4 essential truths about venture investing
Understanding Investment Stages: Pre-Seed vs. Later Rounds
Having dedicated seven years to pre-seed investments, a distinct contrast has become apparent when compared to investing in Series A and subsequent, more mature stages.
The following discussion will focus on four core principles that consistently hold true, regardless of the investment round.
Key Principles Across Investment Stages
These concepts are fundamental to successful investing, whether evaluating a fledgling startup or a rapidly scaling company.
- Team is Paramount: The quality and capabilities of the founding team remain the most critical factor.
- Market Opportunity: A substantial and addressable market is essential for long-term growth.
- Product-Market Fit: Demonstrating a clear alignment between the product and customer needs is vital.
- Capital Efficiency: The ability to achieve significant progress with limited resources is highly valued.
These four elements – team, market, fit, and efficiency – are consistently assessed throughout the entire investment lifecycle.
Pre-Seed Specifics
While these principles are universal, their application differs significantly in the pre-seed phase.
At this early stage, emphasis is placed on the founders’ vision and potential, as concrete data is often limited.
Later-Stage Considerations
As companies progress through Series A and beyond, the focus shifts towards demonstrable traction and financial performance.
Investors will scrutinize metrics like revenue growth, customer acquisition cost, and unit economics.
However, the underlying importance of a strong team and a large market opportunity never diminishes.
Ultimately, successful investing hinges on recognizing these enduring principles and adapting the evaluation criteria to the specific stage of the company’s development.
The Prevalence of Power Laws in Venture Capital
A fundamental principle governing numerous phenomena across the universe is the power law. This principle manifests in diverse areas, from city population distributions to artwork valuations, and even the allocation of wealth. It’s also recognized as the Pareto principle, often summarized as the 80/20 rule.
Venture capital investments are demonstrably subject to this same law, meaning the results from any venture portfolio will likely conform to a power law distribution.
Understanding the Implications
Two key considerations arise from this observation:
Firstly, given the high failure rate of startups, the distribution will be heavily weighted towards minimal or zero returns in the 'long tail'. These minimal returns will be followed by modest gains – single and double returns on investment.
Secondly, substantial successes, when they occur, tend to generate exceptionally large returns. While unicorns (companies valued at $1 billion or more) were uncommon in 2013, as noted by Aileen Lee, they are now more frequent. Leading venture firms actively seek to fund decacorns – companies exceeding a $10 billion valuation.
The Dynamics of Growth
The power law dynamic within venture capital isn't enigmatic. Similar to wealth accumulation, the most successful companies experience accelerated growth.
A startup already achieving $10 million in revenue possesses a significantly higher probability of doubling its revenue repeatedly and surpassing $100 million, compared to a startup currently striving to reach $10 million from a $1 million base.
Scale introduces a paradigm shift – access to greater resources, expanded opportunities, and increased capital availability. Naturally, even highly scaled companies can encounter challenges and ultimately underperform, but this isn’t the central point.
The crucial aspect is that companies that achieve success continue to compound their growth, consistently expanding in size and influence.
Consequently, the overall outcomes of a venture portfolio align with a power law curve.
Performance Differentiation
Exceptional venture capital managers distinguish themselves by securing a disproportionate share of the most significant successes at the upper end of this curve.
Conversely, average managers face a substantial risk of generating no profit at all, due to the steepness of the power law distribution.
Fund Size Dictates Investment Strategy
A common observation from fund of fund managers directed towards General Partners (GPs) is that a fund’s size fundamentally shapes its investment strategy.
Essentially, this highlights the correlation between the amount of capital a fund manages and the way its portfolio is constructed. This relationship stems from practical considerations regarding deal participation and potential returns.
Consider two contrasting scenarios: a manager overseeing a $10 million fund versus one managing a $1 billion fund. Assume both aim to lead investment rounds. If the former focuses on Series A funding, its portfolio will be highly concentrated.
Leading only 1-2 rounds is likely the extent of their activity. Given the inherent power law distribution of investment outcomes, achieving a substantial return with such limited diversification would be improbable.
Conversely, the manager with $1 billion faces a different challenge. The sheer volume of capital necessitates a different approach. Investing in pre-seed and early-seed ventures is often impractical.
Deploying $1 billion would require 500 investments at a $2 million check size. Even with 50% reserves, that still equates to 250 deals. This level of activity is unsustainable. Therefore, larger checks and substantial follow-on investments become essential.
Another crucial factor with larger funds is maintaining adequate ownership. To generate a $1 billion return, the fund needs to hold a 10% stake in a company valued at $10 billion.
This requires careful planning and a well-defined follow-on investment strategy to ensure sufficient equity at the time of exit.
These examples clearly demonstrate the interdependence of fund size and investment strategy. This is why many funds specialize in a specific investment stage:
- Funds managing less than $50 million typically focus on pre-seed and small seed rounds.
- $150 million to $300 million funds generally target seed and small Series A investments.
- $500 million funds usually concentrate on Series A rounds.
- $1 billion funds are often stage-agnostic, but typically avoid investments earlier than Series A, frequently preferring B+ rounds and later.
Recently, a trend has emerged where late-stage megafunds are attempting to participate in earlier funding rounds. For many, this serves as an option for significant follow-on investments in subsequent rounds.
The Significance of Equity Stakes
A crucial lesson is being learned by numerous smaller funds operating in the pre-seed and seed stages: the amount of ownership secured is paramount.
Consider a scenario. A $20 million pre-seed fund makes a $250,000 investment in a seed round valued at $10 million. This equates to a 2.5% stake in the company. What percentage of the company will remain yours if it achieves unicorn status?
Let's assume a highly optimistic, yet still somewhat unrealistic, progression of dilution and valuation increases:
- Series A funding results in 30% dilution at a $40 million valuation.
- Series B funding leads to 15% dilution at a $125 million valuation.
- Series C funding causes 10% dilution at a $300 million valuation.
- Series D funding results in 5% dilution at a $1 billion valuation.
Following this trajectory, your ownership would be reduced to 1.27% – less than half of your initial holding. While a $12.7 million stake is substantial, it’s insufficient to generate a return equal to the $20 million fund size. The solution involves either participating in pro-rata funding rounds, which can be financially straining for smaller funds, or increasing the initial investment amount to secure a larger equity stake.
Let’s examine another example: a $300 million fund acquiring a 20% ownership position during a $5 million to $7 million fundraising round, often categorized as a large seed or a smaller Series A. Applying the same dilution schedule, the fund would retain 14.5% ownership at a $1 billion valuation, representing only a fraction of the fund’s total capital.
In this case, the fund would need to continue investing and maintain its pro-rata share, potentially through Series C.
These calculations highlight several key points:
Ownership is critical – a disciplined approach combined with a degree of good fortune is essential.
Many fund managers also recognize that making small investments in highly competitive deals doesn’t consistently yield optimal results. However, this strategy can be effective if implemented broadly, requiring access to a significant volume of promising opportunities. If substantial ownership cannot be obtained in individual deals, aiming for inclusion in as many of the most promising ventures as possible becomes crucial.
This approach proved successful for Ron Conway at SV Angel, who was widely regarded as a first-choice investor in Silicon Valley. However, building such a reputation and network requires considerable time and experience in the venture capital landscape.
Currently, executing this strategy is increasingly challenging due to the sheer volume of available capital. Therefore, if access to all the top-tier deals with smaller check sizes is limited, a strong focus on securing significant ownership is vital.
Venture Capital Presents a Steep Learning Curve
A common assertion is that venture capital operates as an apprenticeship.
This notion, however, can be deceptive. While guidance from experienced mentors or managers is undoubtedly beneficial, as it is in any profession, it doesn't fully capture the essence of learning venture capital.
The core truth is that mastering the intricacies of venture investing requires substantial time and practical experience. This skill is honed through active participation – through actually making investments.
The primary obstacle lies in the high cost associated with this form of education.
For example, consider a $300 million fund concentrating on leading investment rounds of $5 million to $10 million. Such a firm typically completes 5-7 deals annually, constructing a portfolio of 25-30 companies while maintaining approximately 50% of its capital in reserve.
A new investor, such as an associate or principal joining this firm, will likely spend the initial 9-18 months primarily supporting a partner rather than independently executing deals.
Partners generally retain final decision-making authority on all investments, as they bear ultimate responsibility to the Limited Partners (LPs). This structure can hinder the learning process for junior team members.
How can a junior investment professional truly develop their skills if they lack the opportunity to make investment decisions? It’s akin to navigating without a map, lacking a clear understanding of the journey.
It typically takes several years for a junior investor to gain the trust and opportunity to lead a few investments, and even then, these are often collaborative efforts.
Accelerated learning pathways in venture capital include becoming an angel investor, achieving a significant exit as a founder, or joining a smaller, pre-seed stage fund.
Angel investing, if financially feasible, provides a direct route into the venture landscape. While it involves learning from personal financial mistakes, a dedicated commitment over several years can provide a significant advantage.
A successful founder who has experienced a substantial exit is highly sought after by venture capital firms as a potential partner. This is because their operational experience is highly valued and beneficial when supporting portfolio companies.
- Key Takeaway: Practical experience through investment activity is crucial for mastering venture capital.
Acknowledgements: This post benefited from the editorial contributions of Zann Ali.