The perils of taking seed money from VC funds – By Deepak Srinath

I met three interesting startup’s last week. All of them were founded by entrepreneurs in their late twenties or early thirties, who had been part of product teams in other startup’s or global tech firms. The startup’s were pre-revenue or had just signed up a few customers. Typically, in the Indian VC context, these firms would be considered too early by ‘early stage’ VC funds to do a Series A. They would be asked to come back in 6 months time when they had signed up more customers and had discernible revenue traction. However, to my surprise, all of them claimed to have termsheets or were in serious conversations with VC funds – not seed stage focused funds, but regular VC funds.  What’s even more surprising was that the quantum of funding they were offering ranged from $200K to $500K, not the usual $2 million plus that these funds like to invest.

A few top tier VC funds have started making investments in the realm of angels/seed stage funds. When a VC fund makes a seed type investment, they are essentially purchasing a low cost option to participate in a full round if the startup shapes up well. Unlike an angel investor or a seed fund, a VC fund’s economics don’t work on a  $200 K investment; their economics work on making much larger investments in each of their portfolio firms. So how does this matter to a startup as long as they get the money, right? Maybe not, let me explain.

In most cases when a VC fund makes a seed investment, they contractually tie in an option to lead the next round, which is typically in the $2 to $5 mil range. If the fund exercises this option, the startup loses out on talking to other funds and discovering the best possible valuation and terms. If the fund does not to exercise the option, other funds will be very wary to investing in the startup. Their view will be that if the fund who did the seed round and has an inside view of the startup does not want invest, surely there must be something amiss.

A few VC funds who make seed investments mention that they do not tie in an option on the next round for precisely this reason. Nevertheless, with or without a specific option to invest, if the fund does not participate for whatever reason, other VC’s will wonder what’s going on.

On the other hand when a startup takes money from an angel or seed stage fund, there is no expectation that they will participate in a follow on round. Their model is based on investing a small amount really early and guiding the startup through to a stage where they are ready for a VC fund to come in.

For long we’ve bemoaned the lack of adequate seed stage funding in India. This is clearly changing now with the more angel investors and seed stage funds springing up everyday. From an entrepreneur’s perspective, funding at every stage is critical. However, if entrepreneurs have alternatives, they must think carefully before taking seed money from a VC fund.

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7 Responses to The perils of taking seed money from VC funds – By Deepak Srinath

  1. That is the reason people like Blume Ventures exist!

  2. kishan yalvigi says:

    Hello

    Good article

    I have few quires what is the actual meaning of Series A, Series B ,Series C capital I keep reading I am not able to Grasp these Concepts ???

    Regards
    Kishan yalvigi

  3. Suneel says:

    Hi Srinath, that was a very informative post. The point of taking VC money comes with quite a number of perils and if bad luck is on the startup’s side, they may even get evil VCs who ruin everything.

    I had been recently questioned whether a startup needs to register itself as a company and then start its operations or can it be run like being a sole proprietorship? I ask this question because you are aware of how long the registration takes place and as well as the amount of money required to put in the bank for registration.

    Whats your opinion? Should a startup needs to be registered as pvt. ltd or can it go on as a sole proprietorship thereby reducing the costs?

  4. It really depends on the aspirations of the founders.

    If the founder(s) of the start up want to run a lifestyle business, with no external investors, then a sole proprietorship or partnership if fine. If they want to build a scalable business with equity participation, then registering as a private ltd. is a must. These days the registration process is very quick and efficient (less than 2 weeks).

    -Deepak

  5. Srinath says:

    Deepak, the same argument could also be made for Angel investors. Typically, the formula works in terms of the angel investor putting in a bit of money to create suddenly a large enterprise that VCs will take interest in. My experience is small money begets small enterprises that are just good enough to deliver dividend, rarely a scaled up valuation exercise.

  6. Krushi Reddy says:

    ” From an entrepreneur’s perspective, funding at every stage is critical. However, if entrepreneurs have alternatives, they must think carefully before taking seed money from a VC fund.”

    Just adding a point, as to why entreprenuers should be careful. If the VC fund had invested in the seed funding stage, they will already have a signifant stake with them. Which would help them in making the term sheets in their favour, like allotting more stake in the company (more than when seed money is raised from others) for the same amount of money being pumped into the company. The returns that the investors make at the time they are going to sell their share in the company or when the company goes public is huge.

    Ex: Suppose initail investment by entrepreneurs is $100,000, seed funding is $200,000(assuming the company does not have any sales as of now) the company shouls ideally get 20-25% (according to the industry norms) share in the company. Let series A funding be a $2,000,000 and the post money value is $4,000,000. then the stake gets diluted by 50% which would leave the VC funds with around 62.5% stake in the company, giving them a fair chance of dictating terms while making term sheets from series B investing.This might fetch them higher returns than what they should be getting when the seed funding is done by some other parties.

    On the other hand taking about the VC fund losing on their investment they made as seed funding. The VC fund has a clear idea of how things are going in the company and can come out of the business without making further rounds of investment and their losses would not be as high as the investing in the latter rounds(uncertainity is always there irrespective of the stage of funding). If they see it promising they can pump in more money and make it bigger.

    Either ways it is more profitable for the VC funds than the entreprenuers.

    Deepak this is just my opinion, please do correct me if i went wrong somewhere. Thanks

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