Seed Venture Capital Funds by William M. Keever

Companies receiving seed financing exclusively from Seed VC funds are almost half as likely to raise follow-on financing as those raising seed financing from larger VC funds.   Update by William M. Keever.

After a Series A Crunch Report calculated that more than 1000 companies would be orphaned as the result of the supply-demand imbalance for Series A funding, much of the conversation and angst was around which startups would fail.

However, besides companies, it looks like seed venture capital investors themselves may be impacted.  Why?

Because the data shows that companies that receive seed funding from larger, multi-stage venture capital firms attract follow-on funding at a higher rate than companies that are just funded by seed or micro-VCs.  Let’s let that sink in for a moment as this flies in the face of most of the anecdotes on this topic to-date.

First, we’re defining a Seed VC fund as one with < $100M assets under management and that invests primarily in seed stage financing transactions. The conventional wisdom on the Seed VC vs. multi-stage VC (herein referred to as big VCs) was that big VCs who participate in seed rounds are not good for companies longer-term.  While many have opined on this, two of the more prominent viewpoints were articulated by Chris Dixon (formerly of Founder Collective and now Andreessen Horowitz) and David Hornik (August Capital).

First, let’s look at Chris’ arguments. When he was part of a seed fund, Founder Collective, Chris argued that taking money from a a big VC was problematic for a couple of main reasons.

  • Signaling risk – If the big VC doesn’t follow-on, folks wonder why.  As Chris wrote at the time, “if this top VC that has hundreds of millions of dollars and knows this company the best doesn’t want to invest, why would I?”
  • Lower valuations – “Even in the good scenario when the VC does wants to follow on, you are likely to get a lower valuation than you would have had you taken money from other sources of funding (angels, micro-VCs like Y-combinator).”
Chris acknowledged at the time that he was talking his own book and over time, Chris’ stance on big VC seed investments did soften.  We’d imagine now that he is part of Andreessen Horowitz that his sentiments may be very different.  And while Chris’ argument against big VCs investing in seed rounds were about terms and fundraising prospects, David Hornik argued that the reasons not to take Seed VC money from a big VC came down to the attention and nurturing that a micro-VC can provide.  He wrote:

As a general matter, early stage entrepreneurs don’t just need money, they need help and advice. And if help is no longer part of what you get from your seed investors, I believe the likely success of those investments will diminish.

Worse yet, taking seed investment from traditional venture investors can be counter-productive. It is impossible to imagine how a VC firm that is investing in dozens of early stage startups can find the time to be helpful while also working with their more traditional portfolio. You may get a little of their money and a little of their reputation, but you will get it at the expense of any real help in building your business.

Both Chris’ and David’s arguments sound reasonable, rational and well-constructed.  The problem is that the actual data doesn’t line up at all with the conclusions they’ve drawn.

In the initial Series A Crunch report, we found that Seed VC investments or those seed investments in which a VC participated had a higher rate of receiving follow-on investment than seed investments which were strictly participated in by angel investors.  For seed rounds with VC participation, the rate at which companies received follow-on investment was 46.7% while seed rounds comprised only of angels had follow-on rates of 35.4%.

Based on the above, seed rounds in which VCs participate are better, but what the statistic above didn’t reveal was whether there was a difference in follow-on rate based on the type of VC participating in the seed round.  And diving into that data is where we see that VCs who invest only at the seed stage (Seed VCs) fare quite poorly.

In transactions where a Seed VC and a Big VC (multi-stage) partner up, the rate of follow-on investment is highest at 59%.  When only a Big VC fund participates in a Seed round, the follow-on rate dips but remains nearby at 54%.

However, when only a Seed VC fund participates in a seed financing, the rate of follow-on drops significantly and stands at only 32%.

What does this all mean?

First, it is clear based on the data that having a Big VC fund participate in your seed round not only doesn’t have deleterious impacts on your ability to raise follow-on financing, but relative to only Seed VC investor rounds, it actually appears beneficial.

While it is conceivable (albeit very unlikely) that the companies being funded by Seed VCs don’t require follow-on capital beyond the seed funding, the data indicates that many companies who need follow-on investment simply cannot actually get it. While raising follow-on investment is by no stretch a guarantee of success, the inability to raise follow-on financing means those companies will die or be orphaned. In the medium- to longer-term, it also means that many of the Seed VC funds backing them may face issues as well.  Since venture capital returns tend to follow a Power Law, this is not all that surprising.  A handful of Seed venture capital funds will ultimately drive the vast majority of returns. Lake Wobegon this is not.

In talking with LPs we work with, some of the issues that they’ve shared with us about Seed VC funds they’ve met with,.

  • An oversupply of Seed VC funds - Raising a micro VC fund of $5 or $25 or $50 million has become more common and relatively easier (vs raising a multi-hundred million fund). While LPs in the larger VC funds have to be endowments and pension funds who can write large checks, Seed VC funds have many other funding options. They may raise from institutional LPs but given the lower fundraising amounts, money from wealthy individuals, family offices, etc is also fair game and seems to be plentiful for teams with the right pedigree, the right story, etc.
  • Largely undifferentiated - The theses of these Seed VC funds (primarily technology-focused) are generally remarkably similar.  The thesis tends to have at its center that technology companies can be built more cost-effectively and cheaply today. To this, they add views on specific sectors or geographies which they feel are underserved.
  • Belief in the proprietary dealflow myth - As Naval Ravikant of AngelList has argued many times, this concept is really dead (outside of perhaps the top 20 VC firms).  And smart LPs seem to know this. Yet many Seed VC funds appear to hold onto a belief that their new, still nascent fund will have access to deals that others will not.
  • Relationships with follow-on investors are weak – Outside of the top Seed VC investors, many Seed VCs appear to have few to no ties to sources of follow-on capital and therefore are unable to really help portfolio companies raise additional financing.
The low follow-on rate calculated above also suggests that the idea that the individualized attention a Seed VC fund can provide is of uncertain value in changing the trajectory of a young portfolio company.

Leave a Reply

Your email address will not be published. Required fields are marked *

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>