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I recently met an entrepreneur who was raising money for his startup. Six months prior, he had raised seed money (<$1M) from one of the increasingly popular seed programs big venture firms are offering (big venture firms = roughly $100M fund and larger). As a potential investor, the first question I asked him is “is the big venture firm following on?” The answer was no.
What this means is the entrepreneur is going to have a *really* tough time raising any more money at all, because what all potential investors think is “if this top VC that has hundreds of millions of dollars and knows this company the best doesn’t want to invest, why would I?”
What the entrepreneur didn’t realise is that when you take any money at all from a big VC in a seed round, you are effectively giving them an option on the next round, even though that option isn’t contractual. And, somewhat counterintuitively, the more well respected the VC is, the stronger the negative signal will be when they don’t follow on.
Even in the good scenario when the VC does wants to follow on, you are likely to get a lower valuation than you would have had you taken money from other sources of funding (angels, micro-VCs like Y-combinator).
This isn’t obvious if you haven’t done follow-on fundraising before, but I’ve observed it first hand many times. The reason is you won’t have the freedom to go out and get a true market valuation for your company.
Suppose you have venture firm X as a seed investor and they offer you, say, a $6M pre money valuation for your follow on round (usually called the Series A). Suppose furthermore that if you were free to get a competitive process going that the “true valuation” for your company would be more like $10M pre. If you now go to another firm, Y, and pitch them, one of the first questions is going to be “Is X investing?” You say yes, X has made you an offer.
Now what Y is thinking is either 1) “I should call up X and offer to co-invest at $6 pre,” thereby keeping you at an artificially low valuation, or 2) if that’s not an option (e.g. because you already have 2 VCs in the deal, because X doesn’t think Y is a high quality enough firm to co-invest with, etc) Y is going to hesitate to offer you a term sheet, for fear of being used as a stalking horse.
This is industry lingo for when the entrepreneur uses firm Y to get a higher priced term sheet which X then matches and excludes Y. VCs really don’t like to be used as stalking horses. So what having a big VC in as a seed investor does is prevent you from getting a competitive dynamic going that gets you a true market valuation.
Why are big VCs doing this? If you have a, say, a $200M fund, spending, say, 5% of your fund to get options on 50 companies is a great investment. You could look at this from an options valuation perspective (seed stage startups have super high volatility – the key driver of options price in the Black-Scholes valuation model). More simply, just think of it as “lead gen” for venture capitalists. Basically big VCs are spending 5% of their budget generating captive leads for their real business: investing $10M into a companies at the post-seed stage.
These seed programs are relatively new so we are only starting to see the wreckage they will eventually cause. I predict in a few years, after enough entrepreneurs get burned, what I’ve said above will be conventional wisdom. Unfortunately there are a lot of good companies that will die along the way until that happens.
Disclosure: I sometimes compete with big VCs for investments, so I am not disinterested here.
Chris Dixon is Cofounder of Hunch. He’s also an investor in early-stage technology companies, including Skype (acquired by eBay), Postini (acquired by Google), Flarion (acquired by Qualcomm), Gracenote (acquired by Sony), P.A. Semi (acquired by Apple), Celtel (IPO), BladeLogic (acquired by BMC), TrialPay, Gerson Lehrman Group, ScanScout, OMGPOP, BillShrink, Oddcast, Panjiva, Knewton, and a handful of other startups that are still in stealth mode.
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