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The Seed/Micro-VC Trend: A Boom, Not A Bubble

25 Aug

The current debate among VC practitioners and others in the community over what to make of the current boomlet in seed stage dealmaking has yielded some interesting insights into the past, future and overall health of the greater venture industry.

The seed “boom vs. bubble” discussion is a healthy one, in my view. As in any debate over an emerging trend, one of the factors that bears close examination is whether or not the underlying issues are fleeting and cyclical or whether there are deep and structural changes afoot that would support a wholesale shift in how an industry functions. I, for one, am in this latter camp.

That a sea change in venture capital is underway is hardly news. Versions of this argument have been made with regularity for at least the last couple years. What might surprise some, however, is that the underpinnings for this shift took root almost a decade ago in the wake of tremendous overcapacity in a variety of technology sectors during the internet bubble years of 1996-2000. More recently, outspoken VCs, entrepreneurs and market observers such as Mark Suster, Dave McClure, Chris Dixon and Paul Kedrosky have all weighed in on this debate with intelligent, well-reasoned arguments for their respective positions. All their pieces are well worth reading. While there exists a good deal of overlap on the key points behind these arguments, let me weigh in with a few bullet-points that offer support for my view that the seed/Micro-VC trend we are seeing — particularly in the consumer internet and broad web applications space — is indeed a boom that will continue to reshape the venture industry for some time to come as opposed to a precarious bubble that will inevitably pop, with devastating results.

1. Angels & Seed Funds More Sophisticated Now Than Ever. The current and active angel investor appears quite a bit different from what we saw during the ’96-’00 period. In short, fewer non-tech high-net worth individuals who made their fortunes in shopping centers or tanning salons and more investors that came from the tech world as early employees or founders in some of the biggest names in the tech community, investing either individually or in dedicated vehicles. Google and PayPal alums alone account for an entire ecosystem of seed investors that are almost ubiquitous in today’s seed stage community. This deeper operations bench strength and greater familiarity with the tech community among today’s seed investors provides more stability in some respects. While it is still early days, some observers believe that today’s more seasoned angel is more likely to add greater value to a portfolio company as well as not exhibit the skittishness apparent among less sophisticated angels a decade ago when companies hit inevitable speed bumps.

2. The Institutionalization of Seed Funding. Yes, there are still many individual angels that invest for their own account, in their own deals, with some syndication with other high-net worth angels, but what is most notable in the current market is the trend of dedicated vehicles that look and feel like a venture fund while leveraging the nimbleness and informality of an angel group. Some of these vehicles are traditional “blind pool” funds while others adopt a more fluid Pledge Fund model, described in one of my earlier Adventure Capitalist posts, The Rise Of The Pledge Fund.

These approaches are well-suited to the current venture environment, in my view. Unlike individual angels that invest their own capital on a deal-by-deal basis, dedicated seed funds provide less informality, more structure, a clearer strategy, better process around how (and if) to do follow-on investments, and how to network with the institutional venture class. Additionally, creating a seed stage vehicle means, in most cases, making a multi-year commitment with limited partners. This is positive market signalling to both venture firms — that would like to know whether the seed funds are going to be around long and, hence, whether to bother getting to know them — and for the entrepreneurs themselves who would like to have the comfort to know that the seed stage fund’s committment to the company will be based upon that company’s performance and viability, and not upon some fickle decision by an individual angel.

3. Capital Efficiency Re-shaping the Financing Landscape. As everyone has heard, the cost to develop, build and launch a technology startup has fallen dramatically over the past decade. By some estimates, the cost to produce (design, develop, test, launch, scale) a basic e-commerce application has fallen by 50% every two years since 1995. This is significant and is not reserved for only internet and software companies.

The impact from a financing perspective is equally dramatic. A decade ago it might have required five to ten million dollars in investment capital to take a company to the point that it can be today with less than 1/10th that amount. As a venture fund, we regularly see companies present to us that have a product, customers, traction in the marketplace, legitimate mindshare and brandshare in the community, and are even cash-flow-positive in some cases — all without raising a nickel of outside capital. This would have been almost unthinkable a decade ago. While the obvious consequence of this is that it takes less capital to launch a start-up, in many cases it also takes less capital to sustain one — at least for a period of time. The current trend of capital efficiency means start-ups get farther with less capital—eschewing big raises that large established funds typically need to justify their fund sizes and post sufficient returns for their limited partners.

4. Business Model Innovation Also Altering Financing Landscape. While much has been made of the issue of cost and development time compression at many of today’s start-up companies, another powerful driver affecting the current financing market and the emergence of new Micro-VC investor groups is the role of business model innovation in creating entirely new industries and delivery models (i.e. Software-as-a-Service) and better monetization, tracking, reporting and distribution tools that start-ups can avail themselves of — in real time and very cost-effectively. The impact? Not only can many of today’s emerging companies build and launch their products and services quickly and cheaply, they can also market, distribute, sell and collect on those products and services without massive sales and marketing spend as had been the norm in the recent past. This, again, can negate the requirement of raising a significant amount of outside financing before getting the company to a point where it can realize a significant M&A exit. 

5. Succeed or Fail – Quickly and Cheaply. Former Benchmark Capital partner Andy Rachleff liked to say that start-ups needed to “fail fast and cheap.” His point was to emphasize that start-ups will make numerous mistakes in their development but to make those mistakes quickly, as cheaply as possible, and to pivot to another approach or product or market that has a better chance of being successful. Failure is tough enough; a long, drawn-out and expensive failure is excruciating. It should be noted that this perspective is equally relevant for venture investors. In the current environment, new ideas test cycle more rapidly now. Time compression means shorter time to market, time to revenue, time to exit. Shrewd seed and Micro-VC investors are well-positioned for this and realize that they can back many different companies, with minimal investment at risk, and be able in a matter of months, not years, to get a good sense about whether the original hypothesis for the company is unfolding as had been hoped or not.

6. Emerging Cachet of New Seed/Micro-Funds. One clear shift I have sensed recently is how the new crop of seed stage investment firms are being perceived in the marketplace — and, most tellingly, by the founders and management teams at promising young companies. A couple of years ago I began to notice that the fellow venture investors that I would “bump into in the hallway” when visiting promising young start-ups at their offices or even at technology conferences were becoming less frequently the recognized, established firms and more often were funds that were fairly new to the landscape. In the time since, some of the most talked-about tech companies of recent note received their financial support from these newer investor groups.  The entrepreneurial community has taken notice. At a recent breakfast meeting, I asked a young founder of a buzz-worthy consumer internet company about the firms with which he was hoping to meet to discuss funding. He rattled off a list of names of angels, seed stage funds and early stage firms but not one well-known Sand Hill Road VC fund. I found this startling and somewhat ominous. His perspective, echoed by other entrepreneurs I have since consulted, was that the newer crop of seed stage funds and angels were believed to be “hipper”, more entrepreneur-friendly, and more aligned with the needs and interests of founders and management teams. Whether that perception is accurate or even fair to many storied Sand Hill Road firms — personally, I don’t believe it is — is really beside the point. Clearly, for many emerging companies in the broad web 2.0 sphere, being aligned with a younger firm is becoming highly prized and is being supported by anecdotes of sought-after start-ups eschewing the most august names in the venture community for up-and-coming firms more renown for seed investing in the broad consumer internet space.

7. Many Storied Firms Need to Re-evaluate/Re-Brand to Be Relevant in Early Stage. The points made above are by no means de-facto evidence that storied Sand Hill Road firms are losing their luster or are not garnering their share of buzzed-about companies — they are; but it might be a proverbial shot-across-the-bow and an indication that some healthy re-evaluation and re-appraisal about the value of “brand” in the venture community might be in order. Seed investors like the outspoken and always colorful Dave McClure might be ready to ring the death knell for the traditional venture fund, but I will borrow a phrase from Oscar Wilde and insist that reports of the demise of Sand Hill Road venture firms are wildly exaggerated. That said, Dave makes some valid criticisms. I have some of my own. A quick ecosystem map of the most active venture firms in the broad web 2.0 space illustrates that the consumer internet/mobile apps/digital media community is being dominated by firms that did not even exist five years ago. That is dramatic and says a lot about the state of today’s venture industry.

8. Large Venture Firms Won’t Go Away. Yes, the industry is shrinking. Nothing earth shattering there. There will be a net reduction in the number of active venture firms and, on balance, assets under management (AUM) will decline. This is part of a natural winnowing cycle that, as indicated earlier, has been going on for almost a decade. Start-ups usually fail quickly; venture firms are 10-year vehicles so things are not so brisk. Moreover, one or two well-timed exits can turn things around for a venture firm that looked doomed. So, apart from fee income, there are several other strong motivations for a GP to stick it out in a dormant fund and hope for better days.

My strongest criticism for those so quick to call for the end of the traditional venture fund model is that such a prediction is quite myopic and too heavily skewed via a Web 2.0 prism. The fact is that building significant businesses of sustainable value takes capital, takes real expertise, and takes time. Moreover, while development costs have collapsed in a number of technology areas, others sectors of technology have not seen quite the same advantages. There still exist many attractive areas of investment that require a lot of capital – semiconductors, life sciences, biotechnology, and clean tech, to name just a few — in order to build significant businesses. Seed and Micro-VC alone can’t support those investments on their own. It takes a deep ecosystem of complementary investors with deep pockets and deep relationships in the business community as well as in government, universities, research labs, the military, and the international community. In short, it takes a village.

In summation, there are fundamental changes at work in the venture industry which give significant and lasting advantages to seed and Micro-VC funds that can exploit this market opportunity. This “boom” in seed and Micro-VC activity is not so much a boom as it is a seismic shift in how technology companies will be founded and funded for the foreseeable future. Similarly, capital efficiency and business model innovation are not trends that will go away or be supplanted by something else. As we all know, today’s technology architectures build on those of the past, reducing costs over time and commoditizing things that once required huge budgets and thousands of man-hours to develop. Seed stage investors will be with us for a while and the continued “institutionalization” of that segment of the asset class will bring more order and structure to things that were somewhat fluid in the past. Whether these investor group will remain small, focused and independent or whether legacy funds will seek to add that capability to their organizations is something to be determined. My sense is that there will be a bit of both as standalone seed stage firms and larger established groups can add specific and complementary capabilities to a portfolio company in the current environment.


When Angel capital is not so ‘angelic’

5 Nov

Angel capital can save a company. They can also sink it.Skimming the recent spate of somewhat rosy newspaper and magazine articles touting the resurgence and benefits of angel investing, I was persuaded to dig through some of my older posts on the subject to examine whether my somewhat caveat emptor position on raising angel capital had been swayed. With a few exceptions, it hadn’t. This is not to say that I am a critic of the practice of start-up teams chasing investment dollars from individuals. Capital coming from private individuals is still how many, if not most, start-ups initially get off the ground. Additionally, in a challenging funding environment like the one we currently inhabit, finding individuals ready and able to “top off” institutional investment rounds is often a key element in getting those rounds closed at all. Indeed, one of my more popular posts over the last couple years, The Rise of the Pledge Fund, focused upon the emergence of “fundless” or non-committed funds that were targeting seed stage deals and offering individual angels the administrative, post-investment supervisory and deal flow benefits of a traditional venture fund without some of the drawbacks of being in a committed fund. On balance, I was a fan.

First, let’s define our terms: Most on the venture side prefer to delineate capital raised from well-meaning friends and family from capital being sourced from sophisticated private investors or assorted “angel funds” where there is no pre-existing personal relationship with the entrepreneurs to rely upon. While the money coming from either source may still be green, what it tells a professional (i.e. venture) investor about the opportunity is quite different. Your Aunt Bea putting $25k toward the development of your first prototype tells me she’s a pretty great Aunt and loves her nephew, but tells me nothing about how compelling your opportunity is and whether it’s right for venture capital– now or ever. That same $25k (or better, $250k) coming from well-recognized angel groups like Band of Angels and Tech Coast Angels, or from individual angels like Google backers Ron Conway or Andy Bechtolsheim, however, carries with it some significant gravitas. This is not simply because these groups and individuals have been highly successful and have been investing for many years, but also because each has a highly competitive screening and deal selection process which has the effect of winnowing mediocre deals from consideration. Whether I should admit it or not, all things being equal, a Ron Conway- or Band of Angels-backed venture will simply rise higher in the stack of Exec Summaries on my desk than will the summary of a company that did not secure capital from such recognizable investors. I would expect that to be case with most in the venture community. 

What I am referring to in this post are friends, family and fairly unsophisticated investors where, in my experience, the greatest pitfalls lie. Recognized, sophisticated angel investors aside, where things get a bit tricky is around how, when and upon what terms a young company should accept capital from these well-meaning investors. Generally speaking, the traditional investment path is that a young company collects anywhere from $25,000 to $1mm in friends and family funding to get through Version 0.0 and toward an offering demonstrating enough early validation that it can attract a respected professional investor that can put greater sums to work, open up its extensive rolodex of contacts, and accelerate the company’s growth. Of course, in the current environment these notions of what constitutes “traditional investment paths” are being widely re-evaluated and re-assessed as companies are confronting a particularly tight funding market and being forced to go back to early investors–often angels–and new potential angels to extend the runway, get the product/service further along, and hope the institutional funding market will open up in the months ahead. For those such companies, some pointers to consider:

1. Keep the Cap Table clean. I cannot stress enough to young management teams to do everything in their power to do things right the first time. Put bluntly, there’s rarely the time (or even the chance) to fix it later. Upon incorporation, hire good counsel, and get proper advice on how best to manage the early financings. Despite the best of intentions, it can get hairy fast. The $10k and $15k investments you might be receiving from your Uncle Ted and your college roommate could be the difference in getting things going in the early days, but make sure you have a clear, consistent way of recognizing those investments. There is also the likelihood that, being a cash-starved start-up, in addition to the stock options grants you will need to make to early employees you will need to compensate attorneys, landlords and other professional services providers with some combination of cash, stock, warrants and/or other derivatives. Be careful. Early stage VCs expect to see some small commitments from friends and family but if your Cap Table starts to look like the starting roster for the New York Mets with bits and pieces doled out to every Tom, Dick and Harry you’ve met since junior high school along with different pricing and different vesting schedules it can cause a deal to stall….or to fall apart completely. Cleaning up a compromised Cap Table is at the top of most “I hate to do” lists for many VCs. It tends to cast a pall on a potential funding because, apart from the headaches of cleaning up a messy Cap Table, it also implies a start-up team that is either desperate for funding, or unsophisticated, or likely both.

3. Be smart about who’s on your Board. Sun Tzu might have been right when he said, “Keep your friends close, but your enemies closer,” but he probably wouldn’t have made a very good venture capitalist. Building a well-assembled, complementary and collegial Board of Directors (BoD) is critical, but especially so in the early days when things are happening very rapidly, capital is scarce or non-existant, and everyone needs to grab an oar and help in any capacity they can–early customer meetings, investor introductions, crafting and gaining alignment on product strategy, recruiting, legal, etc. Dysfunctional BoDs are a disaster. Be cautious of an angel who is demanding a Board seat as a condition of his or her investment but cannot really bring germane operating experience, investor relationships, or more capital to the table. Early stage investors also become very leery if they perceive that upon investing in a company they will be inheriting a bad BoD or a problematic, unsophisticated or obstructionist Director that they will be tangling with to get things done. For many VCs, there aren’t that many “I have to do this deal” deals, so most will simply shrug and move on to another opportunity that doesn’t present itself with so many wrinkles that the VC will need to iron out once he or she joins the company’s BoD post-investment.

3. Insist on a No Bully policy. This is not quite the same as the No Jackass Policy I referred to sometime back in a recent blog piece of the same title. That piece was concerned primarily with bad hires. Bullies, on the other hand, tend to appear in the form of angel investors during difficult times. This is one of those times when the term “angel” could hardly be more of a misnomer. When there appears to be blood in the water with a young company, an “angel” can appear that seems willing to fund the company through the rocky patch until the markets improve, but the terms get more and more onerous each time an investment is discussed.  At first, the angel seems excited and willing to be part of the business. Correspondingly, the other Board members and investors are excited at the prospect of fresh outside capital coming into the company to help accelerate the business and get through the rough patch. In time, however, the angel perceives that there is no real competition for the deal and begins to insist on more term concessions until the ‘death by a thousand cuts’ phrase begins to get quoted and re-quoted at the BoD meetings when the investment prospect is discussed. Paired with the increasingly onerous investment terms coming from the angel prospect is often new demands on altering the company’s strategy or its mission, or even the principal business it is in. As company management perceives they could be losing the angel prospect, they often make the mistake of “single-tracking” the investment discussion at the risk of other, more promising prospects and investing hundreds of man-hours responding to document demands, diligence requests, and consuming thousands in legal fees. Inevitably, the terms get progressively worse: The new angel now wants a BoD seat, when that was never a deal point to begin with. Now the angel wants to demand the removal of another BoD member he perceives as “not on board” with the new strategy. Now the angel wants sweeteners and more warrants and a lower valuation and pro-rata investment rights and…and…and. It becomes the proverbial onion that stinks all the more with every layer that’s removed. Once that happens, it becomes a death spiral. Accepting the investment with all the new dreadful terms might buy the company some short-term runway but virtually cripples the business, substantially dilutes everyone’s ownership, saps enthusiasm and motivation from the team, and sets the stage for fights at the monthly BoD meetings where everything happens but the exchange of gunfire. Adding insult to injury, even if the business continues to grow and execute with this unwelcome dynamic at the company, should a professional investor show interest in the company for the next round of funding, that investor will almost undoubtedly lose that interest once he realizes that this less-than-angel investor crammed down the company severely at the last funding and now owns a significant percent of the company for his modest investment. Any experienced VC will sense that something is amiss at the company, that the “angel” and not the management team is driving the business decisions, and he will simply Control-Alt-Delete on participating in the investment.

In summary, capital from friends, family and outsiders still has a critical role to play in start-up development. It fills a key void that, even with venture fund sizes falling and more firms focusing on earlier stage companies, will not likely be filled by the institutional class anytime soon. Properly leveraged, it can fill essential gaps in a company’s development and pave the way for follow-on financings led by institutional class investors or, in some cases, even pave the way for long-term commercialization of a product or service. What is paramount, however, is to not let financial stress force the management team to compromise on the core values and mission of the business or to partner with someone whose brief capital support might only serve to damage the company’s long-term survival.

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