One of the most common questions I get as a VC from seed-stage company founders is "Should I take money from institutional VCs in a seed round?" That's a difficult question, and every start-up is going to have their own approach in answering it. I'll try to work through what to think about in this post.
Any time a company raises a venture round, investors are curious to know whether the current investors in the company are also participating. The reason is simple: the investors who probably know the company best are the ones already on the cap table. They get the investment updates from the CEO, and should be intimately familiar with the business and its future prospects. Thus, their further investment in the company sends a strong signal of how current investors see the business performing. If they are attempting to increase their ownership, it indicates they are bullish on the company. If they are trying to avoid putting more capital into the company, that is probably a sign that the company is no longer a good investment.
This is one of the most visible signals for a company raising capital. Its importance should not be understated.
When it comes time to raise a seed round, many company CEOs try to game this signal by placing only angels and micro-VCs in the syndicate – essentially, any investor that doesn't have the capital base to offer more money in a future round (or so little that it isn't material). In other words, they prevent their company from sending a negative signal, since none of their investors could participate in a future round even if they wanted to.
The downside to this approach should be obvious though – while you limit your downside, you also eliminate your upside. Angels are almost always enthusiastic supporters of all of their companies, for the simple reason that they only get an equity investment when a Series A round is completed when using a convertible note structure. They have strong incentives to sell a company's vision as hard as possible, since otherwise, their investment is worthless. However, that also means that the signal from seed-stage investors is quite weak. Their vote of confidence is not through capital, but rather through words.
Start-up founders are in the risk business, and yet, they often have an aversion to the calculated risk of adding an institutional investor to their seed round. Institutional investors are going to have a choice when the company is ready to raise its first equity round – do we lead the investment, or do we pass? Either choice is of great consequence for the company. If they lead, the investment process is significantly shortened for the founders - saving enormous time early in the company's life cycle. Founders also need to consider the current funding climate where the growth of Series A investments has not increased as fast as the growth of seed rounds. Moving from seed to Series A is now the most difficult step in a typical start-up's financial path.
If the VC passes though, it could be very difficult to recover while seeking capital. A negative signal like a pass from a sophisticated investor is likely to add significant doubt in any partnership meeting that discusses the company - regardless of the actual value of the company itself. It's like applying to college, and one of your letters of recommendation is negative. It is memorable, and that is not good.
That's the gamble though. So what are the primary decision criteria on whether to add an institutional investor? There are several considerations:
How strong is your relationship with the VC firm? The most important criteria the depth of the relationship between your company and the VC firm. The ideal situation here would be for the VC firm to completely understand your idea, have strong partnership support for the company's long-range vision, and a good personal relationship with everyone that might have a say in the future funding of the company (lead partners, associates, etc.). If this relationship is strong, there can be a lot of benefits to adding the VC firm into a round, including connections like finding strong co-investors in future rounds.
What is the deal setup? How much of a seed round the VC firm wants to take (and the founder wants to give) is the next criteria. In a convertible note structure, many firms these days are more hesitant to write large checks without the benefits of equity. Giving a small stub to a VC firm, or even better, several firms, may be the right strategy because large institutional VCs today are less involved with companies with check sizes below $500K. In other words, their negative signal is limited, since they didn't make that much of a bet on the company in the first place, and probably didn't track the company that well. For start-ups looking to raise larger amounts of capital, particularly those companies that are trying to work on big problems that take a long time, it may be advantageous to raise a larger seed round in the low millions of dollars that is an equity round. That way, there is much more limited signaling risk, since the firm is already deeply invested into your success.
What's your risk tolerance? The funding climate for start-ups has changed. Even if a VC firm that seed invested passes on your company, they may provide good contacts to the rest of the investment community that drives the process forward. It is not unheard of for firms to pass for reasons outside of company performance – maybe the firm has changed strategic direction, or the partner on the deal is interested in something else. Again, there is a gamble here like everything in start-up life.
There is no right answer on whether to add institutional investors. I would say that there is a strong aversion to having institutionals among founders in Silicon Valley, although that has changed more in the last year as founders understand the current investment climate better. Build relationships with angels, micro-VCs and institutionals, and see what options make you feel most comfortable.
Posted on May 15, 2013