VCs Finding Seed Financing More Attractive

There was a day not long ago when a venture capitalist wouldn’t even look at a deal if all the entrepreneur was seeking was a minimal investment to get the company off the ground. Such investments were too small to consider and hardly worth their time. While this may have posed a problem for the entrepreneur, it created opportunities for angel investors.

Now, angels may find they have some competition in the market. Despite a quiet year, given the tight fist most VCs have had on their funds, there is a slight hum in the air that these might be improving.

Seed vs. Series A

According to VentureScore, VC deals are starting to increase, but the terms seem to be changing. For the better part of the last decade, VCs have committed themselves to Series A type funding. As investments are starting to heat up, “seed” financing is drawing more of the VC crowd. [1]

While seed financing and Series A deals are similar in the establishment of a valuation and ownership stake, the main difference is in the amount of money invested. Series A financing tends to be between US$500,000 and US$2 million. Seed financing tends to be anything below the US$500,000 benchmark.

This move may seem like something that has resulted from the recent recession, but seed financing isn’t necessarily a new ploy for venture firms. In fact, Y Combinator invested just US$6,000 in the cell phone software maker Loopt in 2007. Said Paul Graham, Internet entrepreneur and founder of the Y Combinator, when asked why he made such a small investment, “It’s gotten to the point now where the most important things you need to found a tech startup are food and rent.” [2]

Micro VCs

Startups really suffered the most when the dot com bubble burst in the early 2000s and the euphoria for Internet ideas died. VCs were suddenly very leery of startups and poured their focus on companies with proven track records. While that was certainly a safe approach, it wasn’t necessarily the most innovative or the one with the highest potential for return. Technology is still an area of intense opportunity, and has been throughout the entire decade. [3]

As valuations have also gone down, it makes sense that amounts raised have also decreased, but this isn’t all bad news. What is emerging is what Philip Smith refers to as Micro-VCs that are taking the place of angel investors in some situations. These investors include Nueva Ventures, Fruition Ventures and Capybara Ventures, who are drawn to the dynamics of great ideas, cheaper costs of execution and lower valuations. This trend of micro-investing and micro-startups could be the key to future growth, but it doesn’t mean the investing is as streamlined as angels can provide. [4]

Implications for Angel Investors

So, what does this change in the atmosphere mean for angel investors? It does mean increased competition and activity in the field, but it can also mean an advantage when the angel really wants to get on board with a particular startup. The key will be to identify the steps the VC will likely take in the deal. Remember, just because they are willing to do seed financing doesn’t mean they are willing to accept seed financing deals.

Remind the entrepreneur of these tips from Caine Moss in the Entrepreneur Corner:

• VCs might expect more than 20-40% of a company even with seed financing
• VCs might expect more than 1x liquidation preference
• VCs are likely to expect Series A-type control rights: they should be allowed one board seat, not control of the board
• VCs may demand certain investors rights they don’t truly deserve
• VCs could want a “super-pro rata” right in seed deals
• VCs may opt to decline to participate in Series A funding when the time comes, which can create a negative market perception. [1]

VC investments can offer substantial advantages to startup companies, but the price may be too high to accept the investment. This is where an angel may hold more appeal. It isn’t more lenient investing; just simply more equitable.

Notes:

[1] Seed is the New Series A for VCs
[2] Thinking Small
[3] Looking for Seed Money? Venture Capital May be the Answer
[4] New Dynamics Emerging in Early Stage Funding