Seed companies are NOT lottery tickets

Foundry’s Seth Levine recently had a great blog post about what can happen when VCs do too many seeds (more here):

I’m seeing an increasing number of Series A pitches where a company has at least one venture investor in its seed, the business is very clearly doing well and where the entrepreneur is simply not pursuing their existing institutional investors for money…

You could call this the VC seed signaling problem.

I think Seth is identifying an important second order effect on what happens when already-busy VCs engage heavily in “low-commitment” seeds.

I’ve written previously about the indigestion problem that exists in the early-stage ecosystem (more here), where at many firms each partner is on 10 to 15 (or more) start-up board seats. I know a few amazing VCs who can handle this work load, but my fear and suspicion is that the entrepreneur is not being well-served in most other situations.

I think we’ve reached a tipping point, however. First, the dollar volume of VC-funded seeds is down 33% (more here). I think people are putting on the brakes because they’re busy.

Second, we know of one prominent VC firm who will no longer seed companies because they’re too busy. Another known firm which invested in over 20 seeds last year is re-thinking its strategy. Of last year’s 20+ seeds, they did NOT win the right to lead the Series A for the “hottest” companies. Thus, they now have money in companies where they had an “option” to invest in the Series A–and, another firm flat-out beat them. So, the seed program has been a negative signal to that VC’s investors.

I sound like a cranky old man for writing this so early this morning, but here are my 2 cents:

  • I don’t think that VC is an “asset class.” It is a “service provider business” that involves insane amounts of passion and commitment to entrepreneurs. Attempts to “scale” it have generally failed miserably, and many firms tried to do so in the Web 1.0 Bubble. At Kepha, we say that our assets walk out our door every day. There is no “franchise value” to the firm except for the personal brands of its partners. That’s why we’ve assigned zero value to our management company (more here). We have no junior staff. We are a partners-only firm because we believe VC is a hard business that takes a long time to learn. We want to field the most experienced and driven team we can to support the entrepreneur.
  • Investing in a high number of seeds is a mixed strategy for a VC firm. Yes, it creates flow and activity. But, being spread too thin can dilute a VC’s effectiveness, and ultimately, damage personal reputations.
  • All entrepreneurs talk to each other. When the news about a VC is good, it creates great in-bound flow. For example, we feel incredibly lucky to be investors in OwnerIQ. My partner Eric Hjerpe seeded it and has nurtured it through lows and highs. The company is now “killing it.” And, we’re also happy that we’ve made customer introductions that have generated $1.5 million of revenue. Time will tell if Kepha succeeds. But, we do have this: focus.
  • Seed companies are not lottery tickets where you buy dozens a year and hope one “hits.” They are nascent teams and strategies that need a lot of support, and usually, some major pivots. At Kepha, each of us invests in only two companies a year. We join the Boards and reserve capital on Day 1 for that company’s future rounds. We are emotionally committed to the entrepreneur.

Of course, many strategies in VC can work. Eric and I, though, have a strategy we believe in. We love going to work each day, and we hope our energy and sense of mission can create good things for entrepreneurs.

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