A while back, I wrote a post here on the “5 Challenges Facing The MicroVC Model.” Since then, I’ve added more and more, and now we’re up to nine. Some LPs I talk to frequently have joked “if there are so many challenges, why do it?” It’s a fair question, and you can read through to post toward the end to hear why.
Now, in 2016, I think the market overall has slowed down to a point where I am personally sensing material changes in how I operate my seed fund. What I’m writing below is, more or less, what I’ve communicated to my LPs in the interest of open communication and transparency, and there may be implications for early-stage founders, as well.
The Challenges For Seed Funds (like me)…
-Slower Pace: I’m expecting the flow of money through the system to slow down overall. This could impact funds as they raise, or commitments to follow-through on capital calls given seed funds don’t have traditional LPs bases. As a result, funds may be more cautious with speed to adjust for this risk.
-Playing With Check Size: Additionally, reducing initial check size is a way to maintain pace but adjust for a fund’s runway. With many seed funds putting in a few hundred thousand here or there, playing the fraction game to keep the deal flow going is another move we can expect to see more often. I don’t see this as a bad thing as round sizes in total may come down. Some rounds frankly don’t need to be as large as they are.
-More To Track: Most seed funds have 1-2 managers to track lots of companies. If pace slows, then those folks would spend more time with the existing portfolio, even dating
-Increased Mortality Rate: The larger seed rounds which started in 2012 and continued through last year are going to start seeing churn. There won’t even be seed extensions for many of these companies, and we are all hoping the acquisition market picks up even for nominal transactions, just so the transitions are smoother.
-End Of Quick Markups: This is the key killer change for seed funds. When I started three years ago, I was lucky that a bunch of investments were seriously marked up by big VCs (what all seed funds hope for) within a 12-month period. Shifting to 2016, I am telling LPs that it may be at least 12 months before we could see the nice 2x to 3-4x markups from the seed rounds, as larger VCs are smartly being more selective, more patient, and also focusing more on larger, future bets and newer companies. ** Hunter Walk tweeted a reply which I hadn’t thought of, which is slower pace of markups (assuming they happen) give earlier investors more time and data to choose which investments to continue on with.
I don’t want this post to be all a downer. I think there are also some important plusses here for seed funds.
The Silver Lining For Seed Funds…
-Costs Are Still Low: The cost of starting up is still falling in the early-stage. Two people who are talented and have a prototype going and want to keep rolling in customers don’t need more than a $300-500k round to keep afloat, have an office, maybe hire one person, and get their bearings. I’ve done lots of these rounds and love them, especially because it forces folks to not raise too much capital early.
-Modest Promises: Seed funds don’t have to return billions of dollars just to return LP principal.
-Tough Times Produce Tougher Players: I see higher percentage of grittier founders coming across my desk, and I love it. It’s easy to quickly pass over teams who lament things like dilution or other trivial matters. The slowdown is making it a bit easier to test for something that’s been elusive for a while: “Why are you doing this?” The folks who do the $3-4m valuation rounds with product and revenue are often pursuing something greater than headlines, and many seed fund managers are dying to meet more with those qualities.
-Lower Valuations: Let’s face it — the prices have dropped, and now small seed funds can actually get 5%+ ownership in a company (on notes!) with a small check. Things have mostly corrected here, yet are still great for founders. Now going from $4m cap at seed to a $8-10m priced at A, and then talking to bigger for VCs for the B round of about $30M give or take all makes sense and leaves options for everyone on the cap table to be made whole.
So, why do it at all? Why stick with seed given all the challenges?
It’s the best place to build a network for the long-term. It’s the time when founders really need you. It’s where all the action is. It’s because having a line to the top of the funnel will ensure deal flow to come for years. It’s because many of the folks at seed either were at larger funds or could have the option to, but they miss the part of working with people early and seeing new and exciting concepts from the beginning. And, seed is the training ground for the next generations of startup investors to cut their teeth. Some will stay at seed and perfect the lifestyle. Some will graduate up to Sand Hill Road and join an existing platform, and come in with a killer network and deal flow engine. Some will ramp up and start their own new Series A funds, which is already under way. Some will join forces and do one of the above. This will be what the next five years is about from the early-stage financing side, and it’s exciting just to be a part of it.