July 19, 2010

As Strategies Shift, VCs Keep Ear to the Ground With More Seed Deals

By Tomio Geron

Not to be outdone by angel investors, an increasing number of well-established venture capital firms are using a variety of tactics to increase their access to start-ups at the earliest of stages.

This frenzy of seed-stage activity is happening mostly with consumer Internet and software-as-a-service start-ups, which are finding success faster and with less capital than ever before. Venture firms want a cut of the action, either forging partnerships with angels or forming programs of their own to get in at low valuations.

These firms are investing far smaller amounts than funds typically require -- often in the five digits -- in order to befriend entrepreneurs and earn a seat at the table in case the company performs well enough to require bigger follow-on rounds. Firms like Index Ventures and FirstMark Capital, for instance, recently set up formal programs that sprinkle small sums into a large number of young start-ups. To get into these seed rounds, venture firms are speeding up their process for approving investments and agreeing to entrepreneur- and angel-friendly terms.

"We think for investing in consumer Internet, the highest reward is at the seed stage level," said George Zachary, partner at Charles River Ventures, which has a seed-investment program. "It's also the highest risk level."

Others, like large investors Norwest Venture Partners and Adams Street Partners, have forked over money to angels or seed-fund managers and allowed them to invest as they see fit.

But their trek downstream is not without questions. Firms that make direct investments only have so much staff to go around, so they run the risk of investing in far more companies than they can manage, or investing in too few to find big hits. Entrepreneurs also say that when these firms don't reinvest, it can send signals to other potential investors that there's something wrong. Then there's the question of whether these tiny deals can lead to big enough returns for large funds.

'We Needed To Change Our Business Model'

Those concerns haven't stopped Index Ventures, which in April began dedicating a small amount of its $440 million fund raised in 2009 to a pool managed by the firm and seed investor Accelerator Group. Index hopes to invest in 20 seed-stage companies over the next two years through its Index Seed program.

"We're trying to dedicate resources to these deals rather than have it be a side show or just in our spare time," said Neil Rimer, Index partner.

Likewise, FirstMark, which started its FirstSteps program last year, has so far invested in 10 seed companies, including Ahalife, a women's shopping site, and GoodCrush, a college-only social-dating service. The firm is also committing up to $19 million to a new fund established by New York City that will make seed investments in local start-ups.

While FirstMark has made a few small seed investments before, it's now investing at a much quicker pace. "So many companies are developing so quickly," said Lawrence Lenihan, chief executive of FirstMark. "They've gotten traction at the seed stage -- maybe more than they would have with an A round back in the day....As a result we needed to change our business model."

These investors are following in the footsteps of other firms that established formal seed programs a few years ago and are seeing some early success.

Charles River Ventures, for instance, began showering a number of stealthy start-ups with six-figure funding rounds in 2006. Its portfolio of 22 young companies generated more than $30 million in total revenue in 2009, Zachary said. Of those 22, nine have since raised a Series A round, with Charles River investing in six of those, while 10 are still in development and three shut down.

"The conversion to successful companies has been higher than we thought it would be," Zachary said.

Charles River benefits by getting in cheap on a hot company. For example, the firm incubated Blipify Inc., whose Web site Blippy.com lets people share their purchases with friends, and seeded it at a $5 million valuation. Three months later, Blippy shopped for Series A funding at a $45 million pre-money valuation and eventually closed an $11.2 million Series A led by August Capital, with Charles River participating.

But Charles River, which manages a $320 million fund closed in 2009, has made a number of changes recently to make its seed investing more entrepreneur- and angel-friendly. For example, the firm's QuickStart program used to invest only with $250,000 convertible notes in seed rounds. It now invests between $25,000 and $100,000 because angel investors thought it was taking too big a stake.

Chares River also dropped a clause in terms that gave the firm a right to invest in a Series A round. The thinking was that that locked in both Charles River and the entrepreneurs too much. Since making the changes to the program six months ago, Charles River has invested in about 15 seed-stage companies.

Other typical terms that venture firms have dropped at the seed stage include "pay to play" provisions, board-seat requirements and large percentage stakes.

Of course, many good-sized venture firms do not have formal seed investing programs, but are active seed investors. Accel Partners, Blue Run Ventures, CMEA Capital, Redpoint Ventures and Sequoia Capital are just a few examples. Other smaller firms, like First Round Capital and Union Square Ventures, specialize in seed investing.

CMEA, for example, incubated and seed-funded image-based advertising start-up Pixazza Inc. in 2008. The company announced today that it has raised a $12 million Series B round.

"We spend a lot of time finding the best teams to invest in super early before they even have a specific product or idea of where they want to go," said Saad Khan, partner at CMEA. "The presumption is if they're really smart they'll figure it out."

Changing The Perception Of VCs

Polaris Venture Partners has taken a slightly different approach with an incubator program called Dogpatch Labs that houses new companies for free in Cambridge, Mass., San Francisco and New York. Polaris has separately made more than 20 seed investments from its current $1 billion fund, but Dogpatch, started in late 2008, helps the firm increase its access to new companies.

Polaris gets no special rights to invest in the companies that participate in Dogpatch. However, the firm has gone on to invest in six current or former Dogpatch companies.

The Dogpatch program has been a big commitment in time and effort, but Polaris General Partner Michael Hirshland said that is what's required to change the perception about venture capitalists.

"It's all about being out there in the entrepreneurial community as opposed to being an institutional VC on the hill with money who you go to ask for money," he said.

Meanwhile, some firms are letting angel investors find new companies by handing them money to invest. One of the best-known cases of this is Sequoia Capital's investments in seed funds managed by start-up incubator Y Combinator. But at least three other small seed funds have quietly raised capital from large venture firms.

Norwest Venture Partners, a multi-stage firm that invests up to $75 million in companies, quietly backed the majority of a $15 million seed fund run by SoftTech VC, according to several people familiar with the matter. Norwest, which raised a $1.2 billion fund last year, leaves the managing to SoftTech's founder Jeff Clavier, one of the prominent angel investors in Web 2.0 and social media, investing more as a financial move than to get an early look at companies.

Clavier and Norwest declined to comment on Norwest's investment.

Similarly, seed firm KPG Ventures' $20 million fund is solely backed by Adams Street Partners, which recently closed a $1.3 billion fund of funds but also makes direct investments. And Naval Ravikant, an angel investor who has bet on more than 50 start-ups including Twitter Inc., runs a $22 million seed fund called The Hit Forge that is funded by Sutter Hill Ventures and other undisclosed individual venture capitalists.

None of these venture firms get special rights to invest in the portfolio companies. This is important so that other venture firms are not scared off by these angel funds, thinking that other investors get special rights.

Signaling And The 'Kiss Of Death'

But for those large firms that do make dozens of direct seed investments, some angels and entrepreneurs are concerned that these firms create an undesired effect called signaling when they don't reinvest. Their withdrawal spooks prospective investors, making it difficult for the company to raise money, they say.

"I do think it's the kiss of death if the sponsoring VC doesn't contribute," said Chris Sacca, an angel investor whose small firm Lowercase Capital just raised $8.5 million from unnamed venture firms, institutions and high-net-worth individuals.

The effect of signaling is hard to evaluate because other potential investors usually don't tell the company they're passing because of this reason. But there is anecdotal evidence that venture firms pay attention.

One company, Triggit Inc., raised seed funding in July 2007 from Bay Partners as well as individual angels. When Triggit tried to raise a Series A round this year, Bay Partners couldn't reinvest because its own future was in doubt after three of its partners left the firm. Triggit Chief Executive Zach Coelius knew what Bay was facing but was not able to tell other firms about it since the information wasn't public.

"When we were getting ready to fund-raise, people would say, 'Why isn't Bay investing?'" Coelius said. "The reason is because I didn't want Bay to invest. But I couldn't tell them why...It created optics problems. I had to dance around that. It wasn't easy."

Triggit eventually did raise a $4.2 Series A from Foundry Group and Spark Capital.

While many venture investors agree this could cause a problem for a start-up, it's not an issue if the company is doing well, they say.

Zachary of Charles River pointed to two of his firm's companies that have received follow-on funding after Charles River decided not to reinvest. BuddyTV, for example, raised a subsequent round from Madrona Venture Group and Gemstar. "They didn't care at all that we didn't invest," Zachary said.

Also, there could be other reasons for a venture firm's decision not to participate that's not tied to the start-up, said SoftTechVC's Clavier. For example, a company could shift into a new direction, competing against a portfolio company of one of its investors.

To lessen the impact of signaling, Founders Fund manages two separate funds to clarify the division: its main fund, which closed in May with $162 million, and a smaller pool of capital called FF Angel for its seed investments.

"It operates as a separate vehicle with no specific commitment to follow on....Just because I made the seed investing decision doesn't mean [Founders Fund] will invest in the A round," said Dave McClure, who manages FF Angel.

Beyond all of this, there's the question of whether these tiny investments can generate big enough returns - even through later follow-ons - for large venture funds to justify their investments.

Bay Partners, which revved up its seed investing a few years ago and has made 19 such deals, scored a big exit last year when one of those companies, software maker SpringSource, sold to VMWare for $420 million. Bay seeded SpringSource with just $600,000 before it raised $37 milion from Accel Partners, Benchmark Capital and Meritech Capital Partners.

Despite successes such as those, it's still too early to judge the long-term performance of these seed programs.

"With a $500 million fund, a $250,000 investment can't move the needle," said angel investor Ravikant, adding that most venture firms are structurally incapable of adapting to seed deals because of their large fund sizes.

Indeed, these venture firms could find it increasingly difficult to manage a larger load of portfolio companies. Partners typically can manage to sit on six to eight boards at most. If it takes an average of seven years for a company to exit, each partner can invest in only about 1.5 companies per year. But because the risk in seed investing is so high, and the amount of investment is so low, that's not enough companies for a traditional fund.

To do this right, said Rob Hayes, managing partner at seed investor First Round Capital, firms have to make about 20 investments per year. First Round, which has managed to stay focused on small deals despite growing to raise a $125 million fund in 2008, handles the board issue by remaining a director for the first 18 months after its investment - somewhat similar to the way an angel operates.

At that point, First Round often will give up a board seat, while still remaining involved as needed. This way, a First Round partner can invest in four companies per year, stay on each board for an average of 18 months, and stay on six boards at a time. "At that steady rate, it's wholly doable," Hayes said.

Most venture firms cannot or do not want to move to this type of system, however. That raises a question of how long large firms can continue to do seed investing.

Ultimately, for many firms it's about trying to be first and having the biggest impact with companies, said Rich Wong, partner at Accel Partners.

"It's important if you want to be engaged in the formation and early direction of the business that you're there with founders, when it's just the two of us together trying to figure out an idea," Wong said.