By Tom Weithman

To the chagrin of technology entrepreneurs everywhere, promising “seed” stage start-ups are likely to have a hard time raising private equity investment for the foreseeable future.

Part of the reason for this lies in the implicit challenges of investing in the earliest stages of company development. These challenges are compounded by systemic issues in the venture capital markets.

Recognized as a leader in statistical analysis on venture capital deals, the PriceWaterhouseCoopers MoneyTree Report categorizes venture capital investments in four categories – seed/start-up, early stage, growth, and later stage.

For PWC, the “seed/start-up” stage is characterized by newly-formed, pre-revenue companies whose concept or product is “probably not fully operational.” PWC data indicates that for the 10- year period from 1997 to 2006, this investment stage took in $12.6B and accounted for some 11% of all venture capital deals done.

On the face of it, these numbers would suggest that an adequate supply of funds is available for technology entrepreneurs. A deeper assessment of “seed” stage investment calls this point into question.

In order to accurately assess the supply and demand of capital at the earliest point of formation, it is necessary to further define the true “seed” stage company.

This definition must be aligned with all three of the fundamental elements on which seed stage investors place their bets – the technology, the people, and the markets. Each of these three variables may be viewed as on its own developmental continuum.

At the earliest point of the technology continuum, the “seed” technology is not only “pre-operational,” but may exist only at the raw idea or “proof-of-concept” stage. At the earliest point of the management continuum, the “team” may consist of a lone inventor – perhaps a committed academic — with no previous entrepreneurial experience.

At the earliest point of the market continuum, the market for the anticipated product or service may not yet have sufficiently coalesced to demonstrate a critical mass of buying power. A seed stage company must be assessed and plotted against each of these three axes.

Companies at the earliest phases of the technology, management, and market spectra, while perhaps possessing the potential to develop to a point where they might attract a downstream venture capital raise, lie outside the boundaries of immediate “venture-readiness.”

These firms are likely not in need of – and indeed may be adversely impacted by – the large sums of money typically deployed by traditional venture capital firms. More often than not, they fall into the seed stage “capital gap,” identified by Dr. Jeffrey Sohl of the University of New Hampshire’s Center for Venture Research, encountered by companies seeking up to their first $2M in private financing.

Closer scrutiny of the PWC numbers bears out this thesis. The average U.S. seed stage investment for the five year period of 2002-2006 was $2.8M, well beyond the gap.

The existence of Sohl’s “capital gap” begs the question: With more money under management by venture capital funds than at any time in U.S. history, why aren’t more venture funds rushing in to arbitrage the opportunities offered by the earliest stages of technology company formation?

The answer lies in both the challenges inherent in true seed stage investing and current trends in the venture capital market.

High Level of Risk at the Seed Stage

With the technology, the management team, and the target market in a state of constant flux, true seed stage companies demand that their investors continuously adapt to risks during the life of the investment, that could not have been reasonably foreseen at the time of the investment. This volatility is increasingly intolerable to traditional venture capitalists and the LPs by whom funds are entrusted.

Time to Liquidity for Seed Stage Investments

Historically, the average time to liquidity for a seed stage investment has been in the 7 to 10 year range. In recent years, however, time to liquidity has lengthened across the entire venture capital asset class. As a result, it has become increasingly difficult for seed stage investments to return distributions within the time horizon demanded by traditional LPs.

High Maintenance Operations

Successful seed stage investing requires significant company mentoring and hands-on engagement by the investor. This level of engagement presupposes a level of experience in company operations, consultative problem solving, and new company formation not found in many venture capital funds.

Hard to Deploy a Small Amount of Capital

It takes just as much rigor for a venture fund to invest a small amount of money as it takes to invest a much larger amount $100K. With multiple pressures in the market forcing VCs to amass bigger war chests, it is simply not economical for funds to put money to work in the smaller lots aligned with seed investment objectives

LP Pressure on Venture Funds

In recent years, private equity firms, hedge funds, and other alternative asset classes have posted large fast returns for LPs. This has resulted in two specific pressures on venture capital funds. First, it has forced venture funds to take on larger and larger LP commitments. Second, it has resulted in an increasing intolerance on the part of LPs for the risk and time horizon associated with early stage investment. Both of these pressures are antithetical to the growth of seed stage investment capacity.

A ten-year view of the PriceWaterhouseCoopers Moneytree statistics reflects that “seed/start-up” deals are becoming both larger and fewer and farther between. In 1997, “seed/start-up” deals accounted for 16.57% of all venture deals tracked by PWC and accounted for 8.9% of all venture dollars disbursed. By 2006, those numbers had dropped to 9.14% and 4.3% respectively.

During this same period, the average size of a “seed/start-up” deal increased by 40%, from $2.5M in 1997 to $3.5M in 2006. This flight from early stage investment reverberates across the true “seed” stage spectrum, with the pain felt most acutely by entrepreneurs falling into Sohl’s “capital gap.” The picture is unlikely to change in the foreseeable future.

Tom Weithman is Managing Director for CIT GAP Funds, a family of seed stage venture funds placing equity investments in Virginia’s high-potential technology and life science start-ups.

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