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Seed firms differ from angels and VCs in that they invest exclusively in the earliest phases-- often when the company is still just an idea. Angels and even VC firms occasionally do this, but they also invest at later stages.

The problems are different in the early stages. For example, in the first couple months a startup may completely redefine their idea. So seed investors usually care less about the idea than the people. This is true of all venture funding, but especially so in the seed stage.

Like VCs, one of the advantages of seed firms is the advice they offer. But because seed firms operate in an earlier phase, they need to offer different kinds of advice. For example, a seed firm should be able to give advice about how to approach VCs, which VCs obviously don't need to do; whereas VCs should be able to give advice about how to hire an "executive team," which is not an issue in the seed stage.

In the earliest phases, a lot of the problems are technical, so seed firms should be able to help with technical as well as business problems.

Seed firms and angel investors generally want to invest in the initial phases of a startup, then hand them off to VC firms for the next round. Occasionally startups go from seed funding direct to acquisition, however, and I expect this to become increasingly common.

Google has been aggressively pursuing this route, and now Yahoo is too. Both now compete directly with VCs. And this is a smart move. Why wait for further funding rounds to jack up a startup's price? When a startup reaches the point where VCs have enough information to invest in it, the acquirer should have enough information to buy it. More information, in fact; with their technical depth, the acquirers should be better at picking winners than VCs.

Venture Capital Funds

VC firms are like seed firms in that they're actual companies, but they invest other people's money, and much larger amounts of it. VC investments average several million dollars. So they tend to come later in the life of a startup, are harder to get, and come with tougher terms.

The word "venture capitalist" is sometimes used loosely for any venture investor, but there is a sharp difference between VCs and other investors: VC firms are organized as funds, much like hedge funds or mutual funds. The fund managers, who are called "general partners," get about 2% of the fund annually as a management fee, plus about 20% of the fund's gains.

There is a very sharp dropoff in performance among VC firms, because in the VC business both success and failure are self-perpetuating. When an investment scores spectacularly, as Google did for Kleiner and Sequoia, it generates a lot of good publicity for the VCs. And many founders prefer to take money from successful VC firms, because of the legitimacy it confers. Hence a vicious (for the losers) cycle: VC firms that have been doing badly will only get the deals the bigger fish have rejected, causing them to continue to do badly.

As a result, of the thousand or so VC funds in the US now, only about 50 are likely to make money, and it is very hard for a new fund to break into this group.

In a sense, the lower-tier VC firms are a bargain for founders. They may not be quite as smart or as well connected as the big-name firms, but they are much hungrier for deals. This means you should be able to get better terms from them.

Better how? The most obvious is valuation: they'll take less of your company. But as well as money, there's power. I think founders will increasingly be able to stay on as CEO, and on terms that will make it fairly hard to fire them later.

The most dramatic change, I predict, is that VCs will allow founders to cash out partially by selling some of their stock direct to the VC firm. VCs have traditionally resisted letting founders get anything before the ultimate "liquidity event." But they're also desperate for deals. And since I know from my own experience that the rule against buying stock from founders is a stupid one, this is a natural place for things to give as venture funding becomes more and more a seller's market.

The disadvantage of taking money from less known firms is that people will assume, correctly or not, that you were turned down by the more exalted ones. But, like where you went to college, the name of your VC stops mattering once you have some performance to measure. So the more confident you are, the less you need a brand-name VC. We funded Viaweb entirely with angel money; it never occurred to us that the backing of a well known VC firm would make us seem more impressive. [5]


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