EDIT

Most recent version of this essay is here: https://github.com/DeBraid/tech-notes/blob/master/Role-Of-Seed-Capital-in-Economic-Development.md

Below is an earlier draft.

Role Of Seed Capital in Economic Development

An essay on transformation role of seed capital for entrepreneurs and it's impact on regional econoic development.

By Derek Braid, aka @Royal_Arse.

VC in Canada 2016

OMERS Ventures estimates that total venture capital (VC) invested into Canadian startups increased 15% year-over-year in 2016. Early-stage startups received most of that increase, while investment in late-stage companies contracted.

It is encouraging to see early-stage companies getting more funding year-over-year. But the fact seed funding was down is alarming, and needs to be corrected.

Clearly seed stage is lacking in Canada, this article aims to explore why pre-seed financing is so important for economic growth.

Runway

Put yourself in the shoes of a talented, ambitious person, lets call her Linda.

Linda is an educated mother of 2. She has a background in a STEM field, and has domain expertise in banking and finance. She is gainfully employed at a large bank, but sees inefficiency everywhere that software could eliminate. She has two colleagues, one a former university roommate, another current coworker, who have an itch to start a startup and would make great co-founders.

What steps should they take to break off and start their own business? They should quit their job to focus on building their new business. Committing time and attention to the new task must be all encompassing in order to succeed!

But, theres a problem: they have good jobs, and families, and mortgages, etc. Like most people under 50, they have limited savings. They need a runway.

Without a runway, you might have to move back in with your parents! That happened to @alec_levin who moved back home with his girlfriend, living at both their parents houses while trying to start a startup. Alec says:

Going back to my parents’ home was one of the hardest things I’ve done.

He continues to describe the great sacrifices required to start a company, and get some cash flow:

At one point I started delivering food for Hurrier on my bike... I froze my ass off for a few months delivering food downtown for about $14 an hour.

What if a small seed round enabled founders like Alec to focus more on their startup and less on immediate cash flow?

Clearly the economy would be better off.

Seed is the Runway.

Seed capital is the runway that lubricates capitalism. It is the minimum basic income to allow founders to eat and sleep in their home without moving back in with their parents, or squatting with 5+ roommates in a small house.

Seed capital reduces the financial risks for startup founders. $100k divided by 3 founders, means they can dedicate 1 year of their lives to nothing but building a new company and be paid just below median income (in Canada).

This is the minimum basic income that someone earning 6-figures will accept to leave their job, take the personal and professional risks required to start a startup.

And that is just to start! The risks are much greater and varied, but the most obvious impediment is that founders are scared of having $0 income. Make that go away with a small seed investment of $100k (in exchange for 5-10% equity in the company).

This is close to YCombinator, the most successful startup incubator in the world, operates.

Passive VC: thing or not a thing?

Passive VC, in my terms, is something like YCombinator (YC). Not exactly like YC, but shares the following characteristics:

a group of seed startups
each startup gets an office for 3 months, and enough money get their MVP polished and shipped
the terms and process are simple and transparent: $100k, 7.5% equity, 13 weeks

The rest will take care of itself. Because equity is involved the incentives of founders and investors are aligned (unlike most of the Toronto-based )

Ego, Performance, Culture

Lets talk about the poisonous impact of ego in investing. Active investors play the losers game despite the data showing how fleeting the returns are for active traders. They want to be the smartest person in the room, or on Earth.

Seed stage investors call themselves 'angels' FFS...

VCs hold onto the cash because it gives them power. Once they invest, the power shift to the entrepreneur.

Of course, in finance there is always institutional reasons that encode for bad behaviour. In VC, growth is over-valued, longevity/durability is under-valued (source: Peter Thiel). Why?

most of the value of startups exists far in the future.

If you run a sophisticated financial model like DCF (discounted cash flow), or do the math on profit streams, there are two components.

A) growth rate B) discount rate

Using PayPal as a case study, (in March of 2001), growth rate was 100% a year, discounting future cash flows by 30%, means roughly 75% of the value of the business came from cash flows 10 years in the future and beyond!

Generally, you can apply this across most high-growth startups.

75-85% of company value is realized 10 years from now...

Because it's so far in the future, everyone wants more growth to realize value sooner. Thiel emphasizes that in Silicon Valley, "we always over-value growth rates and we undervalue durability".

This also solves another pesky issue for VCs: performance bonuses. The culture of banking and finance is that quarterly and annual reports are required. 3 years is a lifetime in banking, and 5-10 years is a career. Most people are looking for their next job by then, and want to have received several annual bonuses. This is why equity is so vital to successful incubators.

Equity ensures the investors are committed to the long term outcome. They have skin in the game, unlike many more-charitable incubators in Toronto. Take equity! Founders: treat yourself to business partners who are actually invested in your success, it will likely work out better for you.

OMERS

OMERS Ventures made 4 investments in 2015. THIS IS INSANE. They raised $260 Million dollars in 2015. Total funding $470 million, they self-proclaim "...our two funds together represent one of the largest long-term private capital pools active in Canada’s venture sector"

From 2011-2015 OMERS Ventures invested in 23 startups, "doubling venture capital spending", via Financial Post.

OMERS vs Canadian VC

Omers is not the only party to blame for the sorry state of Canadian seed funding! Every single VC in Canada should give their head a shake and stop pretending they can pick winners (or produce the data to prove they can!).

The numbers are striking: US investors provided more than HALF all venture capital in Canada. They will skew towards growth rounds because established companies are less likely to die than pre-revenue startups.

Back to the figures. Estimates from OMERS suggest American investors provided ~52% of all venture capital invested in Canadian startups in 2016 ($559 million CAD). Fifty cents on the dollar comes from the US?! Surely this is anomalous? Nope. Last year (2015), US investors contributed ~ half of all VC, a total of $482 million into Canadian market (48% of total).

YC vs. VC

YC is more formulaic than traditional angel / VC.

YC has "batches" (a cohort of startups that starts/stops their incubator program at the same time. Loosely, they operate as follows:

50-60 startups per batch
enter the batch with a specific goal/product in mind
a batch is incubated for 3 months
demo their product the end

Demand for Quality Incubators

Ryerson DMZ is so successful it is busy to the point of being crowded, via Ottawa Business Journal:

The competition for space in the DMZ is high, and some of the startups talked about “squatting” in a facility that is packed to the rafters. Others noted the huge number of companies in the DMZ makes it very difficult to find experienced mentors and sources of funding

List of Incubators in Canada (from 2014, via Mars): https://www.marsdd.com/mars-library/accelerators-incubators/

YC Clones?

One of the key benefits to YC is standardized term sheets and simple process. There is a Montreal-based firm attempting to bring some of the YC magic to Canada.

FounderFuel

FounderFuel describes itself as "3 distinct projects, loosely coupled but complementary: a seed fund (Real Ventures), an accelerator (FounderFuel), a community hub (notman.org)".

Results over 5 years, 9 cohorts and 73 startups, source and here:

13 week program based in Montreal
focused on the pre-seed to seed stage
67 companies since 2011
$6 million in funding from Real Ventures in 2012
14 acquisitions, 13 shutdowns, remaining in operation
investment of ~$100K for ~5% in equity.

The FounderFuel Way

Screening startups, FounderFuel will ask founders as 3 Questions:

Why should people care?
Why should people believe?
Why should people join?

Lessons

time is of the essence. The deadline is a catalyst. “What is your ambitious goal for the next 3 months?"
founders and teams matter the most. Resilience, curiosity, humility and persistence.

Conversely, building a startup ecosystem from scratch is a 20-year investment, via Brad Feld. So be in it for the long haul.

Mid market VC is a trap!

Peter Thiel in his lecture to Stanford student provides this inThere are businesses that are perfectly competitive and there are businesses that are monopolies. There is shockingly little that is in between. startupclass.samaltman.com/courses/lec05/

Over a year since @marcusdaniels wrote: Canada needs more pre-seed & seed in VC. http://www.huffingtonpost.ca/marcus-daniels/pre-seed-funding-venture-capital_b_8451236.html How has landscape changed since?

Daniels lists several reasons more seed (and pre-seed) is good. For starters, the benefits of standardized term sheets are huge!

There is considerable variance in pre-seed term sheets. This is a problem that has been partly resolved in the U.S. via standardized term sheets like "safe," which was developed by the famed Y Combinator accelerator.

Standardized terms removes confusion for founders. Also helps investors understand their risk/reward better. Keep the funding simple, focus on the product (cut out the bankers and lawyers!).