The Perils of Taking Seed Money From VC Funds

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 OLYMPUS DIGITAL CAMERAinvest. 

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. 

[This article has been reproduced from Deepak's blog http://viedeablog.wordpress.com/. Image credit: Schteeve2010/Flickr]