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April 30, 2012

Activist Seeds - The Latest, Subtle Trend in Seed Investing

When I entered the VC business 10 years ago, I tried to keep thinking about venture capital as a business, where the key focus area was on meeting the needs of our target customers -- entrepreneurs and limited partner investors.

In the case of entrepreneurs, those needs have changed radically in these last 10 years.  The surge in seed investing over the last few years has been well-reported and analyzed.  With advances in cloud computing, open source infrastructure, development tools and general "Lean Start-Up" techniques, entrepreneurs need less capital than ever before.  And when entrepreneurs' needs change (i.e., requiring less capital), smart investors adjust to meet those new needs.  Hence, the rise of angels, super-angels, incubators, accelerators, micro-VCs and VC-led seed programs.

But as the "Great Seed Experiment" (as my partner, Michael Greeley, calls it) matures, a new trend is emerging.  Entrepreneurs are beginning to learn the difference between what I'll call Passive Seeds and Activist Seeds.  And entrepreneurs are learning that the difference between the two, although somewhat subtle, matters greatly.

Passive Seeds are when a VC invests a small amount of money (for a $200-500M mid-sized fund, typically $250k or less, for a large $1B fund, perhaps $500k or less), to achieve a very small amount of ownership (typically less than 5%) to simply create an option to participate as a more meaningful investor in the future.  Passive seed programs get most of the press attention because of their sheer volume.  

When you ask venture capitalists about their seed programs, many will brag about how many seed investments they have made (20-40 per year is not uncommon) and how wonderful it is that so few of them "graduate" to become series A investments (perhaps 10-20%) because it shows how discriminating they are.  Other characteristics of passive seeds are that one or two of the partners can make the decision to invest, rather than requiring the entire partnership to approve, and the due diligence is very light.  Additionally, in a passive seed round, VCs don't mind if 3-5 firms participate, as opposed to more tyically 1-2, and each VC partner can juggle a dozen passive seeds at any given time.  Sometimes there are more VC investors than employees in a passive seed!

But entrepreneurs are starting to wise up.  The conventional wisdom has emerged that Passive Seeds from VC investors are bad for start-ups and entrepreneurs.  VCs who make passive seeds are not typically engaged enough in the business to add meaningful value.  Further, they send a bad signal to the funding market when they don't invest in the Series A, thus creating inappropriate leverage on the entrepreneur at the time of the Series A decision.  

Seed investor/venture capitalist/entrepreneur Chris Dixon has written extensively about this issue, and I couldn't agree with him more when he declares, based on his discussions with experienced founders, "there is no room for debate" on the issue.

Activist Seeds VC investors are a different story (which Chris acknowledges, although uses different language).  From the VCs perspective, an activist seed is when the firm commits the full time, resources, and energy into the investment that they would do with a Series A.  From the entrepreneur's perspective, they truly want to raise less capital because of all the positive Lean Start-Up trends noted below, but want the active involvement of a value-added VC firm.  

An activist seed from a VC is typically more like $250K-$1 million and the ownership is closer to 8-10%.  The full partnership approves an activist seed and the due diligence, although abbreviated, is thoughtful and serious.  The firm gets to know the business and the entrepreneur better and thus makes a deeper commitment in making the investment.  

The conversion rate of an activist seed into a larger Series A is more like 50-75% and each VC partner dedicates as much time to an activist seed as he/she does in a larger Series A.  In short, an activist seed is nearly identical to a Series A, just smaller, slightly more streamlined, and informal - all appropriate for the stage of the business and the requirements ahead.

So next time you are discussing a seed round with a VC firm, figure out if their firm's philosophy is activist or passive.  At Flybridge, we firmly believe in activist seeds (two nice examples recently in the news are Crashlytics and ZestCash).  Different firms have different approaches.  Make sure you find out which is which, and make sure it's a fit for your needs.  Here are a few questions you can ask yourself to distinguish between the two:

  • Was the entire partnership engaged in the investment decision process?  Did I meet with and pitch to the entire firm?  This results in a greater sense of commitment and shared ownership. 
  • Did the VC open up her network and make a few value-added introductions to prospective talent, customers and business development partners?  Again, this is an indication that the VC is willing to add value along the way and be more active than passive.
  • Was the due diligence process rigorous? Do they seem to really understand my business and the subtelties around what it takes to win?  Did they ask tough questions, check my personal references to get to know me better, put me in front of prospective customers?

Absent these elements, you are at risk of taking money from a VC that views you as "an option" rather than "an investment" - not a place a hard-charging entrepreneur who needs as many friends on his/her side as possible wants to be!

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From an entrepreneur’s perspective, there is no doubt that an active seed investor is more beneficial. That said, from an investor’s perspective, passive investing makes sense in order to augment diversification and minimize risk; especially for the much larger firms out there today trying to get a little slice of everything. Although I disagree with the strategies like Menlo Park Ventures and Charles River Ventures who began buying “call options” in seed stage companies in less than 24-36 hours after being introduced to the company, it is a way to set them apart from other firms in an increasingly crowded (and frothy) industry.

However, I do believe that no matter how many firms or investors are involved in a deal, it is in EVERYONE’s (investor + entrepreneur) best interest to have an active lead investor. It is clear that value added services many VC firms offer can greatly differ the path of a seed stage company. I think it is important that an entrepreneur should realize this when negotiating a term sheet. They need to make sure the lead investor will be more hands on than others and make sure they are not dealing with a junior associate (compared to a general/managing partner). If the active lead investor can’t provide a specific value or have a suitable network, entrepreneurs can easily turn to the other seed investors and receive the services or introductions they need. While this calls for a very active and investor friendly entrepreneur, it can be easily done.

The scary aspect of this type of investing can be seen in the case of Andreesen Horowitz’s investment in Instagram. At the seed stage, the firm invested in Instagram as well as another company in the same space. After Instagram pivoted (extremely common at the seed stage) they were in direct competition with the firm’s other investment. As a result, Andreesen Horowitz was in a tough position and had to choose a follow on investment with only one of the two companies (they chose the other). In the end, the diversification worked out well as they made over $200M on the acquisition and the other company didn’t go anywhere; however, it created a scary situation for both the investor and the entrepreneur. Especially when dealing with the larger firms out there, seed stage companies can easily get thrown to the wayside. As an entrepreneur, this makes me lean towards much smaller and more concentrated firms such as Flybridge or others as they'll always have an entrepreneur's back.

Great post Jeff. Sometimes it is the entrepreneur who forces the VC into a passive rather than active approach to the seed investment. Entrepreneurs have also been collecting "trophy investors" in a way that makes the cap table look like a wine list with countless trophy bottles...but when you're ready to pick a bottle, none of them are ready to drink. You make the point that you want to get some depth with your investor set. That doesn't necessarily preclude some diversification, but having 20 or 30 investors in a seed round makes herding cats difficult. I also think people have been doing too many "rudderless ship" rounds (no lead, just the snowball effect of small investors). When that happens, the investor base won't coalesce around follow up investing in that company, which can lead to undesirable results no matter how well intentioned the investors are. The short summary: the entrepreneurs need to be open to allow people to dig in.

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The lack of a clear lead or co-lead is a great point I should have included, Ed. If no one or two investors feel ownership and accountability for success, no one will invest the energy and time necessary.

I really liked this post, Jeff, since it touches on the psychological nuances of the chess game also known as investment negotiations.
-Amaury


Interesting. Would love to hear more about what you mean?

I would like to see how I could grab your rss feed to stay updated of any changes on your website, but I cant find it, where is the link for it?

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