Are more VCs headed to seed deals?

More venture firms are perhaps investing in seed rounds as a way to prosper in hard times, according to several people, putting smaller amounts of money into very young companies and hoping for a big hit.

The move is partly a result of several economic trends that are putting pressure on some venture firms. As capital has gotten tighter, firms are raising less money. Fewer funds have been raising fewer dollars every year since at least 2004, according to the National Venture Capital Association, and the most recent statistics, for the second quarter, show 25 firms raising $1.7 billion—the lowest number of funds in one quarter since 1996 and the lowest amount of money raised in a quarter since 2003.

Meanwhile, the number of small funds is expected to grow as large funds shrink, according to a survey by NVCA and Deloitte published in June, with the biggest growth in funds sized from $1 million to $100 million. The survey also showed a slight shift in focus to early stage deals, although over half of VCs said they planned to maintain their current strategy and about one-third said they would shift to later stage deals.

Startups, meanwhile, especially those in information technology, require less money to get started than they did a few years ago because of the free infrastructure provided by the Internet and open source software.

Some of these seed investments are coming from new types of investors (such as Y Combinator, The Founders Fund, Maples Investments and Andreessen Horowitz, among others) that have sprung up in the last two or three years to try to bridge the gap between individual investors and more traditional VCs.

Tandem Entrepreneurs co-founder Doug Renert—who’s worked as a corporate lawyer for Gray Cary, bought and built businesses for Oracle, and served as the CEO of Tello, a short-lived telecommunications startup—says that traditional venture capitalists aren’t well suited to make early stage investments because they’re too impatient for big returns.

Tello was liquidated by its investors, which included Intel Capital, Craig McCaw and several venture firms, in 2006 when it became clear that Tello’s product wasn’t going to be a smash hit, even though the company had cash and could have created several other products, Renert says.

“Early stage companies don’t fit the VC model,” he said recently. “Some of them may eventually, but it’s hard to know in the beginning if you’ve got something very big or a more modest outcome.”

Tandem has raised $15 million and invest about $850,000 in each of its startups, in stages. Its co-founders serve as temporary staff members, helping with marketing, sales, business development and other areas until the startup can take them over. No startups have graduated from Tandem yet.

Flywheel Ventures pursues a similar strategy, according to co-founder Trevor Loy, who says that the firm invests about $600,000 at an average pre-money valuation of $1.5 million, usually in companies with a desirable technology. Flywheel requires its partners to spend 20 hours a week with each of their startups for the first year to 18 months and helps them find good management teams, which Loy calls “the limiting factor” in any startup’s success.

He says the maximum fund size that Flywheel can deploy effectively is $150 million. “It’s a slower, more patient workload,” he says. “Less giving talks to conferences and more showing up a couple of days a week at the company.”

But VC firms with more than $100 million in capital are also doing more seed stage rounds, says Caine Moss, a partner at Wilson Sonsini, which represents both VC firms and tech companies, even though not all of them are good at it.

So far, Moss is operating from a hunch. He went through his spreadsheets and found 14 such deals, priced from about $500,000 to $2 million from March through June of this year.

“I’m confident that it’s more than last year’s comparable figure, but by how much I don’t know,” he says.

Moss is also confident that not all VCs are equipped to manage seed deals, which may require shepherding inexperienced entrepreneurs through changed business plans, products or even entire companies before they’re ready to move on to another funding round.

Some VCs are using seed stage rounds as a way to try out young companies and see if they’re worth backing later in a more conventional Series A funding rounds, offering money and then standing back to see if entrepreneurs “can come back and eliminate risk and show progress,” Moss says. If they can, “the VCs will lead a Series A and become more actively engaged.”