Return of the Seed
January 24, 2005

Early-stage investors and entrepreneurs are emerging from their post-boom hibernation with a different approach to starting up.

Vincent Occhipinti sits at the head of a large table in Palo Alto, California, surrounded by many of his fellow early-stage venture investors. As chairman of the Early Stage Venture Capital Alliance, he begins each meeting by asking the assembled members to stand up and announce the number of deals they’ve done since the last gathering.

Over the past few years, Mr. Occhipinti has come to dread this tradition. He’s often heard “zero” or, in the best case, “one” or “two.” At this most recent meeting, however, he is floored by the responses. “Four deals!” calls out one. “Six deals!” says another. “Eight!” chimes in someone else.

“The experience was overwhelming,” says Mr. Occhipinti, co-founder of Woodside Fund in Redwood Shores, California, which did eight Series A deals of its own in 2004.

After three years of post-boom doldrums, seed- and early-stage venture capital are finally on the rebound. There is some disagreement on which deals qualify as “early-stage” investments. While some VCs consider all money raised before the IPO to be early stage, the generally accepted definition is an investment in the seed round (usually under $1 million) or Series A round (usually in the low millions).

The key is getting into the game while valuations—and staff size—are low. An improved exit environment and more manageable fund sizes are driving VCs to take bigger risks, entrepreneurs to jump back into the garage, and experienced managers to crawl out of the corporate woodwork to join startup teams.

“All of the movements are in the right direction,” says Edward Roberts, a professor at the Massachusetts Institute of Technology’s Sloan School of Management, and an angel investor. “You can see it in the mood of our guys at meetings. You can see it in the willingness of people to talk seriously about making investments today. People are feeling that the marketplace is turning around.”

The new spate of early-stage deals, however, contrasts sharply with those done during the 1990s. VCs are much more reluctant to fund bright-eyed entrepreneurs just entering the garage, or invest in brilliant ideas sketched out on a napkin. Companies receiving early-stage funding today must be more developed and refined than ever before.

In 2000, seed- and early-stage funding represented 54 percent of venture deals, but by 2003 that number had plummeted to less than 30 percent, according to VC research firm VentureOne. Third-quarter 2004 statistics showed a slight up-tick, to almost 32 percent, but even that figure doesn’t tell the whole story, because many of today’s early-stage deals don’t show up in research reports.

Companies used to make a public relations splash immediately after their first funding, but entrepreneurs and VCs are now more cautious about unveiling themselves early on. For example, Mohr Davidow Ventures in Menlo Park, California, early backers of Agile Software and MIPS Technologies, has only publicly disclosed two of its last seven seed investments, according to partner Nancy Schoendorf.

 
Early Stage, Starting to Rise

In venture capital, greater risk always meant higher returns—that is, until the year 2000, when later-stage investors started driving down valuations so far that earlier investors were washed out. Less than two years after pumping $25 million into online financial services firm Juniper Financial, Benchmark Capital’s share of that company was diluted by 75 percent in 2002, after late-stage funding rounds led by the Canadian Imperial Bank of Commerce.

By 2003, many early-stage investors had become so brutalized, they were terrified to do another deal. “So many of the classic VC funds doing Series A financings were saying ‘We’ll sit this one out,’” says Steve Weiss of Grey Heron, a firm based in San Francisco that consults for venture startups. “Why invest early if they were going to get squished in Series B?”

As the market for IPOs and acquisitions gains steam and enterprises exhibit a renewed willingness to spend money, young companies are once again able to score new customers. That means early-stage investments are finally starting to show some upside potential, which, in turn, means startups are actually able to increase their valuations from round to round—just like the textbooks say.

“Two or three years ago we were looking only at B, C, and D rounds, but almost all the deals we’ve done in the last year and a half have been series A,” says Bart Schachter, managing partner at Blueprint Ventures in South San Francisco, California, whose early-stage investments focus on IT infrastructure companies.

Now that VCs are increasingly willing to jump back into the early-stage game, entrepreneurs are taking notice. VCs are finally returning their calls and holding meetings, encouraging them to pursue new ventures. Some entrepreneurs are even scoring multiple term sheets—something unheard of since the gluttony of the bubble days.

“We ended up having to turn people down, or give them smaller allocations,” says Stewart Butterfield, CEO of Ludicorp, which just raised an angel seed round for Flickr, its photo-sharing and social networking service based in Vancouver, British Columbia.

With more venture money at their disposal, early-stage startups are also able to round out their executive teams with experienced managers, many of whom have been hibernating in large public companies since watching their earlier stock options evaporate. Now that the market has turned the corner, they’re putting their faith back into the Silicon Valley startup system.

“CEOs, strategic marketers, and other people who had an option to wait it out did,” says Stuart Davidson, managing partner at Labrador Ventures, a Palo Alto, California-based early-stage venture firm that did twice as many deals in 2004 as it did in 2003. “A lot of those people sitting out are now looking to get back in.”

The Google effect hasn’t hurt either. While massive exits are the exception rather than the rule, the Google IPO showed that the Silicon Valley dream is still alive. You can build a wildly successful public company and become fabulously wealthy in just a few short years.

There were 16 venture-backed technology IPOs in 2004 (including five during the fourth quarter) that raised $2.1 billion, compared to 10 IPOs in 2003 that raised $726 million, according to VentureOne.

“The IPO windows are opening more frequently, so investors are moving from fear to greed,” says Harry Weller, a partner in New Enterprise Associates’ Reston, Virginia office. “People are now willing to take bigger risks because they see bigger exits.”

 
The New Deal

While risk-taking has returned, today’s early-stage deals look quite different from comparable fundings in 1999.

The startups, for one, are more mature. Many entrepreneurs who made big money during the boom have spent the last few years toiling away in the garage on their own nickel, or bootstrapping off of government and university grants that didn’t dry up when venture funding did. These teams often have solid customers, strong revenues, and a well-developed product and business plan before they ever sit down with a VC.

“We are seeing more and more of these fully baked Series A deals,” says Blueprint’s Mr. Schachter. “That’s something we never saw in the past, when people may not have even left their prior jobs before meeting with us.”

By funding well-developed companies at the early stage, savvy VCs are able to minimize their risk. In effect, as Mr. Schachter and others are saying, Series A is the new Series B. In the bad old days, many startups received tens of millions in early-stage funding, rented the most expensive office space, and launched a marketing blitz before finalizing their business plans.

Now, when hyping their portfolio companies, VCs often emphasize capital efficiency as much as market potential. The current goal is to build a complete company from start to exit for less than $20 million. This can mean leveraging everything from low-budget office space and cheaper engineering talent to investing at lower valuations.

Some firms are taking unorthodox paths toward creating capital efficiency. Blueprint Ventures, for its part, has focused on identifying promising technologies within corporations and spinning them out into startups. These deals often take advantage of millions of dollars already spent by corporate R&D departments.

For instance, Blueprint recently led a $6-million Series A investment in a video surveillance company called Vidient. Its Tokyo-based corporate parent NEC had already pumped $10 to $20 million into developing the core software, which was originally intended for broadcast market applications such as automatically pulling highlights from a sports event.

But investors were much more intrigued by the security applications of the software. Several airports and large corporations are already testing its ability to quickly identify suspicious activities in high-risk areas. It’s still an early-stage deal, however, requiring the same heavy lifting of assembling a management team and identifying the appropriate market for the technology, says Mr. Schachter.

Other firms, such as Ignition Partners in Bellevue, Washington, are conserving cash by employing a new twist on existing entrepreneur-in-residence (EIR) programs. Instead of giving an entrepreneur an empty office and a blank slate to come up with the next great idea, Ignition, an early-stage VC firm founded five years ago by Microsoft and McCaw executives, sometimes uses its EIR program to incubate prequels to seed deals. Deals that, in the past, the firm may have funded outright are now shunted over to the EIR program, where they can be fleshed out before capital is fully committed.

“Seed deals used to be ‘let’s figure out a business plan,’” says Ignition partner John Roberts. “Now we look at a seed deal and say: ‘Slow down, be an entrepreneur-in-residence for a quarter. Bang out a bunch of customer meetings. Understand the market better before you take on the cost structure of more employees.’”

 
Finding the Right Guy

The success rate of early-stage venture capital will also benefit from the simple fact that those who do it best are returning to the sector. At the end of the 1990s, the VCs that grew up as early-stage firms suddenly began raising mammoth billion-dollar funds that required putting vast amounts of capital to work. Because early-stage ventures involve smaller deals and at least as much time, they didn’t fit into that system.

In 2004, firms like Kleiner Perkins Caufield & Byers, Charles River Ventures, and Battery Ventures moved away from these bloated funds and raised more modest amounts. As a result, these talented funds can go back to being hands-on and managing a smaller portfolio, using the methods that made them successful in the first place.

With more early-stage capital searching for placement, the balance of power also shifts ever so slightly in the entrepreneur’s favor. Instead of scratching and clawing for a single term sheet at the early stage, the top startups are sometimes showered with several.

Startup consultant Grey Heron’s Steve Weiss is working with one seed-financed software company going after its first institutional round. Barely a month after their first investor meeting, VCs served them with one term sheet, and they received three more over the next two weeks—all during the holiday season.

For the first time in several years, VCs may have to compete for early-stage deals. So venture firms are becoming ever more creative in how they woo and service their startups. Woodside Fund, for example, brings as many as three partners together on a single deal. This allows the firm to be incredibly hands-on in all stages of the mentoring process, especially when it comes to recruiting executives.

For one portfolio company, they interviewed 22 candidates for the CEO position. “For every meaningful executive job at one of our startups, we can spend up to four hours with each qualified candidate,” says Woodside’s Mr. Occhipinti. “That takes a lot of time, but it gives us an advantage over many other funds.”

Naresh Batra, CEO of Woodside portfolio company Intelleflex, experienced that selection process firsthand. The San Jose-based RFID company recently raised an $11-million Series A round. “When I met with them, I was limping and sweating by the time I got out of the building. I was mentally and physically drained. But they spent the same kind of time and effort interviewing candidates to help me build my management team,” says Mr. Baresh.

Other firms avoid heavy competition by looking outside of traditional tech hot spots like Silicon Valley and Boston’s Route 128. Many VCs dabbled with this concept in the late 1990s, but few have gone so far as Draper Fisher Jurvetson managing director Tim Draper, who spent the last 15 years establishing an affiliate network of firms from Portland to Beijing. DFJ now has the connections to search for the next big thing in a place like Pittsburgh.

At the most fundamental level, an increase in early-stage investment means innovation is once again flourishing in the technology industry. The more Vincent Occhipinti hears a VC yelling out “Eight deals!” the greater the likelihood that one of those young companies just may change the world.

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