I came across a blog post this week titled “Why Seed Investing Is Kind of a Sucker Bet.” The headline raised my hackles. I’ve been investing in seed-stage companies for a while now. What was author Jason Lemkin saying?
Once I read it, I realized it wasn’t the screed against seed investing I was expecting. Instead, Lemkin tries to make the case that investing later in Series A and Series B rounds is better than investing earlier in seed rounds.
Mostly because, he says, those rounds are bigger. Investors put up more money and buy more shares. Instead of winding up with a 6% to 7% ownership stake at the seed stage, investors acquire a 15% to 25% stake at the Series A or Series B stage.
That’s a big difference in the size of ownership stakes. But Lemkin argues it’s actually even larger. The additional shares that startups sell in the Series A and B rounds dilute the ownership share of seed investors from 6% to 7% down to roughly 4% to 5%. So Series A and Series B investors own an equity stake that is four to five times bigger than that of seed-stage investors.
And that’s critical, according to Lemkin. Even though seed-stage investors make, on average, 10X on their investment versus the 5X that Series A investors make, “The Series A/B investor will own so, so, so much more. So even if they only make 5x instead of 10x, they will generally make 5x of so much more.”
Inserting hypothetical numbers, for every $10 million a seed-stage investor makes on a $1 million investment, the Series A or B investor makes only $5 million. But they make $25 million in all from their $5 million stake.
That argument doesn’t make much sense for individual investors. Individual investors will take 10X profits over 5X profits every day of the week.
But Lemkin has startup fund managers in mind. They need to make higher dollar amounts from their investments to spread among their many limited partners. And $25 million goes a lot further than $10 million.
The bigger the fund, the larger the checks it can write and the more money (in absolute terms) it makes when those companies grow big and eventually IPO (or get bought out).
This is why individuals and angel investors participate in the relatively small seed rounds but the institutional investors stay away. The stakes are too small to move the needle for the big funds.
A mix of individuals and venture capital funds participate in Series A rounds. And by the time a company hits a Series B round, the amounts (and check sizes) startups are looking for are generally too big for angel and other individual investors (there are some exceptions). From this series on, startups look to institutional investors for money.
I’m fine with this dynamic. But it doesn’t make seed investing, as Lemkin says, a “sucker bet.”
Let’s take the Uber example Lemkin cites in his blog.
The way Lemkin tells the story, seed investors complained that Uber “at $4 million pre-money and $5 million post-money was ‘too expensive.’ It’s because their ownership ended up much, much lower than their friends at Series A, B and C firms. For more work. And more risk.”
But that’s not exactly how it went down. Let’s examine the facts, shall we?
In 2010, UberCab (its name before it was shortened to Uber) raised $1.6 million. Its valuation was around $4 million pre-money and $5.6 million post-money. Adjusted for the two stock splits Uber issued before it IPO’d, shares went for $0.009.
At the IPO price of $45 per share, these seed investors made 5,000X. (Not all of them held on to their shares until the IPO, though.)
These investors included Rob Hayes (First Round Capital). Based on Uber’s IPO price, he made $2.5 billion. David Cohen (Bullet Time Ventures, the venture arm of Techstars) made $248 million. Chris Sacca (Lowercase Capital) made $1.1 billion. And Alfred Lin (chairman and operating chief of Zappos at the time) made $149 million.
I could be wrong. But I don’t think these seed investors did much complaining.
To give Lemkin a bit of credit here, Series A investors also did spectacularly well. Uber’s pre-money valuation for its Series A round a year later had risen tenfold to $40 million. It wasn’t nearly as good as the deal that seed investors got, but it was much better than the $300 million Series B valuation that Uber scored later that year.
Uber is probably not the best example of seed-stage investors not doing as well as Series A or B investors, which is too bad because there is an argument to be had here.
If Lemkin had talked about the greater risk seed investors take on compared with later investors, I would be all ears. As an early-stage investor, whether it’s a seed round or a Series A round, I carefully measure price against risk against potential reward. And these days, I routinely see great deals in both rounds.
But sometimes it’s better to be lucky than careful.
Hayes, the guy who made $2.5 billion from his Uber investment, got a tweet from Uber co-founder Garrett Camp. Hayes sent him an email that read, “I’ll bite. What’s UberCab?”
The rest, as they say, is history.