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The Return of Seed Capital

October 1995

Capital markets are fundamentally cyclical. There are many forces that drive this reality, all ultimately controlled by the laws of supply and demand. The good news this year is that venture capital seed funding is staging a come-back, which is very good news indeed for start-ups whose financing needs cannot be satisfied elsewhere.

As a cycle, the story of why seed capital is back begins with why it originally went away. Long term readers of the Technology Law Bulletin may remember earlier articles describing a harsh reality that arose in the late 1980’s: venture capital monies increasingly originated from enormous pension funds, often flowing through a limited number of individuals who functioned in effect as “gate keepers.” The fund managers of pension plans have always (quite appropriately) been fundamentally conservative, and when they dabble at the high risk end of the investment spectrum, they look for as sure an investment as possible.

Consequently, the bulk of the available money was (and continues to be) available only to those venture capital managers with proven, favorable track records. Additionally, with billions of dollars under investment, pension fund managers have no interest in making the small investments appropriate to fund smaller venture capital funds. Result: money poured into the follow-on funds launched by managers of the most successful existing venture capital funds. In consequence, the great majority of new funding for some time now has been committed to venture capital funds in the $100 to $500 million (and even larger) size range.

The next significant factor which tipped venture capital away from early stage investing is that it takes just as much management time to investigate, invest in, and monitor a small investment as a large one, and seed round financings are traditionally small (on the order of $250,000 to $1.5 million, rather than the $2 to $5 million common in the next round of investment). With hundreds of millions of dollars under management, large funds could (all other things being equal) make more money after overhead on large investments than they could on smaller investments. Besides the economics involved, the managers of most venture capital firms have traditionally been small, closely-knit groups of professionals, and the staff expansion necessary to service hundreds of investments was not attractive to the majority of those in the business, even if experienced personnel could have been found in sufficient numbers to staff increased deal flow.

The third and final factor was that for a time, the prevailing wisdom was that the risk of very early stage investing, even at the lower valuations available at this round, was not rewarded by greater returns, if only because the longer period between investment and reward puts downward pressure on the rate of return.

As is so often the case with significant changes in the flow of investment, what eventually changed was not the nature of start-up opportunities (although the few remaining seed-stage funds certainly benefited from the opportunity to “cherry pick” the market), but the prevailing wisdom. Not only have a number of large, later-stage venture capital funds turned in distinctly undistinguished returns on investment in the last decade, but some of the few remaining early stage funds have recently been announcing very handsome returns indeed.

Most recently, Matrix Partners III, an $80 million Massachusetts fund formed in 1990 and concentrating on early round investment, has been reporting stunning returns to its limited partners. The current value of the stock purchased for a total of under $9 million from just three of its now-public portfolio companies (Cascade Communications, Atria Software and VideoServer) is now (according to some third party estimates) worth almost $2 billion, and three more of its portfolio companies are expected to go public before year’s end. In the judgment of some industry observers, Matrix is the most successful venture capital fund in over a decade.

Not surprisingly, demand to participate in Matrix’s newest fund was heavy, but its managers turned away a number of interested investors in order to limit Matrix Partners IV to $125 million. The reason? The Matrix managers are committed to maintaining their focus on early stage investment, and to making time commitments necessary to successfully nurture the start-up companies they invest in.

With the potential for handsome risk-rewards clearly demonstrated, money has begun to flow once more into other early stage, smaller funds as well. Since venture capital funds, by their nature, take a minimum of three to five years to invest their funds, and the actual investments (especially early round investments) take several more years to mature into successes or failures, this trend can be expected to continue for some time before the performance results are in.

Inevitably, if the trend is strong enough, this cycle too will end. An excess of money, in the hands of too many people with too little experience in early-round investing, will chase a limited number of deals. As a result, demand will drive valuations up (and therefore final returns lower), and some significant portion of the money invested will find its way into weaker companies. Some years from now, when the less expert funds show poor returns, a cloud will doubtless once again hang over seed-stage financing, and the cycle will start anew. Although one might hope that this time, more of the best fund managers might follow Matrix’s lead and resist the urge to abandon early stage investment, this would represent more of a life-style than an economic decision on the part of those involved, since the economics and opportunities of the 1980’s funds will doubtless return to tempt them to abandon their seed capital opportunities to form later-stage megafunds.

In the meantime, opportunities for entrepreneurs to fund new companies will remain better than they have been for many years, and the economy, job markets and later-stage venture capital funds will benefit. Why will venture capitalists benefit? The answer is simple – without seed capital, fewer new companies can be launched, and therefor fewer high-quality later stage companies will seek venture capital.

If markets were to operate on the basis of creating opportunity, rather than exploiting it, and on the basis of fundamentals rather than prevailing wisdom, the seed capital cycle might stabilize. Then entrepreneurs could, in at least one respect, find the long road to success a little easier.