On Venture Financing: Not All Seed Capital Is Created Equal.

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Essays

Many people think of seed funding just as “before Series A” — somewhere in between “back-of-the-napkin” and “company-with-employees-and-monthly-revenue”. And, technically, they are right. Under $2M, a company tends to raise debt, a Series Seed, or perhaps a Series AA. But in the context of seed, there is wide variation in both the size of the round, and the type of seed investors which an entrepreneur can choose. The nuance between these is important, so I’ll describe my understanding of it below.

Friends and Family—
When people in the startup community refer to “cobbling together money from your friends and family” they are referring to this category. It is usually between $10,000 and $100,000 for the whole round. Not everyone has access to this amount of money (or credit). Anyone who claims that anyone can do a start-up, or that it’s a meritocracy, likely has access to rich family and friends. It’s sad, but it’s still true.

The people in this category are not necessarily professional investors, nor are they always accredited. They may not understand that startups are extremely high-risk, or that they take a long time.

Angels—
The angel is a professional investor in your industry, and so understands more detailed nuances of the transaction than, say, your uncle. She may double as an advisor, and in fact the best angels bring more than capital. And she may not be someone you’ve known your whole life, but only professionally. She comes in very early, does a fair amount of diligence, and often likes to come in with a bigger, more substantial partner. Some angel investors can write big checks, but most angels write checks between $10,000 and $250,000, not unlike friends and family. These investors are very helpful advisors early in the business, and as you grow, are often your biggest fan and loudest advocate.

Dedicated Seed Fund (Small Seed)—

Once a professional investor in technology has been at it for a while, she may decide to either raise or join an institutional fund. This happens more often than not, because if your main career function is making investment decisions with your money, why not make it with other people’s money, too? The smallest type of institution is a dedicated seed fund, usually representing pooled capital in a Limited Partnership. At this stage, A firm may decide to invest a relatively small amount of capital, but build a portfolio, offering a thin set of services relevant across that portfolio. Those firms who take this strategy tend to invest between $50,000 and $350,000 in companies. Some of these may ask for equity, so that they can negotiate pro rata and other investor’s rights. In asking for equity, they may offer more in the way of services. The smaller ones may just hope to find dealflow early, or invest in friends and former colleagues who are likelier to provide them with friendly economic terms. Another class of firms at this stage provide a robust suite of services; their resources extend far beyond capital and advisory. Depending on the dynamics, these firms invest only a small amount for a relatively large stake, justified by the fact that they accelerate a business substantially over a short, concentrated period. Many incubators and accelerators follow this model.

Micro VC (Big Seed)—

After a certain size, the hurdle rate rises such that a firm has to make bigger investments in each company it supports, so that they can deploy their capital more quickly, and especially so that they can get bigger allocations in the investments. The range of investment in this category is between $250,000 and $2,000,000. These firms often purport to offer even more services than a small seed fund, though still less than an accelerator. In some cases, they aim for 20% of a business, which what  a lifecycle venture fund might aim for in a Series A investment and beyond. Based on their allocation, these firms sometimes take a board seat, and may maintain pro rata through a company’s early funding rounds. 

“Opportunity Fund” Seed—

Two factors drive this category of investment. First, big funds are getting increasingly competitive, with the value concentrating in a power law distribution, and the few winners vastly outperforming the majority of funds. Second, realizing that start-up companies are able to approach escape velocity earlier and earlier, many big lifecycle funds now invest in start-ups at the seed level, as well. These funds will invest $100,000 to $1.5M in a start-up company, often as a convertible note, as a way of starting the relationship with the entrepreneurs early, and maximizing the opportunity for choosing the right companies to invest in at the life-cycle stage, where these funds will invest $10,000,000 to $25,000,000 over the life of a fund. These investments are very small for a big firm, so they usually devote substantially fewer resources to each investment than they would for their traditional, bigger deals.

Why these nuances matter:

For entrepreneurs:
Not all seed firms will work well with each other. You may already be wise to the fact that big funds with seed investment may be bad signaling (though that is unclear to me) in case they don’t lead your Series A. But it’s worth noting that many Micro-VCs can’t work together on a deal if you’re raising below a certain amount. When you put together your syndicate, it’s worth considering how the needs of each firm line up with the size of your round. Of course, start with the amount of money you you’ll need (more than you think), but keep in mind that as you hone in on your wishlist of advisors and supporters, that they are operating under their own constraints. Try to understand those constraints early.

For investors:
First of all, know what your peers are working with. More experienced investors have developed an instinct for who they tend to fit with in syndicates, structurally, versus not. But when you’ve raised a new fund, or have just raised a second fund that moves you from one category to a next, be mindful about which category you fall in. Start with your needs, but measure those needs against your strengths. Do you know a ton of angels, who can fill out syndicates that you lead? Or are you looking for other seed-focused institutions to join you in rounds? How can you optimize these channels, not just for your venture economics, but for the benefit of entrepreneurs you want to support?

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