« Glue 2012 will be the best Gluecon yet | Getting it Right the 2nd Time (our investment in SEOMoz) »

The Seed Signaling Problem That’s NOT Being Talked About

There’s been plenty of chatter over the past few years about the potential pitfalls for entrepreneurs taking seed money from VCs. This includes a recent and very thorough overview of the issues by Elad Gil which I’d highly recommend reading, even if you’re already familiar with the issues around seed financing (and in particular the so called “party round” where everyone takes a piece but no one takes the lead).

I’ve noticed something recently that’s a bit of the flip side of the same problem that everyone is talking about but that I haven’t seen mentioned yet. I’m seeing an increasing number of Series A pitches where a company has at least one venture investor in its seed, the business is very clearly doing well and where the entrepreneur is simply not pursuing their existing institutional investors for money (note: please give me a little credit here for knowing the difference between an entrepreneur not pursuing money from their existing investors and their being told by their investors that they’re not interested; I’m talking about cases where it’s either pretty clear that the business is seeing excellent traction or where we’ve actually been able to confirm that they’re trying to go around their existing investors).

You could call this the VC seed signaling problem.

A VC throws some money around into a bunch of different seed rounds assuming they’re buying optionality for their Series A. But by essentially ignoring these seed companies some investors are showing them that perhaps they’re not the value added VC that they claimed to be. I’ve heard a variation of this themea number of times in the past few months. Entrepreneurs completely disappointed with the lack of attention they’ve received from their seed investors and as a result choosing to either try to keep them out of their Series A rounds or minimize their participation (most have received pro-rata rights as part of their seed investment so sometimes this becomes a negotiation – again, clearly evidence that these entrepreneurs are indeed telling the truth on this subject as their seed investors try to negotiate for more participation in the Series A).

I find this pretty amusing. At Foundry we view seed investing the same way we view all of our investing – we believe that we’re in this business to add value to the entrepreneurs and companies we back regardless of the capital we have invested (great post from Brad here explaining this in more detail). Clearly that view is not held across our industry.

April 23rd, 2012     Categories: Fundraising, Startups, Venture Economics    
  • http://twitter.com/KyleBWeiss Kyle Weiss

    The seed round is often when the start up is most fragile. Having a networked VC who can help along the early startup is in everyone’s best interest! Kudos to you guys (Foundry Group) for recognizing the seed round is truly an investment for the long haul and not merely a lottery ticket which you hope pans out after the startup does the hard work.

  • bradsvrluga

    Literally just had this conversation w/ GP at one of largest firms in the country this morning. He told me they’d done B rounds in 2 deals in last 6 mos where they’d been Seed investors but then lost out on the A because they hadn’t been paying attention. Remarkable. Forcing them to now completely reconsider their seed strategy.

  • mlstotts

    And these large firms want to get into the incubator business?

  • http://www.swimsweats.com/ Craig

    Great post and attitude.  The right kind of partnership becomes a real win win situation for everyone involved.  Also with crowdfunding on the horizon the best way a VC can differentiate themselves and add value is in the skills and contacts and experience they bring into the relationship.  So much more important for startups and their success than a cash injection.

  • http://twitter.com/Benokur Ben Winokur

    Seth,

    Do you find that the negative signals affect those VCs’ access to deals? If not, the consequences of the VCs’ negative signaling probably have little value as a deterrent.  The uproar about the (original) seed signaling problem arises primarily as a result of the real, and potentially fatal, consequences of an early stage company sending negative signals to potential investors.  VCs who would drive away their portfolio companies in the first place have obviously taken a short-sighted view of their role in the process, and the negative signaling costs, without concrete (read: financial) consequences, are unlikely to cause a significant shift in their behavior. It would be interesting to see if sufficient public information exists to allow seed stage companies to vet VCs at the seed stage based  access to their previous seed investments’ subsequent rounds.  Even if they could access that information, how many seed-stage companies are in a position to refuse an investment?  I’d love to hear your thoughts/opinions on the current (and potential) costs to bad VC behavior in the seed stage.

    • http://www.sethlevine.com sethlevine

      it’s a good question ben. i generally don’t think that many people taking money do a great job of doing their own due diligence. i can understand that it’s easy to get wrapped up/excited about the interest from an investor, but that doesn’t obviate the need to check out who you’re working with. firm and partner. additionally i think there’s also often simply an expectation gap. entrepreneurs expect a certain level of involvement from their investors. investors in some cases expect to stay relatively hands off and “wait and see”. entrepreneurs may see getting to x users (or whatever metric they’re tracking) as success worthy of additional investment while investors may see 3x as the number. again – it’s easy to get wrapped up in the moment but these are questions that should be discussed explicitly before making a decision to take investment.
      to the broader point of whether this will hurt the reputation of some seed programs, i suspect over time yes, although to me it never seems to be quite the overwhelming response that i sometimes expect. i suspect ultimately the real effect will be that vcs who fail to get into their best seed deals at series a will react by limiting their seed activity…

  • http://insomanic.me.uk/ AndyY

    Surely as the entrepreneur it’s prudent to go to market before trying to close a deal with an existing investor simply to get the best terms?

    • http://www.sethlevine.com sethlevine

      Sometimes. But if you have a solid working relationship with your investors sometimes (often, in the case of Seed to Series A) it’s best to just figure out a fair deal and not take the time (often 2 or 3 months) it takes to fundraise from new investors. At a minimum it’s time consuming and for a small business it can be extremely distracting. I can’t tell you how many times I’ve seen companies with 5 people really slow down when 2 founders go on the road to “test the market”.