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Signal or Noise? NEA’s Experience with Signaling Risk in Seed Investing

*This post is a follow-up to my “Ask a VC” interview with Leena Rao at TechCrunch who posed the question, “Why does a $2.6 billion fund make seed investments?” 

NEA is one of the largest VC firms by assets under management, and has quietly become one of the most active seed investors in the industry. Launching a seed program was controversial, both within the firm and throughout the seed investment community. The primary concern was “signaling risk”, or the notion that when a large VC fund makes a seed investment but chooses not to invest in a Series A round, the company’s ability to raise additional capital is significantly impaired. That negative “signal” could damage both the reputation of the company and the relationship between the entrepreneur and its investor. After 35 years of building a reputation of trust and respect with entrepreneurs, we probably worried as much—or more—about this “signaling risk” than anyone. As a result, since launching a dedicated seed program in early 2011, it’s something we have proactively measured and monitored from day one. The early results so far have been surprising to many with whom we’ve shared the data.

NEA’s seed program has made more than 50 investments totaling north of $20 million. The portfolio spans multiple sectors of technology (consumer, enterprise, healthcare, energy) and geography (Silicon Valley, Boston, New York, LA, and DC) and represents the diversity of interests and strategies employed by our global partnership. We have recently analyzed our first cohort of 35 seed investments, all of whom raised their initial seed rounds between March 2011 and July 2012.  The data is as follows:

  • 35 total companies (100%)
  •  5 Series A Investments Led by NEA (14%)
  •  9 Series A Investments Led by Other VCs (26%)
  •  14 Total Series A Investments (40%)
  •  5 Wind Downs or <2x M&A exits (~14%)
  •  16 companies currently “too early to tell” *(46%) 

*this category includes companies that have not yet tried to raise capital, have raised seed extensions in advance of Series A, or are otherwise too early to tell

Given all of our concern about signaling risk, we expected to see more companies that are NOT funded by NEA struggle to raise a Series A.  Instead, we have found the opposite.

  •  At this stage, 40% of our seed companies are getting financed by a VC firm, NEA or otherwise, at Series A.  Our best guess is that more than 50% will be successful when this cohort fully matures.
  • Our seed funded companies have been almost 2x more likely to get financed by another VC firm, NOT NEA.  This is the exact opposite of what you would expect to see if signaling risk was significant in determining whether or not other VC firms would invest in NEA seeded companies.

The fact is that many VC firms choose to invest in NEA-seeded companies even if NEA does not lead the Series A.  There are many reasons why this occurs, but a few of the more consistent ones are:

  • Strong Fundamentals Speak for Themselves:  When we seed a company, we invest in great people, differentiated products, and large market opportunities. These fundamentals tend to be more important than the brand name or composition of a company’s investor syndicate, and tend to be highly sought after by many VC firms including NEA.
  • Entrepreneurs Have Many Choices:  We are privileged to work with great entrepreneurs who have many options for financing their company.  Many times other VCs are willing to offer more attractive options than we are able to provide.  We are thrilled when our seed companies reach these important milestones, independent of the dollar amounts we’ve invested.
  • We Are Not Always the Best Long Term Partner:  Seed companies change course frequently, and pivot into spaces or sectors that align better with other VC firms or partners. These shifts could also result in direct competition with companies in our existing portfolio, and when this occurs we do everything we can to manage conflict and maintain trust with our entrepreneurs and co-investors.
  • VCs Don’t Always Follow the Herd:  The VC community is diverse and sophisticated, and many firms weigh investments on their merits as they see them, not another firm’s opinion.  Herd mentality is less prevalent in venture capital than some might think.

On this last point, it is important to remember that building a successful start-up is one of the hardest undertakings on the planet.  It should not be surprising that investing in start-ups is equally challenging.  When we make a decision to invest—or not—in a Series A, it does NOT always mean we’ve made the right call.  We are human and we make mistakes. We aim not to repeat those mistakes at Series B, Series C, and beyond.

To be clear, we are not claiming that signaling risk does not exist.  To this day we are still very careful and selective about our seed investing for this very reason.  Entrepreneurs have many choices for how to build their seed syndicates, and those that choose to work with NEA get a partner with a long term perspective, at any and every stage of their growth, no matter how much money we’ve invested.  We aspire to help entrepreneurs build very large companies, and have a track record of doing so that spans four decades.  This is the strongest signal we send to our entrepreneurs, to our co-investors, and to the market, and it is a signal that hopefully continues to drown out the noise of signaling risk.

Jon Sakoda is a Partner at NEA and co-heads NEA’s seed investing program. Jon’s perspectives on VC and entrepreneurship can be found at www.jonsakoda.com or on Twitter @jonsakoda.

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