships across the 3 deal types that we do: super-seed, seed and “real.”

All of the firms in the disruptor class (True, FRC, Foundry, Spark, IA, USV, FC, Maples, and many others) get this equation, and pay sincere and dedicated attention to the Founder's equity position. This is a great thing.

Most of us (and esp the super-angels) have been Founders ourselves before (some many times) and it's no surprise that our products are more attractive to Founders b/c we understand what they need most (and importantly the stuff they don't need).

It's an exciting time in the ecosystem. Bubble or no-bubble, and just like the startups we fund, as long as we keep the customer (Founder) interests top of mind, the best entrepreneurs will keep selecting these deals as they are best designed for today's market.

http://www.cdixon.org chris dixon

Great comments, Jon. Totally agree. Like the phrase “disruptor class” since as you point out it's not all seed funds.
Beth

Hi Jon,

I appreciate your transparency in sharing a bit more about your deal structures and approach towards entrepreneurs.

Thanks,
Beth
http://twitter.com/NukeGold Nuke Goldstein

This is a great approach, after all it is both the investors' as well as the founders' job early on to ensure that the core team's motivation and the reward are sustained. At the end of the day most startups are nothing without the steadfast dedication of the founders who created and carry the vision and IP.

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http://www.graduatetutor.com Senith

Thanks for sharing. Will has a interesting formula on how much to ask for at seed stage at http://www.2-speed.com/2010/07/how-much-should-…

thought some of your readers might be interested.
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Chris Dixon

It’s not that seed investors are smarter – it’s that entrepreneurs are