Why Seed? Why Now? (Part 2)

Henry Wong, Artemis Ventures

An Investor's Perspective: The Case for Seed Stage Venture Investing Today

Despite the current economic recession, investing in seed stage technology companies remains a compelling investment strategy more than ever. Surprisingly, there is little written to date on the increasing value of seed stage investing during recessionary periods, despite an increasing focus by many investment firms and individuals on just such a strategy. This article will address the reasons why allocating capital to this historically high performing asset class in today's depressed market climate will help maximize investor returns tomorrow. Although seed stage companies encompass a breadth of industries, this report will focus specifically on the high technology and communications industries. Finally, the research presented in this report is based upon U.S. data only, and thus the conclusions drawn are only appropriate for investors considering an investment in venture capital funds targeting U.S. investments.

In the first half of this article, Part I discussed why high technology continues to play a large and ever increasing role in driving and growing our economy. In particular, technology investment opportunities will continue to be attractive by providing high returns on investment for investors. Part II showed that seed stage investments continue to outshine all other asset classes and investment vehicles, even in today's depressed economy.

Part III will discuss current trends in venture capital, which have created tremendous and underserved investment opportunities in today's seed stage startups. Finally, Part IV will demonstrate that seed stage investing can be used as an effective hedge strategy in today's weak economic climate, and also provide investment strategies for investors to capitalize on this financial opportunity. In sum, the Artemis Ventures investment team remains more bullish than ever on seed stage technology investing.

III. Current Trends Widen Seed Stage Opportunity

Despite the attractive returns in seed stage investing, financial investors continue to invest in companies with reduced development risk. In 2000 alone, only $230M was invested in seed stage companies, while over $22B was invested in post seed stage companies. This meant that post seed investing accounted for nearly 13 times the amount of deals invested in seed stage companies (See Figure 7).

Figure 7: Seed v. First Round Investment in 2000

Seed Stage 142 Deals $231.7 M
First Round 1,937 Deals $22,052.8 B

Source: Venture Economics/NVCA

Not only does seed stage account for only a fraction of the amount invested in the post seed round, but investment in seed is on a downward trend. Figure 8 suggests venture investing is moving away from seed stage investing. Where seed stage accounted for 48% of new deals a year ago in 2Q of 2000, that number has dropped sharply to 30% in 2Q of 2001. Thus, the last few quarters actually suggest that many investors are moving away from seed stage, as the percent of seed deals as a part of the overall number of deals financed continues to trend downward. At the same time, second and third round financings are trending upwards, indicating a flight of capital to later stage investing.

Figure 8: Decreasing Investment in Seed Stage
Source: PricewaterhouseCoopers MoneyTree Survey

There is more evidence supporting the underserved landscape of seed investing. Further analysis shows that notwithstanding the increase in the amount invested and the number of companies raising money (Figure 9 and Figure 10 respectively), the average round sizes have increased in correspondence (Figure 11). The resulting effect is that many venture firms today are taking their investment focus off seed stage and focusing instead on later stage financings.

Figure 9: Total Invested ($M)


Source: Venture Economics/NVCA

Figure 10: U.S. Venture Investing - No. of Cos.

Source: Venture Economics/NVCA

Figure 11: Average Round Size ($M)

Source: Venture Economics/NVCA

In Figure 12, data shows that seed stage has always been only a fraction of the amount raised when compared with other rounds. This data further supports that many investors abandoned seed stage investing and focused on investing in later rounds in recent years. Ultimately, the lack of players in this space has created a huge financial opportunity for investors wise enough to recognize these trends.

Figure 12: Deals by Investment Stage
Source: Venture Economics/NVCA

To further compound this lack of seed stage capital and magnify the existing opportunity to invest, consider these important trends in the private equity markets:

  • "angel" investments in seed stage companies have dramatically reduced since the market downturn;
  • despite recent claims by many venture capitalists to "return to seed investing," many have formed multi-billion dollar funds and are thus unable to invest in seed stage companies;
  • many funds are preoccupied with "putting out fires" and raising "bailout" funds for their current portfolio companies (and not doing deals), thus increasing the scarcity of seed stage capital to entrepreneurs.

What has occurred in the past 18 months, in which many high net worth investors, or "angel investors," have seen their net worth reduced dramatically, is well documented. The chart in Figure 13 shows the record number of deals being closed by investors during the Internet bubble and the beginning of trouble in 2000 when NASDAQ began its 18 month fall. As the portfolio value of many angels continued to drop, many faced liquidity constraints. The resulting illiquidity precluded angel investors from allocating anymore capital to seed stage companies. Thus, the retreat of the angel investors, who traditionally have accounted for a large percentage of dollars invested in seed stage companies, further exacerbated the scarcity of capital for entrepreneurs in the post "bubble" economy.

Figure 13: Retreat of Angels

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Next, a majority of venture investors who use to invest in seed stage, are now managing large funds which preclude them from investing in seed stage companies. There is an ever increasing trend in venture capital fundraising to raise larger and larger funds. In Figure 14, data shows that over 90% of venture funds today are over $100M, compared with pre-bubble funds averaging around $60M. In fact, Figure 15 shows that approximately 40% of funds under management today are managing $1B+, while over half of VC dollars are now in funds greater than $500M.

Figure 14: Funds Get Bigger and Bigger

Figure 15: VC Funds Under Management by Size
Source: Venture One

Although the greatest amount of VC money in history is now available to invest in entrepreneurship, large fund dynamics preclude managers from investing in seed stage companies. As many funds have moved 'upstream' and raised increasingly large funds, the money managed per professional has increased as well. In 1995, the average investment professional managed approximately $20M. In 2001, this figure ballooned to nearly $75M per professional, including managers of billion dollar plus funds (the "mega-funds"). While the amount under management has increased over the years, the addition of qualified investment professionals has not kept pace to offset this extraordinary growth. This means that investment professionals today must put to work a larger amount of money in the same amount of time it took them in previous years.

As investment professionals' limits are stretched, their resources allocated to each company is negatively affected. Moreover, the VC must invest funds in a proactive manner in order to achieve a satisfactory return on investment for its limited partners. The venture capitalist has only two strategies at this point: (1) invest in many companies and not allocate enough time to each investment ("spray and pray" approach), or (2) allocate larger amounts of capital into a few companies which, under the normal mortal stresses of time, they will have enough bandwidth to look after. Several mega-funds, including Crosspoint Ventures, chose a third option. After ample consideration, the principals chose to return the committed capital to its limited partners when faced with the unenviable task of achieving high IRRs for its Fund in a depressed market. The rationale becomes clear for the venture capitalist as the tools of his/her trade depend upon the careful feeding and nurturing of companies. Although the spray and pray model works in limited scope in upward trending economies, the answer becomes even more clear for the investment professional in recession markets which preclude 'spray and pray.'

To understand why a majority of today's funds preclude seed investing, it is important to look at the economics behind a venture fund. In today's environment, seed stage valuations typically range $2M to $4M (see Figure 16). Assuming the average investment professional needs to put $75M to work in 3 - 5 years, that means roughly $38M in fresh capital will be allocated to new companies and the rest for follow-on investing. That also means the venture capitalist could invest about $8M per year if they paced themselves over a five year period; in a more aggressive three year timeframe, this number could be well over $10M per year, per professional. At today's typical seed stage valuation ($2M), the typical venture professional will have to do 4 deals per year for five years. What does this mean? That means the venture professional will end up with 20 board seats and 20 companies to look after at the end of five years. This is in addition to any existing board seats already held by the investment professional from previous funds. As we've witnessed in the past 18 months, this pace is unsustainable and becomes ultimately unmanageable.

Figure 16: Median Pre-money Valuations by Round Class
Source: PricewaterhouseCoopers MoneyTree Survey, Venture One

Now consider an alternative scenario: what if the investment professional put more money to work per seed stage deal, say $5 to $7M? The answer this time comes from the entrepreneur's perspective, a symbiotic partner for the venture capitalist. Seed valuations today simply cannot support a $5M to $7M investment. It causes too much dilution too soon for the entrepreneur. Here is a numerical example to illustrate this point: If a typical pre-money valuation of a seed stage entrepreneur is $2M, then an additional outside investment of $5M would make the post money valuation of the company $7M. This means the entrepreneur went from owning all of his/her company to now owning fewer than 30%, while the outside investor owns approximately 70%. Considering further dilution in future rounds and shares needed to allocate and incentivize current and future key team members, the forced dilution becomes undesirable. Thus, the rational answer for the entrepreneur is to take less money today (perhaps $1M) and build a more valuable company in the future to hedge against dilution from outside investors. In today's market, the pre-money value of the company will usually equal the amount of funding the entrepreneur is seeking. Thus, entrepreneurs own about 50% of the company post financing and have enough incentive to continue to build value for its shareholders.

The last reason why a majority of funds today cannot invest in seed stage companies is more qualitative than quantitative. Seed stage companies not only need less money than their later stage counterparts, but they also require much more hands-on help. Given that the number of board seats for partners in large funds are in the double digits these days, this leaves little time for them to allocate to the bandwidth-consuming task of developing companies at the seed stage. In a sense, many of the investment professionals have transitioned from being company builders to portfolio managers. On a final observation, the triage in the marketplace has forced many fund managers to focus on their portfolio instead of looking at new deals. Many have even entered the marketplace with intentions of raising "annex" or "bailout" funds; funds with stated intentions to rescue troubled companies. These factors will continue to prohibit other players from capitalizing on the investment opportunity in seed stage investment. Given these foregoing reasons, venture investors will likely allocate larger amounts to later stage companies and further vacate the seed stage space. This vacuum effect created by retreating angels and venture capitalists has created a huge opportunity for financial investors dedicated to seed stage investing.

IV. Investment Strategies in Seed Stage

The financial opportunity in seed stage investing remains as compelling as ever. In fact, seed stage investing may make even more sense in down markets as a hedge against volatile market conditions. This section addresses the different strategies private investors, alternative asset institutions, and strategic investors can employ to take advantage of this growing opportunity.

For the individual investor, there are three options to 'play' in this area: (1) direct investment into seed stage companies, (2) investment in a fund of funds manager, or (3) become a limited partner in a seed stage venture capital fund. Direct investment into a company can pay huge rewards, but requires an in-depth knowledge of the business and industry to make a sound investment decision. For this reason alone, direct private equity investment in seed stage companies is fraught with problems for the individual investor. Seed stage investing is not for the faint of heart, as many of yesterdays' angel investors found out too late. There exists a high degree of risk in 'putting your eggs in one basket'; and generally, diversification is a more sound financial strategy. Lack of control, liquidity, ability to influence management and company direction, and due diligence requirements generally make direct investing into seed stage companies undesirable for most individuals. The typical exception is the retired executive who is interested in mentoring an entrepreneur. These instances are few and far between and relatively small when compared to how much angel money falls into the hands of entrepreneurs.

Individual investors can also invest in a fund of funds manager, who will in turn, invest in a seed stage venture capital firm. The drawback with this strategy is that many institutions, endowments, universities, foundations, fund of funds, etc. are 'behind the curve' and do not recognize the value in seed stage investment yet. While many claim to be over allocated to 'early' stage venture, seed is a distinct financial opportunity offering different risk-return scenarios. As an illustrative example, consider the number of fund of funds managers backing mega-funds in recent years and not doing the 'math' on whether the model will actually work. The verdict is still out on mega-funds, but a majority of industry pundits believe they will end up giving capital back to limited partners or else splitting up into smaller funds. Furthermore, fund of funds managers are 'portfolio' managers and are not in the trenches fighting with entrepreneurs as seed stage venture capitalists must do. In other words, the level of control alternative asset managers have in formulating and directing a seed stage company is absolutely zero. Finally, alternative asset managers are generally more diversified and not as focused in on any particular asset class.

Investment in a seed stage venture capital fund is perhaps the most effective way to take advantage of this emerging financial opportunity. As discussed earlier, seed stage investing is the highest performing asset class and can provide a 'shelter' during volatile market conditions. Of course, higher returns means higher risk as well. A discussion fully weighted on the benefits of seed stage private equity investing which ignores the obvious high risk nature of this asset class would not be a complete picture. Among the many risks to consider include: illiquidity, high minimum commitments, and manager risk. Investors must be able to wait on average 5 - 7 years before seeing liquidity in their investments. Also, accredited investors who allocate a portion of their assets to seed stage may find it a good way to diversify risk in recession markets. In terms of manager risk, it is important to invest with principals whom have deep operational experience. The best performing seed stage venture funds typically have experienced principals whom have built companies from development to exit, as opposed to having experience as service professionals. Finally, the size of fund is an important factor to consider as well. Back too small a fund, and investor value is exposed to dilution occurring from future rounds of financing in which the fund is fully committed and cannot participate. Back too large a fund and you run into the 'mega-fund' phenomenon discussed earlier. Seed funds ranging from $100M - $200M are typically 'just right,' and allow managers enough capital to hedge against dilution as well as provide a size actually manageable given a 5-7 year investment cycle.

For the alternative asset managers and other related institutions, investing in a successful seed stage venture capital fund is also an effective way to diversify risk and fill a 'void' in its existing portfolio. Although many of these investors claim to have invested in early stage funds, a close examination of their portfolio will show they have allocated barely, if any at all, assets to seed stage venture managers. Once again, it is important to note the difference in "seed" versus "early" stage investing, the latter of which is well saturated. Allocating a portion of assets to seed stage will help boost returns and help offset significant allocations to later stage venture and mega-funds to create a well diversified portfolio (See Figure 17).

Figure 17: Alternative Assets: Risk v. Return
Source: Datastream, Venture Economics, Tuna Hedge Fund Aggregate Index, 1986-3Q00

For strategic investors, or corporations, the implications are obvious: invest in the seed stage to access next generation technology and outsource research and development. For corporations, return on investment is usually a secondary goal, and plays second fiddle to the company's long-term strategic goals. Given the strategic philosophy of this type of investor, investing into a Fund of Funds is problematic because it does not serve to achieve any of its long-term strategic goals. Likewise, investing directly into seed stage companies is problematic too because most strategic investors do not have the requisite experience in nurturing seed stage companies and simply do not have the required bandwidth to do so. This issue is further compounded by the fact that most strategic investors do not hold board seats due to legal liability reasons; thus, are not able to influence the direction of the seed stage company. Investing in a seed stage venture fund is the best way for a strategic investor to expose itself to this sector without the liability risk.

In fact, it makes much more sense for strategic investors to invest in seed stage technology rather than try to duplicate in-house the innovation which occurs in an entrepreneurial environment. Other benefits include long-term return on investment, potential products/services serving the enterprise, expansion of distribution capability, growing of market potential for its existing product lines, etc. Moreover, developing relationships with seed stage investors allows the company to take a 'first look' at new technologies and possibly an acquisition target in the future to increase shareholder value. Investments into seed stage venture funds could be structured whereby the strategic investor gets co-investment rights or follow-on rights. This can ultimately tighten the relationship between the strategic corporation and the seed stage company for an even deeper relationship.

In all cases, investing in a seed stage venture capital fund can be used as a hedge to increase returns in the long-term, and reduce short-term risk during an economic recession. For example, if the typical recession lasts 11 months and the growth cycle averages 50 months, it would be wise to invest in a seed stage fund as a 'safe-harbor' during volatile times. When the investment becomes liquid again in roughly five years, the recession will be over and a growth cycle will have commenced. Liquidating securities during this period will increase overall value in your portfolio in the long-term, but preserve a solid asset value base in the short-term. Thus, investing in seed stage companies during a economic recession or down markets can increase your overall return on investment, while at the same decrease your portfolio risk.


The Artemis Ventures Team is more bullish than ever on the significant upside potential in seed stage technology companies. If seed stage investing was a good idea before the market downturn, then it is an even better idea during a recession when investors are "seeking shelter from the storm." Appreciating assets over a five to seven year investment cycle will typically outlast recessions and provide investors with the highest rate of return for any asset class at the same time. Current fund dynamics and investment trends have created a huge gap for deserving and talented entrepreneurs. While the usual suspects have vacated this space, the addressable market opportunity has been magnified tenfold. Investing in a seed stage venture capital fund is the best option to capitalize on this trend and diversify holdings. In our opinion, wise investors and financial managers should seriously consider the benefits of seeking out qualified seed fund managers and allocating a portion of their assets to them.

Copyright ¸2002, Henry Wong, Artemis Ventures

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