Monday, September 19, 2016

Should you take small checks from deep pockets?

So you’ve recently started a company, you’ve started to talk to angel investors and seed funds about your seed round, and suddenly a large VC appears on the scene and wants to invest. What should you do?

First of all, congrats. If a large fund wants to invest in your startup, that’s a great validation. Second, if you can get the brand, credibility, network and support of a Tier 1 VC into your startup early on, that can be extremely beneficial. So you should definitely consider it. It’s a complicated question, though, and you have to carefully consider the pros as well as the cons.

In this post I’ll try to shed some light on this question. As a disclosure and caveat, being a seed VC I’m not a disinterested observer, since we occasionally compete with bigger funds on seed deals. I’ll try to be as unbiased as possible, and if you disagree with my views you’re more than welcome to chime in, e.g. in the comments section.

Further below is a simple matrix that might be helpful to founders as they consider having a large fund participate in their seed round. But first, in case you’re not familiar with the issue, here’s a quick primer. If you know what the “signaling risk” debate is about, you can skip the next fext few paragraphs.

Some years ago, many large VCs – $200-400M+ funds that typically invest anything from $5M to $20M or more in Series A/B/C rounds – started to make seed investments, placing a sometimes large number of oftentimes tiny bets in very early-stage companies. The intention behind these investments is not to make a great return on these initial bets. Consider a $400M fund that invests, say, $250k in a startup. Even if that investment yields a rare and spectacular 100x return, it means only $25M in exit proceeds for the fund. That’s a lot of money for you and me, but not a lot of money for a $400M fund that needs around $1.2-1.5B of exit proceeds to deliver a good return to its LPs. If a large fund writes a tiny check (i.e. tiny relative to the size of the fund), there’s almost zero chance that the investment will move the needle for the fund.

So what is the intention behind these investments? The answer is access to Series A rounds. The idea is that one invests, say, $250k in 50 companies, watch them carefully and then try to lead (and maybe pre-empt) the Series A rounds of the ones that do best. Even if most of these seed bets don’t work out – as long as the VC gained access to a handful of great Series A deals, it’s money well spent. At least superficially it makes a lot of sense for large VCs to employ such a strategy. Whether it’s also a good strategy in the long run, or if it leads to brand dilution and eventually adverse selection, is a different question and beyond the scope of this post.

For entrepreneurs, more VCs investing into seed rounds means easier access to capital. And as mentioned before, founders who raise a seed round from a large VC also get the benefit of getting a brand name VC on board early on and potentially they can tap into the firm’s support network. So far, so good - sounds like a win/win.

The downside of taking a small check from a large investor is what’s called “signaling risk”. What this refers to is the situation that arises when you want to raise your Series A round and your VC doesn’t want to lead. In that case, any outside investor who you’re talking to will wonder why your existing investor – who as an insider has or could have a great understanding of the business – doesn’t want to invest. Everybody in the market knows that if a large VC invests small amounts the purpose is optionality, so if the VC then doesn’t try to seize the option, people will wonder why.

There might be good reasons why your VC doesn’t want to invest despite the fact that your company is doing well, and you might still be able to convince other investors to take the lead. But as you can imagine, it won’t be easy: Investors see large numbers of potential investments and have to decide quickly and based on incomplete information which ones they take a closer look at. That’s why they are highly receptive to any kind of signal. If they hear that the large VC who did the seed round doesn’t want to do the Series A, they might not even want to take the time to dig in deeper and might pass right away. As Chris Dixon wrote in a post some years ago, “If Sequoia gave you seed money before but now doesn’t want to follow on, you’re probably dead.”

Long story short, raising a seed round from a large VC has clear upside but also big risks. How should founders decide?

Let’s look at the data. CBInsights has some very interesting data which shows that statistically, startups that raised a seed round from a large VC have a higher chance of raising a Series A later on. What the data doesn’t tell us is whether that is (A) because these startups benefitted from having a large VC on board early on or (B) because they were better companies than the average seed startup in the first place. Since the analysis was based on ca. twenty Tier 1 VCs – Benchmark, Sequoia, Union Square etc. – I believe there’s no question that the subset of startups that received seed funding from one of these firms is of much higher quality than the overall average. These firms all have massive deal-flow and are the best firms in the industry. They know how to pick well. I’m sure both (A) and (B) play a role, but since we don’t know the relative impact of the two factors, the statistics don’t answer the question.

Another, maybe more helpful way of looking at it is this:

1) Does the VC act with conviction or does he/she just want a cheap option, as Fred Destin put it.

2) How confident are you that you’ll have strong traction by the time you want to raise your Series A?

Putting these two factors together gives you a simple matrix:

Here’s how to read the matrix:
  • Top left: If the level of conviction of BigVC (at the time of the seed investment) is high and your traction (by the time you want to raise your next round) is extremely poor, there’s a chance that BigVC will put in some more money (to give you a chance to figure it out, turn things around, pivot,...). It’s not very likely, but since it’s easier for a large VC than for small investors to finance your company for another six months or so, having a large VC on board might be advantageous if you end up in this cell of the matrix. Based on this logic, my verdict for this scenario is slightly positive (that is, if you expect to end up in this cell, take money from BigVC).
  • Bottom left:  If the level of conviction of BigVC is low and your traction is extremely poor, BigVC will most likely not give you more money and probably nobody else wants to invest neither. In this case, the fact that you’ve raised money from a large VC probably doesn’t matter, but it further reduces the chances of raising from other investors. My verdict: Slightly negative.
  • Top middle: In the high-conviction / OK-ish traction scenario there’s a decent chance that BigVC will finance the company through a few iterations or pivots, something that is harder to do without a big investor on board. On the flip side, if BigVC does not invest in this scenario, that will create a very bad signal (as explained above) and greatly reduce your chances to raise from other investors. My verdict: Hard to predict, it can go both ways, so let’s say neutral.
  • Bottom middle: If BigVC invested with little conviction and your traction is OK but not great, it’s very likely that BigVC will not invest further. This is extremely problematic as it creates a bad signal (as explained above) and greatly reduces your chances to raise from other investors. My verdict: Strongly negative.
  • Top right and bottom right: If you have excellent traction, everything else doesn’t matter that much. If BigVC wants to lead or pre-empt your round, you might save a lot of time (but you might not get the best valuation). If BigVC doesn’t want to invest for some reason, you’ll find other investors, but it will be harder. My verdict: Slightly positive for high-conviction, slightly negative for low-conviction.

If you’ve read until here and you’re more confused than when you started to read, here’s the take-away of the analysis:

If the big VC who wants to invest in your seed round acts with little conviction, i.e. he/she really just wants a cheap option, you’re better off saying no regardless of what kind of traction you expect to have by the time you raise the next round. There’s very little upside but very strong downside. So if you have the opportunity to raise a small amount from a large VC and you know that the fund places dozens or maybe even hundreds of these bets, my advice is to say no.

If the big VC acts with strong conviction, there’s strong upside but also significant risk. In this case I don’t have a general advice, and the right decision depends on the level of conviction of the VC and on the value-add that he/she delivers. There are a few things you can do to to find out more about the strategy and value-add of the investor. First, ask the investor how many seed deals the firm has done in the last years and in how many of these cases they led or strongly participated in the A-round. Second, talk to a number of founders who have received a seed investment from the firm and ask them how it's like to work with the firm. Keep in mind that however you decide, it's an extremely important and irreversible decision - so think through it carefully and do your due diligence.