Why Seed Investing Is Less Risky Than Later Stage Investing

Ever since I've been in the venture business, some 20 years now, it's been accepted wisdom that early stage, particularly seed stage, investing is inherently more risky than later stage investing. I guess it depends on how you measure risk. In the financial markets, risk is defined as tbe variation of returns around the expected return (the standard deviation from the mean). The more variability in the returns, the more risk there is. And from that perspective I am sure that early stage investing is more risky than later stage investing. But that's largely the limited partner's perspective.

My personal experience suggests something else. As a VC making direct investments in companies, I think we take on way more risk when we invest in a later stage company than an early stage company. Here's three big reasons why:

1) You can't play the poker game. I blogged this before so click on that link and read the whole post, but my basic point is in seed/early stage investing you ante a little, see your cards, decide if you want to invest more in your hand, see some more cards, etc, etc. You get to stage your risk capital as the investment shows itself to you over a number of years. You can manage all kinds of risk this way; management risk, valuation risk, technology risk; and market risk. Classic later stage investors want to be in the last venture round and in that scenario, you are putting all your chips on the table before you've really seen your cards.

2) Later stage investors can't impact the development of the company. They have to accept the direction that has been put in place before they came in. We typically invest in pre-revenue companies. Usually they have the technology platform in place and in most cases, they have launched something with some success. But getting the business model and market entry strategy (the angle of attack) right is key. Is this going to  be an enterpise software model, an advertising model, a commerce model, or something else? That's as important a decision as any company can make. Later stage investors have to accept the direction of the company. It's very unlikely that they can change it after their investment, and if they find themselves doing that, something has gone wrong with their investment.

3) Later stage investors take "past sins" risk. When you invest at or near the formation of the company, you are involved in all those decisions that can come back to bite you later on. You can impact the choice of the other investors, how the securities are structured, how the technology is protected, how the employees are compensated, how employees are let go, how the contracts with customers are structured, etc, etc. You can insure that its' done right. That people are treated fairly and equitably so that nobody comes back to bite you in the rear end later on. When you invest in a later stage company, you can diligence this stuff, you can get indemnified, and you can try to protect yourself, but my experience is that when something comes back to bite a company, it bites everyone including the people who were not at the table when the mistakes were made.

When I go back over time and look at my personal portfolio, some 50+ companies, I see this fact so clearly. The returns are higher on the seed/first round investments I've made and the loss rates are significantly lower as well. I suppose that's also an indication that I am better at seed/early stage investing and that there are others who are better at later stage investing than me. But I'd be curious if others in the venture business feel this way too.

Comments

[howard lindzon]

I think the big factor here though is if you have the money to do a follow on or have the contacts to help the company get more mopney if they execute

[Roger Matus]

InBoxer was the recipient of seed funds from First Round Capital. While the money was necessary, I honestly believe that having Josh Kopelman of First Round on our Board of Directors was one of the best things to happen to our company. His advice and counsel has made significant contribution to our success.

Roger Matus, CEO
Blog: Death By Email

[Stephen L. McKay]

Great post Fred!

As a sometimes angel investor I do agree with you.

[James D Kirk]

Hey Fred, very informative and makes me curious from the "seed investee" point of view: What might be some ways that new start-ups can best prepare themselves for the right types and amounts of investments at the seed level? (Or is that such a big answer that it might be the topic of another entire post?)

Go Boldly!

[Rob Long]

I know precisely zero about the venture business -- something I'm trying to rectify -- but it doesn't seem all that different, in some ways, from hearing a feature film or television show pitch. You're really betting on a person, or a small team, that you have confidence in to execute (and tweak, and modify, and optimize) a project. Maybe the reason early stage venture is more successful is because you don't have any distracting details to take the focus off of the core question: is this, or are these, the guys who can execute something great? You're essentially betting on a person, not an idea. Is this true in the venture business, or am I reaching?

Years ago, when my first TV show was cancelled, I was young enough to call up the network president and demand an explanation. He told me that the show wasn't performing and probably wouldn't. And that he never really was confident that this kind of show would succeed. "So why did you order it if you didn't have confidence in it?" I asked. "Because I like you guys," he said. And I guess he was telling the truth because he put us on the air a couple of times after that. Though the comparison breaks down here because we never delivered a hit for him, and actually cost him a lot of money. So, um, never mind.

[Joe Duck]

Excellent post Fred. Your observation, combined with Jeff Clavier recently noting the challenges of VC investing and that VCs lose money on average, make me less envious.

In fact I'm wondering how much the VC biz is driven by the perception and the hope of big gains rather than actual big gains.

[Fraser]

What are your thoughts on Peter Ripp's arguement that's similar to yours above, except for the one glaring disagreement with respect to the first point.

While you claim that a small ante is the best way to mitigate risk, Peter argues that through a significantly large ante you can maximize risk mitigation by giving the company years to experiment and fail, and regroup to try again.

[Tubby Bartles]

I don't think you are seeing that seed investing is less risky. Instead, I think you are seeing higher returns on your larger investments because you were involved earlier. Unlike pure later stage investors, you put the hard work in up front building the company and got a reward in insider information as a result.

If you were *just* a seed investor (e.g., you couldn't and didn't follow with larger amounts later), I suspect you would get a very, very different dealflow than you do now. You would also be treated differently by the follow-on investors if you weren't participating in future rounds as well. Pure seed investing is still quite risky.

So this post does contain a good observation, but I don't think it's that seed investing is less risky. I think it's that you get better returns on later investments if you participate early on.

[Neal]

Interesting post. As an entrepreneur who is regularly pitching to angels/seed investors here are my observations about what is getting funded today (these are valid for web 2.0 platform):

- people who have a track record of past success

AND/OR

- if your company is already seeing significant traffic

Based on the above, you are automatically lowering the risk of your investment. Companies like dogster, Wikia, etc. are great examples. In the Valley the serious angel investors have started asking the question - whats your traffic, how many page views can you get, etc. When you start seeing the kind of questions that VCs usually worry about being asked by Angels, then you know that even though you might be seeing a 100K check you are still going through the rigors of an institutional investor.

[isaac]

Its very interesting that there are few similar thinkings in China VC industry because the firms are chasing more quick IPO returns than incubating a small business from day one to exit day.

Though I don't think they are right. But its time also a "risk" we should consider in captial management?

[Ethan]

If this is true, how do you explain the consistently lower, more volatile aggregate returns on early stage investments vs. late stage? Perhaps you are simply a much smarter vc than all others at the early stage (that would be a fun post to read). That said, I would agree if you said that late stage VC firms are floating into the realm of PE (in the American sense) these days, and, as such, late stage VC partners might be accepting different risks than they imagined. But, again, the numbers don't seem to support your argument at this point (as attractive as it sounds).

[Michael Aronson]

Fred- glad you learned something in my class at Wharton more than a few years ago!

As a founder of 5 successful technology companies (and now investors in a dozen more through our fund, which invests in early stage companies out of PENN), I would MUCH rather deal with the early stage issues that the later ones.

I agree wholeheartedly with your comments. I'll add a few more. When you are involved early you have the ability to actually influence design (for software) and initial channel strategies (assuming you know something about this). For our Medical deals, we have influence over the clinical study design (in animals) and patent strategies. Most importantly you can develop relationships with the key members of the management teams, something that will never happen when they already have a number of other investors. This starts a virtuous cycle of seeing these folks in follow-up deals after a successful exits. We like to keep our early stage deals close at hand (8 of our 11 have been incubated with us) Our latest deal is with a four-time winner who was part of the team at our second startup.

When potential investors ask us about the risks of early stage investing, I ask them if they ski. I tell them that for me to down a diamond ski run would be foolardy and I'd probably brak a leg or worse. On the other hand, I 've done so many early stage deals that their is little that I have not seen before and can hopefully fix (with the CEO, I try and avoid the wrong CEO upfront, unless we can change concurrent with the first investment)

Michael

[nik]

Here is another interesting point on Vinod Khosla's record on seed investing - http://paul.kedrosky.com/archives/2006/07/04/the_seed_ventur.html

[bob]

"We typically invest in pre-revenue companies. Usually they have the technology platform in place and in most cases, they have launched something with some success."

That's early stage??

[Stephen Harris]

I didn't find much that I agree with in the post suggesting early stage investing is less risky than later. First, the notion of starting with a small ante and paying to see each successive card ignores the fact that whether the ante is big or small, they face the same risk.....100% loss. It is also counter-intuitive to me that paying to see each card is less risky than seeing all the cards and then deciding what, or if, to pay. As to the post's second point, that early stage investors can impact the development of the company, I think the writer has fallen prey to an ill-conceived notion that investors are better at directing critical strategies than entrepreneurs. While this may be true in certain cases and/or regarding certain types of issues, I do believe that more of the wealth and success registered in the entrepreneurial/venture world come from the efforts, instincts and skills of entrepreneurs, not financiers. (By the way, I'm a long-time venture capitalist, so I can't be accused of being self-serving). And as to the final point, "past sins risk", I would respond that everyone and every entity has a past, and therefore past sins risk. Coming in further down the time line gives that much more time for the skeletons to find their way out of the closet, particularly if the entity has enjoyed some measure of success to that point. Again, is it better to decide what to pay for what's happened or to invest your money and find out later?

[Mattan Lurie]

Great post.... BUT ...

Much as a I love early stage investments, I don't agree that late stage investors don't add value.

My firm invested in one good local company as a late-stage investment, which we added A LOT of value. We brought in other strategic investors, took the company international, built their foreign sales offices, placed our team members in the company to shephard them through their growth, brought in an investment bank, managed the internal process of the public listing, listed the company in US, and even now are driving hard to grow the company.
And all of that in just 6 months from investment date. I'm not sure I would discount that so quickly the value of a good, company-building late stage investor. My two cents.

Now, having said that, I wish there was much much more seed stage investment capital. So many good companies fold because too much capital wants to sit in the late stage. There really is a market gap at the seed and early stage (at least here in China, where I work)

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[Terence Mak]

Dear Gentleman,

THis is a very interesting Blog. As a founder of a few companies, I wish that we have such folks like you folks here in Asia. I often seen great opportunities but the investment climiate here favours later stage companies with track record and is ready to go listing.. Investors here generally are less risky and knowledge of technology is limited. So tech deals are often bypass till later stages.

I am working on 2 projects that have Global Protential but am having problems finding the right investors here who even understand the technology.

If anyone of you gentleman out there knows any early stage investors, would greatly apprecaite a email and I be happy to send some information on the Project I am working on.

In the past 3 months more than 60 million of investment capital have been invested by VCs in the Space I am working on.

Regards
Terence Mak