Not every fundraise is easy and sometimes you wind up having to take a higher quantity of smaller checks than you’d like. On the other hand, some people try and pad the cap table with a bunch of big names or industry vets, even if their check size is small, just to build the network. They have an idealized vision of how easy it’s going to be to utilize everyone once the business gets going.
The reality is that the last thing most founders will have time for is writing up investor updates. They’ve got tons of other things that seem more pressing and the last thing they need is a bunch of scrutiny and questions from people who wrote small checks. Not only that, sending out important information in e-mails to lots of people increases the possibility that confidential information gets out.
Still, I think it’s worthwhile to keep all of your investors in the loop for a lot of non-obvious reasons. Maybe it’s an e-mail or maybe it’s just a quarterly phone call that everyone on the cap table can dial-in to. Whatever it is, here are the benefits of keeping everyone—no matter how small, in the loop:
1) When you don’t hear from a founder, it makes an investor feel unappreciated.
Small investors are people, too—and there’s no upside to having a bunch of your cap table feel negatively in any way about the company. These people all have some expertise and experience, and by never reaching out to them for anything, it can feel like you don’t think they have anything to contribute besides money. No one’s saying you have to throw someone a parade every month for writing a $10k check—but sometimes a little nod of involvement goes a long way, especially given that statistically, most startup outcomes aren’t that great. Maybe one day you’ll be able to write everyone a big check at the end, but until then, taking a “That’s what the money is for!” Madmen approach isn’t a good bed, especially if you ever plan on doing another startup.
2) There’s a Butterfly Effect to not being top of mind and not having info on a company.
Investors talk to other investors, to media and to talent, and it’s great when they can share why they’re excited, in a general sense, about your company—or that they’re excited at all. When you have no information about what’s being accomplished at a company, you’re not got to share anything, and people are going to wonder whether not mentioning you is a signal that things aren’t going well. That’s going to make fundraising and hiring even a tiny nudge harder than it needs to be, and certainly costing you more time than the e-mail update would take.
3) Small investors are more aligned.
The way preference works, small investors who just do early rounds are actually much more aligned with founders than later stage VCs who are looking to pour more in to get a bigger outcome. They may not have as much experience as your larger VCs, but their preference is invaluable if you’re looking for a wide spectrum of feedback. Is it worth going for your Series D or thinking about getting to break-even now? Your seed investors might have a different take and diversity of perspective always makes for better decisions.
4) Sometimes, they can surprise you.
People can have pretty random networks, especially around hiring. By keeping your needs top of mind with regular updates, you might get a lot more out of your early investors than you expected in terms of introductions. Recruiting is one of those things where getting a note that a particular hire has been difficult is much more effective than just posting a job into the ether.
5) You actually might need them.
Setting a precedent for updating your investors should start early—early enough where you might actually need to reach out to them in a pinch. Sometimes, rounds fall apart, and if the last thing they heard was that things were going great, then all of the sudden you’re doing a bridge to make payroll, the likelihood they’re going to be excited to write a check will be pretty small. Even in later rounds, you never know what money they might be connected to and they might be able to hook you up with some random family office that you never heard of to help close a difficult raise.
If nothing else, I also just think it’s a sign of respect. Someone gave you their money (or their investors’ money) and I think besides your hard work, the least you can do for them is just let them know how its doing. They might not have a right to that information based on the legal docs, but it’s just the right thing to do by someone—and it also keeps you in the mindset of being responsible for people’s capital when you’re actually interacting with them. As we’ve seen over the past few years, it wouldn’t hurt our industry to make corporate responsibility a little higher priority.
Using the proliferation of newly GPS-enabled mobile devices to enable taxi hailing and beat out stagnant incumbent providers was always going to be a big win for consumers. It provided a better service than existing cabs were going to be able to do for at least several years—cutting out lots of unnecessary overhead in the system.
Yet, it shouldn’t have been an outcome as big as it was. Had it been built differently, it would have and could have been a less valuable, but better company and that should have been fine with everyone.
It could have championed fair pay and a national minimum wage—incorporating it into its brand. Would that have cut into its growth? Maybe—but in the long run it would have created happier drivers and a base of more loyal customers feeling better about their brand.
It could have made HR, diversity and employee experience a priority from the start. There’s no reason why a culture needs to fall apart at the seams in a hypergrowth startup. The damage done to the company’s brand do to internal scandals and mismanagement was an economic reality that was the result of really short term thinking.
It could have made accountability around driver behavior more of a priority, but instead it pulled out of cities that required higher levels of screening.
Instead, we got one of the most lucrative startup investments of all time from a company built off of a legion of drivers unable to make a living wage after expenses, without benefits, and not even classified as employees even when they work for the company for full time hours.
But, the VCs did their job—as designed. It’s a tricky subject, because VCs only exist to make money—not really to oversee the running of these companies as beneficial to the world, unless it gets so bad that it affects the economic outcome.
Not only that, we have other portfolio companies to worry about. So, the extent to which any one VC would be openly critical of another’s portfolio company or the investors behind it is limited by the fact that you’ve got other companies that need their late round money. I have a portfolio where 50% of the investments have founders that come from diverse backgrounds—and yes, I want them to get money from all of the still-active funds on Uber’s cap table that benefitted from the IPO.
So, the extent to which any one fund will call out the other funds on the cap table that sat quietly on the sidelines for three years after Sarah Lacy called the company out in 2014 is going to be somewhat limited. The company’s misogynist culture was well documented before Susan Fowler tipped the scales in 2017 and I don’t recall a single investor saying anything about it up to that point.
What if the early investors—some of whom had decades long reputations for being on the forefront of social issues—had made all of their companies sign diversity pledges and been active and public from day one instead of quiet for seven years? Perhaps I’m being too cynical, but when the problems get this big, I think I’d rather hear “I could have done more” than “I tried”.
Everyone is documenting through e-mail screenshots how they invested or didn’t invest in the early days of Uber—showing off their access to the early deal as a badge of honor, but where are the screenshots of the 2014, 2015 e-mails to the team showing their concern about the journalist harassment issues, driver earnings, or privacy concerns?
The too little too late around Ubers culture created a missed opportunity to build an empowering industry leader on social issues—because, at its core, matching drivers to more work is a good thing. Everyone could have done more and until we acknowledge that, this will keep happening.
What if all of the early investors in Uber had, as part of their criteria, a vetting of how serious the company was at creating a healthy culture and a company that would be an impact trendsetter—either because they believed that was the best way to create sustainable economic benefits, or because that was required of them by their investors?
That’s who really should be driving this—because that’s who the bosses of the VCs are. If all of these foundations and endowments that fund VCs start asking about what their social impact screens are, because they want to make sure their money is improving the world, VCs will start behaving differently.
What if the kind of portfolio diversity, became a sought out feature that LPs look for and not just a nice to have—not just from diverse managers, but from everyone? How many LPs are asking the top tier funds what they’re doing to enforce and oversee values and culture from a board perspective?
Does any fund that invested in Uber fear not being able to raise their next fund because their underlying companies might not perform well around these other criteria? Nope.
Until the underlying money starts shifting, we’re going to see more of the same—waiting until the problems get really bad, only calling things out when the cats are out of the bad and it’s politically safe to do so, and championing business models that come at the expense of workers and economic equality.
When I was growing up, I watched Seinfeld religiously—literally every single Thursday night from the premiere to the end without missing a single one. Not only did I really love the show, but I was that committed to it because of the reinforcement I experienced by being part of a community that also watched when I did. The next day, I couldn’t wait to see my classmates and repeat whatever the key line from the episode was. It was almost more enjoyable to laugh about the episode the next day with friends than it was to watch it on my own the night before.
The other nice thing about live, scheduled TV—something I’ve come to appreciate now—is that sometimes there was nothing on worth watching. I would flip through the channels and if I didn’t find anything to watch, I would turn it off.
When’s the last time you hit up an on-demand streaming service, came up empty, and decided to do something else instead?
What else did I do? I might have read a book, called up a friend, or went outside for a walk—all things that as I evaluate my habits today are probably more productive than watching Iron Man for the 8th time or clip compilations of West Wing.
The behavior is even more pronounced with kids today. They know that Frozen is available to watch anytime the mood strikes them. They can ask Alexa to play their favorite song.
They never have to sit through anything they don’t initially like.
Some of the most enriching and enjoyable activities I experience in my life now are scheduled and they involve other real live people… in person.
I’ve been playing on the same softball team for almost 14 years. We started playing in our mid-late 20’s as a way to meet new people. Now, as the number of kids and significant others rises on our team, it’s our way to stay connected with our friends—it’s a thing we make time for to keep people in our lives.
I’ve abandoned going to the gym anytime I want to work out by myself in favor of group classes at Conbody—where I see a lot of the same people on a regular basis and trainers that I’ve become friendly with. Interestingly, social media enhances my relationship with these real life people—it gives me a window into their life outside of the gym so I can see who really loves their dog or who likes photography. This makes my real life interaction with them more substantive. Making time for Conbody classes in my schedule is not only a great motivator, but it provides important accountability. I’m going to hear it if I don’t show up for a week.
Meditation is a similar experience to working out—anyone can find a video or an app to watch, but the experience lacks for the kind of community that is built up when you gather live humans at a particular time to experience the same moment. For a lot of people, getting stuck in your own head for too long isn’t a positive experience. It might feel lonely or the whole thing might be super intimidating.
That’s why I got excited when my friend Stephen Sokoler told me he was building Journey Meditation. Journey is a live, guided meditation experience and a community of participants. Friendly teachers bring their own style and experience to the session and it’s something you make time to participate in on a particular schedule.
If you’ve ever wanted to meditate, were curious about it, or tried other methods that didn’t stick—consider joining a community where there are no spoilers, because everyone is experiencing it at the same time. Meditation is a practice of calming focus—where you exercise your ability to narrow the beam of sensory overload. Technology especially throws way too many things at you at once, and the ability to let what doesn’t matter or what you find distracting from your mission pass around you is a useful defense mechanism for today’s world.
Over the years, we’ve seen a revolution in how labor is supplied because of technology.
First, we saw simple outsourcing—taking one person doing one job and moving the job over to a cheaper person in another geography. That only worked because you could connect everyone via technology—routing phonecalls, e-mails, design documents, etc. halfway across the world so that working with someone in India was as seamless as if they were on another floor in your building.
As emerging markets start to achieve more equality with the rest of the world in labor cost, that arbitrage starts to go away. The best people start to charge more, or they simply move to the US, and the time and efficiency cost of working with lower skilled labor starts to not be worth it anymore.
To gain next level efficiencies, we worked on breaking up the tasks that go into a job. If you have two people, a skilled and a less skilled person, if you could microchunk the tasks requiring less skill, move them over to the less skilled person, and make the more skilled person not only more productive but probably happier.
That gave rise to platforms like Amazon Mechanical Turk on the lower side of the skill spectrum or marketplaces like Upwork and Taskrabbit where you want someone a bit better, but the tasks are still pretty straightforward. In all of these cases, workers are working as individual contributors—while one person might be managing multiple people, the workers are not connected to each other as a feature of the platform.
Uber and Lyft largely work the same way. Driving is obviously a more complex task than identifying whether an image has a puppy in it, but lots of people can do it, and as long as the driver doesn’t crash or kill you on the way to the movie theater, you’re pretty much ok getting anyone.
If you needed anything done by someone not in your employ for anything more complicated, you are basically looking at some kind of agency work—because more complicated work generally requires teams of people working together. For the longest time, teamwork was inefficient—requiring lots of overhead in planning and setup to get a team with a variety of skills all on the same page and working together on a complex project.
Every new job or set of tasks was treated as unique and constructing teams was viewed as a challenge—so agency work from McKinsey to IDEO, or your corporate law firm, was very expensive.
That’s starting to change as companies realize that for many aspects of teamwork, 80% of most work frankly isn’t that hard and looks somewhat similar to a lot of the other work. You could build semi-rigid operating plans that cover most of the jobs that come through.
Take Block Renovation. Block takes the stressful and sometimes disastrous process of remodeling and makes it simple. Instead of going out into the market and getting a contractor, which is essentially an agency, and an architect (another agency), it focuses on the 80% of bathrooms where all you’re doing is just taking out old stuff and putting in new stuff. They preselect the inventory of fixtures, create standardized pricing, and vet for the basics of contractor reliability—has references, is licensed, etc. The bar is lower here because the jobs are simpler—and the worst aspect of having work done, the price negotiation, is done upfront.
They’re eliminating the work that a customer needs to do in a marketplace—the sorting, vetting and labor management—and turning it into a service with something of a guarantee, which puts the marketplace aspects on the backend under the management of the company.
In short, they’re offering Certainty on Demand. If your job fits their criteria, they’re selling the certainty that at the end of X time, you will definitely have a new bathroom. That’s much easier to do when you’ve taken apart the process and put it back together again in a way that optimizes for getting to the finish line with certainty over and over again at scale.
Investors took notice and gave the company over $4mm in its seed round.
It’s a model that is starting to get repeated in the market. Bench looked at the process of bookkeeping, realized that 80% of the clients had the same simple, straightforward set of needs, and built in automation to service them more efficiently and less expensively than an accounting firm that treats every new client’s set of needs from scratch. Noken replaces a traditional travel agency quite effectively for 80% of the trips in the market where the person is going to a new country wants to see all the stuff that everyone agrees you should probably see. At the same time, they figure out which customer decisions are major consumer satisfaction leverage points—like the quality of the hotel. Just a handful of choice can make an automated process appeal to the vast majority of the market. These platforms enable automation to solve higher order problems effectively, driving above market revenues for lower cost tasks. Consumers are thrilled with the experience, which often seems like “magic” that they are being served so well on such “low” costs compared to full service agencies. Axiom does this for law—providing “the same” legal service for way cheaper because it has filtered which tasks it makes sense for it to do and has more throughput than a traditional legal firm.
Wethos is now doing this for a variety of higher order labor outsourcing—like website design, PR campaigns, or social media marketing. Creating a new website isn’t a job for just one person—someone needs to think about the site copy, someone else needs to do the visual design, and someone else needs to do the front end coding necessarily to implement that design.
There are a multitude of higher order projects that fit this same pattern—too complex for just one person, but 80% similarly structured to a million other similar projects that came before it. Instead of paying for a full on agency with all its custom overhead, Wethos can quickly spin up a group of people from its talent network, give them a team playbook for a straightforward product, and help you accomplish your goal for a serious discount to a traditional agency. The full potential of a creative agency is something you wouldn’t have taken advantage of with a project like this—much in the same way that Block Renovation doesn’t need to hire an architect for every new bathroom they give a facelift to,
The exciting aspect of these startups is that they can turn on revenues from day one—they often experience solid margins from the beginning, and those margins improve over time as they expand the number of playbooks they research and implement. Wethos will add more verticals of work. Noken will add more countries. Block will do kitchens one day and the list goes on.
Labor will find itself able to complete more task, more appropriately funneled to the right level of work, and business will get more efficient, thanks not only to technology but to thoughtful process design.
I'm a bit tired of tweeting, donating, protesting, etc. to end gun violence--so I'll take a different tact in the wake of the Christchurch shooting.
If you're an investor, employee, or just user of a large media distribution network, please ask the hard questions about the responsibilities of those platforms to prevent the spread of hate and violence--again and again until these platforms take their role seriously.
It's just not acceptable that violent people see online platforms as a viable channel for their hate and that, after all this time, the "smartest innovators in the world" still seem at a loss as to how to stop it. How many ways have we heard Youtube tell us that hundreds of hours of video gets uploaded to Youtube every second--and they make it seem super easy, but yet they can't get out in front of people trying to share a mass shooting livestream over and over again? Isn't building an infrastructure to ingest all of those videos with the kind of uptime it has pretty darn hard? Is it really possible that your $500k/year engineers can somehow build the world's best infrastructure but can't be held accountable to figure out how to put a safety on the damn thing when someone wants to use it as a weapon?
This is what happens when your tech largely gets built by people at the top of the social food chain--it escapes their imaginations that someone might want to use it to hurt someone else because they're so rarely the victim of anything.
Diversity isn't about numbers--it's about changing the way we design our products to better our society.
Across the world, various economic development organizations, government agencies, and non-profits are putting in admirable and well-intentioned efforts to develop startup ecosystems. They’re building campuses, districts, buildings, spaces, as well as running new educational efforts and contests—basically anything they can think of to foster the growth of new and innovative companies.
One thing they’re spending very little time on could wind up being the reason why all of these efforts dry up. Very little time and effort is spent helping professional, full time investors raise capital for venture funds. Everyone is excited when a new company gets funded in their ecosystem, but no one spends much time thinking about where the money comes from to fund that deal.
To care about this issue, you have to believe one thing—that the presence of full time, professional investors in an ecosystem catalyzes funding rounds better than a collection of part time angels, accelerators, and/or government entities that usually don’t lead deals. Accelerators can be great, but they’re not giving companies enough money to achieve the kind of escape velocity needed to get on the radar of national Series A firms that will invest anywhere. At some point, a real seed round needs to get raised—and it needs to get led by someone. Angels will often sit on the sidelines until someone comes in to set the terms and write a bigger check.
Take the example of goTenna, a thriving communications hardware startup located in Downtown Brooklyn that employees almost 50 people. I backed that company in 2013 when it was basically a table top science project, but the key was a series of connections that could have only been possible as a full time investor. I first met Daniela Perdomo, goTenna’s founder, at SXSW. So, number one is that I needed to be at least engaged enough as an investor to be out there attending gatherings of innovative people.
Second, I sought her out at that conference because I saw on SXSW’s intranet that she had listed NYC Resistor, a hardware hacking space and collective, on her bio. Resistor is a bit under the radar as a very cool community—and so being associated with it was a signal that I could have only known about if, again, I spent all of my efforts as a seed investor turning over every rock looking for opportunity. This isn’t the kind of thing your average high net worth individual who occasionally does a deal would know about.
This company would have had a much harder time getting a seed round together had it not been for the presence of professional seed fund investors—and my seed fund wouldn’t exist had it not been for the 50 different individuals and entities who participated in my first fund.
Yet, do you know how many of those investors came through intros made by those who have a strategic economic development interest in fostering the NYC ecosystem?
Not a one—and through conversations with other seed funds I know, this is pretty widespread. A lot of these strategic entities have boards that are filled with some of the most successful high net worth individuals, family offices, foundations, etc. but the connections are not being made to support the funds that are supposed to be funding all these local startups.
I was talking with someone who worked for one of these entities recently and they gave me some insight as to why. This person told me that their group was worried about these folks “getting hit up all the time”.
This is exactly the wrong way to think about the economic opportunity presented by innovation. Innovation isn’t a charity—it’s a ticket to a very interesting and exciting future.
Wealthy people trade that wealth for interestingness—and the opportunity to economically participate in the upside of your local startup ecosystem is super interesting to many people. Not only that—these people are doing all sorts of different kinds of deals—and you don’t do deals without deal flow. No one has to say yes, but rather than this seeming like a bother, anyone with an investment mindset is going to welcome the opportunity to roll up their sleeves and dive into thinking about an opportunity.
Not only that, but for many in the real estate world, their economic upside is already tied to innovation. The growth of the local NYC startup community has been a huge moneymaker for many of those folks and can continue to be if the ecosystem continues to roll.
This won’t happen if all the seed funds become institutional, get larger, and stop writing the kinds of small checks that turn science projects into 50 person companies.
The other reason why development related entities that support startups should be making these introductions is because of some of the indirect roles VCs can play in the startup ecosystem. By being full time in the community—they can make connections to help market various programs and opportunities. They can help filter who these organizations should be focusing their time in supporting. They can also help generate interest across different types of wealth through their history of success. There’s no better way to get a room full of people who made money in real estate, manufacturing, or natural resources to care about tech startups than to have a professional investor up in front of a room sharing their approach, their wins and translating the enormous amounts of individual deal risk they appear to be taking into a sensible investment philosophy others can buy into.
Raising for a seed fund is exceptionally difficult. Institutions typically don’t participate until you’ve already got a few funds under your belt, and even when they do, their average check size is often too large for what you’re trying to put to work. That leaves seed funds out trying to gather a random mix of high net worth individuals and family offices, which is a bit like trying to find a needle in a haystack in a dark room with one hand tied behind your back.
It’s not exactly like anyone puts “willing venture fund investor” on their LinkedIn profile.
If you really want a solid startup ecosystem, you need multiple seed funds all coming at the community from different perspectives both funding a wide variety of companies but also working collaboratively together. It’s not just about having one dedicated fund—you need many funds coming together in a marketplace of ideas.
No one is asking the Mayor to tweet their fund prospectus, but hosting informal meetings with members of community economic development boards, looking into small baskets of endowment funding that can go into local early stage funds, and just generally being willing to help because they understand that we can’t fund your local startups unless someone funds us would be enormously helpful.
Some VCs peel off of other funds to start their own and they have the benefit of a track record from their previous firm to show. Obviously, that’s ideal, but that’s not where everyone starts.
If you’re lacking for track record as a firm, here’s three exercises you should walk through to help turn your pitch and due diligence meetings from guesswork into something more substantive.
The Fantasy Cash Flow Model
When I was an analyst at the General Motors pension fund, investing in VC funds, I had to build a model of how I thought they would perform. It started out with initial investment size, pricing, and outcome behavior for each deal and then it made a prediction around the distribution of outcomes.
It’s easy to say you’re going to be a 3x fund, but how does the math actually get you there. If you’re not actually modeling this out with a spreadsheet, I don’t know how you can look an LP in the face and say this. Build up your model of what you think the individual financial outcomes will be over time—layer that on with follow-on decisions, fees, carry, etc. I think the results will surprise you how hard it is to be successful.
A Time and Attention Model
How much time will you be spending on each portfolio company? Taking board seats? For how long? How long is your partner meeting going to be? Will you be going to the gym at all? Spending any time with family? How much do you sleep?
You give money away for a living—and so you’re going to get overloaded with requests. Once you do distribute the capital, you’re giving it to companies that will need a lot of help. How will you provide it across 30 investments? Will you have analysts? Partners? Will that increase the work?
Figuring out how you’ll spend your fully loaded time is something any LP will want to understand in order to know if you can handle going from just angel investing or doing whatever you were doing before to running a portfolio full time. Here’s what my model said.
The Backtesting Model
In the public markets world, when you start a new fund, you backtest it. You take your investment model and run it against the past to see if it would have worked. Want to only invest in diverse boards? Only companies with a certain contribution margin? Maybe you only care about growth. Whatever it is, could you have run that model successfully over the past five years? Not all prior performance is a guarantee—but it would be nice to know if this would have worked in the past.
I ask the same of new managers. Had you actually had your fund in the four years prior to today—which deals would you have legitimately been able to do? This is actually easily referenced.
For example, let’s say I had a more national fund. Because I had previously met Jack Dorsey through the Union Square Ventures network, in 2009 I was able to grab coffee with him before he launched Square. He demoed the product to me and I wound up being dollars #476 and #477 to be swiped on the very first Square prototype. I was blown away.
Had I had a fund, I could have said, “Hey, let me invest in this…” and maybe I could have squeezed $25k into the round. It’s at least plausible—versus being someone who had never met him at all who said they’re starting a fintech fund and Square is the kind of thing they would have invested in. It wasn’t likely that a fund who had no prior connection to him at all would have gotten in.
If you’re looking for more tips and advice on starting out as a first time fund manager, you should check out the webinar I’m putting on with Carta next week covering all the basics and stupid questions that aren’t so stupid.
You hear this from VC’s a lot: “We need to own X% of your company to make our returns.”
They back it up with sensible math—owning 20% of a billion dollar outcome returns a $200mm VC fund, and, of course, you’re trying to at least return the fund. So, no one really questions the ownership model.
Yet, when you buy shares of Apple or Facebook, you don’t even think about what percent of the company you own. How then, do you expect to make money when you’re buying on the public market?
Everyone knows the answer to that.
“Buy low, sell high.”
Seems like that should translate over to the venture world, too. After all, all we’re really doing as VCs is buying shares, aren’t we? How come VCs don’t think about it that way?
There are two reasons. First, price discipline doesn’t work in overly competitive markets. When there are too many funds in a market, keeping your entry price reasonable is going to get you shut out of a lot of deals. If you’re a first check lead VC for pre-seed rounds in New York, you can keep your head on when it comes to price, but in SF if you’re trying to fund companies from YC, good luck with your price discipline.
Second, you can only get so many dollars into “cheap” seed shares. If you raise $100mm, you can’t put it all to work upfront because the rounds aren’t big enough—so you have to raise more capital. Dilution becomes the enemy—and you tell your investors that you don’t want to own a smaller and smaller percent of your “best” companies. You need to write bigger checks to maintain ownership.
What you’re not saying to your investors is that you’re buying more and more expensive shares at a lower return.
I guess that doesn’t have the same ring to it.
Funds that lead Series A, B, and C rounds have serious capital needs. They’re not only leading larger rounds, but may need to bridge companies they’ve otherwise made large investments into that have higher burn rates. Sometimes, you’re the only one around the table who wants to do a Series B and that requires real cash.
That’s not what seed funds are doing. Seed funds specialize in doing a lot of work for not a lot of money—and I suspect that’s why they’re getting larger. We do the work of sorting through the pitch decks of everyone and their mother, finding the diamonds in the rough, helping them turn an idea into something that looks like a company—and we do it for a fraction of the management fees of our later stage counterparts.
The incentive to want a larger fund is real—more staff, better office, better salaries—but the investment strategy really doesn’t make much sense if you ask me.
I took the time to model out some returns using share price as a basis—to figure out if the price you’re paying when you buy up is worth the difference in the outcomes.
Here’s a very plain vanilla model. It doesn’t take into consideration options, down rounds, or recaps. It’s just a model of the share price of a company going up and to the right smoothly until it exits for $300mm, and the outcomes for the shares purchased in each round of financing.
Seed round investors get a tidy 18.2x return—which means in this model I’d return half my $15mm fund on one $300mm exit—since I front load most of my investment into the first round and write checks of $350-400k.
Later round investors who pay up get less, obviously.
Keeping fund size the same, they also wind up putting less into the first round of their winners while at the same time putting less into the losers. They hold their cash back until they have more data, and lean in as a company is outperforming.
That creates a tradeoff of paying up for more information. How much do they hold back? This is the data of what your investment dollar distribution looks like if you’re doing the pro-rata of each of these rounds.
Obviously, if you’re only doing the seed, you’re putting 100% of the fund into the seed. If you’re holding back to do your pro-rata in a seed+ round, you’re holding back about 32 cents on the dollar. Doing your pro-rata in the Series A? That means you’re only going to get 37 cents into the cheapest round and you’re holding back the other 63 cents for later, more expensive investing. That means your winners are giving you just under a 9x return, because, on average you’re paying twice as much.
At least you’re avoiding putting more of these dollars into the losers, through, right?
Yes, but you have to be really good at that to make it a better fund overall—like, REALLY good.
I created a few fund mix scenarios and estimated what the overall fund return would be given that mix.
Here are the following outcomes:
Big Winners: Exit at $300mm No downrounds
Solids: Exit at Series B Post No downrounds
Meh: Exit at Seed+ Post No downrounds
Capital Back: Capital Return
Wipeouts: No Return
Then, I estimated a seed fund’s mix of dollars necessary to get a 3.3x return without follow-ons:
It’s not unlike what you hear a lot—that about 10% of the fund or so generates most of the returns. Throw in a couple more solid returners, a few singles and doubles, and you’ve paid for the fact that half your portfolio was a complete wipeout.
Some call it lucky. I call it disciplined—because you’re buying in cheap enough to make your winners return enough to make up for the duds.
If you keep on going through the seed+, you’ve got to be a bit better allocating your dollars. Only about a third of your dollars can go into the duds and you’re up closer to 15% of your dollars going into winners to get the same fund return.
The pattern continues through the A. If you’re following on that far, you’ve got to be that much better in your dollar allocation to get the same returns:
How much better? Well, now a quarter of your portfolio has to be invested into the big winners and only 15% can be in the duds. That’s actually kind of a problem—because, at seed, a lot of funds will admit that half your seed bets aren’t going to make it—but our math earlier gave us the following:
This is the dollar distribution of your investments when you do pro-rata through the A. About 37% of your dollars will be in the seed rounds, and if half of them went bust, then you definitely invested more than 15% of your fund in those rounds. Not sure how you get around that math—unless somehow you’re able to know ahead of time they’ll be duds and you put less in them. It begs the question of why you invested in the first place.
Obviously, the math and estimates here are super variable, but the point of this is that we have walk right up to the edge of suspending reality to just get the same returns as in the no follow-on model. Imagine what the math needs to look like for this model to be demonstrably better by following on all the way through.
Keep buying up, and the pattern continues…
Follow on all the way through a Series C and you’ve got to put in a full 90% of your dollars into your big winners to get in the ballpark of the no-follow model. Again, that’s going to be super hard to do, because if you invested through the A on all your companies, you put in about 15% of your dollars into the duds…
Here’s how your dollar into a company shakes out if you’re doing pro-rata across rounds. In a one company model, it’s about 30%—but since half your seeds don’t make it to A, you cut the 14% A round follow in half. I don’t know how many seeds make it to seed+ or how many seed+’s there are, but the point is, you don’t have much margin for error if only 10% of your portfolio is allowed to be invested in the duds.
Following on is just really, really hard work if you’re going to get the same returns.
The nice thing is that you don’t need the same returns, because you have more management fees and a bigger fund—so less carry on a larger base is still more money.
If you’re a larger LP, you don’t have much choice to put the money to work either. If you need to invest $25mm at a time, you’re still better off in venture capital than in the public market if you can access good managers. If you’re a smaller investor, however, and you can get your check size into any fund—the math points to trying to get into the fund buying in at the lowest average share price across its portfolio. It’s a lot easier to make a better multiple of return there—and if it’s all the same to you check-size-wise, then smaller seems better.
I’m sure someone else can build a much better model than I can, and throw in a lot more complexity around return expectations—but to even build a model at all probably makes me top quartile in terms of GP analytics. I’m absolutely stunned at how few managers, especially new ones, ever bother taking a shot at doing any fund cashflow models. Too many times I hear echos of what’s been talked and blogged about without any data behind the thinking. What might work for a larger fund may not hold true for a smaller one—so before you take someone else’s strategy as your own, take the time to do some math around it.
Also, we all need to play to our strengths. Some investors are better at dealing with more data—and others might be better “first pitch” hitters. What’s important is that you’ve thought through how good you need to be if the data says you need to be better than average to make your math work.
Most people seemed to agree—some disagreed, but a few people were like “Why do you care? What does it matter as long as they’re out there writing checks?”
Some people thought it was a privileged way to enforce hierarchies and to equate money with value—and I understand where they’re coming from. The issue is that nomenclature creates a certain set of expectations that founders use to allocate the most precious of their resources—their time. They want to make sure that they can achieve fundraising goals as fast as possible and I am nothing if not a passionate defender of a founder’s time. That means deciding who to take 1:1 meetings with, who to travel for, or who to take 2nd or 3rd meetings with—and size of check has a major impact on that.
It used to be that the only people who could even get into angel rounds were high net worth individuals that could write at least $25,000 checks—so if someone said they were an angel investor, you could assume this was their minimum check size. With the advent of platforms like Angel List, now you could be investing with just $1000—which is great for the democratization of the asset class. Everyone should be able to access any investment—but it becomes confusing for founders to figure out where they should spend their time. It becomes even more confusing when they’re out going to conferences and reading articles that feature interviews with “angel investors” because they’re assuming these are folks with a certain type of experience that could be very different than reality. Crowd investing platforms allow anyone to be an investor even if they’ve never even interacted with the team—so you could have made two dozen investments and still have very little firsthand knowledge of what life is like at a startup or what early stage founders go through.
With new technology should come new terminology. I would propose that we call these types of investors “syndicate investors”—super useful folks who join with others to help rounds get raised on various crowd investing platforms. They could speak to this experience quite well if you were going that route and it would help differentiate from the kind of folks sought out for direct relationships and bigger checks. To me, an angel investor is someone who writes at least $10k checks (if not actually $25k) directly into company cap tables (as opposed to into syndicates or SPVs) and at least has some direct relationship with the founder. Other relationships can be very valuable and helpful, but I think we should call them something else.
A similar problem happens at venture firms—where no longer are you seeing clear cut terms like analyst, associate, and general partner. Now, everyone’s a partner, blurring the line around who can actually lead an investment and get a deal done. I was the first analyst at Union Square Ventures and so I get why this is done—because who wants to talk to the analyst? They don’t have pull and so founders try to go around them—defeating their purpose of screening for a partner.
Still, I think founders (and other VCs) who desire to make connections with investment professionals who have the “power of the purse” should be able to differentiate. When I was an analyst, I never took founder meetings on my own without either Fred Wilson or Brad Burnham because I didn’t feel experienced enough to vet the companies. When I wrote or spoke, I talked mostly about what I learned from the firm’s partners and what their actions were versus speaking authoritatively on my own. Today, the blurring of titles means that you have to go a few layers deeper in someone’s bio to understand what kind of experience they’re coming from and what kind of pull they might have in their firm—and I can’t see how this is better for founders trying to allocate their time and attention.
Partners, in my mind, should have carried interest (upside) in the fund and be able to lead deals and take board seats. They should be the kinds of key people that limited partners are basing their investment decisions on the fund itself on—not two to three year rotational employees. If you want to call someone else part of the “investment team”, that’s cool, let’s not try to make it seem like the person who just got their MBA has the same experience and pull as the person who started the firm. They’re an important teammate, but for founders, experience and influence is a meaningful signal on how to spend their time.
I feel the same way about someone who calls themselves a “VC”. You might work for a venture capital firm, but unless you’re an equity partner in that firm (and I would like to think a significant one) that writes checks, sits on boards, I wouldn’t consider you a “venture capitalist”. I believe the name creates a certain set of expectations and founders make assumptions about it enough that you should be a bit discerning about how you use it.
Call me old fashioned, but back in my day, I was happy working for a VC firm, but content to use my actual title of analyst so people didn’t think I was on the same level as the VCs who actually started the firm.
While most of the money that goes into VC funds comes from institutions that are highly experienced in the asset class, some family offices and high net worth individuals also invest in VC. They’re trying to get exposure and diversification at the same time, while potentially seeing co-investment deal flow.
A lot of VC fund pitches—and I know this because I used to vet VCs for a living as an institutional limited partner at a pension fund—sound the same. They all have great networks, above market performance and some special sauce that sounds nice but you’re not 100% clear it makes sense as a way to boost returns or get access to deals.
Here are five questions I would ask any new or emerging VC fund:
In the five years before you had this fund (in case they have a short track record) what deals could you have legitimately gotten into that fit your strategy that would have been winners?
Could you have led any of these deals?
If every single fund at your size/stage/geography/strategy said yes to a deal, where are you in the order of preference for founders to accept a check from? (i.e. If you’re a Series A fund in NYC, and you, USV, Firstmark, RRE, etc all submit term sheets, who gets in and in what order?)
Explain the math that gets you to a 2-3x net (after fees) return—how many deals, how much in each deal, at what valuation, what exit expectations, follow on or not, etc. If they haven’t done this math, they shouldn’t be managing your money.
What risks have you taken that others haven’t—and why did you think they were worth taking?
If you want to learn more about how VC funds get evaluated and you’re either an accredited investor, a non-partner at a VC fund, or work on behalf of a family office, check out this event tomorrow. We are especially focused on bringing diverse attendees into the room. If you’re not sure if you qualify, e-mail me. No current non-accredited founders, please.