Tuesday, April 17, 2012

VC Signaling Coming Home To Roost

"I believe they have seed money from [VC FIRM NAME REDACTED]. We generally don't talk to startups that have taken seed money from institutional VCs – we think its a bad idea for the entrepreneur and it creates a tough dynamic for us (either we are a stalking horse for the existing investor or there is some reason the existing investor doesn't want to invest)." 
- Recent email from a senior VC partner to me.
Dear Entrepreneur - remember that TechCrunch story you placed about your funding round that mentioned the VCs who invested in your seed round?  Unfortunately that TechCrunch (or VentureBeat, or PandoDaily, or GigaOm, or AllThingsD) announcement may be about to bite you in the ass, big time.

While this will not occur to all entrepreneurs taking VC money as a small part of their seed (and in some cases the VCs may be quite helpful), I have seen a number of situations lately where the VC signal has hurt the entrepreneurs ability to raise a Series A.  The key is to be thoughtful about who you take money from, how they will help you, and ultimately, ways to mitigate the signaling if you do end up taking VC money.

I have previously written about the costs and benefits of letting a VC into your seed round.  Over the last 18-24 months a number of VCs [1] have started making small investments ($100K to $500K) in a large number of early stage companies.  Some individual VC firms have made (my guesstimate) on the order of 50-100+ of these.

Unfortunately, a number of the startups who took VC money in their seed stage are now running into signaling issues - which makes it much harder for them to raise a series A round.  A number of companies I know have had their series A round fall apart due to VC signaling.  Other smart investors such as Chris Dixon have pointed out this increase in signaling as well.

Why VCs Make Lots of Small Investments - Option Value
VC economics suggest that a small amount of money does not matter much to a VC with a large fund.  For example, for a $500 million fund, making 100 investments of $100K each is only $10 million, or 2% of the fund.

In contrast, only a dozen or so startups started each year really matter to a VC from a financial return perspective.  A VC needs to own a large percentage (e.g. 20-40%) of a company with an exit in the hundreds of millions of dollars in order to have a chance of returning the money in their fund (much less making the bilions of dollars that is the multiple of the fund they aspire to return).

To a VC, having the inside scoop or relationship to a large number of startups is therefore worth a lot more then the $10-$20 million more and more funds are putting aside to make dozens or hundreds of small investments.  Getting to know the founders, being on the startups investor update emails (and learning who is doing well or poorly), or alternatively, having transparency into when the founders are raising their series A round are all type of relationship and information access the VCs crave.

By making lots and lots of small investments, the VCs have these relationships and more information access.  The VCs are basically buying a bunch of options on a big part of the Silicon Valley startup scene.

While this trend is great for VCs, it is on average bad for the entrepreneurs taking their money.  Short term, it seems great ("higher valuation??  fewer people to raise money from?? great!") but long term it backfires ("no one will fund my series A??")

The unfortunate issue for entrepreneurs is that having a VC invest in your seed round can come back to haunt you when you raise a Series A.

Once you go out to raise a series A round, there are three potential scenarios in terms of the state of your startup:
1. The company has true breakout traction.  This is like 1% of startups.  These startups can set whatever terms they want irrespective of signal.
2. The company is doing OK, but not breaking out in any obvious way.  This is most startups.
3. The startup is obviously failing.  This startup will soon die and is irrelevant for the purpose of this post.

For companies in bucket 2, which is most companies, any sign of weakness can ruin the company's ability to raise more money.  Not raising more money means a startup either dies, becomes profitable, or needs to sell.  For most company, this means death or early exit.

Unfortunately, having a VC in your round creates that signal of weakness that, all else being equal, may get in the way of you successfully closing a round.  In particular, if the VC who invested in your seed does not pursue you for a series A, then all the other VCs will view this as a sign that your company is not good.  The reasoning is that the VC in your seed should know you better then anyone else.  If your seed round VC is passing on your company, then other VCs think it is probably a bad investment.

Now, the numbers are against you.  If a venture fund does 30 seed investments a year, but only 10 series A (including companies they did not seed invest in), then this means AT MOST 1 out of 3 startups will get a follow on investment.  This means the majority of companies that take VC money in their seed will have negative signaling.

1. A top tier venture firm investing.
As Dixon points out,[4] top tier firms send larger negative signals than lower tier VCs.  If one of the better known firms passed on you, the lesser known firms will be more likely to pass too.  This does not hold as true the other way around.

When raising a series A, most venture funds don't know whether a VC has passed on you or not. However, if a TechCrunch post has been published with your seed funding announcement mentioning your VC investors, all the other VCs will see this when researching your company.  They will all call up your seed investor VC to ask about the company and whether that VC is trying to invest in you.  If the answer is "no", a strong negative signal has been sent to everyone else.  Remember VCs are constantly calling each other for opinions [2].

2. Having multiple VCs in your round.
Having one VC from you seed pass on you is something you can explain away (see below).  Having 3 VCs in your seed all pass on your series A is not explainable.

3. The VC investing larger amounts in your seed.
If a VC invests $100K in your seed, you can try to explain it away as so small an amount that they never spent time with you.  A $500K investment suggests the VC spent more time with you.  This means that the VC passing on your series A is sending an even bigger signal that your company is not worth pursuing.

1. Claim the VC has made a competitive investment.
If the VC has to pass on you due to a competitive situation, then the signal goes away.  Find something in the VCs portfolio that helps explain why the VC can not invest in you.

2. Point out the VC has spent zero time with you.
The VC signal is driven by the fact that the VC knows you well and has still decided to pass.  Given the large number of seed investments these VCs are making, it is often truthful to point out that the VC really spent 0 time with you and has no proprietary information. (Which raises the question - why did you have them invest again?).

You can also point out that the VC has done a very large number of seed investments, and the partners are thus way over committed.

3. Get the VC to say they are still considering you for investment.
If you can, get the VC to agree to a pro rata in your series A [3].  This will allow you to truthfully state you are still talking with them about investment (even if they don't plan to lead).

4. Raise a bridge.
Raising a bridge round from angels or smaller funds helps wipe the signal clean as your latest round will no longer inclue the VC.  Downside is that bridges often occur at a lower valuation and are more dilutive.

As an entrepreneur, you are usually tempted to take VC money in a seed round for one of the following options:
  • Round size.  As seed rounds have grown from ~$500K to >>$1 million in size (in part due to valuations going up) it is harder to find enough people who can write large enough checks to fill your round.  Some entrepreneurs add venture firms to the round to fill the round quickly.
  • Price insensitivity.  VCs are really price insensitive in a seed round.  They are viewing your seed as a way to get the inside scoop on your eventual series A, and $100K really does not matter to them from a fund perspective.  This means the overall valuation of your company will often go up if VCs participate.
  • Brand.  Some entrepreneurs get enamored with the VC brand and the bragging rights that come with it, or think the brand association of the VC will help them hire people.  In some cases this can be helpful, in some cases not (depending in part on how many seeds the VC has done).
  • Connections and help.  VCs promise connections and company building help.  Unfortunately, if a VC has made 30 or 40 or 50 investments all of $100K size in the past year, they will not be able to help all the startups equally.   Many VCs are also more likely to prioritize their "day job" of startups where they sit on the board and own 20% of the company over a startup where they own a few %.  Some VCs actually come through on connections or advice in a big way, but many don't (this is also true frankly of angels with a lot of investments).  Do your diligence to see how helpful the VCs have been in the past to companies that they make small investments in.
  • Pre-emptive bids.  Sometimes, having a VC in your seed leads them to overpay early for your series A, sparing you the pain of having to run a full blown fund raise.
A large number of seed rounds in the last 12-18 months have included traditional venture funds as investors.  Sometimes having a VC in your seed can be super helpful.  However, a number of the the companies who raised from VCs are now regretting it, as having a VC in your seed round can backfire.  There are a number of ways to mitigate this signaling risk.

[1] By "VC" I mean a traditional, large venture capital fund that invests in series A-C rounds and will compete for a series A against other VCs.  I think that the "super angels", which are really early stage VCs, are safe to take money from for a seed round.  Although they compete with each other on seed rounds, they typically do not also do series A, so there is no signaling risk associated with them.

[2] VCs call each other a lot.  This is odd given that they are all competing for the same financing rounds.  In some cases, this is professional courtesy - e.g. to offer an existing investor a pro rata.  Or it could be that they already sit on another company's board together, and your company comes up while they are talking about shared business.  But fundamentally it is also often a way for a number of people with herd mentality to compare notes.

[3] "Pro rata" means the VC invests enough in the new round to maintain their original ownership stake in the company.  E.g. if they bought 5% in the seed, they invest enough money in the series A to not get diluted, and thus they maintain their 5% stake.

[4] I find that sometimes I will have a blog post written, not post it, and then Chris Dixon will publish something with many of the same points (often, better written).  This signaling post is a good example of overlap in perspectives, that took me a while to actually post.

Thanks to Hiten Shah for suggesting I go ahead and publish this post anyways.


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