Decoding the Institutional Seed Stage Wine List

Over the years I’ve become a wine enthusiast of sorts. Although I’m nowhere near a connoisseur, I genuinely love sampling new wines whenever given the opportunity. However, more often than not I’m presented with encyclopedia sized wine catalogues when dining out. Like most things in life, options are great but only up to a certain juncture. Even well educated wine drinkers (not myself) can get tripped up when there are too many choices.   

For entrepreneurs, raising a seed round from VC’s in today’s market can feel similarly confusing. Along with the slew of larger traditional venture funds that dabble in seed stage investing, there are now nearly 300 “Micro-VC” firms dedicated to investing at the seed stage. The chart below provides a trend line of the approximate number of Micro-VC firms in the market.

Institutional Seed Stage funds by year (“Micro-VC”) June 2015. Based off my tracking of Micro-VC funds.

As is with choosing a type of wine, choosing the right venture partners is a highly personal choice, and requires a sophisticated understanding of your company’s needs to determine optimal investor fit. Of course, the downside of picking an incompatible funding partner is exponentially higher than choosing the wrong wine (although I’m sure that statement will upset a few sommeliers out there).

To decode some of this confusion, there are some basic items that entrepreneurs should consider when evaluating potential institutional seed stage investors.

1/ Can you lead my round?

Frequently, I see entrepreneurs spending countless weeks courting prospective investors only to discover that those investors will not participate until a lead investor comes in. A lead investor is any investor that anchors a round of capital, typically by setting terms of a priced round, or in the case of a convertible note, writing the largest check. For smaller investors, lead investors play the important role of representing the investor base as it relates to company building and tracking activities.

While it’s rational to assume that every venture firm regardless of size can lead a round, it’s no longer always the case, particularly within the Micro-VC market. Through an analysis of roughly 250 institutional seed funds that I tracked through 6/30/15, nearly ~48% had fund sizes that were $25MM or under (many of which were sub-$15MM). Many of these firms don’t have the ability to truly lead rounds, and instead rely on a syndicate partner to act as lead. While these smaller firms can be great partners, it’s important to recognize that closing them will often mean securing a lead investor first. Also note that institutional lead investors can help galvanize a round by using their network to secure a large portion of the remaining capital in the round. This isn’t to say that you should ignore working with non-lead investors, as some can help you secure a lead, but it’s critical to understand their ability to lead up front when talking to potential seed investors.

2/ Can you provide me with more capital?

Unlike traditional venture capital firms that invest across several rounds, institutional seed firms commonly participate in only 1-2 rounds of funding, and rarely have the financial capacity to provide significant follow-on capital absent a new lead investor. As a result, a massive premium is placed upon your ability to meet the performance milestones necessary for another successful round of capital. With the looming threat of a potential funding contraction, it’s reasonable to believe that the Series A bar will push higher in the short to medium term. Based on recent data released by CB Insights, it appears that we are already experiencing a bit of a pullback at the early stages (although too early to proclaim a trend). Additionally, with sheer number of new institutional seed funds, it wouldn’t be at all surprising if the number of institutional seed financings outpaces the number of Series A rounds by a large margin next year, creating a supply/demand imbalance for A rounds (dare I dig up the Series A crunch term again?).

These factors could translate to a slew of seed stage companies that require seed extension rounds from existing investors to get them to the Series A round. As such, It’s important to understand if your investor syndicate has the capacity to do so if the situation dictates.

3/ How strong is your relationship with traditional venture firms?

One of the primary responsibilities of a seed investor is to help portfolio companies secure a lead for the next round of capital. The best seed investors have great relationships with the top traditional venture firms, and have a track record that evidences the strength of those relationships. Measuring this is no more cumbersome than going through a firm’s existing portfolio and checking the % of companies that have gone on to raise A rounds from top traditional venture firms (CB Insights and Mattermark do a great job in comprehensively providing this data). It’s also good to note who the firm commonly co-invests with , as the stronger the syndicate, the higher the probability of getting the next round done with the investors you want – Of course, no syndicate can save you from poor performance and execution

4/ What is your bedside manner?

The most important consideration when evaluating potential investors relates to mode of engagement post-investment. While nearly every prospective investor will deliver prose centered on their networks and operating know-how, it’s important to distinguish reality from rhetoric.

• Interview investors just as they interview you – Ask specific questions on how they work with companies and how they anticipate working with you. Make sure the cadence of communication and overall vision aligns with your style. Don’t take any risks here, as a bad lead investor-founder relationship can be just as destructive to a startup as any other factor.
• Reference checks – Most investors list their portfolios on their websites  Call a few founders that the partner, not just the firm, has worked with. Because the most accurate barometer of partnerships is during periods of challenge, it’s beneficial to call on a few of the investor’s portfolio companies that “failed”.
• Understand fund economics – If you’re a first time founder that wants a ton of hands-on partner experience, don’t expect that from a partner that has allocated $250k into your company out of their $400MM fund. As you’d expect, there is correlation between amount of investment: fund size to partner time.

Like the abundance of wine selections available, there too is a profusion of funding options for entrepreneurs. Though the list can be daunting, the number of institutional seed capital options today should be viewed a huge positive for entrepreneurs. The process doesn’t have to be stressful if you know what to look for.

Rather than feeling overwhelmed, look forward to raising your chosen glass of wine with your new investor.