Why LP’s Passed on Seed Funds 10 Years Ago (And What’s Happened Since)

Collections: Themes and thoughts

This year will mark the 10th year anniversary of NextView. I’ll be writing a number of posts looking back over the first decade of the life of this firm. In some ways, this feels like an eternity.  But in the grand scheme of things, 10 years is a blip, and one that had a continuous bull market in tech.  So whatever conclusions or observations I draw should be seen in this context.

Like a number of funds of our era, early fundraising was not terribly easy. There were way more skeptics than there were believers, and even the believers at different institutions were fighting the push-back of their own colleagues internally.  Even though it looks pretty clear that seed investing has been fairly successful during this period, some of the objections are legitimate and should still be taken seriously today. The reality is that seed investing as a strategy was not a new thing back in 2011, and one could point to multiple prior waves where this sort of investing just didn’t work.

I want to share the top 3 most common areas of push-back that we faced as a new institutional seed fund and share some perspective on what we’ve learned in the last 10 years that might shed some insight into the years ahead.

Objection #1: Adverse Selection

The objection goes something like this: “yes, I can see rookie founders turning to you for a seed round. But won’t all good founders go to established firms that raise series A’s out of the gate?”

Our response was that this might happen. But 1) many of the best companies were created by rookie founders and 2) there are legitimate reasons why an experienced founder who could raise a large series A might choose a right-sized seed for better alignment, optionality, and early support.

What has happened is that over the last 10 years, the vast majority of successful startups have raised some sort of a seed round prior to a series A. Today, multiple rounds are often raised, due to the atomization of the seed space. Some proven winners do still jump to a large series A out of the gate, but there have been quite a few high-profile blow-ups of companies that took this route. It turns out capital is not a weapon, especially in the early stages of building a business, and even experienced founders who can raise huge sums often realize this and right-size their asks.

But what has also happened over the last 10 years is the massive expansion of the series A and lifecycle fund market. As funds grew substantially, it made less sense for a $700M+ fund to lead a $5M series A with a $4M check. They waited for more and more traction, and were able to write bigger and bigger checks to get to their ownership target. This expanded the definition of seed to include $5M+ rounds, and you often hear of seed firms now passing on deals because they are “too early” .  More recently, to come full-circle, large lifecycle funds have been coming back to these large seed rounds as the competitive dynamics of post-traction series A’s has gone out of control.

My view is that our original thesis was correct, it just looks a little different. Most companies do raise some sort of institutional seed round early on and many great companies of the last 10 years were founded by relative rookies. Some founders do continue to raise large rounds out of the gate, which are hard for seed VC’s to participate in, even if they are called “seeds”. But the seed market and quality of founders raising seeds overall has been very robust over the last 10 years and should continue going forward.

Objection # 2: You don’t reserve enough and are going to get crushed

There are two versions of this objection. One makes no sense. The other is totally valid.

The first version is that most seed funds don’t reserve nearly as much for follow-on investments as lifecycle funds.  Therefore, the argument goes that seed funds will not own enough of their companies at exit to make it worth their while. This is baloney.

The mistake that LPs made at the time was this false gospel that VC’s need to own the magic 20% at exit. This makes no sense when what matters is OWNERSHIP RELATIVE TO FUND SIZE.  A $20M fund that owns 3% at exit is equivalent from a return standpoint to a $500M fund that owns 75% at exit. I don’t know many $500M funds that own 75% of a large scale company. I do know ~$20M seed funds that own 3% of a large scale company.

The problem is that reserves work against initial ownership and fund size. The more you reserve, the less you will own up front or the bigger you fund has to be (or both). Both factors will hurt your ownership relative to fund size. So yes, seed funds will own less. And yes, a seed fund may have a tougher time holding on to their ownership down the road, and thus get diluted down. And yes, seed funds will have a harder time concentrating large dollars into their winners. But guess what?  All of those things have a much smaller impact to fund level returns than a) getting into the right companies and b) having superior ownership relative to fund size. The first version of this objection never made sense.

The second version of this objection is more legitimate in my view. It’s that when things go south, seed funds will have a hard time defending themselves against larger funds that might do a recap or put in a pay-to-play.  We’ve experienced this first hand, but as I speak to my peers in the market, the severity of this issue has been fairly modest. There are a few reasons.

First, the winners in most portfolios don’t often have a true recap round. We’ve had multiple companies in our early funds that hit bumps and had to raise flat rounds, which hurts from a dilution standpoint but doesn’t wipe out our position. We own less of these companies than we’d like, but they still have the potential to return multiples of our fund.

When we have been converted to common or very deeply diluted from a pay-to-play, the companies have either failed anyway or were not blockbuster outcomes. There is an argument then about whether this is a good use to capital in the first place, or just throwing good money after bad.

Second, some lifecycle investors realize that this is a multi-turn game with seed funds.  We help surface seed companies to them and typically don’t compete against them for new rounds or for follow-on dollars. In turn, some funds have a more friendly posture towards us and try to structure deals that incentive syndicate investors in a way that doesn’t massively disadvantage the seed investors. That said, we definitely don’t bank on this as a firm, even though we do see ourselves playing a multi-turn game with all of our later stage coinvestors.

The third factor is probably the biggest, which is that we’ve been in a very fortunate market environment. Even the “oh shit” moment of Covid lasted 1-2 quarters for most tech startups not servicing the travel or hospitality industries.  This means that there have been relatively few instances where a really great company hits some sort of a market buzzsaw and must accept a recap even though things were looking very promising. I fully admit that if we had a prolonged bear market in tech, this would happen more and it would probably result in pretty ugly performance from seed funds. I think this is a real issue. What will be interesting to see if whether seed funds that have raised their “opportunity funds” will use these dollars to defend their existing portfolio if the market turns really sour.

Objection #3: Is This a Means to an End?

Some LPs were skeptical about seed funds because it seemed like a means to an end. Are GP’s really believers that this is the best way to invest and multiply capital? Or was this a convenient justification to get into the business, only to raise bigger and bigger funds and move upstream later? Not that there is anything wrong with being a later stage investor, but the LP’s wanted to believe that if they were drinking the seed fund kool-aid, that the kool-aid salesman actually believed that it was the best drink. They hoped that the kool-aid salesman wasn’t just using this as a way to eventually sell coke like everyone else down the road (ok, I took the analogy too far).

Our response was that we were motivated to focus on seed because 1) this is what we enjoy, care about, and are good at and 2) we’re going to make money on carried interest and this was the best way to get there. From an industry standpoint, I think this have turned out to be only partially true.

On motivations, it’s hard to really decipher what people truly believe. Many seed funds have stayed true to their core and the GP’s at those funds genuinely believe that this is their highest professional calling, even if they could do something else. But others were obviously viewing seed investing as a means to an end and crept later and later stage once the opportunity presented itself

From an economic standpoint, the reality is that generating 5X returns on a $25M fund is great.  You make $100M in profit in the fund, and 20% of that is $20M. Great money for great performance. Unfortunately, a $500M fund that generates a 1.5X creates $250M of profit, and 20% of that is $50M. That’s great money for meh performance. Along the way, the $500M fund generates 20x the fee income without nearly 20x the expense base.

So, the economic incentive for increasing fund size is pretty astronomical. And if an investor has success with a smaller fund, it’s only natural that he or she will convince themselves that they’d be equally good investing a larger and larger fund.  So it’s not surprising that quite a few of the seed funds that began in the first half of the past decade now raise funds that are hundreds of millions of dollars in size or more. They still claim to do seed, but really, they just moved upsteam because they believed they could be similarly successful and the economic incentive is great.

This is why I’m so impressed by GPs that have had amazing success, but have kept their fund sizes at a fraction of what they could raise. First Round Capital and USV don’t have small funds, but could easily raise 5X+ more capital than they do. Smaller funds like Baseline, FC, or others have similarly stayed very disciplined. It’s very impressive.

That said, these groups and others have increased their fund sizes despite this discipline, and so have we. This is because the market actually has changed. As seed has become the mainstream path to early-stage financing, the definition of seed has changed, and if one is to be a credible first institutional seed investor, he or she would need a fund big enough to be competitive and write $1-2M initial checks. This requires some increase in fund size even with a fairly modest sized portfolio. For us, I honestly believe that we are investing in more or less the same types of companies today that we were investing in 10 years ago, but the dynamics of these rounds mean that we are able to be the best partners with a fund closer to $100M vs. our initial fund of $20M.

On top of this has been the rise of opportunity funds and select funds. Some have criticized this as a quest for more AUM and strategy creep.  But for the most part, I see these as a pretty good thing and a great deal for LPs. When a select fund is constrained to investing in companies where the GP has an unfair access and information advantage (usually existing portfolio companies) and fees are discounted or only charged on called capital, this seems like a very fair deal. There is significant economic value that is available to seed funds in the mid-late stage financing rounds of their companies where they have pro-rata rights. It makes perfect sense for them to find a way to monetize those rights. And doing it via a select fund is better than expanding fund size or doing SPVs (which are very difficult to execute on consistently).

What wasn’t asked but should have been on our radar: YC

This post is way too long already, but I thought I’d make special mention of the one question LP’s didn’t ask but really should have in retrospect. And that question is: “How Are you Going to Compete / Coexist with YC”. I would say that more than any other seed fund or seed focused initiative of a large fund, YC has created the most problems for seed VC’s.  I’m not critical of them for that. Consider this a hat tip.  I see YC as Tiger Woods in his prime, and all the rest of the seed funds are playing to be Phil Mickelson.

YC has just been extraordinary. They invest at a lower cost basis than almost all seed VC’s, have the biggest portfolio out of all of us, and have the most enviable track record of success. The combination of huge portfolio + huge success creates the most amazing barrier to entry I’ve seen in the VC business. They are a force, but very few LPs identified them as such when we were raising our funds, and I failed to do so as well. When we started in 2011, YC was in its awkward growth/teenage years as they were expanding the classes pretty aggressively.  That year, they invested in Segment. The year before, they invested in AirBnB. A year later, they did Coinbase and Instacart. Then Doordash. If there are venture capital history books, NextView will be a minor mention in the chapter about the 2011-2021 era. But huge sections will be devoted to YC.

YC is a problem for seed funds because it sucks the oxygen out of the room from a talent standpoint. The hottest companies coming out of YC don’t raise rounds that fit the ownership goals of most seed VC’s. And quite a few founders make the choice to do YC first rather than raise a traditional seed or pre-seed round. That said, there are many companies that seed funds back that never consider YC, and quite a few great companies do raise money from seed funds before or after the program.  But I’d say that it’s obvious that YC has been the most powerful force in the seed stage startup and VC industry over the last 10 years.  Respect!