Hooks Johnston on Seed Investing

August 4, 2010

We focus our efforts at Ballast Point Ventures on growth equity or “expansion capital” financing, meaning we tend to invest once a company has generated at least a few million dollars in revenue and has proven the viability of the business model.  Of course, from a 20,000 foot perspective of the private equity spectrum, these still qualify as “early stage” companies, and on occasion we will invest in a very early stage company if we have partnered with the entrepreneur previously.

But we don’t make “seed investments” which are at very earliest stage of the venture capital spectrum.  While seed investing isn’t a part of our investment strategy, we know that such investments are a key piece of the venture capital ecosystem and need to be encouraged.  Most of these investments are done by “angel investors”, and as we have discussed previously, there are a number of important initiatives that would help encourage seed investing.  However, while seed investing by institutional investors is rare, there are a small handful of firms that make such investments in the Southeast as part of their broader investment strategy.

One such firm that we respect and admire – we have known the principals there for a number of years dating back to their previous firms – is Valhalla Partners in Northern Virginia.  We recently received a newsletter from Valhalla with an interesting essay by Co-Founding Partner Hooks Johnston on seed investing.    We think it offers some valuable insight and wisdom on how to think about seed investing that should prove useful to angel investors and other firms throughout the Southeast that are considering investments at the earliest point in a company’s life cycle.

Partners’ Viewpoint: Hooks Johnston on Seed Investing

Valhalla Partners has now done a number of seed investments, and I would like to pass on some of the things we’ve learned about investing at this stage.

The two central facts of seed investments are 1) the opportunity to participate in a high-growth investment at the earliest possible stage and 2) a daunting set of risks. Investing wisely in seed-stage opportunities means understanding both sides of the equation.

The upside of seed-stage deals can be tremendous, both financially and in terms of making a difference. Prior to Valhalla I was one of a group of angels that invested in webMethods, which began as a husband-and-wife team meeting weekly at the Silver Diner and turned into a very successful public offering (and a great exit). The original idea of webMethods was just the sketch of a product. It had to be built, tested, brought to market, and sold in a repeatable, scalable way.

In addition to an untested product idea, seed-stage investments may involve significant team risk. The team is typically incomplete and frequently the “team” is just a founder or a couple of founders who themselves may not be experienced managers. You can’t assume that you can just define objectives and leave the team to execute; you need to invest a substantial amount of time working with the team as they execute on their objectives and encounter unexpected obstacles.

To mitigate these risks, we try, first of all, to invest in potentially very big ideas, since only a giant win can compensate for the level of risk in a seed investment. A second way to mitigate risk is to invest with a syndicate with experience in seed investments, whether angels or, if the right deal can be structured, with other institutational investors.

To succeed, we have found that the plan for a seed investment needs to involve objective, verifiable, and determinative proof points that can be observed in the very near-term. If the proof points are not objective and verifiable, there will be no clean way to find out if they have been met. If they are not determinative, the seed investment will not have proved enough about the product and the market to warrant a Series A investment.

Lastly, of course, you need to be willing to let go if the proof points are not testing out.

One advantage we have in the mid-Atlantic is being knowledgeable about government programs for seed-stage investing. In addition to the Small Business Innovation Research (SBIR) programs run by many Federal agencies, there are seed-level grants from state or quasi-governmental entities such as Virginia’s Center for Innovative Technology. And government entities can be customers as well as investors, or, with a group like In-Q-Tel (the venture capital arm of the intelligence community), both.

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