Today we cover Part 2 of Dispelling Conventional Wisdom in VC with Eric Paley of Founder Collective. In this segment we address:
- I wanted to get your quick take on follow-on investing. There was a recent twitter convo w/ you, Parker Tompson, Semil Shah & Nick Ducoff on Follow-on funding… Nick made the statement: Knowing when to double down is the key to solving the “I wish I owned more of my winners and less of my losers” paradox. And you said you strongly disagreed, stating that “Venture funds are made on the first check and destroyed on the follow on checks.” Wow, that was certainly a shocker to read. Why do think following on is not wise?
- Why small, early investments by large firms can create conflicts for founders when they’re raising their next round
- Why many early investors actually have a weighted average cost basis of a Series B investor without knowing it
- The paradox of pro-rata where investors want to pay the lowest price but also want their existing portfolio to raise at the highest valuations
- Eric’s thoughts on concentrated vs. diversified portfolios
- His final thoughts on key takeaways from the study and items running counter to conventional wisdom
- Eric on Twitter
- Eric’s Blog
- Founder Collective
- FC on Twitter
- Eric’s article: Overdosing on VC: Lessons from 71 IPOs
1- Capital as a Magnifier
Before we got into the study, Eric first reviewed the fundamental principles of raising capital. He said that “VC is a magnifier of whatever you have… it can magnify good things or bad.” There is pressure for VCs to deploy capital and increase their AUM. They want to raise fast and deploy fast. Which is great for strong businesses that are under-capitalized. But for those that haven’t determined how to grow in an accretive way, capital magnifies the problems. While growth is the best way to assess if the market cares about your product, companies often throw money at things that aren’t working. Founders and investors are equally culpable… the founders are chasing growth and investors are pushing for it. Yet scaling things that don’t work, damages the long-term potential of the business and is very hard to unwind. Remember that the money has no intelligence. It’s just a multiplier of good or bad.
And the results of Eric’s IPO study showed no causation or even correlation between the amount of capital raised and the exit outcomes. Just because one can raise $20M on $80M pre, doesn’t mean they wouldn’t be better off taking $10M on a $40M pre. Even though the founders suffer the same dilution for each, capital is not the driver of successful outcomes it is merely an enabler.
2- Pro-Rata Founder Impact
We spent a lot of time discussing the impacts of pro-rata. Let’s first address the situation for founders…
When early investors have additional dry powder, it sounds great to entrepreneurs. It’s presented that this helps reduce the funding burden in future rounds. However, what often happens is that when things are going really well, there is no scarcity of capital and, in fact, allowing early investors to take their pro-rata presents a difficult challenge for many founders. I just went through this situation w/ a founder doing a Series A. There was so much demand for the round that he was feeling the pressure from all sides to limit the follow-ons. So, unfortunately, when things are going well, this is not a positive.
Let’s look at the other side, when things are not going well. When a startup is struggling and the founder really needs follow-on money, the VC is typically much less interested in participating. It’s their right to participate but it’s not an obligation. So, when things are going great, the founder doesn’t need the follow-on and when things are going poorly, they need it and can’t get it.
Let’s look at one other scenario where capital reserves can be an asset. If the early investor preempts the Series A, sets the price and invests the capital, this can provide a lot of value. It’s a significant time-saver for the founder. Rather than take a hundred calls and find a lead, they’ve got a lead and a large commitment. However, very few firms do this. Early investors are not incentivized to price a new round. A pro-rata entitles the investor to maintain their equity percentage and even increase their percentage w/ supra pro rata. So, no matter where the price ends up, they know what percentage they’re entitled to… thus eliminating the incentive for them to lead.
3- Follow-on Investor Impact
The conventional wisdom is that following on w/ your winners is the best way to drive better returns. As Eric articulated, if you look at the incentives in the industry, it’s obvious why this is the conventional wisdom. Fund managers are rewarded by having larger amounts of AUM, which drives them to deploy more capital. And, the easiest way to deploy more capital is to double, triple or quadruple down on your existing portcos. If you’re reserving $4 for every initial $1 that you invest, your weighted average cost basis is a Series B investment. If you look at the average price you paid for equity in startups, that price is much closer to a later stage valuation. And many of these firms consider themselves to be seed firms, expecting seed-stage multiples.
This also increases risk significantly as the fund ends up with a really concentrated portfolio. The majority of the dollars invested will be in a small number of perceived winners. And if these don’t work out, it’s catastrophic to the portfolio. The range of outcomes has much fatter tails with some funds doing well, while others lose the majority of their committed capital. Contrast this with a diversified portfolio where the manager stays at the seed stage, invests more money in each company at that stage and also makes many more investments.
Those that argue the merits of following on, often present the fully optimized portfolio, where they followed on to the winners and passed on their losers. But, the data suggests that VCs are actually very poor at distinguishing between the winners and the losers when making follow-on investment decisions.
Another negative is that these seed turned Series B investors are only investing in their existing portfolio at these later rounds. Without realizing it they’ve become Series B investors that only have access to a very small number of companies being funded at B. If access is everything in venture, why would an investor limit their self of such a small slice of the market. According to Eric, this would mean that every firm believes that their Series B graduates will outperform the all other Series B companies getting funded.
A final counter-intuitive aspect is that pro-rata investors want to invest more money when the price is higher. So, while typically investors want the best price, those already in the deal put more money in when the price is high. Eric told us the situation w/ his company Brontes where a previous investor wouldn’t lead the deal at $30M b/c the price was too high but when someone else lead at $50M, they wanted to make an even larger investment.
The final point that Eric made on the problem w/ pro-rata is that, from a returns standpoint, the first check in is always the check with the highest returns. For those really looking to improve their returns and not just assets under management, maybe the focus should be investing more early, instead of late.