VC Signalling Risk in Seed Rounds
CB Insights just published an interesting post about signalling risk i.e. the startup survival risk generated by getting a Tier I VC into the seed round who does not follow their money into the Series A.
The data suggests getting no support from a brand name on your next round decreases you overall chance of getting financed (these conditional probabilities are a bit doubtful given the clear correlation between these events).
As usual, however, statistics only tell part of the story and hide a more complex reality.
VC's do seeds for a reason
It's worth reminding everyone that investors commit limited amount of money in seed rounds for a reason, and that is to manage their capital at risk; in other words, to have the option to not follow their initial money in a promising but fundamentally unproven project.
The arguments between VC's in this regard center around whether (non-seed focused) VC funds just want a cheap option or act with conviction when they invest at seed.
I remember one fund blatantly telling entrepreneurs "here is $500K and we will see you in six months". This has the benefit of being transparent but is hardly the kind of engagement and commitment you want from an investor.
Nevertheless, whichever side you are on ("option portfolio" vs. "invest with conviction") tends to depend on your own fund strategy and each investor has a tendency to preach for their own chapel, so take all pronouncements with a pinch of salt.
Understand the risk you are taking
Getting money from a Tier I fund at any point in your life tends to maximize your chances of success (or so the industry would have you believe :-)), provided your company does well (duh). The "branded" seed investor should be very clear with the entrepreneur when it comes to describing the social contract that is being entered into : "you can take our money and leverage our advice, brand and network, but we may not back in the future and that competitive advantage you gain today (in recruitment, closing clients or partners, getting press etc.) may become an anchor around your neck. By taking our money, you increase your risk profile". Founders can then decide what level of risk they are willing to live with and how confident they are in their success.
Take statistics with a pinch of salt
Following the money may not mean showing a great deal of support, and you have to be a bit savvy about the positioning exercises undertaking by VC firms. It's for example fairly easy to say : "we will always write the second check, provided you can get an external lead we like" when that second check is small. If I'm investing $200K in your seed round and reserving $200K as token support money, I'm still not committing a ton of capital to your business but I can say with a straight face that I was supportive in the follow-on.
You get my drift; your branded capital partner may be willing to show support but that support can become a token amount and not fundamentally resolve your signalling issue. The real question the new investor will be asking themselves is "but why isn't Tier I fund X leading or co-leading this next round and leaning in" so you cannot really get away from some level of signalling risk this way. But it helps, and certainly flatters the statistics!
Without sample size and average amount reinvested, it's tough to read too much into these numbers, even though from my knowledge of the market the rate of follow-on seems to reflect the various firms' seed strategies.
Different strategies for different funds
Some investors will do a ton of seeds and the market will understand that they cannot possibly follow across the portfolio. They effectively dilute the signalling effect by breadth. Some investors will back Angellist angel syndicates and follow the money automatically and avoid signalling risk by construct.
In general it's certainly better to take money from firms who are as selective about seeds as they are about Series A. By definition this money is harder to get. The best thing to do is to have a very detailed and open conversation with your incoming investor about their seed strategy:
- How many seeds do you do per fund and per year ?
- How often do you follow your money ?
- Do you always write the second check ?
- How often do you end up leading the Series A ?
- What milestones / proof points are we signing up to ?
Accel London and Seeds in Europe
Whilst, again, I am completely non-normative about seed strategies (different methods work for different funds in different markets), Accel London definitely falls in the camp of the "highly selective" seed investors. We do them, but extremely carefully.
The European market is quite shallow at Series A and B and there are only very few strong brands, which in my mind amplifies the signalling effect dramatically. There is also sometimes a cultural difference at play, which is that in the US entrepreneurs who do not get follow-on money will usually say "oh well, we did not not perform well enough" whereas some European entrepreneurs will blame the bailing investor for putting the last nail in their coffin ("by not supporting me you killed me my company"). Both of these statements are partially true.
This makes raising seed from tier I VC's a somewhat tricky but generally worthwhile exercise. It's just important to walk into the relationship with your eyes wide open.