When the press writes about the dwindling endowments of Harvard and Yale, I think to myself, this can’t be good for VC fundraising. News about these two universities notwithstanding, it has been well known for some time that, as a group, the large institutions that are the traditional investors in funds – the endowments, the pensions, the foundations, insurance and finance companies – have suffered. And as these groups have pulled back, so too has the venture capital business. So when we now see articles such as this one, expressing what seems of late to be prevailing opinion, that early-stage ventures are better off without too much money in the bank, we are amused by the coincidence. When we observe one VC fund after another begin to target “seed” investments of several hundred thousand dollars, rather than the millions more typical for a first institutional round, we understand why that is.
Entrepreneurs, however, ought to be careful. The initial money taken by new ventures is called “seed” finance for a reason. In nature the seed is the first element of life, out of which a plant blossoms or does not, and is that which determines the plant, or absence thereof when a seed has gone bad. In enterprise, the source of seed capital is not insignificant. Traditionally these financings have been provided by individual “angel” investors, or angel groups, which comes with one very critical advantage: It is universally known that small investors such as angels have limited resources to contemplate follow-on financings, especially if these follow-on rounds are of a higher order of magnitude than the seed capital provided. Moreover, angel investors are typically independent, or at least not officially affiliated with a particular institution. Thus, when the time comes for that (multi)million-dollar institutional round, few would question an angel’s low level of interest or participation.
Can the same be said of a VC? Entrepreneurs who seed their business with capital from a venture fund have to realize that at this point their fate is largely tied to that of the venture fund itself. If, based on a variety of external or internal factors, this institution that has seeded the enterprise does not or cannot participate in a follow-on round, there will be a significant taint on the underlying business and a real challenge to the capital raising process. Investing in follow-on institutional rounds is what VCs do and what their funds are for, and any failure to do so on behalf of the seeded business will fuel anxiety and raise questions among outside investors who will be asked to take the VC’s place. (Most likely aware of their own importance to subsequent rounds, moreover, it should be assumed that VCs will not neglect to negotiate terms accordingly, if an when the time comes.) And if, conversely, the liquidity environment reverses, entrepreneurs may find themselves forced to take in more capital, at more deeply dilutive consequence, than they might wish… because such are the whims and fancies of the institutional capital markets, which are there foremost to put capital to work when it’s available.
There is no perfect scenario, really, when taking in outside capital. The seed round, however, could be the most important in the entrepreneur’s growth cycle. The more a company has grown and the more it has matured, the more commoditized and the more expansive will be its capitalization alternatives. At the seed stage, however, entrepreneurs should assume that the financing selection is as critical an ingredient in the business plan as any marketing strategy or technical implementation.
