Last week we announced a significant new strategic investor in Sablono, a startup developing software for the construction industry. Sablono is one of six seed-stage investments we made last year. This little seed company has done very well: Three out of the six companies got externally funded, and we have another big A round on the way. Still, we are constantly discussing how we, as an early-stage fund, need to tackle seed.
The early-stage fund’s core business is the A round – take a relatively large stake, follow up with the winners and wind up with a big piece of the company at the exit. The portfolio is sufficiently small to allow partners to be deeply involved in their companies, and enable the team to be familiar enough with the portfolio to collectively add value.
Still, we are constantly thinking about seed investments. I think most early-stage funds go through a similar process.
Several factors drive VCs to seed, starting with the fact that seed makes up a big percentage of deal flow. A good early-stage fund gets a lot of seed opportunities, because it’s close to the market.
Seed is also a good way for new VCs to meet many entrepreneurs, stay relevant, and train to identify good investments. Associates and principals want to invest too. Letting them write a $100,000-200,000 check is easier than allowing them to write a bigger check without an investment track record or board experience.
Finally, funds also want to be close to the angel community, both for deal flow and because a lot of the angels are serial entrepreneurs. When they come through the door with something they care about, most VC partners want to be in the game.
On the other hand, there is the official line: The idea that investing in seed builds a good pipeline for A-round investing. This is the story VCs tell to LPs, internally and to entrepreneurs.
I tend to agree with the first line of reasoning. But I don’t agree with the value of small-seed investing to the funds financial performance.
A good A-round VC is a “lean and mean” organization. At HPV, we have four people managing two funds with 150 million Euros in assets. We have our own method for sourcing, diligence, investing, assisting, and doing follow-ons in our portfolio companies.
Seed investments are a completely different beast, mostly because of the disparity in time and effort. Since the main focus of the VC is on making and managing the “big” investments, seed receives much less attention. It’s simply not worth it to diligence a $100,000 investment for a month (as we do for A rounds). As a result, the bar is set lower. That is also true for post investment work. Since a fund can’t realistically allocate a Partner’s time to the seed investment (although they may say they will), it’s usually a junior investor who winds up cutting her teeth on small investments.
There’s also the issue of follow-on investments. A lot has been said about the signaling effect of big funds not following on with seed investments. But it is also true that sometimes it becomes harder to say “no” to companies in which you’re already an investor. You get attached to the team, you don’t want to admit to failure — or what usually happens is your investment will trigger another, bigger check, which will keep the company alive. There is a temptation to make one small investment after another and wind up with real money in a company that never went through the process.
None of this applies to “big” seed – $1-1.5 million rounds with a lead VC putting up half or more of the cash. This model actually works, as it can be a way for a fund to become involved early on, and the amount is sufficient to merit treatment like a serious investment. My partner, Yaron, and I have done well with this model, investing in companies like Yadata (sold to Microsoft) and Soluto (sold to Asurion). Such companies also have more runway and a better cap table — both big issues, especially for German companies.
I do think that pre-seed investments are important to keep close to the market and informed, but I don’t believe they should be a burden on the fund. A good VC partner makes sure he or she knows what’s going on by putting some of his or her own money to work in angel investing. That is part of our commitment to our investors and a value we can bring to the fund. And in the end, rules are made to be broken in the VC world, so no matter how we decide to treat seed investment and how iron-clad our reasoning is, if we see something great, we’ll just go for it.
Shmuel Chafets is a partner at Hasso Plattner Ventures.