I’ve been having this conversation quite a few times over the last several weeks, so I thought it would be important to do a post on this.The question that I often get asked is “how should I think about the composition of my seed round?”
This is related to my prior post on how to think about VC’s in seed rounds, but I’ll try to be more specific. By way of background, of our 12 investments at NextView, 4 were with only angels, 3 were only with seed funds, and 5 were with some combination of VCs, angels, and seed funds.
It seems like a high-class problem for an entrepreneur to be able to influence round composition, and it is. But I find that once a company has investor interest, many other folks tend to want to pile on. How should an entrepreneur think about the different options on the table? Here are a few of the typical configurations and the pros and cons of each.
The One VC Led Seed
- Definition: This is the case when a large (ie: greater than $200M fund size) VC takes a significant portion of a seed round, and maybe leaves 50% or less of the round available for angels or seed funds. In this case, the VC will typically take a board seat, be very active in the company, and the entrepreneur has basically gone through the standard investment process of the firm.
- Pros: High degree of VC commitment, easier to attract good value-added folks to fill out the round. More dry powder in case there is a need for an extension and the VC feels supportive of the company.
- Cons: Locked in to the incentives of the VC around outcome size, portfolio strategy, etc.
- Series A Dynamics: This is a middle-of-the-road outcome in terms of optimizing your next round of financing. If the company is doing really well, the VC will have an incentive to try to do more of the next round at perhaps not the highest possible valuation. Their aggressiveness sends a signal to the market. But, it’s very typical for a VC to say “we are committed to half the series A, go find an outside lead” and be helpful in making that happen. That’s probably what would happen if the company is doing well and is a fine outcome IMHO. This is what happened with Gemvara (FKA Paragon Lake). We saw the series A at my prior firm, Highland was committed for half the series A, which we took as a positive signal of support. But if the VC is not participating in the follow-on round for any reason, you’ll be in a pretty difficult spot.
The Two VC Led Seed
- Definition: This is a the case where two large VC’s partner to take a significant portion of the round together, often leaving only a small piece for value added angels or seed investors. In this case, the VC’s really consider this a true investment of both time and reputation. This tends to be more common on the East Coast where there is more of a history of firms buddying up with the intention of doing the next couple rounds of financing together. Often, the VC partners have worked together before and both have deep domain experience that is very relevant to the company. This is distinguished from a round with multiple VC’s that are not leading.
- Pros: Lots of help from the VC’s. Potential for very quick and easy series A and even series B if things go well. Lots of credibility at even a very early stage.
- Cons: Not much space for new investors in future rounds. Locked in to the incentives of the VCs. Limited options for series A.
- Series A Dynamics: When a seed round like this happens, you are banking on the VC’s to lead your series A round together. It’s harder to go outside and create competition for the round unless you are absolutely knocking the cover off the ball. But, if you were able to get the right investors to participate together in the seed, it can work out well. We did this quite a bit at Spark with Tumblr (Spark & USV) and Admeld (Spark & Foundry).
Angel Round Led By A Micro VC or Seed Fund
- Definition: This is a the case where there are no large VC’s investing in a round but a dedicated seed fund or Micro VC is acting as the lead. Often, a member of the seed fund’s team will take a board seat and be actively involved. Sometimes, there will be multiple seed funds participating, or there will just be one and a number of angels.
- Pros: Good incentive alignment. Round can come together quickly. Lots of optionality and less signaling in future rounds. Strong credibility in the market if the round is led by a respected seed fund.
- Cons: Will need to attract outside capital for subsequent rounds. Varying degrees of willingness to do an inside round or bridge.
- Series A Dynamics: Your seed investors are well aligned to help you raise your series A from the best parter at the highest price that makes sense for the company. The potential for competition is high. The downside is that some funds are very reluctant to do inside rounds or extensions, so it is up to the entrepreneur to gain external validation from the market.
Individual Angels Only
- Definition: This is a round comprised only of individual angels. In the best case, a very sophisticated angel acts as the lead for the round that others can participate in. In the worst case, there is no angel that emerges as a true lead.
- Pros: Good incentive alignment. Can get some support/help from multiple angels
- Cons: If there is no lead, it’s much harder to actually pull the round together. Also hard to raise a larger amount of capital (ie: >$500K) since most angels are writing modest sized checks. There may be a lack of credibility from the perspective of partners, customers, or potential series A investors unless the angels are very well known and respected.
- Series A Dynamics: This really depends on who the angels are. In theory, most angels should be well aligned to help you raise your series A. If you have well known angels, they can be a strong asset. The downside is that angels usually have limited capacity and interest in following on.
The Large VC Chip-In
- Definition: This is an angel round of many different potential compositions, but includes at least one or more large VC chipping in a small % of the round.
- Pros: Good to get another very smart person around the table who can help the company.
- Cons: Usually won’t get that VC’s full time or attention. The investment is explicitly an option to keep tabs on the company and potentially participate in the series A if things are looking good.
- Series A Dynamics: Others have talked quite a bit about this. I’ve heard the argument that investor signaling is reduced if there are more VC’s in the round, but I’m not sure if that is necessarily true. I do think that entrepreneurs have become savvier at navigating these situations and maximizing their outcomes if things are going well (such as our investment in RentJuice that had Highland as a small investor prior them leading their first true VC round). Of all the scenarios, this is the trickiest and most idiosyncratic. It’s possible that the VC’s participation can exert a lot of negative influence in the future round, and it’s also possible that that VC’s gets very aggressive and catalyzes a pre-emptive series A. In any case, it’s important for entrepreneurs to have their eyes wide open if they enter into a round with this composition.