23 5 / 2018
Are you an investment or an option?
Early stage fundraising is an interesting beast, because there are all kinds of reasons why VCs invest at this stage.
Some background:
There are essentially two camps of investors: A) those with a concentrated portfolio and B) those with a large, diverse portfolio.
Diversified portfolios:
Funds like YC, 500 Startups, and Techstars, etc all have diverse portfolio strategies. They invest in lots of companies. Say on 100 companies in a given portfolio, there may be a lot of losses, but a portfolio of this size only needs couple of outsized winners to not only make up for the losses but also return great multiples for the overall fund. Because downside risk is mitigated by investing in a lot of companies, funds that utilize diverse portfolio strategies often have consistent results fund after fund – there isn’t as much variation across funds as you might see with a concentrated portfolio.
Concentrated portfolios:
Funds like Sequoia, A16Z, Benchmark, etc all have concentrated portfolio strategies. The invest in few companies, so there’s little room for error. Of course, any outsized winners will make the overall fund really really fantastic, because there are not that many losses to compensate for. These funds tend to have high variability across the industry. Certainly there are top tier funds who are able to consistently return solid multiples fund after fund, but there are also many many more funds who can’t even return 1x, because the variability in this model is very high. In other words, this model, compared to the diversified portfolio model is much higher risk and higher reward (for better or worse).
A couple of thoughts:
1) Some funds invest early to capture more ownership. Others want to buy an option.
This is a point I didn’t fully understand until I became an investor. Because large Sand Hill VCs largely make their money on a concentrated portfolio strategy, they need to really really have strong confidence that their investments are going to work out.
By the time startups get to the series B level, it’s fairly clear whether a business is working and printing money. Hot companies are highly sought after. It’s very competitive to try to win a hot series B deal, because every investor is chasing the same company. As a result, there are a lot of large funds that will essentially buy a much smaller option at the series A level to be able to get potential access to a hot series B deal. If some of those series A deals don’t turn out to be excellent businesses, then it’s just a small amount of money relative to the fund that didn’t work out. But, if there is a hot deal in that group of series A deals, then it provides access to pour in tons of money and make a lot of money at the series B level. Funds that make their money on later stage deals and who only invest at the earlier stages to buy an option don’t care so much about valuation. They are only trying to buy a seat at the table to invest a lot in your company later when it’s clear you’re a winner – they are not trying to buy any ownership now.
In the past couple of years, series B deals became way too hot and competitive. So a number of big funds have come down to invest at the series A to increase their optionality on capturing winners at the series B level. Now that seed and series A are starting to bleed together, you are now seeing some large Sand Hill VCs do seed deals again.
In contrast, microfunds (small funds) largely only invest at the earliest stages (seed stages) because their money only goes far at these stages. For most of these folks, they are trying to capture as much ownership at the earliest levels, because they do not have more capital to invest at the later stages.
2) In general, microfunds are more valuation sensitive than bigger funds
As a result, because microfunds are trying to capture most of their ownership in a company at the earliest stages, they are going to be much more valuation sensitive than a fund that is just trying to buy an option to invest in you in later rounds. I’ve noticed that this can be a difference of as much as 2-3x on valuation caps!
In general, funds that do fewer (or no) follow on checks will be more valuation sensitive, because they really only have one or two chances to buy as much of your company as possible.
Obviously, from an entrepreneur’s perspective, valuation is an important consideration, but it’s not the only one. Even though larger funds will tend to be willing to invest at higher valuations, there is also more signaling risk that comes with an investment that is perceived as an option-investment. I.e. if a fund invests in your company, and they typically make their money on series B rounds, and they don’t invest in your series B round, then many investors will wonder what is wrong w/ the company. In contrast, no one cares if a small microfund doesn’t follow on, because they don’t have the capital to do so and are not known for doing so.
So hopefully this provides some context as to how investors of big and small funds are thinking about your valuation. But ultimately, in the end, valuation is really a matter of supply and demand as I’ve written about before. And if no one is demanding your round, then it’s a moot point. And if everyone wants in, no matter how valuation-sensitive the microfund, they may get swept up in clamoring to invest in your round.
Fundraising is a nebulous process that I aim to make more transparent. To learn more secrets and tips, subscribe to my newsletter.
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