Is there a seed bubble?

Paul Kedrosky just claimed there is a super seed bubble. As I can count about 12 super seed funds in New York, many of which are new, I agree there is more money flowing in to super seed funds than in 2006-2008.  But to claim there is a bubble, you need to claim that the amount of money flowing in needs to be reduced.

There will be less super seed funds if it is not as rewarding as the investors hope.  Super seed funds make their returns on acquisitions and IPO’s of their investments.  That is when the investors and partners get capital back.  So, to assess the bubble, you have to see if the exits will be less than the investors are expecting.  Will the money that can come out in M&A and IPOs be enough to provide returns to the capital going in?

Lets say there are 25 super seed funds with $20 million to invest.
Say they aim to own 7.5% of companies when they exit in 7 years.
Say they want an average annual return of 12% across their fund.
So, can their surviving companies exit for:

[ 25 funds X  $20 million invested X ( (1 + 12% )^ 7 years ) ] / 7.5% ownership

= $15B.

Assuming the exits are over a 5 year period, that’s exits of $3B a year (i’m excluding the fact that some exits have liquidity challenges in the early years).

Given tech companies are sitting on lots of cash: Cisco has nearly $40 billion in cash reserves; Microsoft, $37 billion; and Apple, $23 billion. It seems possible these companies can get $3B from their coffers.  Add in 2 IPOs, and you’re there.

I would say that only the seed investors who partake in the homeruns will make it.  The $3B in annual exits will be driven by the YouTube, Google, AdMob, Zappos, and other large exits.  So, seed investors need to be in lots of deals to increase their chances of being in the few big winners.  But, overall, the super seed industry will survive!

I’ll be fixing the math/assumptions as I hear from y’all.

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  • Rob Go

    Interesting analysis. I think your number of seed funds and aum for the sector is over-stated. At least half of the funds are not really seed funds. They are arms of traditional VC’s that I think don’t fit into the category. I would say that as a rule too, returns are concentrated into the best funds. So I think the question isn’t really one of raw numbers as much as how many high-quality funds are out there. By my estimation, there are really less than 5.

  • Phil

    Rob – Good point. I don’t how exactly to define the super seed funds Kedrosky is talking about. Should it include First Round Capital? the part of Seqoia that partnered with Paul Graham? the part of Firstmark/Pequot that does seed deals? older groups like Common Angels?

    My first guess was that $500M is seeding companies (25 funds & $20M). Perhaps its many more funds and less $M per fund.

  • ZiyaGB

    I like your math, however your assumption that all 25 make what they planned (12%) is not going to hold true for all 25. I think you need to add another factor, say only 10% or so will make 12% and the rest will not (pick a low number for them if you want). If you make this alteration, the amount of annual exists will come down to something lower… However, overall I tend to agree with your point, that not all funds (angel or vc) will come out making acceptable returns without hitting a few home-runs.

  • Phil

    ZiyaGB: I was estimating an average return across all funds of 12%–some will be much higher & many will be lower.