Some complexities of VC seed investing

Should there be a difference between seed investment and "Series A investment?"

Mark Suster, a partner at GRP Partners, has an outstanding post up this morning titled VC Seed Funding is Dead, Long Live VC Seed Funding. Mark started blogging recently and has quickly turned into my second favorite VC blogger (after Fred Wilson) – if you don’t subscribe to his feed, you should.

Mark just did his first seed deal, a $500k investment in a company called Ad.ly, and his post is a long essay on how he’s thinking about seed investing these days.  He makes the appropriate warning (and differentiation) between VC investors who view seed investments as “options” on future rounds (e.g. they toss a little money in and then generally ignore the company until the next financing) and “active seed investors” (like First Round Capital, SoftTechVC, True Ventures, Union Square Ventures, and O’Reilly AlphaTech) who view the seed investment as their first round of several as they help get a company up and running.

I’ve been making seed investments since 1994.  I don’t know the actual number that I’ve done, but as a VC (starting in 1996) it’s probably more than 25.  In our most recent fund (Foundry Group) that we raised in 2007, we’ve made six seed investments (AdMeld, Gnip, Lijit, Next Big Sound, Standing Cloud, and Trada) out of 17 investments in the fund to date and have one more that we expect to close this week.  Interestingly, we did only two of these by ourselves; the other four included co-investors such as First Round Capital, Spark, SoftTechVC, Boulder Ventures, and Alsop Louie.

In my world, there is no real difference between a seed investment and a “Series A investment.”  Ironically, when I started doing this, seed investments were the Series A investment; at some point in the last decade a bunch of VCs started saying “we only do Series A investments” so the seed investment became “less than the Series A” investment, although it never got relabeled so you see a lot of Series A (seed) and Series A-2 (the next round after the seed) investment rounds these days.  Regardless, in my world, a seed investment is the first round – when I make a seed investment I’m committed.

VC’s keep reinventing seed programs.  In 1994 when I was first making angel investments with my own money that I got from selling my first company I encountered several VC firms that had “seed programs.”  These firms had an accelerated way to invest $250k in an entrepreneur to help him get up and running quickly.  These investments were always convertible debt that converted into the Series A round at a discount.  The entrepreneur quickly got $250k, the VC got a seat (usually a controlling seat) at the table for the next round, and off they went.  I participated in a few of these – some that worked (e.g. a new VC came in and led the next round) and a few that didn’t (no new VC showed up, the entrepreneurs and the seed VC watched tensions escalate, and eventually there was an unhappy ending.)

Over time, I soured on the “convertible note seed funding” approach.  I’ve written about this in the past, but at the minimum I think it misaligns the entrepreneurs and the early stage VC.  More importantly, in my experience, it’s a signaling device – the seed VC isn’t as committed in a convertible note round as they are when they price a seed round and do it as a typical VC preferred financing, albeit with lighter terms.

One key thing for an entrepreneur to test with a potential seed round VC is whether or not the VC will invest in the next round by themselves.  The specific question is “Do I need an outside lead for the next round, or will you do it yourself?” While either case is fine, this sets the ground rules clearly for financings going forward.  In our case, we are perfectly happy to do the first few rounds of financing ourselves.  Some other great seed investors, especially those with smaller funds need a new investor to lead the next round.  Then there are traditional early stage VCs who have specialized seed programs where the rules of engagement are that there needs to be a new investor to lead the next round.  Knowing where you stand and what the ground rules are before you consummate the seed round is important.

With the emergence of pre-seed programs like TechStars I’ve had more visibility into VC seed investing activity from other VCs.  In Boulder, we just finished year three of TechStars and while plenty of the TechStars companies have their first round of financing include angel investors, I think six of the ten companies this year have (or will) close VC-led seed rounds.  I haven’t decided if there is actually more seed activity in 2009, or if VCs are focused on hunting for seed deals in more qualified places.  Regardless, being a great VC seed investor isn’t a no brainer and I encourage entrepreneurs to make sure they know how their VC investor is going to behave when it comes time to raise the next round.