Revisited: big VCs investing in seed rounds

A few years ago, the trend of companies raising smaller seed rounds combined with the emergence of new seed funds caused many big VCs to create seed investment programs. This triggered a debate among entrepreneurs and investors about whether it was risky for seed-stage companies to take small investments from large VCs. (I blogged about the issue here, here, here).

Since then, enough founders have directly experienced the downside of taking seed money from big VCs that I think it’s safe to say there is no more room for debate. I can think of about 15 founders I’ve spoken to recently who tried or are trying to raise Series As but are seriously hampered by the fact that a big VC invested in the seed round but isn’t participating in the Series A. (I’d love to mention specific companies and firms but it wouldn’t be appropriate for me to do so – I guess I’ll just have to cite Jay Rosen’s “I’m there, let me tell you what I see” principle of reporting).

There are two important nuances to point out here. First, there are big VCs who invest in seed rounds the right way – with the genuine expectation to follow on and the intention to help out during the seed stage (some that I’ve invested with include USV, True, and Spark). One important sign of this is how much they want to invest. If a $300M fund wants to invest $100K, they are buying an option. If they want to invest $500K, they are more likely making an investment.

The second nuance can be counterintuitive: the danger of taking seed money is positively correlated with the reputation of the firm. If a top VC invests in the seed round and then passes on the A, other VCs will have difficulty overlooking that the smartest money that knows the company the best isn’t following on. If the VC isn’t well respected, it is easier for other VCs to second guess them.

I’m not revisiting this issue to criticize big VCs. A healthy startup environment requires smart, ethical investors at all stages. But I don’t think these big VC seed programs benefit anyone. And there are enough angry entrepreneurs out there that I expect the message will get through.

75 thoughts on “Revisited: big VCs investing in seed rounds

  1. natsturner says:

    Great post Chris – couldn’t agree more with what I’ve seen out there.  If a big VC is technically buying an option, if they don’t exercise said option anyone else starts to ask why and assume there’s a reason (and sometimes there may not be other than their perceived lack of time or loss of interest). 

  2. How can one legally work another justification for a VC not following on in future rounds?

    E.g. can there be a restriction for VCs in seed rounds that they can’t invest in Series A? Or a restriction forcing them to increase their current ownership % of the company or not invest? This would maybe allow startups to justify to other investors why VC didn’t follow on.

  3. But that would defeat the purpose of these VC seed programs. The whole goal is to have an inside track on the Series A. Remember their model works generally when they invest ~$10M per company.

  4. iPaulLee says:

    I think the corollary here is also related to valuation. For large megafunds, that have significant capital to deploy, there is very little difference between an $8MM cap or $12MM cap. They are looking for options on early stage companies… Entrepreneurs should factor in other factors beyond just valuation and brand name. Having a big vc firm invest $100K of a $1MM round at a $10MM cap sounds great for the headline but you should consider all the other factors that Chris mentions.

  5. i’ve struggled to understand this debate….i’m sure largely because i’m self-funded, and so am a foreigner in this world……but are you suggesting buying an option is unethical? or that entrepreneurs feel this way? i don’t sympathize here…..it seems to me if an entrepreneur is concerned about follow on signaling, they should raise the price of the option (i.e. more cash for less equity), or should choose their investors more carefully if they value investors that care…..but i don’t see this as an ethical issue really, as i don’t see how anyone is being dishonest and if i were an LP i would be delighted to see a fund’s general partners astutely employ an options strategy.  

    moreover, options based strategies allow more investments to be made, which helps more entrepreneurs get funded…..if fund ABC only makes serious committments, they going to make far fewer investments…..and they will understandably want to focus more on entrepreneurs they trust who have a proven track record. in other words, high commitment strategies require a higher win rate, while funds with options strategies can have a lower win rate so long as losses are kept small; this allows funds to be spread out and a broader set of ideas to be explored. it also allows funds to experiment more with how they can create network effects amongst within portfolio (as a larger data set enables this). at least that is the way it seems to me, from my outsider perspective…..  

  6. I’m not claiming it’s unethical . I’m just trying to get the message out to founders to, as you say, pick your investors wisely, and specifically to understand each investor’s motive for participating in a seed round.

  7. I’m a little skeptical. If you knew a list of great companies that are unable to raise an A for this reason, wouldn’t you be investing more in them yourself? Sounds like a real opportunity.

    Why not post a list of great seed-stage companies worthy of an A, and silently include some of the companies affected by this supposed issue?

  8. Very interesting.  I wonder if the issue could be somewhat mitigated (if not completely addressed) if those top VC funds separated a bit more clearly from their seed effort. In several cases I’ve seen, those seed investments obey different rules within those top tier funds (e.g., not all partners need to agree), and in some cases, come from different pools of money altogether. Perhaps it would help if they pushed the separation logic a bit more, for example by giving more independence to the seed fund, and perhaps giving it a different name altogether (not related to the VC fund’s name), while making it clear on their websites that those investment decisions are made differently.  But at the end of the day, I agree that reputational and economic (e.g., investing $500k rather than $100k) incentives are probably more effective.

  9. I don’t have the money to lead Series As. Also, even if I did I’d probably be a bit concerned myself if a big VC I trusted wasn’t following on. They have information I don’t and I’d be wondering what led to their passing on the A.

  10. Funds do this, but usually separate between Series A/B and “growth.” E.g. USV has a new growth fund with a separate manager, separate LPs etc. I think one problem with VCs trying to do seed for the sake of seed (and not options on A) is the economics just aren’t that compelling. If you have a $500M fund you are making $10M a year in management fees plus carry fees. You have to have a mindboggling well performing seed fund to make a dent in those numbers.

  11. Strange, in your post above you seemed so sure that they are all great investments.

    Love to see that post of great seed-stage companies. I’m serious, it would be of interest and benefit to lots of people.

    The mistake, if any, is to boast of a seed investment by anyone who could also do an A. Accepting their money seems harmless.

  12. Do you think that a company who takes a seed from a top tier firm, and then has that top tier firm pass, should easily get a A round from other investors? 

    Are there common cases where the company is indeed strong, but the investor passed for unrelated issues, and the company now is in deep trouble? 

  13. Having just
    gone through this process it’s even more nuanced than the two points you make. 

    Even if you
    have the VC committed to the A round it may be seen as a negative by certain
    funds because they will get less equity in the A round or maybe they don’t have a great history co investing with that fund or partner so they’ll pass. The reverse is also possible (your investor doesn’t want certain funds in the A).

    That said, in addition
    to being incredibly helpful through the post seed investment our VC introduced us to another VC they had good history with and together they co-lead our A round. So we’re proof it can
    work. 

  14. I would say they are all or most “fundable under normal circumstances.” Not necessarily great. (Although one of the hottest startups out there had this happen and overcame it).

  15. I’ve seen cases where e.g. 1) the sponsor from the fund left the firm, 2) a company pivoted, creating a conflict with another investment, 3) the VC just not paying much attention. I’ve also seen cases where the company just didn’t perform as they had led people to expect and investors (perhaps justifiably) lost faith.

  16. Good point about having a VC in seed restrict your options. I find that even when the VC wants to participate, it can create the issues you describe in addition to others: e.g. other VCs think they are being used as stalking horses to set price and don’t want to make an offer, hence reducing company’s ability to get a market valuation.

    I agree it can also work. It depends on the VC, the company’s performance, etc.

  17. So then if there are cases like that, why can’t the investor see the truth for what it is? If they don’t have access to that information, the entrepreneur can tell them why. It strikes me that your thesis about this signaling problem relies in very imperfect information flow and perhaps even illogical investors. 

    But both problems are solvable by better communication and picking better investors to interact with. 

  18. Totally agree. 

    Taking a small amount from a big name/big fund generally means you’ll get very little attention from them, their option check will make almost no difference in that firm’s next round funding decision, and you may suffer potential signaling risk.

    If you are going to take money from a sizable institutional fund, you better make sure that firm takes a meaningful amount (amount of capital deployed and/or meaningful ownership %) in order to get the benefits of the relationship and not just assume the costs.

  19. The entrepreneur usually does try to tell a story about why the big VC didn’t invest. But the problem is all the other VCs know those are might be just excuses, and it is very difficult for the prospective VC to know the truth.

    Yes, venture investments are made with very imperfect information.

  20. I can see how it would be stupid to _talk about_ a seed investment from anyone who could lead an A.

    But what’s wrong with accepting the money? And if you did, why on earth would you talk about it?

  21. Yes, with YC season now we are seeing this in action with 10M+ seed valuations, uncapped notes etc. Those tend to attract option seekers and turn away people looking for returns on their seed investments.

  22. You have to disclose the investment. It’s on the cap table which you have to share. And it was probably in the press when your funding got announced. You can wait to disclose it but that would only make you look deceitful.

  23. If you use the big VC’s name for press early on, it’s hard to complain when someone checks whether they participate in the A.

    It’s not deceitful to describe your seed as being done by “nine investors, including X, Y, and Z”. 

    And I dont see where you’d disclose it otherwise prior to getting a term sheet.

  24. You’re right, Paul,notes don’t show up on a cap table.  Most founders, when going into fundraising, will have created a pro-forma cap table to evaluate the impact of various funding options.  Those cap tables will indeed have information on notes.  If that pro-forma cap table doesn’t exist, I’ll create my own and request any documentation that impacts the cap table.  And those requests will be pre-term sheet.

  25. Good post, Chris.  Choosing investors is also a function of valuation.  Inevitably, I think star struck founders will ignore your advice about choosing their investors, retain large valuations in the seed, and take big VC money.  I wonder how many of them, once their runway expires, will have to do down ‘bridge’ rounds with both new and existing investors.  Series A capital will probablybe off the table until they validate with this new set of investors.

  26. Pitch perfect – as always – and interesting that aside from a few nuances – nothing substantive has really changed.  

    Also worth a quick visit – is the Caine Moss piece in VentureBeat on elements to watch for in the actual docs (circa 2009).  As he points out – it’s tempting (as a matter of convenience mostly) to use Series A docs for Series Seed – but there are some important differences to watch for – and it’s an *ideal* time to make sure everyone really is committed/aligned.

    http://venturebeat.com/2009/08/24/seed-is-the-new-series-a-for-vcs/ 

  27. Chris- like the strait opinion. So with ones decision as to which  seed stage, is Seeds working relationship with series A good, bad or both?  Also, Can you speak a little more about investment conflicts of interest within a VC firm and  between VCs firms? Including the issues of pivot and investments made post your startup. 

  28. I think the market dynamics will self-correct to account for this in two ways: (1) Top VC’s that pass on A rounds are looking to get into the “best” deals” which will only drive those valuations higher….leading to (2) Not all VC’s being able to get into high-demand deals and will have to shift attention to better values. I think the stigma will go down with time as it will  become more the norm than the exception.

  29. joeagliozzo says:

    This is the same situation the startup faces at all stages of fundraising, after the first round – if your previous investor won’t lead or at least participate you are in trouble. So if you accept that, then whether your early stage investor is a VC or not, it doesn’t matter. You got funded, had your shot, and didn’t show enough progress to go on to the next stage. The moral of the story is, no matter who your seed stage investor is/are, you better have defined milestones in mind and communicate those and then hit those milestones.

  30. I think you may be missing the point.  Maybe the VCs are indeed making rational decisions, maybe they aren’t.  From the entrepreneur’s perspective, it doesn’t matter – either way hurts you.

  31. Great post as always Chris – I tell entrepreneurs if you are taking seed money form a larger fund, make sure its a LOT – I’m not sure that $500k from a $300m fund gets that much attention (I prefer $1m as the hurdle) or make sure the partner takes a board seat (mostly impossible with such a small amount).

    You want involvement not optionality at your expense

  32. Cory says:

    2 separate founder-friends of mine ran head first into this signalling problem when they recently tried to raise their Series As. Neither has been able to close his round yet, and it’s been a nightmare for them and their teams. I haven’t gotten the latest updates from them in over a month, but last I checked they’re both just hoping for smaller follow-on rounds w/ an expanded circle of angels.

    Both founders knew the danger into which they were putting themselves, but they were sold pretty hard by these particular VC firms, and they just couldn’t resist the brand name. Plus, they were both overly optimistic, and they thought that there was no way their VCs would want to pass on them after seeing their continued growth. 

    These guys both asked me for advice about what to do in their situation, and it was pretty tough for me to offer anything substantial. I mentioned that they might have better luck doing another angel round, which is what they’re doing. They’re running into the same issues, but angels seem to be much more understanding and willing to back them.

    Is there any way to spin the situation when approaching other VCs while still remaining 100% honest and upfront about it? 

    Any other advice you would give them? Chris? Anyone? 

  33. PaulSutter says:

    Certainly there are cases where you’ll need to reveal it before you get a term sheet, and then you should. But often you won’t. And most of all, don’t go around boasting about a big vc being in the seed unless you’re ready to answer why they’re not interested in the A.

    You have to represent things for what they are. If a big fund makes a tiny investment as a way of placing an option, you’re getting what you deserve if you trumpet to the world that they are backing you.

  34. in another time, if an early stage VC decided to stop funding a deal, they would get wiped out. pay to play was the ethos. i still think that way.

    it’s not right to treat angels that way of course. but VCs are different. sadly angels can get hurt in cramdowns designed to penalize the early stage VCs who stopped supporting the company. so can founders.

    maybe we’ve move past that time and aren’t going back to it. but it is hard for me to forget the lessons learned in my first 20 years in the business.

  35. Have you ever actually been through the Series A fund raising process? what are you basing your claims on? I’ve seen it hundreds of times and have never seen a case where a list of all investors/note holders wasn’t requested long before a term sheet was delivered. Almost always discussed in first meeting.

  36. PaulSutter says:

    I’ve closed six venture rounds in companies I’ve founded and been in many pitches of seed funded companies looking for an A.

    In all of those meetings, the investors ask “who is in the seed?” and the answer above, “nine investors, including X, Y, and Z” was perfectly appropriate, it would have been awkward and a waste of time to list all nine investors.

    The basic rule of raising money is that you don’t name the other investors who are looking at leading the round.

  37. In addition to the cases you mention, I’ve seen cases where it’s the entrepreneur ‘passing’ on the firm and not the firm passing on the entrepreneur simply because the big fund did absolutely nothing to help the company at the early stage and therefore the company has no interest in taking their money.

    Not sure if this is truly relevant to the convo, but figured it should be noted.

  38. Inherently flawed argument and I am surprised that this is not more obvious. 
    If a big VC doesn’t follow up in a Series A, then you have received money for a company that was never worth it.  Congrats to you.  The same VC would of course never have given you money, had he known what he knows now.  And potential other Series A investors of course get the message.  Fact is that your company is toast.  Congrats for having had the opportunity to give it a try with somebody else’s money.
    All you are saying, Chris, is that it is easier to trick angel investors than it is to trick big VCs who know what they are doing.  Duh. 

  39. “If a big VC doesn’t follow up in a Series A, then you have received money for a company that was never worth it.”
    This assumes Big VCs make perfect decisions, which is just silly.

  40. David Lee says:

    great post, GB. We like to say that big VC seed money comes with higher risks and “higher risks = higher costs.” So the VC needs to bring additional value add to offset these higher costs. If so, great. If not, then they should pass. So they should really dig as to what value the firm will add.

    And yes, we’ve seen it be a big issue if the VC doesn’t follow on. Not as debilitating as 5 years ago since there’s more capital out there, but definitely harder. We call it the “factory refurbished” issue. You’ll probably have some buyers but it’s not like the box is unopened.

  41. I guess the takeaway is that if a well known VC provides seed funding and then doesn’t follow on to your Series A round, other VCs are going to take that as a strong data point not to invest as well. This seems rather obvious to an outsider.

    Although I am sure its quite tempting when your in the moment and may not be thinking through all the possible future outcomes.

  42. Yaniv Tal says:

    Allow me to play the social engineer. I wrote out an equation (using series) that I think perfectly describes this situation. I started putting it in but I’ll spare you guys since I doubt anyone would read it anyway.

    Let me just try to describe it briefly:

    A startup should take seed funding from a VC if and only if:

    Desire(working with a specific VC)*P(getting an A from said VC)
    ——————————————————————————————–
    Desire(Working with other VCs) * P(getting an A from other VCs)

    > some ugly number

    where Desire is a real number from 0 to 1.

    What some people are saying is that P(getting an A from said VC) = P(getting an A from other VCs) which if it were true, would indicate that the company should just choose based on Desire(working with the specific VC). This assumption itself assumes perfect knowledge, namely, that all the VC’s are privy to the same information and make decisions using the same criteria. Obviously this is not true. We could analyze further what this discrepancy looks like mathematically but I guess there are better uses of time.

    Suffice it to say that if a company REALLY wants to work with a particular VC and they are confident that they will deliver, it would make sense for them to take the seed from that VC. The second that either of those begin to taper off, it makes the case for using angel investors much stronger. Hopefully enough other people like to think of problems analytically to justify me outing myself as a total nerd.

  43. Yaniv Tal says:

    it’s too bad that disqus doesn’t have an equation editor..  here’s a free multimillion dollar idea: a speech to mathtype equation smartphone app. i’d pay $20 for that easy.

    it might seem weird to write out equations for problems like this but i like to do it because it keeps my math skills sharp and you’d be surprised how applicable math and analysis can be to all sorts of problems. usually when you have a gut intuition about something, your brain is actually doing this kind of processing but you focus on whatever connections jump to your mind first. by formalizing issues like these into equations, you’re forced to think about all of the variables and you start to see intricate relationships all at once. with issues of business, you’re almost always dealing with probabilities. that makes the math harder but it’s all the more reason to formalize the thoughts. probability is a tricky beast and the underlying fundamentals rarely mirror intuition. people tend to grab data points and draw conclusions or “lessons learned” from them though discrete data points rarely give the whole picture. by viewing the equations you can really internalize the relationships and fine tune the constants over time with experience.

  44. i was cofounder and ceo in a deal a few years ago where an early stage vc decided to stop funding, and the company attempted to exercise the wipe out right, but the other vc’s in the deal stepped in and forced the company to waive that provision — any such a move required the preferred shareholders consent, and the other vc’s were not willing to take any such action against one of their own. (that was explicitly why they explained their decision to veto the action; there was no other reason to not exercise that contractual right.)

    my point is, if companies want to have penalties for non-participation by a preferred shareholder, they should also make sure the company gets to exercise that right in its sole discretion, and not have that right be a de facto right of the preferred shareholders themselves…

  45. Yeah in my investing I save ~30% of capital for “defensive capital” in case I need to reup when pay-to-play or seemingly artificially low down rounds come back (presumably in a downturn).

    When I mention this to anyone who didn’t live through 2001-2003, I have to explain to them about this possibility – and they look at me like one of those guys stockpiling guns and soup in his backyard bomb shelter.

  46. This is a very interesting post considering that we’ve recently done a Seed with a mix of VCs/Angels & the pre-emptive rights clause was one we belabored the most during the term sheet negotiations. 

    I’m not sure how the Series A will play out yet (too early to tell), but I think it will be very much dependent on the milestones we have committed to.

  47. I’m not an expert but more thinking…

    They either have to maintain their current share, or they’re totally out. That way if they’re out, you can at least say to other investors, that they couldn’t take their full share at this point and so they can’t invest in the new round. Anything which smudges the lines as to their reasoning for not taking the chance to invest.

    Again this doesn’t take into account back channelling etc… But just really focused on how to use legal structures to excuse their reluctance to take part.

  48. Yes, I meant the pro-rata rights for subsequent raises. Actually, to be correct, I don’t have USV. It was Fred/Joanne that invested as angels, and Rho is the major VC there.

  49. Very interesting post Chris.

    What are the advantages of accepting BigNameVC in a seed round?

    Wondering what others have experienced in terms of helping with recruiting, press, intros, and advising vs the angel route.

    My perception is that BigNameVC would really help validate your company and help with press but may not be as helpful in advising and intros.

  50. dsjoerg says:

    “If a big VC doesn’t follow up in a Series A, then you have received money for a company that was never worth it. ”
    Not necessarily.  There are other reasons why they might not be following up, for example perhaps your firm’s prospects are in the gray zone between clear success and clear failure and they are no longer interested in that zone, or perhaps the VC has decided to change their strategy and focus on bigger companies, or your key relationship at the VC has left the firm.

    The problem Chris is highlighting is that when the VC doesn’t follow up, everyone else will assume, as you have, that the company itself is no good.

  51. If these are the reasons for the VC not following up, then that’s very easy to see for other potential investors (everybody knows if a VC fund changes strategy) and hence wouldn’t deter new investments.  

    The easiest explanation is usually the one closest to the truth.  If a VC doesn’t follow up, then mostly that is due to the fact that the VC made a mistake.  Why is that so hard to see?

  52. dsjoerg says:

    Another reason for the VC not to follow up is that they’re unhappy with the terms they’re being offered.  When/if you sign with a big-name VC, you have less leverage in future negotiations because if they walk, it hurts you a lot more than it hurts them.

  53. Wrong.  If you can afford to offer such company-friendly terms, then obviously you have no trouble finding series a investors and you don’t care if they don’t join.  This is only an issue if you have trouble finding investors, in which case you would be a fool to insist on terms.  

  54. “sadly angels can get hurt in cramdowns designed to penalize the early stage VCs who stopped supporting the company. so can founders.”

    Explain the rationale behind this kind of behaviour?

  55. dsjoerg says:

    When you say Wrong, Obviously and Fool, it doesnt make people want to discuss anything with you, and they just wonder if you’re trolling.  Be nice or else I’ll start making meme pictures of you!

    Also, your arguments assume that venture investing is a perfect-information game.  Perfect-information games are notorious for being universally acknowledged as such.  The lack of such universal acknowledgement regarding venture investing, here and elsewhere, calls that idea into serious question.

    In games of imperfect information, signaling effects become important.  To circle back directly to your point, while there are good sources of information about the general investing environment, the sources of information about the investment prospects for your own company are harder to come by.  All you get from potential investors are indications of interest, which might be geniune, or they might be just shopping…  and then you start negotiating with your lead, and how tough should you be with them?

  56. Chris.
    Can you please give a simple and brief outline for new IT Entrepreneurs how and when to approach a VC?  
    Are there any one day seminars to attend on East Coast to understand how to secure seed money and who to approach.
    Thanks

  57. @cdixon:disqus can you please clarify an important point: 
    Are signaling issues raised if you raise an angel/seed round (500K – 1.5M) from a ‘seed-stage’ VC, such as Founder Collective, Felicis, FRC, Floodgate, Baseline, and your seed-stage VC chooses not to participate in a follow-on round of funding during your series A?

  58. Most seed funds either don’t do follow ons or do small amounts (pro-rata). It’s all about expectations. If the funds get bigger and start leading A rounds, then expectations change.

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