Although seed investing has become increasingly the domain of specialized seed funds, large lifecycle VC’s continue to participate as well. In the last three investments I’ve made, there has either been a lifecycle VC involved or one was interested but didn’t end up being part of the syndicate.
There has been a bunch written about the signalling risks associated with large VCs investing in seeds. It logically makes sense that this risk exists, but some data suggests that the effect isn’t as strong as one might think. I think the answer is that there are two approaches to seed investments by large VC’s, and the implications are different for each. There is also a large gray zone in the middle that many companies end up falling into.
Approach #1: Tagging a Deal
This is a strategy where a large, multi-stage VC makes a small, passive investment in a company, usually under $500K. Usually, the investment process is very fast – you don’t need to do a full partner meeting, they don’t take a board seat, the VC is price insensitive, etc. Also, in this case the large VC is not leading the round.
The VC pitches to the entrepreneur that despite the small dollars, they really like the opportunity and the entrepreneur will get nearly the same benefits of working with the VC as a typical deal. They will also argue that they will be waiting in the wings to do the series A very seamlessly once the company has started making progress along a few key milestones.
In reality, what usually ends up happening is that the company is put in a different bucket of investments that don’t really count as core deals. If you come out of the gate really hot, you probably will get some love from the firm, but if you show some mis-steps early or things get off to a slow start, you can be quickly forgotten. When the Series A happens, you are in a tough spot because it’s very easy for the VC to walk away from their tiny investment, and not having their participation will make life much more difficult.
Internally, the lifecycle VC probably talks about this investment as “tagging the deal”. Or, “buying an option to lead the A”. Or something like that. That’s not a good situation to be in, typically.
The only silver lining here is that the very fact that the large VC was willing to do anything means that they see some potential that the company can be a venture scale opportunity. Given that opportunity size ends up being the #2 reason most VCs pass, this is actually some helpful validation that if things go well, at least some VCs are likely to think that the company can be really big.
Approach #2: A High Conviction Seed
Approach #2 is very different from #1. In this case, the large VC buys its target ownership at the seed round (usually around 20%). In order to maintain their 20% ownership, they can write a relatively small check at the A to maintain their pro-rata. Most funds will end up having a third party lead the series A in this scenario, because they already have the ownership they want. They may buy up a little, but it won’t be fishy if they don’t lead the A since they already have 20% ownership.
Few large VC firms pursue a seed strategy like this on a regular basis, but some do. For the entrepreneur, this would mean that the investor is leading the round, probably taking a board seat, and that you’ve pitched the full partnership and gone through a complete process to get to that point. Although the dollars invested is relatively small for the fund, the VC knows that managing a seed investment will take up just as much time as a later stage company (or more). So although the smaller dollars means they have less to lose, the disparity between time and dollars suggests that the investor is really enthusiastic about the opportunity and has high conviction. It also means that if things are going slower than expected, the VC probably will have less difficulty giving the company some additional capital to flip another card or two, since they’ve already invested the time and energy of a full-scale investment.
The Gray Zone
There ends up being a big gray zone between 1 and 2, and a lot of rounds end up falling into this category. In this case, the VC does not own its full ownership, but is not chipping in a meaningless amount either. They are not leading the round, but are one of the 2 or 3 biggest investors in the seed. Sometimes, a VC gets here not because of an explicit strategy but because of deal dynamics. To the VC in this position, the ideal outcome for the next round is usually one of two things. The first path is that the VC likes what she sees, then pre-empts the series A and can own a nice chunk of the company for relatively fewer dollars. The other outcome is that the VC commits to the round but works to bring in another partner to help price it. This can be a fair bit of dilution for the founders as you have two firms trying to get to their 20%, so ideally this can happen for a large enough capital raise to make it worth it.
I think it’s fairly obvious that if you can avoid approach #1, you should. Tagging a deal is entirely in an investor’s best interests, but not really in the founders’ interest. Approach # 2 is quite good, as you have a high-conviction, hands-on partner working with you with lots of capital behind them. But this doesn’t happen all that often. You also trade off the potential of having a bit more diversity in your investor base, and having funds involved that specialize in companies at the seed stage.
The Gray Zone is tricky, but can be made to work. But I usually counsel entrepreneurs in this position to do the extra legwork to push the investor closer in the direction of a high-conviction seed. This means some combination of:
- Pitching the entire partnership and allowing the VC to do real due diligence.
- Having the VC invest at a level that is not a complete throwaway for their fund. At minimum, $500K, but more likely closer to $1M. This is a bit counter-intuitive. But I think that if you are going to have a large VC in your seed round, you want them invested at as high a level as possible so they feel more fully committed.
- Have the VC take a board observer seat. Or if not, commit to a regular cadence of meetings to monitor your progress and find ways to be helpful.
Think about this list. It should really be in the VC’s best interest to do these things. But if you find them pushing back, it means that they are hesitant to fully sign-up to make a high-conviction investment in your company. Instead, it shows that they are trying to shove you into their bucket of low-conviction, tagged deals. And that’s not where you want to be.