Why Have Venture Capitalists Shifted To Seed Stage Investing?

On the heels of my last post on venture capital’s role in innovation, I decided to take a look at how active venture capitalists were in funding companies that are early in their innovation lifecycle. The proxy for this is the earliest stage at which venture capital can come in – seed capital or start-up investment. What I found was surprising. The chart below shows the percentage of new venture capital investment (in terms of dollar value) that went to seed /start-up stage companies each year over the last 15 years. This is the best way to look at this type of data - absolute figures tell you more about what the venture market is doing overall - to understand real deal trends you have to examine changes in proportions of investment over time.

What’s clearly surprising about this data is the recent spike in seed investment (relative to other stages) by venture capitalists. 32% of all new venture investment this year has gone to seed stage deals. What’s driving this?

I know for a fact that pure seed-stage venture funds have had trouble raising funds over the past few years (relative to balanced and later stage funds), which means that traditional venture funds are now leaning more towards seed stage deals. I can think of a few reasons why:

• Venture capital firms are being forced to engage in cheaper, earlier stage deals because syndicate partners are increasingly tougher to find for later stage deals.

• Venture capitalists are still worried about the future of the exit markets (the IPO market and M&A activity) and therefore are hesitant to engage in later stage deals. These are deals in which they would have to reserve adequate capital for if subsequent venture rounds are needed to sustain the companies. We've seen a lot of firms face reserve shortfalls over the past year as the exit markets have essentially been closed. Venture capitalists with the expectation that exit markets will remain tight would clearly be detered from making later stage investments and would perfer less capital intensive earlier stage deals.

• Perhaps venture capitalists are simply going back to their roots and finally taking more risk again. There’s probably the realization that outsized returns can only be attained by generating higher return multiples off of earlier stage deals. Some of this might be pressure from limited partners - low multiple later stage deals just are not attractive, particularly when you consider the fees and illiquidity that come with commitments to venture funds.

Regardless of the reason, this shift to earlier stage investing can only be a good thing for the venture industry. The firms that are truly good at building companies and working with entrepreneurs will stand out and perhaps help repair the image of the venture industry.

Data Source: NVCA PricewaterhouseCoopers/National Venture Capital Association.

PricewaterhouseCoopers/National Venture Capital Association. MoneyTree™ Report, Data: Thomson Reuters.