Wednesday, July 21, 2010

Should You Let a VC Invest in Your Seed Round?

During the prolonged frenzy of raising a seed round, many entrepreneurs wonder whether it is worth including one or more VCs in the seed as a part of the round (e.g. buying 10% of the company, as opposed to, say, the VC buying 25% of the company during the seed).  This has a lot more tradeoffs than one would initially think and is in part driven by VC economics, which I wrote about earlier.

I usually advise entrepreneurs against including a venture fund as a small part of their seed.  That said, there have been a number of successful companies seeded by a venture fund (e.g AdMob) and my own company, Mixer Labs, benefited from having a venture fund (Sequoia, who was very helpful) as part of the seed.  

It is very situation dependent and as an entrepreneur you should weight the plusses and minuses of having a VC in your seed round when making the decision.

Benefits of raising part of your seed from VCs:
  • You have a deep pocketed investor who can, if things are going well, invest more money in the startup (although if things go well, you will be able to raise money anyhow).
  •  Raise it fast!  VCs can deploy what they consider “small” amounts of capital quickly – e.g. $250K-$500K won’t impact a $400 million fund. 
o   Sometimes a decision to invest this little is left to a single partner or two partners versus having the whole partnership weigh in.  
o   This has a downside too – VCs will happily write off this amount and may not support a startup in which they deployed so little capital
  • Branding.  The VC brand may help you attract talent or get potential hires interested.
  • Advice & structure.  Some entrepreneurs could use the structure and advice provided by the VC joining the board (assuming enough of the company is bought to justify partner time).  A top tier angel can often fill this need as well.

Drawbacks to including VCs in your seed:
  • Signaling.  This is the big one.  When you go out to raise a series A, investors will wonder why you don’t raise the money from the venture fund that already invested in your seed.
o   If the VC in the seed does not invest in your series A, other investors will view this as a big red flag – i.e. why would the VC who knows your business best not invest?  This will lead to a lot of investors to pass on your company without really getting to understand the situation.
o   If the existing VC wants to invest and you go to other investors to get a competitive bid, the new investors will think you are using them to merely drive up the valuation you will get from the existing investor, whom they often assume you will chose for the series A (since you already know the VC that invested in the seed).  This means your valuation for the round may end up lower then it could have been.
o   There are ways to navigate the issues above, but it adds friction to an already time sucking process of raising money.
  • If you don’t raise money from a venture fund, you can get other venture funds to more actively work for you.
o   Investors always want to prove their value in case you raise a series A, so will spend time making introductions, meeting periodically to discuss strategy etc.  So not having a venture fund in your round will means lots of other funds may still help you out. 
  • Venture investors are more likely to stop supporting an early stage company if things don’t go well and the seed money is running out.
o   This is not out of malice, but rather a calculated business decision on the option value of the partners time.  Why have the partner spend a lot of time on a “bad” investment when there is always a new entrepreneur walking through the door.   Angels may have a larger vested interest in the company or be helping out for reasons other then just financial return.

What do you thinks?  Know of good examples of partial seeds by VCs leading to especially good/bad outcomes?

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