Activist vs. passive seed investors

Apr 30, 2012

When I entered the VC business 10 years ago, I tried to keep thinking about venture capital as a business, where the key focus area was on meeting the needs of our target customers -- entrepreneurs and limited partner investors.

In the case of entrepreneurs, those needs have changed radically in these last 10 years. The surge in seed investing has been well-reported and analyzed. With advances in cloud computing, open source infrastructure, development tools and general "Lean Start-Up" techniques, entrepreneurs need less capital than ever before. And when entrepreneurial needs change (i.e., requiring less capital), smart investors adjust to meet those new needs. Hence, the rise of angels, super-angels, incubators, accelerators, micro-VCs and VC-led seed programs.

But as the "Great Seed Experiment" matures, a new trend is emerging. Entrepreneurs are beginning to learn the difference between what I'll call Passive Seeds and Activist Seeds. And entrepreneurs are learning that the difference between the two, although somewhat subtle, matters greatly.

Passive Seeds are when a VC invests a small amount of money (for a $200-500M mid-sized fund, typically $250k or less, for a large $1B fund, perhaps $500k or less), to achieve a very small amount of ownership (typically less than 5%) that creates an option to participate as a more meaningful investor in the future. Passive seed programs get most of the press attention because of their sheer volume.

When you ask venture capitalists about their seed programs, many will brag about how many seed investments they have made (20-40 per year is not uncommon) and how wonderful it is that so few of them "graduate" to become Series A investments (perhaps 10-20%) because it shows how discriminating they are. Other characteristics of passive seeds is that one or two of the partners can make the decision to invest, rather than requiring the entire partnership to approve, and the due diligence is very light. Additionally, in a passive seed round, VCs don't mind if 3-5 firms participate, as opposed to more tyically 1-2, and each VC partner can juggle a dozen passive seeds at any given time. Sometimes there are more VC investors than employees in a passive seed!

But entrepreneurs are starting to wise up. The conventional wisdom has emerged that Passive Seeds from VC investors are bad for start-ups and entrepreneurs. VCs who make passive seeds are not typically engaged enough in the business to add meaningful value. Further, they send a bad signal to the funding market when they don't invest in the Series A, thus creating inappropriate leverage on the entrepreneur at the time of the Series A decision.

Seed investor/venture capitalist/entrepreneur Chris Dixon has written extensively about this issue, and I couldn't agree with him more when he declares, based on his discussions with experienced founders, "there is no room for debate" on the issue.

Activist Seeds VC investors are a different story (which Chris acknowledges, although uses different language). From the VC's perspective, an activist seed is when the firm commits the fulltime, resources, and energy into the investment that they would do with a Series A. From the entrepreneur's perspective, they truly wants to raise less capital because of all the positive Lean Start-Up trends noted below, but wants the active involvement of a value-added VC firm.

An activist seed from a VC is typically more like $250K-$1 million and the ownership is closer to 8-10%. The full partnership approves a passive seed and the due diligence, although abbreviated, is thoughtful and serious. The firm gets to know the business and the entrepreneur better and thus makes a deeper commitment in making the investment.

The conversion rate of an activist seed into a larger Series A is more like 50-75% and each VC partner dedicates as much time to an activist seed as they do a larger Series A. In short, an activist seed is nearly identical to a Series A, just smaller, slightly more streamlined, and informal - all appropriate for the stage of the business and the requirements ahead.

So next time you are discussing a seed round with a VC firm, figure out if their firm's philosophy is activist or passive. At Flybridge, we firmly believe in activist seeds (two nice examples recently in the news are Crashlytics and ZestCash). Different firms have different approaches. Make sure you find out which is which, and make sure it's a fit for your needs. Here are a few questions you can ask yourself to distinguish between the two:

  • Was the entire partnership engaged in the investment decision process? Did I meet with and pitch to the entire firm? This results in a greater sense of commitment and shared ownership.
  • Did the VC open up her network and make a few value-added introductions to prospective talent, customers and business development partners? Again, this is an indication that the VC is willing to add value along the way and be more active than passive.
  • Was the due diligence process rigorous? Do they seem to really understand my business and the subtelties around what it takes to win? Did they ask tough questions, check my personal references to get to know me better, put me in front of prospective customers?

Absent these elements, you are at risk of taking money from a VC that views you as "an option" rather than "an investment" - not a place a hard-charging entrepreneur who needs as many friends on their side as possible wants to be!

<!-- BEGIN KAPOST ANALYTICS CODE -->Jeff Bussgang is general partner at venture capital firm Flybridge Capital Partners. You can follow him on Twitter @bussgang

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