Impacts on Seed Stage Returns

Let us say you gave an angel/seed stage investor $100 to invest in 100 different companies in $1 increments.  The odds are that fifty of those investments will yield a return of less than $1 each – meaning you won’t even get all (or possibly any of) your money back.  This is according to a Kauffman Foundation survey done a couple of years ago.  It’s not to say that the returns from the asset class are bad.  In fact, the study found that the average return from the asset class is 2.6x the investment in 3.5 years or about a 27% IRR.

So what are we make of the above facts?  Well… investors need to offset the negative IRR investments with investments that have really high IRRs.  Seven of those 100 investments are likely to return more than 10 times the original dollar.  That’s the offset.

In order to do better than average ideally you want to do two things to improve your returns: decrease the number less than 1x returns and increase the number of >10x returns. Luckily Kauffman provides a blueprint for that as well.  According to their survey, the 3 factors that positively impact angel/seed stage returns are:

  1. a rigorous due diligence process (to weed out bad outcomes from the start),
  2. a high level of experience and expertise in the investment sector (to lend any investment context to the environment) and
  3. being a helpful mentor once you do invest in the company (to help the company avoid operational errors that can be especially dooming as a company is first started).

As I look at my process, there are a couple of things I do to keep my thinking on track and aligned with this guidance.

First of all, I only invest in what I know.  I know enterprise technology.  I covered it as a buy side analyst, I covered it as a sell side analyst, I worked with it when I ran corporate development for a public company and my current employer RTP Ventures, invests in enterprise almost exclusively.  I often see what I think are amazing deals in Internet or eCommerce or B2C spaces and regardless I pass.  For one thing, I don’t know what I don’t know and could easily miss something when evaluating a deal.  For another, since I probably know little, I can’t be very helpful to the company as they go through their stages of development.  And finally, I don’t have very many good connections to ‘follow on’ investors in most other tech sectors.  So I agree with Kauffman.org when they say stick to your knitting.

The second important part of the process for me (and the first for Kauffman) is diligence.  Everybody should have their own diligence list and process that they go through methodically for every deal they do.  Certainly it is harder at the angel/seed stage because ether is just not as much to diligence.  However, when I’m first looking at a company I think through a decision tree that looks something like this:

decision treeThis is to just make sure that I’m weeding out deals that have high level issues.

The next thing I do is put the company/deal through a rating system.  This is a way to compare deals that might otherwise be like apples and oranges.  It is also a way to dig in on some things that might otherwise be intangible.  And finally it is a good record in case you need to look back on deals.  Skyler Fernandes at Simon Venture Group was the first to share his document here.  I modified his document for my own use.

And then of course I do proper diligence, which means compiling documents, talking to employees and customers and industry experts on the finer points.

The purpose of diligence should be to uncover all the issues that define the risks.  If you know what those are you can then decide if you are comfortable with them.

And once the investment is made, that’s when the real work starts.  By my estimation a seed stage company can make maybe two small mistakes or one medium mistake in the 12 to 18 months that the seed stage money is meant to last.  Any more than that and the next funding round becomes difficult.

That’s why proximity to the investment is important.  An investor should want to stay in contact with the teams that have been invested in and see what is going on.  It’s best if you can grab a coffee or a breakfast with the entrepreneur and talk.  Talking about obstacles, pitfalls, best practices and experiences is the best way to help prevent early mistakes. That’s one of the biggest parts of mentoring.

Mentoring is the third important factor in successful seed stage investing.  Hopefully in your career you have helped to build a business and have some operational, product and financial experience that you can bring to bear.  In the beginning getting things on track and keeping things on track is the most helpful thing you can do.

The Kauffman can be found at: http://sites.kauffman.org/pdf/angel_groups_111207.pdf