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An Analysis on Seed Funding in 2010 (Part 1 of 2)

Written By: Gary 17 August 2010 Other Posts By: Gary

This is a guest post by Gary Whitehill who was kind enough to allow Founders Block to repost his article, originally published on August 11th, 2010.

The entrepreneur community is more closely knit than you’d believe, and when someone picks up on a notable event or trend, the blogosphere literally lights up with posts.

As far as entrepreneur blogs go, the flavor of the month appears to be the debate about whether the seed funding phenomenon is a bubble waiting to burst, or whether it’s a viable means of funding pre-revenue/start-up businesses. This is my take on the landscape.

First Off – What Are Seed Funds?

There was a time when if you wanted to fund your company you had four options, approach:

  1. A bank
  2. An angel investor
  3. A venture capitalist
  4. OR ………… have an asinine risk tolerance and fund the project yourself with your own money.

At a certain threshold of funding, there was a catch twenty-two because banks are notoriously risk averse, and don’t normally fund businesses that have yet to prove themselves. Meanwhile, traditional VC firms couldn’t justify investing less than $3M-$5M in a Series A round, mainly because ROI based on growth trajectory (when investing in small amounts) wasn’t worth their while, especially when holding $700M+ under management.

This left the entrepreneur with little choice but to either:

  • Take a small angel round
  • Settle for a crappy mid-size “hodgepodge” round that diluted the heck out of their equity
  • Bootstrap their business and risk getting stuck behind better funded market entrants
  • Come up with the collateral the banks demanded (usually a lien on their home)
  • Give up their dream (NOT an option)

Enter the emergence of a fifth player, seed capital funds.

All of a sudden they are popping out of the woodwork. Most notably are Lowercase Capital ($5MM) by Chris Sacca, 500 Start-ups ($30M) by Dave McClure, and Floodgate ($73M) by Mike Maples.

These types of funds are set up specifically to provide funding to mostly “wet behind the ear” ideas and entrepreneurs. Based on deal flow that has recently been funded, aside from a great idea and a rockstar team, the requirements for an entrepreneur to get their hands on that crucial first funding injection are low in comparison to previous thresholds. However, it certainly is worth noting that there are folks who stick to their investment strategy no matter the deal size, such as Brad Feld of Foundry Group.

Second – Where Did They Come From?

Seed funds have arisen due to a perfect storm in the funding environment:

Start-up costs continue to be driven lower = more efficiency = less investment needed = exponential decrease in barrier to entry

  • Ex. off shoring, open sourcing technologies, search engine marketing
  • Dissemination of high quality and value add content (blogs, videos, events)
  • Venture Hacks and their very worthwhile project AngelList

Venture capital funds have gotten HUGE = restricted to certain size investments

  • The downside to companies needing less money is that VC’s essentially become pigeon-holed. They’re stuck investing a certain amount or risk their LP’s having a heart attack
  • OR are they stuck? (see two sections down)

IPO market remains virtually stagnant = must explore other options for exit = can’t drive up valuation (to make ROI) or there won’t be a buyer

Valuations are lower = companies are more attractive through an outright acquisition

  • Especially if they’re a cash flow machine
  • Companies want a secure means to cash in this economy (called a “war chest”)

Elasticity on the back-end is created when less money is poured into the company on the front-end. Why?

  • Founders keep more of the pie = they’re happy
  • Company hasn’t been overpriced. = investor is happy
  • Note: When companies raise a ton of money on the front-end everyone is forced to hit toward only a “homerun.”

What are the Strategies Seed Funds Employ?

Well, to be frank, it goes one of two ways:

A “Fly by Night” Strategy = Quantity

  • Writing a check after a 20min presentation
  • Little to no communication with the entrepreneur (except when they’re raising money)
  • Primary goal: obtain an ROI on their investment

A “Operator” Strategy = Quality

  • Performing meaningful due diligence
  • Acting as a mentor – tinkering but not with overruling brashness
  • Primary goal: investing time/energy into the growth of the co-founders and ultimately building a profitable and scalable company

I could provide examples of both investing strategies on both coasts (Silicon Valley and New York City) but I will leave that tree for someone else to bark up.

Which do you want? Based on my experience, I will take an “operator” any day – never the fly by night. What’s best for you? Well, weigh the cost/benefit of both and make an educated decision. You know your business better than anyone else on this planet.

But WAIT…. There’s More…… VC’s Enter the Market

The interesting thing is that we’re now seeing tons and tons of venture capital firms pushing down into the seed space as well. That is both a good and bad thing for entrepreneurs. Literally, this is a good thing for entrepreneurs if you’re informed, and a bad thing if you don’t take the time to read posts like this or others which try to educate you on what’s going on right now.

THE GOOD – Why have venture capital firms pushed into the seed market?

They’ve realized that since companies don’t need as much money as they used to, then they have to increase the frequency of investments. That’s not very scalable as you go up the funding hierarchy ($5MM+).

So instead, VC’s pivoted and decided to do two things:

  • Keep investing in the $2M-$5M space as they always have (with follow-on rounds of course)
  • Push down with an allocated amount of their fund, remain true to their investment strategy, and invest in 2x, 5x or even 10x more companies (with $50K-$2M) than what they would have through their normal strategy.

Before the seed funding phenomenon, most venture capitalists were putting all their marbles in 7-10 companies/yr. Although that seems like a “portfolio strategy,” I would argue this new Seed/VC model mitigates risk significantly more.

Additionally, since companies have less cash invested = less pressure to meet a high valuation = easier to exit. What does this translate to for the VC industry? A VERY BIG DEAL. The fact that VC’s can invest $125K into 30 companies (hoping for modest returns) versus investing a $4M chunk into one company (hoping they’ll hit a “homerun”) is HUGE for everyone. Just as pointed out above, it creates elasticity and everyone is happy.

THE BAD – Who are all these Venture Capitalists?

Mark Suster clearly delineates his investment strategy here. Most venture capital firms do not. Furthermore, as the seed investment line for angels, super angels and venture capitalists has blurred – so has reality for some investors that they’re qualified to enter additional funding spaces. That is not a good thing.

As outlined above – understand what your VC is looking for and the investment strategy they employ – are they in it as an “operator” or are they looking for “fly by night” opportunities? Trust me, it makes a big difference whether your investor is looking as their investment as a “true investment” (operator) or just simply as options on the next round (fly by night).

The Interesting Byproduct – Regardless of Who Funds You

Another byproduct of the fact that start-ups are significantly more efficient in getting off the ground and scaling is that their timeline to revenue has become much shorter.

Many companies become revenue wheel-houses in just a few short months now –a-days (although varying industry dynamics play a role) because the s-curve of innovation for companies has drastically sped up within the past few years. Thus, the time in which it takes companies to reach a real (and sustainable) business model has drastically decreased. That is a good thing for all stakeholders.

Part 2 will be available on Thursday, August 19th.

As a successful, under-30 serial entrepreneur, Gary’s game-changing endeavors have been featured on television and in magazines and newspapers across the nation. Gary is a member of the AOL Small Business Board of Directors and the founder of New York Entrepreneur Week (NYEW), The Relentless Foundation and Whitehill International, each of which reflect his entrepreneurial drive and relentless energy

For more innovative entrepreneurial strategies visit Gary’s website and follow him on twitter.

Related posts:

  1. A Peek Inside the NYC Venture Capital Ecosystem
  2. Steve Blank: The Rise of the Lean VC – Consumer Internet Gets Its Own Investors
  3. Getting Caught Mid-Pivot: Lessons from the Imercive Postmortem
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  • http://foundersblock.com/articles/an-analysis-on-seed-funding-in-2010-part-2-of-2/ Founders Block » Blog Archive » An Analysis on Seed Funding in 2010 (Part 2 of 2)

    [...] This is a guest post by Gary Whitehill who was kind enough to allow Founders Block to repost his article, originally published on August 11th, 2010. In case you missed Part 1. [...]

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