In many ways, today's seed-stage tech investing is a return to traditional early stage venture capital in which investing in people and ideas, primarily pre-product, was standard practice. The big difference today is that the cost of starting a tech company has gone down significantly. For a variety of reasons, hypotheses can be tested with a few hundred thousand dollars rather than millions, and early customer traction can be demonstrated quickly. In recognition of their early involvement and willingness to take on high risk, investors can get in at much lower valuations and have the opportunity to obtain significant ownership.
While the renaissance of this investment sector was at first dominated by angel investors, micro venture capitalists (seed-stage specialists) have emerged during the last decade or so. These investors distinguish themselves from "super angels," by building firms that offer distinct services to assist entrepreneurs at the earliest stages of their journey. Such platforms of service, and the communities that many foster, serve to both add value and entice an entrepreneur to be part of the portfolio. In other words, it's a win-win-win — it improves deal flow for the venture capitalist, provides value beyond just capital to the entrepreneur, and enhances the overall portfolio.
As a consequence of these firms' success, institutional money directed toward the sector is growing. According to First Republic Bank, an organization that tracks this segment closely, institutional investment in this sector more than doubled during the past five years with the $2.1 billion invested in 89 funds in 2012 being dwarfed by $4.4 billion invested in 136 funds in 2016.
A different model
The potential for outsized returns with minimal capital invested is always interesting to limited partners, but historically the risk associated with seed-stage has been a hard obstacle to overcome. Now, it's clear that given the low basis of investment and techniques employed to increase the likelihood of a startup's success, even modest outcomes can generate an attractive return; and given the relatively small fund sizes, these outcomes have a significant impact on overall fund performance.
One of the reasons the risk profile is changing is that overall portfolio construction in early stage investing has changed.
The old view of how venture funds generated returns was that you lost money on roughly two-thirds of investments, you got a decent multiple on a few and a winner carried the fund. That is no longer a productive way to invest, because as fund sizes have increased and initial public offerings have become less common post-2000, a single home run provides too little significance to have the needed impact on the fund — if you had such a winner.
Today, the dynamics of funding have changed. General partners can reach follow-on financing decision points quickly and cost-effectively — 1), to fund additional growth; 2), to pursue a pivot; or 3), to sell or not fund. In the new portfolio model, you have fewer aggregate dollar losses from the losers, more positive outcomes, and the winner can be more impactful.
While thoughtful portfolio construction is important, equally so is strategy. If you have a low cost basis, and a company thesis is disproven, you can cut the loss quickly and strategically vector out dollars toward the things that are working. Further, the early investment gives the general partner a seat at the table for unprecedented visibility and the option to increase or dial down ownership in future rounds.
Finally, seed investors are specialists who have a different skill set. They typically have more operational experience with early stage companies; and they're good at assisting entrepreneurs at developing the company's DNA during the first 18 months or so. They don't have to be the ones to take the company from $50 million to $100 million; the best managers know this and often roll off of boards to make room for investors who can bring later-stage value.
Market rationalization and selectivity
Not surprisingly, the initial success of these specialist micro-VC firms has brought a flood of new entrants into the sector and with it more institutional money. Many of these new entrants don't necessarily have the skill set to either assess or add value to companies at the earliest stages; they often employ a "spray and pray" approach that is predicated on investing small amounts of capital in dozens or even hundreds of companies expecting that some will be winners.
The effect that this has had on the seed-stage investment sector is also not surprising. Without the skills to identify and cultivate startup companies, many of these managers are not able to show limited partners evidence of success. They are not able to raise successor funds and their portfolio companies are stranded without capital as those companies lack the progress to successfully raise follow-on capital from series-A VCs.
This is typical of many investment sectors in which hyper growth (and hype) is followed by rationalization and then steady growth. Investment in the internet itself went through this with the boom years of the late 1990s, the bust years of the early 2000s and the steady, significant growth that followed. Likewise, this market must separate the wheat from the chaff to enable that steady, profitable growth.
What does this mean for institutions?
With the right-sizing of the seed-stage sector, there will be carnage, but the potential remains enormous. How do limited partners navigate through rough seas to this promising new world?
It's not easy. As with all asset classes, a portfolio of various managers with different specializations — to mitigate risk and ensure access to the most rewarding opportunities — is a must. To make the right decisions, LPs themselves must become experts on seed investing. And, if they are just starting out or are new to venture capital, they may lack the critical hindsight and networks to properly identify and evaluate opportunities. To complicate matters even more, with the best managers, it's almost impossible to find a seat at the table. So, they must look for the most promising new managers, which brings us full circle back to outsized risk, or roulette.
For limited partners to invest with seed-stage managers, a dedicated and capable team with boots on the ground in the relevant hotbeds of such activity is required. Absent of making the investment in such an effort or developing a relationship with a partner, the risk may be too great.
Jason Andris is managing director at Venture Investment Associates, Peapack, N.J. This article represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.