Is Seed Investing Here to Stay?

11/16/12Follow @zhurama

Seed stage investing has been growing tremendously and continues to accelerate. Just in the past year, according to CB Insights, it has grown from 15 percent of total U.S. VC investment volume in Q3 2011 to 31 percent of deal volume in Q3 2012. While it’s still a small allocation in total dollars invested, currently 3 percent, it has made significant changes in the startup market landscape.

New York now has the highest percentage volume of seed investments (more so than even the Bay Area) driven largely by consumer Internet deals—in Q3 2012, one out of every two deals done in NYC is a seed vs. one out of every three in Cali. The rise of incubators and co-working spaces has gone hand in hand with this wave—New York had 0 startup incubators 3 years ago and now has 12, with spaces such as General Assembly and WeWork Labs each housing hundreds of early stage companies.

How have seed investments fared thus far? Looking at a Venture Source data set I pulled from 2007 to 2010 (4 years and 800 companies that originated as seed investments), those companies have shown good survival rates in terms of raising follow-on financing. About 60 percent raised Series A financing during that time period, and of those, 41 percent raised a Series B, and of those, 38 percent raised a Series C.

From the same data set above, 12 percent, or 96 of the 800 companies that started as seeds, have been acquired (as of October 2012). For those with price-paid data available, which is a small set, the median price paid to capital invested ratio is much higher than the average venture-backed exit (by a factor of 2-3), indicating that seeds are relatively capital efficient. The exit price paid is, not surprisingly, also much lower, with a shorter time horizon to exit. This trend seems to support smaller investments for a relatively quick and modest-sized exit.

What’s driving the acquisitions? I think acquisition hires or “acq-hire” is a major driver. In fact, there is a feedback loop: more seed money ties up more engineers in greater numbers of early stage startups and creates market scarcity, which drives higher willingness to acq-hire those engineers. Cash-rich incumbents who are the buyers have the economics to leverage those engineers to work on products that have huge scale and monetization. For example, a good engineer that can improve Google’s advertising engine by an incremental percentage can justify a big willingness to pay, and the fact that the engineer has proven the ability to build and launch something significant is a good hiring screening mechanism. This acq-hire buyer behavior drives the M&A environment for small exits and, in turn, more seed investment.

The next natural question is, will this trend continue? The driving forces here seem to be capital efficiency to build product, the cost to go to market, supply of entrepreneurs, and the investment capital which follows. We’re already seeing the seed trend creep into the enterprise market with more seed investments there. One difference with the enterprise market is the requirement on the entrepreneur to have more prior B2B sales experience; and sales cycles are longer, so go-to-market is less capital efficient than in consumer tech. But we’ve already seen SaaS and the try-before-buy model start to reduce the barriers significantly.

What about seed investing in hardware? Maybe. Low-cost 3D printers are already reducing the cost to prototype, and companies like Kickstarter and Quirky are reducing barriers to get going with an idea for physical products.

The jury is still out on whether seed investing is here to stay. It’s certainly not slowing down in terms of new companies created. What has changed in the landscape is a well-paved path towards smaller exits. I’d also argue that the availability of APIs, development ecosystems, and platforms has allowed software startups to create value on top of these existing technologies quickly, be discovered, and position themselves for acquisition by large platform players looking to enhance the value of their broad-based offerings.

My prediction is that we’ll see the seed investing trend continue as long as those conditions hold true, which will in turn create new and different opportunities for follow-on venture capital investments.

Wan Li Zhu is a venture capitalist at Fairhaven Capital. Follow @zhurama

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