Earlier this week I did a one hour interview on “Meet the Angels” sponsored by Tech Coast Angels (one of the LA Angel groups.) It was supposed to live but for some reason there were some problems getting into the webcast. It’s now up on the web – if you were trying to watch it and couldn’t, it’s posted below.
I was thinking more about my post from yesterday titled Addressing The VC Seed Investor Signaling Problem. There were a bunch of good comments that caused me to realize that I wrote the post from the perspective of a VC, not an entrepreneur. As I mulled the comments over, I realized something very specific.
If a VC invests in a seed round but then doesn’t invest in the next round, there is a signaling problem, regardless of what the VC does with their investment.
When I read the post carefully, I realized that I implied that the VC firm’s strategy of selling back their seed investment might address part of the signaling problem. In hindsight, it doesn’t address this at all. It addresses a different problem – the free rider problem.
Most VC’s hate when other VC’s act as free riders. A free rider is defined as someone who invests in an early round but then doesn’t participate in future rounds. Note that I explicitly said “other VCs” and not angel investors. Most VCs expect that angel investors will only invest in the first round or two, so they get exempted from free rider status. I also exempt “super angels” / “seed-only VCs” from this – if you clearly define your role as an investor in the first round or two, and you never participate in later rounds, then you won’t end up being classified as a free rider. But, once you start participating in later rounds, the expectation of your financial participation changes.
Early stage VCs are often expected to play at least pro-rata in following rounds. When companies are successful, the early investors often (but not always) back off their pro-rata. But, when companies go sideways or struggle, the early investors are often expected, by their co-investors – to continue to participate pro-rata until the company either succeeds or fails. In many cases, the consequences for not participating are significant and you can get a taste for this from the post on the term Pay-to-Play that my partner Jason and I wrote in 2005.
The firm that I mentioned in the previous post addresses the free rider problem by saying “look, we’ll make it easy, we don’t support going forward so we’ll sell back our equity to the company, entrepreneurs, or angels and get out of the way for new VC investors.” While this doesn’t address signaling, it does eliminate the free rider – in this case the VC that is not going to participate going forward.
When things are going great, none of this matters. But when things aren’t, they matter a lot. If I shift from the perspective of a VC to the perspective of an entrepreneur, I would only want VCs as seed investors who have a proven track record of consistently following their seed investments with future investments. This will never happen 100% of the time – there are definitely seed investments that don’t make it. In addition, there are often cases where the entrepreneur doesn’t have choices and has to work with whoever shows up with a check. But to hand wave over the issue is illogical.
Now, as a VC, I don’t want to co-invest with free riders. I’m exempting angels, super angels, and “seed-only VCs” from this. But if I co-invest with someone, I want to know that they are going to work with us to continue to fund the company, not walk away 50% of the time “because” – well – whatever “because” means.
The collision between signaling and free riders is what creates a lot of dissonance. In the current wave of seed and angel investing activity, we haven’t hit a hard down cycle yet. We will. When we do, these two issues are going to pop to the forefront. Anyone who participates in the early stage investment ecosystem (entrepreneurs, angels, and VCs) should make sure they spend some time thinking about this and incorporating it into their own strategy, before it is upon them.
One of the most common criticisms of VC investors making seed investments is something that has become known as “the signaling problem.” The explanation of this problem is that VCs create a “negative perception” about a company if they make a seed investment but then don’t follow through and make a next round investment. Another way to say this is that a VC creates a “signaling situation” with their seed investment – if they don’t follow on in the next round they are “sending a signal” that something is wrong with the company (hence the label “signaling problem.”)
Last week I spoke with a partner at a large VC firm whose firm has been around for a long time. They have a new seed program (as of a few years ago) after eschewing seed investments from 2002 to 2008. The partner that I talked to told me that they are doing 30 seed investments out of their newest fund.
I was surprised on two levels – the first is that they have a very visible anti-seed reputation. I pointed out that their market reputation was that they didn’t do seed investments nor did they do many Series A investments. He said “we changed that a few years ago.” I suggested that their web site didn’t talk about their seed program; he responded “yeah, we need to work on our web site.”
The second, more important thing, was that I couldn’t make the math work on their fund. I asked them how many of the seed investments they expected to follow with regular first round investments. He said “half of them”. So – 15 of their investments in the fund would come from their seed program. I asked how many other investments they’d have in the fund. He said 30. So they’ll end up with 45 active investments in the fund (high for their fund size) of which 33% came from seed investments.
I then asked how they were going to deal with the “signaling problem” for seed investments they didn’t follow on with. Here he said something that made me pause: “We’ll sell them back to the founders, the company, or the angels at somewhere between $1 and our cost.” I probed on this (as in “seriously, can you give me some examples?”) Without naming names he explained three situations in the past two years where they’ve done this. And, in each case, his firm had decided not to follow on, took themselves out of the cap table, and the three companies were able to raise additional financing (in one case from a different VC firm.)
I thought this was a pretty clever way to deal with this issue. While it doesn’t eliminate the problem created by the signaling issue, it addresses part of it. I don’t know if this firm will follow through on unwinding their positions in 15 of the 30 seed investments they make. I also don’t know how they’ll feel when one of the 15 they decided not to follow goes on to be massively successful and their seed piece, if they had kept it, would have returned a meaningful amount of money to them. But if they do take this approach it seems like they should shout it from the rooftops as part of their VC / seed positioning statement.
I’m not a fan of this “spray and pray” seed investing strategy for VCs. Instead, when we make a seed investment, we don’t treat it any differently than our non-seed investments. Rather than repeat our approach here, take a look at the post How I Think About Seed Investing As A VC that I wrote a month ago. That said, I found the approach of selling back the seed investment at $1 to be an interesting way to address part of the signaling problem.
Following is a post on super angels I wrote yesterday for PEHub.
In the beginning, there were angel investors. And it was good. As individual angel investors made more and more investments, they became super angels. One day a super angel woke up and thought to himself, “Gosh, I could do a lot more investments if I had a fund.” And so the super angels became micro-VCs (or “institutionalized super angels”). Everyone was excited and on the seventh day they did another deal instead of resting.
I’m a huge fan of the super angel movement. Some of my best friends are super angels and I’ve put my own money where my mouth is in funds like Chris Sacca’s, Dave McClure’s, Jeff Clavier’s, Roger Ehrenberg’s, and David Cohen’s. Not only am I an investor in these super angels, I love to have them on board with our investments at Foundry Group. And whenever they bring me something they’ve been working on, I always pay attention–as I know they know what I like to invest in.
But recently the super angel mantra of “traditional VCs suck” has reached a fevered pitch. What started out in Silicon Valley as a new wave of angel investors has evolved into a belief that “VCs are lousy seed investors” and “no one needs a VC–just raise your money from super angels and go to town.”
Fred Wilson from Union Square Ventures recently wrote an excellent blog post titled “The Expanding Birthrate of Web Startups.” As with many of Fred’s posts, the comment section was as useful as the post, and early-stage investors such as Mark Suster, Charlie O’Donnell, Roger Ehrenberg, and Anonymous Coward weighed in. The comments ranged from the now cliche-ish “VCs suck” to “What happens when super angel-backed companies need a new round” to “Companies will never need more capital. It’s a new world out there.” As I read through the comments, I kept pondering the same thought: “What happens in five years?”
Let’s consider a few situations. Take a typical super angel. Assume success. Investors (LPs and individuals like me) want to invest money with the super angel. The super angel probably creates a fund and raises a lot more money. Now the super angel is a micro-VC. Continue to assume success. More money is able to be raised. Now the micro-VC is a mini-VC. Does this keep scaling, or does the mini-VC succumb to the same challenges that $200 million funds ran into when they turned into $1 billion funds?
Now, take a super angel with a 20-company portfolio. The super angel is hyper-connected and works closely with the entrepreneurs he/she invests in. Suddenly he/she has 100 investments. Are the entrepreneurs getting the same attention from that angel–especially when they enter year three of their life, hit a bunch of speed bumps and need a lot of help? Or does this super angel just turn his/her back and say, “Well, that’s the breaks.”
Finally, take a super angel who is used to making $25,000 to $100,000 per investment. He/she becomes a micro-VC, raises a bigger fund, and now invests $500,000 per deal. Is there a difference in his/her behavior with regard to the $25,000 investments vs. the $500,000 investments?
I think the super angel movement is awesome, but the generalization that all VCs suck at seed investing doesn’t make sense to me. Correspondingly, the idea that entrepreneurs only need super angels doesn’t make sense either. There’s a renewed focus and interest in early-stage investing going on in the United States, and it’s being stimulated by a lot of factors. It’s a powerful thing that will continue to evolve, change and challenge all of the participants.
My partner Seth Levine has a detailed post up today titled Trada – from the beginning that describes the creation and financing of Trada. Foundry Group is the seed investor in Trada and Seth’s post describes one example of what I think is effective VC seed investing.
The meat of the funding story follows:
“Of course coming up with the idea is the easy part. Executing against that idea is another matter. In this case neither Niel (nor I) had any interest in creating a traditional syndicate to fund the company. Instead we quickly put our heads together about a financing (we like to say it was over beers, but the truth is more mundane – we hammered out the details in a 10 minute conversation in the conference room of the Foundry office). We decided that we wanted to bring in some experts to help us with the business and together flew around pitching the business to a small handful of strategic angel investors to pull together a small syndicate that became the initial Trada investor base. Niel and I hammered out a second financing in similar fashion (again around the Foundry conference table, this time without the need for an angel roadshow). It’s a great example of how we like to work with entrepreneurs – especially those that we have a long history with. We like to be involved early (in this case before an idea for a business even existed) and we think of our angel investments as a down payment on a subsequent investment in the business (we’ realize that we need to give early businesses some time to develop).”
The short version is that the seed round was figured out in ten minutes – this was the “Series A”. A few strategic angels were added to this round. We did a second financing by ourselves at an increased valuation – this was the “Series B”. Recently Google Ventures led the a $5.75m “Series C” round.
The terms on the Series A and B were straightforward as Niel Robertson, the founder/CEO of Trada is a sophisticated entrepreneur (Trada is his third company) so he had no patience (nor did we) for silly, complex early stage terms. More importantly, the two key aspects of any deal – price and control – we able to be negotiated quickly between Seth and Niel, partly because of their long history working together which was built on mutual respect and trust.
When we funded the Series A (the seed round) of Trada, we fully expected we were at the beginning of a multi-round journey. Seth does a great job of explaining how it got started – I encourage you to read his post for an example of one of the financing cases where I think a VC can be an excellent seed investor.
Last week saw an explosion of discussion around seed investing, including plenty of negative comments around VCs as seed investors. While I agree that many VCs are crummy seed investors, I think there are some that are excellent seed investors. This prompted me to write a post titled AngelList Boulder and Some Thoughts on Seed Investing where I promised to write up some of my thoughts on how and why VCs could be good seed investors.
Before I got around to starting, there were three excellent posts that, if you are interested in this topic, are must reads. They are:
- Fred Wilson: Lead Investors, Dipshit Companies, and Funding Every Entrepreneur
- Mark Suster: Understanding a VC’s Seed Funding Policy is Critical
- Dave McClure: MoneyBall for Startups: Invest BEFORE Product/Market Fit, Double-Down AFTER
All three of these posts lay out clear points of view on the authors seed strategy. And importantly, Mark encourages all entrepreneurs to make sure they understand a VC’s seed strategy before taking money, which I strongly agree with.
Before I start talking about good and bad VC seed strategies, I thought I’d explain mine. For context, about 25% of the investments we make at Foundry Group are seed investments. But before Foundry Group, my partners and I were involved in many seed investments, both at Mobius Venture Capital. In addition, I’ve made many seed investments as an angel investor in two time periods,1994-1996 and 2006-2007, and seen many more through my involvement as a co-founder of TechStars. Our strategy has evolved from this experience and is different from my angel investor strategy (which I’ve explained in my post Suggestions for Angel Investors.)
As a VC, I do not differentiate between a seed investment and any other investment that I make. At Foundry Group, we are comfortable investing as little as $250k in a round (a seed investment for us) all the way up to $10m in a round. We think about each investment – whether it’s $250k or $10m – the same way, and commit to participating in the business for the long term.
Specifically, our seed investments are not “options on the next round.” We price our seed rounds as equity investments, always lead or co-lead (as Fred describes in Lead Investors, Dipshit Companies, and Funding Every Entrepreneur), and treat them the same way we would with a $10m investment.
I have three partners and all of us are involved in all of our investments. So, when we make a seed investment, it gets everyone’s attention. We try hard not to smother it with love, but we recognize that we usually each have something unique to add to a seed investment and try to help accordingly. As a result, we are all emotionally involved in the investment (a phrase you’ll see in later posts about this topic) which I believe is both beneficial to the entrepreneur and extremely important to the VC firm.
When we make a seed investment, we fully expect to invest at least the same amount that we invested in the seed round without thinking hard about it. One of our strongly held beliefs is that it often takes several years for a company to find its mojo and we are willing to work through the challenging first few years. As a result, we don’t believe that there is a particularly critical “go forward or not” decision point immediately following the seed round. Now, this doesn’t mean that the follow on round is blindly done – we are very internally critical of the progress a company is (or isn’t) making, but we try to firmly put ourselves on the side of the entrepreneur in this discussion and work together when things start off slowly, or differently, than expected.
At Foundry Group, we describe ourselves as being “syndication agnostic”. This means we are completely indifferent as to whether we fund something ourselves or with other VCs (e.g. each are equally happy situations.) In addition, we are equally delighted to co-invest with angels and super angels, or not. Basically, we are happy in any case, are making a decision to invest independent of anyone else, and defer to the entrepreneur on who they want to have involved.
Finally, we are deliberate about the areas we invest in (our “themes”). We see a ton of seed investment opportunities, but only invest in a few. Many of the opportunities we see are outside of our themes. We have consciously decided to only invest in areas we know well and think we can be meaningfully additive to and constrain our focus to these themes (although the themes expand and evolve with our experience.) This lens allows us to spend the vast majority of our time on companies we are either investors in or likely to be investors in, and limits our time “exploring lots of things that have a low probability of being an investment for us.”
Taking Mark’s lead from his post, I’m going to put up a more specific post on the Foundry Group blog that lays this out in a very specific way. I’ll also follow this post with some examples, as I’ve got seven to choose from: AdMeld, Gnip, Lijit, Mandlebrot, Next Big Sound, Standing Cloud, and Trada. And, in case you are wondering, here are two recent examples of how seed investments blossom: AdMeld Raised $15 Million Round from Norwest Venture Partners and Time Warner and Trada Raises $5.75 Million Round From Google Ventures.
Ah – well – another day passed and there was once again a ton of chatter around angel investing. A lot of it was prompted by AngelConf 2010 which you can watch recordings of on Justin.tv (AngelConf 2010 Part 1 and AngelConf 2010 Part 2). While there continues to be plenty of negative VC tone and “disruptive change is here” (ala traditional VC is over), there were also some great nuggets, including my favorite line from Joshua Schachter of typical VC behavior of SHITS (Show High Interest Then Stall).
But I think the two best posts to come out of yesterday are Lead Investors, Dipshit Companies, and Funding Every Entrepreneur by Fred Wilson and MoneyBall for Startups by Dave McClure. While they come at things from very different angles, they are both very insightful and important. Importantly, they are willing to use words in their posts that Goldman Sachs has apparently banned in email as of yesterday.
We are packing up the Homer house today and I’m looking forward to diving back into the fray next week in Boulder.
I was in a meeting with Rich Miner from Google Ventures on Friday with some entrepreneurs we are working with on a potential investment. While the team isn’t a rookie team, they’ve never worked with VCs before and they’ve been wrestling around the dynamics of how to interact with the two VCs in the room (me and Rich) and the various angels that are part of the seed round we are planning to do.
In the middle of the discussion, Rich used a brilliant metaphor of “VC as produce suppler”. The CEO was talking about how she realized she was the lead chef in the kitchen, but viewed us as some combination between sous chefs, owners, and the diners in the restaurant. This was apparent in the interactions – was she trying to “please us”, listen to us and do what we said, or put us to work? This was made even hard with the handful of angels involved – where did they fit in? And, it was clear that the kitchen was getting crowded.
In this middle of what was a rambling conversation, Rich said “think of us as produce suppliers.” He said something like: “We bring you produce. Some of it will be awesome and you’ll want to use it immediately. Some will be moldy, or won’t fit in your recipes, or you won’t need any more of it. And sometimes we won’t show up. Occasionally you’ll want to put us to work in the kitchen teaching you how to make a new dish with our produce. Other times you’ll politely ask us to get out of the kitchen so you can get some work done. And – ultimately – all of us – the investors (VC and angels), the entrepreneurs, and the employees are the owners!”
I’ve editorialized, but I stopped, wrote it down, and asked Rich if I could blog it. It’s one of the best, freshest, and crisp metaphors for the VC / CEO relationship that I’ve ever heard.
The video from the second panel I was on at Google I/O 2010 – Technology, innovation, computer science, & more: A VC panel – is up. Dick Costolo – the COO of Twitter – is the moderator and my fellow panelists are Albert Wenger, Chris Dixon, Dave McClure, and Paul Graham. Someone didn’t like the title so it was renamed “VCs Who Code” but apparently that didn’t stick with the official event panel namers.
While I stopped writing production code in the early 1990’s, I still fuck around with something each summer when I’m in Alaska (in past years it has been Perl, Ruby, and PHP.) I haven’t decided what it is going to be this year, but it’ll probably be Python as I’m seriously considering taking 6.189 using MIT OpenCourseWare.
For the curious ones in the crowd, I’m a self declared “excellent BASIC programmer.” When I got my Apple ][ in 1979 the only choices were BASIC and 6502 Assembler. I learned each, but only wrote commercial software on the IBM PC in BASIC (and compiled BASIC, back when getting a BASIC program to compile was a trick in and of itself) between 1983 and 1985 (using Btrieve as the database manager.) By 1986 I was doing a lot more work in Dataflex and Pascal. At MIT, I learned Scheme (via 6.001) and was ok with it, but never did any production work with LISP even though every time I looked at a Symbolics machine I drooled. I learned a handful of other languages in school, such as CLU and IBM System/370 Assembler (and something on a Prime computer – I can’t remember what) but never used any of it outside a class. Feld Technologies did most of its work with Clarion, although I never really learned it well enough to do anything production quality since by that point I wasn’t coding regularly anymore. While I was proficient with a bunch of database languages such as dBase, Paradox, and R:Base, I never liked any of them and we never really wrote production systems in them (although we took over and managed a lot of crap that other people had tried to write.) Oh – and I was pretty good with Lotus 1-2-3 Macros.
In some parallel universe, I sit in front a computer all day and write code.
While some people hate the phrase “failing fast”, I find it instructive when it’s used to signify that one isn’t going to pursue a particular path in the context of a larger set of activities. A few weeks ago, I wrote a post about The Proliferation of Standardized Seed Financing Documents. It generated several hundred email responses and a handful of phone calls. A week or so later, my partner Jason Mendelson wrote a post titled Why There Will Never be a Standard Set of Seed Documents. I’ve concluded that Jason is right so rather than torture myself, I’m failing fast with regard to trying to help create a set of standardized seed documents.
Since I received so many private responses to the original post, I thought I’d summarize them here by type of respondent.
Lawyers: By far the largest numbers of responses were from lawyers offering to help (thanks!) I didn’t count them up, but I got well over 100 emails from all over the US. In many cases, the lawyer offered to come to the meeting, share their seed documentation, and work to make sure that seed documents were complete and acceptable to their firm. The vast majority of lawyers provided solid background on all the seed investment work they had done. Several weighed in with their views of the potential issues, often sighting the NVCA standard document process which everyone seemed to refer to as some version of “a mess.” A few made sure to remind me that east coast lawyers needed to be involved or the docs wouldn’t work on the east coast. A few brave ones told me why I was destined to fail but wished me luck anyway. Fortunately, due to the magic of Gist, I now have contact information for a whole bunch of lawyers I didn’t know before.
Entrepreneurs: The next largest number of respondents were entrepreneurs. I think all of them cheered me on, told me how much they hated paying lawyers for their seed documents, and asked if there was some way to reduce everything to a few standard pages, not unlike a mortgage document. A few told me “don’t include lawyer X in the process – he charged me $70,000 for my seed deal” and a few suggested that lawyers should have to use paper and crayons instead of word processors. Several asked if I’d be interested in funding their companies. All demonstrated a sense of humor about the situation.
VCs: The VC comments came in a few different flavors. A few said “I don’t see the problem – it’s fine having multiple seed documents.” Another reminded me that “great is the enemy of good” (although the real, and more relevant quote is “The perfect is the enemy of the good”) and the existing forms floating around are “very good – much better than they used to be.” Another suggested that none of the standard docs worked for him, but he was perfectly happy to sign the forms from Law Firm Z without any modification. Several asked me whether I was still watching 24 (yes, I will watch it to the bitter end.) I received private emails from each of my partners containing a slightly different version of “are you out of your fucking mind?”
LPs: I only had one email from an LP. It was a short one. “Don’t waste your time on this.”
After pondering all of this, I realized that I was both trying to solve a problem that didn’t really want to be solved while at the same time falling into a common trap of working on something that, while on the surface seems like a good idea, isn’t really my issue to solve, at least not in this way. As many of you know, the issue is not only the term sheet, but also the underlying documents supporting the deal. I think this is a nuance that is often missed, as the seed docs need to be robust enough to easily support a next round financing (Series A or Series B) since the seed financing is rarely the last one. So, while a simple term sheet might be able to be agreed on, I realized that getting the actual docs agreed on would be a miserable, and likely impossible, thing to try to deal with.
Hence my failing fast. While in theory this might be a great idea, I’ve concluded that I can’t be successful at this. There are plenty of people – namely all the lawyers that work with startups – that have a much greater incentive than I do to get this right, be efficient for the entrepreneurs they work with, and be cost-effective for the companies they bill. So, I’m going to leave it to them.