Nearly all VC investors have an ownership percentage they are shooting for. For most large funds, it’s 20%. I’ve blogged about the mysterious 20% ownership threshold before.
If it seems arbitrary, that’s because it is. Usually, this ownership number is justified based on what would be considered an ownership that is “meaningful” for a fund. But that logic kind of falls apart when you consider that “meaningful” should be totally relative to fund size.
Here’s what I mean. Take an example of a company that exits for $400M (which is relatively heroic when you consider the vast majority of successful exits are far below this level). If a $200M VC fund has 20% ownership, this exit returns 40% of that VC’s fund. That’s pretty meaningful! If that same VC were able to produce 5 exits of this scale, that would return 2X on the fund. Pretty good (but funny enough, still not spectacular considering that that is $2B in enterprise value).
But if that same VC is operating out of a $400M fund, those exits are HALF as meaningful. Each $400M exit returns 20% of the fund, and the 5 combined only return a 1X. Obviously, it gets worse or better as the fund size increases or decreases. You would think then that this would necessitate that larger funds target more ownership, but that ends up not really being the case. Instead, those funds try to invest in companies that can be “bigger”, but at the early stage, it’s hard to differentiate companies that could be $400M exits vs. $1B exits.
The reason that larger funds can’t consistently target more ownership (say, 30%+) is because of competition in the market. There are enough players out there that ownership tends to settle at the 20% range for new series A investors (and often series B investors).
One weapon that large funds do have is more capital. This can be leveraged in a couple ways. First, a larger fund is more able to wait. The thinking goes “if I’m going to only get 20% ownership anyway, why don’t I wait until the next round, and then invest. I might have to invest more ($10-15M instead of $5) but I still get similar ownership and presumably a lot less risk.
The other thing larger funds are able to do is compete more aggressively on the series A by expanding round size. The large fund may say to the founder,” wouldn’t you rather just raise $8M instead of $5M for the same (or marginally more) dilution?” It ends up being a pretty compelling argument. Although cost basis does matter to all investors, in a world where you are probably only going to get 20% ownership, the difference between investing $4, $5, or $6M to get there isn’t that meaningful.
Investors also talk about the concept of “buying up”. This means increasing ownership in a company over time. Again, larger funds are able to do this better by using their capital as a weapon and leading or co-leading later rounds, trying to do super-pro rata in the next round, or buying secondaries. But these situations are pretty hard to predict, so it’s tough for funds to try to do this systematically.
Where “buying up” gets a bit hairy is in the seed to series A rounds. This is why investor signaling is an issue. Almost all large funds are trying to get to 20% ownership, and in truth, they are expecting (hoping) for more than 20% ownership for a company that they seed. But for funds that make smaller, passive bets at the seed stage (eg <$500K) they are likely to have much less ownership than their target. Thus, these funds will need to try to increase ownership significantly to hit their 20% bogey.
For example, if a seed round happens at $5M post money, and the VC invested $500K, that VC owns 10% of the company. This VC now needs to buy an additional 10% at least at the next round to hit their target ownership. This implies:
- If the big VC isn’t trying to buy up, there is a risk that new investors will wonder if there is something about the company that makes it less attractive (negative signaling)
- If you want a new outside VC investor, you will end up with an additional 10% dilution if you are trying to keep everyone happy (assuming other seed investors just want to take their pro-rata or less).
And most VC’s that employ a high-velocity seed strategy invest less than $500K, which amplifies the problem.
Ultimately, companies raise capital from good investors if they are working on a big problem and are showing exceptional progress. The dynamics around VC ownership come into play once a few different investors are interested in a company’s round. But in the final innings of discussions with investors and deal negotiations, I find many entrepreneurs to be pretty surprised at how ownership targets drive the dynamics of the deal. It’s a little arbitrary, but it pays to be thoughtful about this stuff because it can have meaningful downstream implications.
I was chatting with Nick Chirls from Betaworks recently and we talked a bit about Angelist syndicates and the incentives surrounding it. Betaworks was one of the first investors to use Syndicates on the platform in their investment with Estimote (a really cool company, BTW).
Nick reminded of an interesting perverse incentive that syndicates creates. Note, this IN NO WAY drove Betaworks’ decisions in this case, but he just pointed out that these incentive will exist almost by definition of how syndicates works. Essentially, Angelist syndicates creates an incentive to:
- Invest a little less
- Be less price sensitive
- Have a lower bar
Why? The answer is a) “free” leverage on one’s dollars and b) deal-by-deal carry.
On a), this drives the price sensitivity. As an investor, you are essentially now able to get more of an economic interest in a company than before on the same dollars. Thus, you are on balance more tolerant of risk (thus lower bar) and can get the same financial outcome even if you invest at a slightly higher price (thus less price sensitive). Or, another approach is to say that you can now get the same economic interest with a smaller investment (this, invest less).
The other (and to me, the bigger) issue here is the incentive around deal by deal carry. In early stage investing, deal-by-deal carry is awesome for the person doing the investing (the VC or the angel), and is pretty bad for that person’s investors. Almost no early stage funds have deal-by-deal carry. The reason is that the riskiness of early stage investing means that one has to build a portfolio of investments to be successful. Our profits in this portfolio of investments drive our carry in the fund.
But obviously, a VC or angel should be required to return their investors’ capital first before really earning that carry on the profit. However, this is not the case with deal by deal carry. You can lose money overall, but earn a nice chunk of carry along the way.
Simple example: Let’s say I’m a $10M fund. I invest in 10 companies at $1M each. If 9 completely fail and 1 makes a 9X return, I have returned $9M of the $10M. I earn no carry.
Now let’s say I’m an angelist syndicator. Let’s say I make a small investments in 10 companies, but attract $1M in syndicate capital for each of those companies. So, it’s like a $10M fund. If 9 fail and 1 makes 9X, I am able to get a carry on that 1 9X return. So, if I charge a 20% carry, I make 20% x $8M, which is $1.6M (of which Angelist takes a cut). That’s pretty awesome when my overall performance was actually a loss of capital.
Of course, because each syndicate has different investors, there is no way to force me to pay back my overall principal before taking carry. But the incentives in this situation is for me to be more risk loving overall. And if I can get really good leverage on my dollars, I could basically write pretty small checks into a lot of companies, but bank on the beautiful benefits of deal by deal carry to save the day for me.
This should come to roost at some point, because over time, syndicate members will stop following an angel who loses money on average. But this won’t happen very quickly as long as I catch a hot deal now and then. Even if I lost money along the way, but got a 20X on one investment, I think that one 20X would be enough to attract more capital behind me for a few years. Obviously, not all actors on angelist are going to do unnatural things because of these dynamics (the best definitely won’t). But these incentives definitely exist and aren’t great for a “follower” on angelist, or for any investor in any early-stage fund that gets deal-by-deal carry.
I think Nick is going to have some specific thoughts and reactions to this, so I look forward to continuing the discussion!
I continue to be on a kick towards better and more systematic decision-making.
One exercise I’ve tried is to codify my mental decision-tree for early stage investing. Essentially, it is the internal dialog I tend to have with myself when evaluating companies. But by charting it out, it helped me to be more explicit about what attributes I’m looking for, and how my opinion about different attributes feeds into an ultimate decision.
Rather than replicate the entire decision three, I thought I’d share just a flavor. The first high-level questions I ask are:
1. Is this an awesome founder?
2. Is this a market I want to have an investment in? This incorporates both the total size potential of the opportunity and the attractiveness of the market itself.
3. Is there strong founder market fit? Is this an authentic idea, and does the capability of the founding team map well towards the needs of the market in the early stages of the business?
Here is the tree with some commentary on the different combinations below.
So, a couple combinations:
- If 1 = yes, 2 = no, it’s usually a no. I’m generally a believer that markets beat teams. But that said, I’m actually typically very open minded about what markets I’d like to have an investment in.
- If 1=yes, 2=yes, and 3=no, I think it’s difficult to invest pre-product and before some evidence of product/market ft. I think founder/market fit is incredibly important early on. We have invested in some companies of this profile where we loved the founder but our perception was that founder/market fit wasn’t that strong (ThredUp is a good example). But in those cases, very early metrics went a long way towards mitigating the risk.
- If 1=YES YES YES then we might still move forward early on. Basically, this is the rare (0.01% of less) exception where you feel like you have HAVE to back a truly extraordinary founder. In the case where this extraordinary founder is pursuing an unattractive market, we need to ask ourselves, is this founder wrong about the market, or could we be wrong?. We still tend to have a bias that markets tend to win, but we will dig to figure out if we aren’t missing something. If the market is attractive and there just isn’t great founder/market fit, we will be open minded as well. There are just some rare entrepreneurs that you want to be in business with in almost any circumstance. But it’s definitely a very small minority. Jack Dorsey comes to mind here with Square. Not exactly founder/market fit, but it didn’t really matter.
- Sub-point: Actually, in a way, Jack did have founder/market fit with square because of what the company required. His personal brand and influence in the technology industry enabled him to raise large amounts of capital with relatively little traction and get to the very top of all major financial institutions, both pretty important advantages in starting a payments company of this sort.
- If 1 = Yes, 2 = yes, 3=yes, then I’d seriously consider investing pre-launch. This isn’t a formula by any means, but I find that when founders I really like are going after an authentic idea in a space I like, I’m much more willing to jump in pre-product. This describes quite a few of our portfolio companies actually. Not all will work out, but in many cases, I feel perfectly fine about having taken the plunge.
- If 1 = No, 2 = yes, 3=yes, then I’d need to see some evidence of product market fit or traction. Even then, it’s really hard to get excited about an investment unless I’m really excited about the people leading the company. But I am also congizent that how one comes off in a fundraise is not always perfectly correlated with their capabilities – and there is something about delivering results that makes you think twice about your first impressions of people. If the reason that 1=No is because of any fear of integrity or something similar, then it is really a no-go. But if it’s more of a question about capabilities, then it’s important to stay open-minded. It’s easy to underestimate people.
Of course, there is a lot more going through my mind, plus some really important “softer” considerations that are beautifully articulated by my old colleague Bijan here. The point of this post isn’t to say that this is the right way to do things or to say that I follow this approach strictly. But I did think it would be interesting for founders to see an attempt at simplifying what is usually the black box of an investor’s mind.
I’ve been hearing a similar lament recently from founders of seed stage companies. It goes something like this:
“I thought seed funds would be faster at getting to a decision than large funds. But I’m finding these guys are actually pretty slow, and do so much work vs. some large funds that make decisions surprisingly quickly.”
I’ve been thinking a lot about deal selection in Venture Capital, so this meme is particularly interesting to me. Here’s what I make of it.
Many seed funds are getting slower in decision-making. This is good in some ways, but bad in some ways. Here’s why I think this is happening
- More seed funds are realizing that they need to have more concentrated portfolios to generate good returns. In other words, these funds need to be pickier, choose their spots better, and say “no” more. By definition, this means that they will work harder to build conviction around an opportunity and move more slowly. This is good because when you get a “yes” from a seed fund, you are more likely to have a partner who has thought deeply about your business and be in a better position to help. In theory, this could turn a 3-7 day process into a 7-15 day process. Still reasonably fast in the scheme of things.
- Many seed funds are growing up, which is leading to more distractions and more reasons to be slower and more pessimistic. Many of these investors have larger portfolios now, which is a major tax on time. These investors have come face to face with more companies that have failed or are struggling, especially in the wake of the series A crunch, so the problems with early stage companies are more salient than ever. This leads more seed funds to approach investments with a defensive mentality vs an offensive one. In early stage investing, offense wins.
- Many seed funds are expanding their teams. What used to be a 1-person show now involves multiple investors, and potentially multiple levels of professionals. These firms are working through how to best collaborate as a team and drive to efficient decisions quickly. But in the meantime, this additional set of people adds complexity and friction to the decision-making process.
- Many seed investors don’t lead or have limited experience leading. What they’ve found is that it’s reasonably effective to hang-around-the-hoop as a deal is coming together, and pounce once a high-quality syndicate seems to be forming. This leads these investors to not drive aggressively towards a decision, rather keep a conversation going slowly to maintain optionality if/when someone really good does decide to lead.
On the flip side, large funds move faster than many would think. It doesn’t always seem that way, because just like seed investors, large funds will “hang around the hoop” on many of the companies that they like but are not chasing aggressively. But they can move pretty quickly driven by a few reasons.
- Some partners at larger funds just have tons of experience to draw from and enough political capital in their firms to make stuff happen quickly. I was having breakfast today with a partner at a large, top-tier venture fund, and he remarked that one of his colleagues, who is over 60, is in the “prime of his career”. And what impressed him most was the speed and decisiveness of his thinking. If you are talking to the right partner and your company is right in their power alley, you could have an extremely fast process
- The level of competitiveness among larger funds is ridiculously intense and has only been getting more so. This is probably less true at the seed stage, but that intensity has spilled over into all segments where these firms invest. This increased competitiveness has forced these funds to figure out how to be agile. I find that the “best” funds often are also the ones that drive fastest to a decision, and compress a fair bit of work into a short amount of time if they are really serious about an investment. I’ve often heard entrepreneurs remark positively about the speed of great funds. I’ve never heard an entrepreneur remark positively about the speed of mediocre funds.
- Some funds continue to do high-velocity, passive seed investments. These investments have the signaling risk that has been talked about ad-nauseam. These investments also have a separate process, by which one or two partners can decide to pull the trigger, without necessarily getting full partnership buy-in. In this case, I see speed as a negative signal, not a positive one.
Overall, I’m a believer that VCs can and should make careful but fast decisions. You can do a lot of reference calls and market due diligence in 3-7 days. The trick is to make the decision up-front to clear one’s schedule and do the work, with the goal of driving to an independent decision. In an ideal world, this allows everyone to win. Investors make good decisions. Entrepreneurs get investors that have well informed opinions and high conviction around their companies. And this can get done in a reasonable amount of time so founders can keep their foot on the gas and keep building their companies.
I’m often asked to share advice about raising the first few rounds of capital for a young startup. I’m actually on my way to an accelerator right now where I was asked to lead a few sessions on this topic.
There is a ton out there on the internet about the tactics of raising money. Paul Graham wrote a really comprehensive essay a few weeks ago that mirrors most of the advice I tend to give. Read it here.
But my over-arching observation is that fundraising is extremely unpredictable.
This is pretty puzzling to most people. One would think that fundraising could be a pretty rational process. Pick the 5-8 firms that seem to be the best fit, get a good introduction, focus on the 2-4 that really dig in, and go from there.
I’ve even seen series A firms give this general advice to their portfolio companies. ”Run a small process” and see what happens. The thought is you can always talk to more folks later.
From my perspective, this is typically pretty bad advice. The conversion funnel above is accurate, but only mid-way through your funnel. The top of the funnel needs to be much larger to have an effective fundraise.
This is because there are so many reasons why VC’s can pass on an investment, and it’s pretty impossible to really account for all the variables prospectively. Here are some examples:
- No experience in the space
- Bad experience in the space
- Partner had a bad experience in the space
- No comparable companies have been acquired recently
- No comparable companies have gone public recently
- Comparable company had an IPO that tanked
- Consumer is out of favor
- Enterprise is out of favor
- Too capital efficient
- Too capital intensive
- Great early traction, but I don’t see how it gets big
- Big idea, but you should start with something smaller to prove traction
- Great traction, but engagement is bad
- Engagement is great, but it doesn’t matter without traction
- The team is unknown
- The team is too well known
- Partner just did a deal
- Partner is dealing with tons of issues with their portfolio
- Partner has personal issues
- Partner is about to join another firm
- Annual meeting prep is taking too much time
- Fundraising is taking too much time
- There is some wierd conflict that is impossible to uncover ahead of time
- Wife thinks the idea is bad
- etc etc etc
This is just a subset. But there are many more. Maybe when a company is further along, the realistic set of investors is smaller, and a relationship has been built over time that allows for a narrow scope. But early on, in the seed, Series A, and even the Series B round, I think it behooves founders to assume a 50% factor of unpredictability, and double the number of groups they plan to talk to. Then as Paul Graham says, run a breadth-first search and parallel process. Ideally, you’d like to get to a point where you have 6-8 potential leads really digging in mid-way through your funnel. So get there, you need to have 2X the number of really quality conversations in the beginning, which probably means that you need another 1.5X the number of potential investors before a bunch of firms get disqualified for one reason or another.
There may the concern that your round seems “shopped” and can get stale if everyone knows you’ve been raising money for a while. This is the reason to do things simultaneously rather than sequentially. It’s very natural to think “I’ll focus time on my 4 best prospects, then if those don’t look good I’ll move on to my next 4, then so on. Don’t do this. You have to parallel process.
I now that sounds like a lot. It is – and you will feel like a maniac during this process. But if you are honest with yourself about how investors are receiving your story and triage the funnel appropriately, you can accurately and quickly hone it down to the smaller subset of serious prospects pretty quickly. But it is almost always beneficial to put in the shoe leather to do this because I guarantee that one of those serious prospects will be a group you didn’t expect to be in the mix when you started fundraising.