Humans Deserve Better Trilogy

Powerful change happens when enough humans live determined.

  • Manifesto Rule No. 24

    ENTREPRENEURSHIP ISN’T A TRAVEL GUIDE TO FOLLOW. IT’S AN ADVENTURE TO UNDERTAKE.

  • Manifesto Rule No. 1

    When in doubt – call someone who truly, unconditionally loves you.

  • Manifesto Rule No. 2

    Stop at nothing to achieve everything the universe has to offer.

  • Manifesto Rule No. 3

    When feeling huffy: – Step back, Be a teacher, Take a deep breath, Smile and realize this too shall pass as just a glimmer within a lifetime of happiness.

The Seed Funding Phenomenon Bubble of 2010

The seed funding phenomenon is a bubble waiting to burst. This is my take on the landscape.

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 leaves 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
      • HUGE props to Nivi & Naval for making the process more fluid
  • 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…… Venture Capitalists Enter the Market

The interesting thing is that we’re now seeing 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.

Seed Fund Opinions Numero Uno – The Nay Sayers

In a recent blog post, Paul Kredowsky voiced his disapproval of the seed funding phenomenon. However, his post is less about the entrepreneur, than the seed funding companies themselves.

His argument boils down to the fact that he believes many of the seed investors out there are running on very tight budgets themselves. They’re investing small amounts in lots of new ventures, in hopes that one or two of those ventures will become “homeruns.” That of course is not a good idea.

His point of view has validity. The challenge with seed funding investors spreading their own resources too thin is that if something goes erroneous in one of their portfolio investments, and capital must be deployed unexpectedly, the investor’s hands become tied. The funder also won’t have the necessary capital to allocate toward companies that actually do succeed, and who seek a follow-on second round of funding. This dynamic will force entrepreneurs to then search out their funding from traditional venture capital firms – which is the most expensive money they could take.

Seed Fund Opinions Numero Dos – The Fans

In response to Paul Kredowsky’s post, warning of a seed funding bubble burst, Chris Dixon made a post of his own, which tempered enthusiasm with caution.

As Chris points out in his post, we’ve come a long way from the dotcom bubble of the nineties. Both entrepreneurs and seed fund investors are savvier, and more skilled in business than their forerunners.

Chris rightly points out that as long as:

  • Seed fund investors are exercising a little caution choosing their investment vehicles
  • Entrepreneurs have both business acumen and a good idea

….. then the seed funding model can work, and is a valuable asset to a market where company founders struggled for years to obtain funding.

Of course, Chris’s post also mentions a huge wild card that traditional banks, VC’s and seed funds must watch out for – the economy in general. Then again, business is all about risk.

Time Will Tell

Of course, not everyone has a definitive negative or positive outlook on the seed funding phenomenon. Both Fred Wilson and John Boyd chimed in on the discussion and agree that the seed funding model is necessary, but that it will need a lot of tweaking to become a long-term viable option for start-ups.

A few years ago, entrepreneurs who sought to secure small amounts of funding to launch their start-up would have struggled to find any options that matched their needs. With the proliferation of seed funds, that’s no longer the case.

In the end, there are only two real questions:

  • Have the seed funders have backed the right horses?
  • Will the funders be able to deploy capital when the next round of funding is needed?

I certainly hope so on both fronts.

What It All Means For You – The Idea & Early-Stage Entrepreneur

Of course, you may be wondering how this all relates to you. Well, if you’ve been hoping to build a start-up but have been stumped about where to turn to find the seed capital you need, now just might be the right time for you.

If you have a great idea and your funding options are limited or nonexistent, then seed funding might just be the alternative to bootstrapping that you’ve been looking for.

However, BE AWARE – as the industry matures, there will be may be interesting consequences:

Skyrocketing valuations – What is your Justification?

There are two reasons I believe valuations could skyrocket literally overnight:

  • The year 2008 sets a perfect prescient for this point – as was the case with the private equity buyout craze – seeing that more professional seed funds are entering the market, supply and demand (number of potential companies and their valuations) will begin to shift.

As a result, bidding wars will begin and valuations will skyrocket. This will inevitably drive out certain investors – whether individuals, seed funds, or VC’s playing the seed game and most likely bring the horse right back to the water – true venture capital funding terms ($2M-5M).

  • Funders and entrepreneurs actually become too savvy at the process – because of too many entrants.

I know I am going to get some push back here because many folks will refute that there are a ton of great companies out there to fund (lots of supply). Let me be clear: I do agree with that statement. However, my point is if the seed funding game gets too big, meaning too many angels and VC’s magically think they can run a seed fund, then there’s going to be a lot more white noise in the marketplace. This becomes a forcing function for why funders and entrepreneurs will get more savvy in the process and why valuations will go up – because those who don’t know what they’re doing will make noise, create fragmentation and the result are valuations rocketing upward.

A simple solution to the above though would to build another simple platform such as TheFunded. Instead, lets call it “TheSeeding.com” (domain is open at the time I wrote this) so that everyone has an open source way of knowing who’s full of b*llshit and who is not.

On the flip side, I also believe there are a few variables that may keep the valuation war from happening regardless:

  • Investors won’t tolerate ridiculous valuations because they know the IPO market is stagnant. High or overly optimistic valuations are not a good thing today.
  • Another shift in technology that exponentially decreases the barrier to entry once again

My advice:do your homework before searching for seed funding, and make sure that you have a backup plan for your second round of funding – just in case things go pear shaped.

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Leave a Comment

  1. LM Novelius says:

    “Dont worry about Funding if you dont need it, today is cheaper to start a business” Noah Everett

    • Correct. Today it is cheaper to start a business than every before.

      But that is only half the story….on the other hand it is exponentially harder to rise above the ‘white noise’ to create, capture, and convert attention from your target market into long-term, sustainable, and scalable loyalty. Couple on top of this that at some point your market must be willing and able to pay for you solution and all of a sudden the outlook isn’t as crystal clear.

      A few stats for you: 425m people attempt to start 305m businesses a year globally, only 100m of the launch, and of those, only 1 in 1000 become sustainable. Out of those, only 1 in 1000 receive any sort of investment funding.