Seed Investing and Paper Lanterns

March 24, 2011 — Leave a comment

I have a friend who lives high up in a building, and has a terrace, and likes to set off Chinese paper lanterns late at night. The aerodynamics are such that the wind flows up the side of the building and carries these lanterns directly upward. Watching a fleet of these soar is inspiring … it’s amazing to believe that such a fragile construction of paper and plywood, filled with flame, can actually fly.

I was with him once at a beach house owned by a friend of his, in the Dominican Republic. He thought that seeing these lanterns fly out above the ocean would be magnificent. The first one he lit flew directly sideways, actually hit a woman’s head 40 feet away, and then careened into the building. Thankfully no one caught on fire, but everyone was pissed. Turns out that when you are launching fragile and combustible objects, it really, really matters which way the wind is blowing.

That experience (seeing a woman nearly burn to death and multi-million dollar beach house nearly go up in flames) reminded me of our first fund. We raised a $43MM seed stage fund in 2000, and proceeded to invest relatively quickly in over 70 companies. Shockingly, that fund looks like it will actually make money, based on some outsized exits (Optasite, @Last, Glycofi, Pump Audio) and some unrealized winners (Everyday Health, Newforma, GetWell Networks). This compares to the median fund from the vintage, which is worth $0.83 on the dollar. That notwithstanding, like most seed stage investors, we were doing the equivalent of launching a fleet of Chinese lanterns. From 2000 through 2005, the wind was against us, and a lot of those lanterns were extinguished or went in bad directions.

If you are a seed stage investor, there are three categories of good outcomes. The first is that the company gets purchased without needing new capital, and you make a quick return. The second is that you raise a next round at an uptick, and then sell, and you make a quick return. The third is that you raise a series of follow on rounds, at accelerating upticks, and you sell the company (or go public) for a very meaningful return. All of these things depend on picking great companies who make real progress, but I would submit they depend more on the environment, ie, which way the wind is blowing.

Right now, and for the last few years, we have had ideal conditions in the consumer web sector for this kind of investing. A group of eager acquirers focused on talent and willing to pay up? Check. Tons of investor interest in the sector, willing to pay up for companies with traction? Check. A Cambrian period of innovation coupled with low cost company building and marketing tools so that early demonstrable momentum can be achieved on short dollars? Check.

How long will this go on? My friend and very talented investor Shana Fisher has a framework where she points out that from 1995-2000, anyone randomly investing in early stage made money, from 2000-2005 anyone randomly investing lost money, and from 2005-2010, anyone randomly investing made money. I don’t love the next step in that sequence.

My personal view is that these conditions will continue for a while at least. Some of the dynamics involved are secular, rather than cyclical. Further, there are some folks who have leaned into the seed stage model and made an art of it, in a way we never did. First Round Capital comes to mind. Actually, come to think of it, they are the only ones who come to mind…

For our part, we moved onto more traditional early stage investing. Our latest fund is $135MM in size, we typically lead Series A rounds with $2-3MM, and we are focused on building a manageable number of high impact companies where we own an average of slightly over 20%. That requires us to get in early, which is why we have a tight sector focus on financial service and media, areas where we can get comfortable on little data and where we can sell our way into competitive deals based on our ability to help. The wind will always play a role, but hopefully we are launching rockets, not paper lanterns.

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