136. Dispelling Conventional Wisdom in VC, Part 2 | Should Seed Investors Follow-on? (Eric Paley)

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Today we cover Part 2 of Dispelling Conventional Wisdom in VC with Eric Paley of Founder Collective. In this segment we address:

  • Eric Paley Founder CollectiveI 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

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Key Takeaways:

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.


Tip of the Week:   What Killed Sprig?


*Please excuse any errors in the below transcript

Nick: Right. Well, you know, talking about sort of over, over capitalization as also related to sort of the follow on investing discussion. And I want to get your take on this. There was a recent Twitter conversation. You were involved, #Parker Thompson, #Semil Shah, #Nick Ducoff, all talking about this follow on funding discussion. And, and #Nick made the statement – Knowing when to double down is the key to solving the “I wish I owned more of the winners and less of the losers” paradox. And you said you strongly disagree. You stated that “Venture funds are made on the first check and destroyed on the follow on checks”. You know, that, that was a pretty shocking statement to read, but, you know, I’ve tended to agree with you. I mean, my firm’s philosophy is quite similar. But I’d love to hear your take and, and the logic behind your comment.

Eric: Yes. So this is getting into inside baseball for folks who don’t follow the venture industry very closely, but the conventional wisdom in venture capital is that backing up the trucks on your winners is the way to create a great fund. And that pro-rata, which means the right to follow-on and the same percentage ownership as you have from previous rounds, is a critical part of building a good portfolio.

Nick: Right.

Eric: That’s conventional wisdom. I would argue that if you look at the incentives in the industry, it becomes really obvious why the conventional wisdom is the conventional wisdom. So it just so happens, let’s even assume the conventional wisdom is true, it lines up perfectly with the incentives in the industry, which is capital under management. Right? Assets under management. In order to execute a strong follow-on strategy per the standard wisdom of our industry, you need more capital. So much so that a lot of our peer seed funds reserve $4 for every initial dollar they invest. Now a couple things. First of all, that sounds really good I think to entrepreneurs. Right? That your investor who wrote the first check has 4 more dollars preserved for the dollar they wrote up front. They, they put a million in and they’ve got another 4 million on the sidelines ready for you. I would argue that that never helps entrepreneurs unfortunately. The reason it never helps entrepreneurs, and this gets into a very interesting misalignment, it’s presented as helping entrepreneurs. When I was an entrepreneur, we called this dry powder, and we thought that was really valuable. What ends up happening is that when things are going well in your business, you never need that money. There are always people who want to write checks and it’s easier to attract other capital and usually it’s beneficial to do so because you get to a market clearing price. And frankly, the new capital that comes in also cares about what percentage of the company they own. And the pro-rata of your existing investors makes it very, very hard to get a deal done. So in most cases when companies are doing well, they end up, the founders end up very much misaligned with their existing investors, because their existing investors are insistent on pro-rata but the founders are actually not excited for them to take pro-rata. The problem gets even worse. I’ve never, pretty much never met, maybe there is a handful of founders, that wouldn’t have preferred their existing investors if they like them just preempt a new financing round, save them the pains of going out to raise money, and just agree on what the founder perceived to be a fair price and the, and the investors if they could find a fair price then they could agree upon. That is often a very preferred paradigm and it never happens, virtually never happens.

Nick: Just having existing investors lead the round, price the round and then put together a syndicate?

Eric: Or, or not bring anyone new in.

Nick: Okay

Eric: Right?

Nick: Okay

Eric: But the reason that so rarely happens, and there are few funds that actually do that well, but the reason it so rarely happens is again because of pro-rata. Because your existing investors are entitled under any circumstances to own what they currently own, they have very little incentive to preempt a round. Let’s let somebody else lead it, I always, and figure out the price, I don’t need to figure out the price, I always am still entitled to the amount I’m entitled to. Right? So

Nick: Right

Eric: I may as well

Nick: Right

Eric: sit on the sidelines passively, which 95% of VCs do. And I admire the ones who don’t do that. And let you go out and figure out who should fund your company and who should set the price, and I’ll just sit here passively and do my pro-rata check. So that’s yet another reason why pro-rata is not very helpful. The third reason it’s not very helpful is when a founder needs money, they’re struggling and they can’t easily go find it elsewhere, no VC needs a special right to invest. Right? All the founder need do is ask and hopefully the VC chooses to participate. But remember the pro-rata right is free option to the VC not to the founder. And so it’s usually in times where you most need the money that the, the VC says well, I’m not as interested, the company’s not going that well, I’m not that excited to write another check. But at a minimum they do not need a pro-rata right to do that. So, you know, the good VC will be there for their companies, assuming the company has a credible plan going forward, whether or not they have special pro-rata rights. So let’s start with, I think we’ve disqualified the notion that pro-rata is of actual value to founders. Now let’s talk about it as a returns driver, not as a management fee driver,

Nick: Right

Eric: for the general partners, but as a returns driver for limited partners and frankly for the GP in carried interest, which is a much longer term way of thinking about it. Which frankly, we have the privilege to do because we’re the biggest investors in our own funds. So we spend a lot of time thinking about multiples of return not just assets under management. The reality is the check that has the highest return for any VC fund, no matter what stage they invest in, is the first check. Right?

Nick: Yep

Eric: The only time the first check doesn’t have the highest return is if there’s some kind of turnaround, major down round, recapitalization. And I think most of the data shows that’s been a very tough part of the venture market. So, you know, power to you if you’re really good at turnarounds and down rounds and recapitalizations. But historically those are very hard businesses to make successful because those businesses tend to be in death spirals, they have really bad cultures, there’s so many reasons why those are really tough. So lets focus on companies that generally speaking they may go through some ups and downs but overall end up being the winners. And most of those companies, even if they hit some tough spots along the way, they don’t get recapitalized.

Nick: #Eric, couldn’t an exception be a, a firm that makes really small bets at pre-seed or seed stage and then they really take their ownership position at the A stage?

Eric: Well, I would argue that’s a really big conflict for the founders for a whole series of reasons.

Nick: I would agree. But those firms do exist for sure.

Eric: They do, they do exist. I’m not saying any of these strategies are bad strategies. All I’m saying is despite their big ownership they like to take in the next round, and by the way if they do that in a way where they preempt the next round, that can actually be very valuable to founders. But if they do it in a way where they ask for supra pro-rata rights, they get to make a decision later whether they want to take a very big chunk in the next round causes all kinds of misalignment

Nick: Yeah

Eric: problems for founders. And yet, at the same time, almost always the first check they, I mean still the first check they write is going to be the highest multiples check they’re going to invest.

Nick: Oh for sure.

Eric: Right? So the math that nobody does in our industry for whatever reason, I, we talked to all our LPs about this and they always tell us that nobody ever talks about this, is what was the weighted average cost basis of your dollar invested across your portfolio.

Nick: Okay.

Eric: Was it weighted average at 5 million post? Was it weighted average at 50 million post? And we can agree, I think everyone in the industry would agree that if you only invested at seed, you’d have the lowest weighted average cost basis.

Nick: Right

Eric: Right?

Nick: Yeah

Eric: You know, in the same, you know, in the same portfolio of companies. Right?

Nick: Yep

Eric: If you’re investing in A, your weighted average cost basis goes up. If you invest in B, your weighted average cost basis goes up higher. The implication of this is as a fund that we do follow on in the A because we’ve learned over time showing support in the A, we don’t lead but showing support is really important to the founders. And then we tend, we’re done after that.

Nick: Got it. You don’t want negative signals and,

Eric: Right. We, we avoid those signals. For us, our weighted average cost basis is a blend between mostly seed and a little bit of Series A. If you’re reserving $4 for every primary dollar you invest, your weighted average cost basis is Series B.

Nick: Got it.

Eric: Right? Now nobody talks about that. Now it’s very interesting, there are very few VC funds who want to be Series B investors. But for whatever reason, and I think it’s somewhat fascinating, they would rather be Series B investors on average only with rights to invest in their own existing portfolio that be Series B investors with rights to invest in the world of opportunities.

Nick: Well, their own portfolio is probably the only opportunities they can access at later stages.

Eric: Maybe. But that’s like saying like the narrow slice of the venture industry that is my own portfolio will always outperform the access I can get across the entire Series C, Series B stage of the venture industry.

Nick: Sure. If you did that in public markets with only your existing stock investments, you’d have problems.

Eric: But I don’t even think it’s only, it’s true in privates. Right? I have plenty of LPs who like to do direct investing who are not well known, who get into great Series B deals and pick and choose. Right? And so I don’t, I’m not convinced that Series B investors don’t get access when they’re excited to do investments. In fact, because we know that most VCs like to sit on the sidelines and just exercise their pro-rata rights, there’s plenty of opportunity to all these different stages. Right? The other fascinating thing about pro-rata is it’s always at a market clearing price. So it’s interesting, right, people like to invest more money because this is how the pro-rata math works, the higher the price is in the round on their company. Right? And yet it’s one single investor leading that round with a term sheet and it’s always the market clearing price.

Nick: Right.

Eric: And so, you know, is, how often is that a bargain? Right? I mean, I had a situation in a company I founded, #Brontes, where we asked one of our inside VCs, who had been clambering for more ownership, to lead the Series B at a certain price that we felt was very fair. They declined because they thought the price was too high. That price was, just to put some numbers on it, was 30M pre. We went out in the market and we secured a term sheet of 50M pre. And they kicked and screamed that they didn’t get super pro-rata at 50M pre. And it’s amazing, right? Because they could have had super pro-rata at 30M.

Nick: Wow!

Eric: And they thought it was to expensive. But at 50, all of a sudden they were really upset they couldn’t have it.

Nick: Unreal.

Eric: And so, but, but, it’s not unreal. That’s our industry.

Nick: Yeah

Eric: Right? And, and I said to them look I love you guys but I could have really used your help, I wish I didn’t have to go do this whole fund raising, I would have happily done it at 30. Given the unknowns and who knew I could get to 50. I didn’t know that. But now I’ve done it and I, I’m not going to give you super pro-rata. And, and so I just think that’s going on every day and I think if you really line all that up and take a really hard look at it, what you see is for somebody who’s writing a million dollar check upfront and, and putting 5M in over time in, you know, in their intention, always at the highest possible price, blending their cost basis to a very high number, you know, the real risk of their portfolio is not the million bucks they put in as first check. It’s the 4M they put in over time in companies that really don’t work out of 5M total. Right? It’s the rest of the capital that they’re piling in because they see other good investors writing big checks at high prices. When those companies don’t work out, it’s catastrophic, it’s really material.

Nick: Oh sure.

Eric: And then the other thing, I will give you one more thought exercise on this whole thing, because the appreciation of these companies where you write these really big checks and pro-rata is usually relatively steep, your first check is worth so much at the time you write your second check, that it almost doesn’t matter. So, you know, if you’ve written this first check, it’s a million bucks, companies appreciate at 5x by then, that first check is worth $5M, okay?

Nick: Yep

Eric: If your pro-rata now is $2M on this next check, right, how much does it really matter whether at that Series A stage or Series B stage you owned $5M of the company or $7M of the company? I, I mean, it matters. If it ends up being your greatest company, it will always matter. And that’s the problem with all this math.

Nick: Yeah

Eric: It’s when people analyze it, they analyze it based on if I had fully optimized the portfolio, would it have been better to write all these follow on checks. Then the answer is for any really good portfolio, of course it will be better.

Nick: Absolutely. Assuming incredible outsized outcomes.

Eric: That’s right. And then you, you, you don’t even write checks into the good ones in follow-on. You only write checks into the bad ones on follow ons.

Nick: #Charlie O’Donnell said that on the show. He said “I don’t know which ones are the good ones or not at Series A”.

Eric: And the data shows that most VCs have not been good at that. Only my friend #Roger Ehrenberg is actually really good at that, at #IA Ventures. I’m, he like, he and I have had this debate a hundred times. And now I’ve concluded at some point I still believe that pro-rata is not a great strategy but for #Roger it is because he seems to be immune to the high price signals of, of really prestigious VCs coming into his companies, and exceptionally discerning at what are really the good opportunities for pro-rata and what are not, and power to him. But absent #Roger, I still think it’s, it’s really a strategy that is a necessity of having a very large capital base. Right? And, and, you know, so we’ve chosen not to. We’ve chosen to have a small capital base because we think that is the multiples optimization strategy on the fund. A lot of inside baseball there.

Nick: Yeah. I’m with you on that. It’s, it’s not conventional wisdom for sure. Right? Everybody else seems to be saying you got to double down on your winners. But if you don’t really know who the winners are then, then that’s pretty difficult. There might be a counter argument here that, you know, there’s the concentrated portfolio theory. So assuming, you know, every bet you make you believe is,

Eric: There, there’s no question. We’re a relatively diversified portfolio and we’re very concentrated at a certain stage. Right? And there’s no question that if you can do an exceptionally concentrated portfolio in only the very best companies, and follow on in only the best of that, that set, and avoid all the ones that, you know, they get you 3x multiples but they diminish your overall multiple, you will have, you, that will be an extraordinary, extraordinary outcome. I just think it is a, you know, algorithmically optimized outcome that virtually no human investor is able to achieve.

Nick: Got you. Any other key takeaways from either the study or, you know, other forms of conventional wisdom in VC that, that you find to just not be true?

Eric: I mean, I, i think that thematic point which isn’t really reflecting in the study, although if you look at the 71 companies you’d never think of those as not, not all of them but many of them are sort of in esoteric spaces that are not hot themes. So and then we did our own analysis on looking at themes based on when a certain words, search terms in Google became popularized, it always massively trails the founding of the, of the really successful companies in those spaces. So I think that’s not conventional wisdom in the industry. I think the idea that seed investors are really material follow-on investors has a whole lot of misalignments where your founders are constantly selling you because they know if you don’t invest the signals going to be really bad. And I think that’s pretty counter, you know, to how the industry thinks. And it’s, it’s a way that we try to drive an alignment that is really different. But I think that’s also really relevant to the seed stage. I think if somebody’s writing a, a $5M check in Series A or higher, you almost need, you, you have to assume that they’re, they need to be follow-on investors over time in some way. Because it’s a particular gap at seed, right, because the checks are so not material to large funds.

Nick: Yep

Eric: And if the large funds are writing material checks, I think at least you know that they’ve got, that it’s hard for them to walk away.

Nick: Right.

Eric: And, and that has some value to the founders.

Nick: #Eric, if we could address any topic here on the show, what topic do you think should be addressed and who would you like to hear speak about it?

Eric: Who! Umm, you know, we’ve got an enormous diversity problem and gender gap in the venture industry. I think #Mitch Kapor is doing about as much on that front as, as anyone I know. Plus he’s obviously one of the real sort of legendary leaders and entrepreneurs in our field. So that comes to mind as an important topic to tackle and, and a really thoughtful person to talk to about it. But the, of course there’s so many.

Nick: Yeah. You’ve mentioned many investors on the show today. If you could choose one, which investor has influenced and inspired you most?

Eric: I, you know, I just told that story about, I think I would have to say #David Frankel. And, and I, I think partially because our thought processes are so complimentary but also so different. But also the empathy by which we, the three of us including #Micah, are able to talk through and think through and debate all this stuff. And that’s given me such a front row seat to the way he’s done what he’s done as a investor. So I, I don’t, I don’t think I’ve had as front row a seat to anyone else’s thinking that I admire as much as #David. So I, I, I couldn’t, he’d definitely be the person.

Nick: Awesome! And finally, what’s the best way for listeners to, to connect with you?

Eric: I’m on Twitter @epaley. I’m pretty, I’m pretty actively on there. If you’re trying to get us to take a look at what you’re up to, the best way to do that is to send a power point to contact@foundercollective. That’s actually not the best way. The best way is somebody we know in common if possible to introduce you and tell me how awesome you are, because that obviously helps a little bit get above the noise. But otherwise we really do look at everything that comes in through Contact and try to be responsive to that as, as sort of an open front door to what we’re doing. So if it’s, you know, dialoguing with me, @epaley. If it’s specially around an opportunity we should look at, you know, figure out who we know in common that helps. If you don’t, Contact is the best way and we do our best to keep up with all that.

Nick: Awesome. Well, it’s a big thrill having you on, #Eric. I’ve been a big fan of yours for a long time. Love the study that you did and I appreciate you talking through it here on the show today.

Eric: My pleasure. Thanks for making the time and, and for inviting me.

Nick: Awesome. Thanks #Eric.