Redeye VC

Josh Kopelman

Managing Director of First Round Capital.

espite being coastally challenged (currently living in Philadelphia), Josh has been an active entrepreneur and investor in the Internet industry since its commercialization. In 1992, while he was a student at the Wharton School of the University of Pennsylvania, Josh co-founded Infonautics Corporation – an Internet information company. In 1996, Infonautics went public on the NASDAQ stock exchange.

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A whole bunch of seed...

Corianderseeds I woke up this morning to some interesting news.  Charles River Ventures is now investing at the seed-stage.  This is a smart reaction on their part to several market trends:

  • The fact that it costs less to start a software/Internet business these days,
  • The fact that there are fewer large exits (both via IPO and M&A) taking place, and
  • The fact that, over the long-term (10+ years), seed-stage investing has had a higher return than any other stage of venture investing.


It also is a recognition of some of the challenges that larger venture funds face.  Take a hypothetical traditional $400M VC firm.  In order to achieve a 20% IRR, the fund must return 3x their initial capital over a 6 year term -- or $1.2B.  Now say this hypothetical VC firm typically owns 20% of their portfolio companies at exit (an industry average).  That means that at exit their portfolio needs to create $6 Billion dollars worth of market value (ie, $1.2B / 20%).  Assuming that their average investment size is $20M, that means that they invest in 20 companies -- this assumes an average exit valuation of $300M PER COMPANY.  Given the tight IPO Market and an average M&A exit value of less approximately $150M, this math creates some real challenges.

I've only interacted with Charles River a few times (we were co-investors in Odeo together) but think very highly of them.  They have an enviable track record and a sterling reputation.  I think they are one of a few pro-active venture firms who are proactively seeking new investment models (I've now heard of two other venture firms that are establishing seed-stage programs).

However, I've always thought that there were some inherent conflicts that arose when venture funds moved to the seed-stage.  I'd be interested in hearing my readers thoughts on:

  • I've always believed that one of the key roles a seed-stage investor plays is to help their portfolio companies raise a Series A round.  One of the reasons I don't like bridge loans, is that there is not alignment of interest between the lender and the entrepreneur.  As a lender, I would convert into the price of the next round -- motivating me to keep the next round valuation low.  As a shareholder, my motivation is aligned with the entrepreneur -- we both get rewarded by a higher second round valuation.

  • When an venture investor has an option (but not an obligation) to take a certain percentage of your next round, I've always thought it created the potential for some bad optics.  If they exercise their option, and participate in the round, it could be a wonderful thing for the company.  But if they choose not to exercise their option, what signal is it sending to other potential investors?  As a small ($<50M) seed-stage fund, no one expects my fund (First Round Capital ) to be a lead investor in subsequent rounds...But if a larger VC firm has the option anddoesn't use it -- does that cause other venture funds to wonder why?

  • Finally, as the First Round Capital website states, "we look to take an active role in most of the companies we invest in. We believe our insight and expertise are far more valuable than our capital -- and we look for entrepreneurs who feel the same."  Our whole business model is to roll-up our sleeves and actively help the company develop it's strategy/partnerships/business model, etc.  In fact, we tend to be far more active in the early-stages of a company than in the later stages.  Given the size of larger VC funds, are their partners able to actively get involved in a seed-stage deal?

Thoughts?

UPDATE:  Matt Marshall at VentureBeat has interesting insights here and Fred Wilson of Union Square shares his analysis here...

Comments

Andy

While I applaud any movement towards earlier stage investing, I think the best seed investing is the active kind, as those stage ventures require the most guidance and support. I wonder whether a spray and pray approach can work . . .

Gerald Joseph

I'm definitely in favor of traditional VCs taking bigger roles at seed stage.

But for this emerging trend to become a permanent fixture in the VC industry, issues of administrative execution and VCs fiduciary responsibilities to LPs must be openly discussed.

Angel investors are emerging as viable seed stage and even small or medium sized Series A round investors. This occurs due to the fact that angels invest their own money.

VCs typically invest 'other peoples money' and should probably create wholly-owned seed stage VC subsidiaries or partner with small VCs, angels, incubators, and 'internet labs' to build a portfolio of early stage investments with the idea of evaluating open betas then making commitments to play prominent roles in standard-sized Series A investments within one year, thus publicly giving the startup a vote of confidence by shouldering the brunt of the Series A risk.

To participate in the seed stage and have an ‘option’ on the Series A is not a strategically sustainable position.

CoryS

With so many investment dollars interested in tapping into the non-public markets with an angle on tech and growth, are there really a couple different issues/opportunities developing?

First, the traditional VC market's value proposition on 'active management' inherently means that a VC's core talents, plus an appropriate investment theme, are why an larger institution invests for a winning return. Thinking about this from a strategic standpoint, the VC business model (either in one firm or across firms) could have a scalability problem since active, qualified managers, relying on specific experience of certain individuals, are scarce. Hence, the value-add, boutique VC investor would seem to be an appropriate positioning to assist in the exploitation of good ideas/sector start ups in need of strategic assistance and capital. Though, I wonder if that is the only market positioning for VC's, or should I say, early stage investment firms.

With seemingly large institutional investor interest in tech/growth companies being challenged with ever more hurdles in place to invest in them publicly, is there a new need for a different style of VC 'fund managers' that are good at identifying trends and investments, but focus on picking a larger number of themes and potential winners, focusing on oversight/performance instead of active engagement?

Having heard insight from PE and VC investors about making decisions on 'smart money' v. 'cheap money', I wonder if the market has appropriately fragmented into ways to tap into the capital interested higher risk investments across the investment spectrum.

Perhaps there are firms with this focus that I've missed.

AlFromChicago

Josh --

I think you're spot on on point number 3. I think pure 'investing' at the seed stage without planning on taking on significant operational tasks is very very difficult -- and at the end of the day VCs are around doing great deals and not "running" the businesses they are in. We are taking it the other way -- for example, we did an investment in RealClearPolitics.com and then took over the Publishing tasks of the company -- so our value add is pretty clear -- and then we target companies where we can add that value.

I think the other problem is lifetime needs of cash for some of these companies. Some funds like Fred's seem to be taking much smaller dollar approaches per deal which makes sense. But at the end of the day if CRV still needs to put to use $20MM per deal it can also lead to conflicts that an inexperienced entrepreneur may miss. For example, where Participate Media generally wants our business to cash flow ASAP and re-invest the cash flow to grow the business, a VC helping at the seed stage may continually encourage spending and investing that allows them to get to their $20MM nut, at the right time, with all the right provisions.

The biggest problem I have with this is that I think most of these businesses (and we're also starting several from scratch like BuzzTracker.com) will not need more than $1.5-2 MM to get to nice cash flow businesses, at which point they can raise additional capital from outside the VC community easily.

Vaibhav Domkundwar - Better Labs

I totally agree with your analysis. The structure needs to be a lot simpler to make the seed model scale and for entreprenuers to be comfortable with it, atleast from my perspective as an entreprenuer.

However, now that more funds are opening up to smaller seed funding idea, the other part of the equation is really about making that money last longer, develop the initial product/service version with a smaller burn and test and evolve it slowly. Even with $250K a 4 person team cannot really scale beyond 6 months, unless you do a reddit model which may or may not be for everybody.

At Better Labs (http://www.betterlabs.net), we have just started to open up our model to work with early stage startups in the Valley to deliver their alpha, beta and 1.0 versions which allows the founding team to run faster and more economically, as they evolve their service with user feedback. Look out for iLetYou (http://www.iletyou.com - the first one of our startup partners) going into Private Beta in the next few days. This fits right into the founder's roadmap, who raise between $200k and $500K, as we can work with them on a 18 month plan.

Greg Cohn

From an entrepreneur's point of view, it is always attractive to have more options in pursuing capital and getting pedigreed folks involved early. Especially if you don't have a lot of friends and family to draw on, this seems like a great path to seed capital.

The thing that would give me pause touches on your first question Josh but goes beyond it, and I'd love to know what you and other VC's think about this question: would CRV's option to participate create leverage unfavorable to the entrepreneur by discouraging other VC's from leading a follow-on investment, thus reducing the upward pressure on valuation that multiple bidders would create?

Only a churl of a Founder wouldn't offer participation to CRV anyway in this situation (barring a bad experience of some kind), so locking in some option seems harmless, but the math says CRV will have the option to have a larger position than any other follow-on investor and I wonder how palatable that is to other market-maker VC's.

Rem Koning

The move to seed stage investing, in light of the recent talk about the broken VC model (ie, the Sevin Rosen fund dissolution), makes sense. With too many dollars chasing fewer VC "ready" firms, the move by CRV into less developed ventures looks smart. At the seed stage there likely is less competition, which should give CRV a better crop of companies to pick from.

Why then is there less firms of the typical VC size? Chris Anderson's theory of abundance provides a nice model for this shift. With technology so cheap it makes sense that there are less firms that need typical VC funding, no longer do start ups need the big tech bucks.

Within the abundance model then, the CRV move is pretty innovative. It allows them to shrink down to the new size of internet tech. companies. While the technicalties of the loan may be not perfect, the move seems like a direction that other firms may want to follow.

Nitesh

The key is to make the initial fund raising process as painless as possible. I've heard of too many friends spending too much time fund raising rather than focusing on building a product. Part of the reason that many people just fund projects themselves is simply because it's a lot faster.

just.a.guy

"...I'd love to know what you and other VC's think about this question: would CRV's option to participate create leverage unfavorable to the entrepreneur by discouraging other VC's from leading a follow-on investment, thus reducing the upward pressure on valuation that multiple bidders would create?..."

Precisely. That's exactly why they reserve the right to do half the round. It gives the ILLUSION of financing flexibility where it doesn't really exist. Why not?

If the founders want another party at the table, the round size necessarily grows larger (as both firms want to put real money to work), which necessarily increases dilution to the founder (how big a pre can you really ever justify on $250K worth of progress? typically not that big)

so you wind up back at square one, with the seed player/CRV leading the round (or nobody doing it because if they don't nobody else will).

If you raise your $250K from Mr. Kopelman or other seed investors and make really interesting progress, don't think that CRV and others won't be banging down the door for a piece of the action anyway... meaning, if you can get good seed stage investors with good contacts / coinvestments with other good VCs, but without the strings of a deal like CRV's, DO IT. because the announced deal just gives the illusion of flexibility.

...

finally, though, I would say the answer is YES to the third question. partners in larger funds absolutely get involved and add value at the seed stage -- but usually with an eye toward putting more money to work if things break the right way. That's exactly why CRV's announced loan program has those strings attached -- to give the illusion of flexibility while ultimately force-fitting you into their financing model.

Dan H McKinney

Josh,
You probably know where we come out on this as we are very much like minded. The ultimate alignment (and where many mis-alignments occur) is with exits. The fund model we jointly suscribe to is one that is smaller and can therefore make more modest investments. The ultimate alignment comes as a result of the additional exit options that result from not requiring exits exceeding the average $150M M&A exit.

Brian Berliner

I wrote up some comments related to Fred Wilson and Josh's take on the CRV QuickStart program announcement:

http://www.brianberliner.com/2006/11/01/crv-quickstart-its-all-about-the-dealflow/

I also agree that point 3) is key for any entrepreneur. They want an investor that will roll up their sleeves and help them get the company off the ground and going in the right direction. Hard to say if CRV will provide that service, but there's absolutely no reason why they cannot.

Enjoy!

-Brian

Dave

term sheets, size of funds, and all other numerics aside... what i care about above all other things:
* really smart investors
* smart investors i like to work with, and who are willing to help / add value
* all of the above + willing & able to do deals quickly

from what i know of josh, he fits the bill on all points. (probably jeff clavier fits this profile too).

Ran Naim

There are pleanty smart people out there who make their living based on these points.

You can find some posts on the subject (in hebrew) at Kusem.com

Michael Aronson

We are an early stage fund and will not do bridge loans in software companies for many of the reasons mentioned, we insis upon pricing the A round. We DO do bridge loans in medical device companies for a number of reasons. The A round requirements are large $4m+ while the companies must be initiating animal studies which are not that expensive. We hope that a deep pocketed knowledgable fund will sign up for the A into which we will covert at a nice discount. Plus we know that the Funds in the sector will push valuation way down , probably much further than we could. So far it has worked out well...

Eric Jackson

Hi Josh:

I believe that CRV is part of a trend. There will be many bigger VCs doing their best to emulate First Round.

However, I think there will be winners and losers through this:

Winners:

- The bluest of "blue-chip" VCs. The Sequoias and KPCBs of the world shine brighter when the maddening crowd is rushing to chase the latest trend of VC investing. They've been there and done that time-and-again.
- Existing Angel Investors who have a track-record. When a space gets hot (i.e., angel investing), those who have been there for a while are the old wise men. You, Jeff Clavier, and others will see a rise for their services even as others rush in. There will be a flight to quality.
- Traditional VCs who are able to make the leap and really differentiate from other angel investors. Although CRV is a great firm, their success is not guaranteed. They need dealflow; their GPs needs to be seen as credible by non-nascent entrepreneurs; and they really need to be able to deliver value to their investments (beyond the simple "we love to roll up our shirtsleeves alongside our investee companies" platitudes).

Losers:

- Stuck-in-the-middle VCs: Those VCs who do a little bit of angel investing and a little bit of traditional are likely to do neither well.
- Former Great VCs who don't adapt to changing times: Remember when Softbank was king of the hill? Hot VCs who have yet to reach the echelon of Sequoia and KPCB are not assured of long-term success. They are also likely to stick-to-what-they-(think-they-)know-best. Dangerous, when the rules of the game are changing
- Later-stage/Mezzanine Investors: They just got even less relevant.

Thanks,

Eric

http://breakoutperformance.blogspot.com/2006/11/are-angels-new-vcs.html

will

"The fact that it costs less to start a software/Internet business these days" . . true very true . . . but it costs a lot more than ever to start a family in the bayarea than ever . . .. . instead of looking at the eonomics of an investment, VC's needs to address the increasing risk asymmetry between investors (deal focused) and entrepreneurs (life focused) . . .

Brandt Cannici

You mentioned that under the system that Charles River Ventures is investing there becomes a conflict of interest as the company is valued at the Series A Round. However, with typical equity investments that conflict happens at the Seed round, when both parties know each other least and the future is most uncertain. This is the time, when we entrepreneurs want to negotiate least, because that is time we could spend on our core duties.

Additionally, while of course it is a VCs job to mitigate risk, I get a feeling from the venture community that they need some proven, tried and true model. If everything is proven how will you ever be the explosive innovator on the market? At the Web 2.0 Summit everyone was after the new YouTube of this vertical market and the MySpace of that. Those are now regurgitations of old concepts and not innovations anymore. Paradigm breaking teams need money to take the market on aggressively and early, but there seem to be few sources for that.

In the end, end no matter which way you structure a deal there will be problems and risks on both sides. I think what they have is a great product aimed at innovators, it pushes back valuation to a more stable time when parties are more comfortable with each other, the offer is quick, easy, and upfront, and it allows entrepreneurs do what we do best, focus on the product and the market.

Larry Kubal

Some great comments and perspectives -- which I personally believe are directionally correct. However, I would like to make a couple of quick points of my own.
1.) your typical venture fund example (which I have used in discussions in various forms myself) assumes $20M in for 20% of the company. That is an average $80M pre-money valuation across all rounds. If that is typical of all venture funds, then Steve Dow is correct and the model is broken. I am at a small, early stage fund where our series A pre-money valuations average about $5M pre-money over the last 17 years. Over the life of an investment, our average pre-money across all rounds might get to $25M pre-money. This does not require extraordinary exit markets to achieve typical venture type returns. Accordingly, I do not believe that the market is broken for capital efficient, very early stage investors who invest small sums, early at low valuations.
2.) The CVR loan program makes little sense to me. It sounds like a "plant and pray" or "throwing spaghetti against the wall" sort of strategy. It is structurally very difficult for even a mid-size fund to deploy small amounts of capital in seed efforts because the scarce commodity is partners' time. Without that time and the needed mentoring and monitoring that is involved, buying call options on early stage companies through a CVR type loan program seems to me ill-conceived and ill-fated.

Nabeel Hyatt

This is absolutely true, and I posted a bit about in on my blog.

Good to see CRV trying to get involved and innovate -- but it's certainly an issue for a entrepreneur to effectively box himself in for $250k.

http://nabeel.typepad.com/brinking/2006/11/vcs_look_to_com.html

AnnaHopn

Hi, Thanks for article. Everytime like to read you. AnnaHopn

Charlie

Can i take a one small photo from your blog?

hermes bags

This is absolutely true, and I posted a bit about in on my blog.

Rick

I have a problem and question, I'm a serial entrepreneur, iv got a million and 1 ideas to make money, such as downloadable smart phone gaming apps which users play to win prizes or coupons for stuff and advertising though out the game targeting local and global markets, with 6 billion phones and virtually all of Asia using mobile phones to connect to the Internet, I think any company would be keen to have sub minimal advertising projected within the gaming app if I had 10 million free downloads. But how do I get VCs bothered to invest if it's just an idea?

And the problem is I'd fund it myself if I could afford to, even with owning 55 houses in the UK I find it a struggle to pay for the current staff because I have 2 other startup websites I'm trying to get off the ground, all my rental profits are going in to funding them, and I can't re finance my houses for cash because the bank would never give me the money. I'm launching a free version of liveperson.com because they make $10 million per month and are on the NYSE, they spent $15 mill developing their website, iv spend less than $100k so I can afford to give away a product which is a loss leader because it's totally automated, I guess my aim is to be brought out so that I can invest my own money to do other companies.

Is there and VC or seed funder that would just invest in me at a point of having no customers, do all VCs want traction?

I'd love to become a seed funder myself and just go looking for great ideas, but I feel I have to get a few more companies off the ground first. I wanted to invest in africa because entry level there is soo much lower. What legal requirements are there to become a seed funder? If I were to use other peoples money? Does the FSA need to be involved. Can anyone do this? I feel I have what it needs to spot the right teck idea or website, I just don't have enough resources to do them all:(

I feel helpless, too many ideas, not enough cash and resources to do them and VCs ignoring my emails, it's as if they really don't want entrepreneurs contacting them. I'd rather put my efforts in to setting up what I can than wasting all my efforts trying to convince VCs. I think VCs, angels, seed funders, need to make it easier to approach them otherwise entrepreneures will give up and the ideas will be lost forever and everyone loses:(


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