A whole bunch of seed...

by Josh Kopelman,

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) 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...