I’m a big fan of startups actually existing – not only becoming important enough to customers or users that you start to exist, but ALSO being important enough to your VCs that you continue to exist when things suck. If things are great, super, but I don’t build my plans around upmarkets.
The trick to being important to institutional VCs is to be undeniable to their Limited Partners (LPs). Plausible deniability equals death when things are bad. Unfortunately, all this only crystallized for me in the last year. Where have I been all my [working] life?
Sez the VC to their LP, “Oh, that little thing; that wasn’t one of our real portfolio companies. We were just in that deal for the call-option value. We need to do that early-stage crap to understand what’s going on a year or two later when a startup sector is mature enough to matter.”
Sez the VC to the startup founder, “We do seed through growth stage.” “We care deeply about every investment, no matter how small.” “We’re stage-agnostic.”
When a fund that’s too big calls you to pitch them, DON’T. Feel free to #blamerafer. Send them this post and let them attempt to refute it. Relationship building with later stage investors is fine when you are flush – maybe – but it’s distracting and destructive when you are actually raising a round that is suited for smaller funds.
NB: Casual readers can conveniently skip this paragraph.
As a rule of thumb, VCs pitch their LPs on having 20 to 25 deals per fund. The number of deals is the outcome of how much time the VCs are promising to spend on each portfolio company balanced against how much diversification the LPs are comfortable with and more subtly, how few people the VC General Partners (GPs) want to share their management fees with. Twenty is a fine number to work with here. VCs also generally pitch a follow-on investment reserve policy of 40 – 60%. Using 50% for simplicity’s sake, VCs expect that their first check to a portfolio company will be on average half the money they invest in that company over the life of the fund. This percentage is somewhat misleading in that follow-on investing roughly follows a power law where a few startups receive a lot of follow-on funding and most get none. However, in this post, we only care about that first check, so let’s do the math on an initial investment from a $200 million fund. Twenty deals over $200 million is an average of $10 million per deal. Reserving $5 million of $10 million per deal is a $5 million first check per portfolio company.
If you need a lead investor who will contribute $5 million to your round, then a $200 million fund is spot on! If you need $3 million, it still might be ok, but I would not sleep particularly well.
Sez the VC to their LP, “Yes, we had to abandon those guys, and we’re not proud of it, but we were worried about [revisionist history] from the very beginning in spite of their awesome market opportunity. That’s why the initial investment was so far below our average.”
If you need $1 million lead investor check and you get it from a $200 million fund, then your value is as a call option on a market sector, a way for them to to try out a principal/junior partner they aren’t quite sure about, or something else that is about the VC solely serving their own needs. However, if you get $10 million dollars as a first investment out of a $200 million fund, then it becomes very difficult for them to explain to their LPs why they blew an over-sized first investment on some loser startup. Congratulations, they just married your company (They can probably still fire you). VCs really, really, really want to keep the same LPs from fund to fund and overexposure to a startup what whiffs makes keeping LPs harder.
There are obvious exceptions to the rule of thumb above (Yay, Kent!), but they are exclusively small funds. The bigger the fund, the less opportunity the GPs have to deviate from the model above. Over $200 million, forget it – they are locked in to the model. And the big funds are the ones that cause problems by investing in early-stage companies that they can later abandon without penalty.
“The bigger the fund, the less opportunity the GPs have to deviate from the model above. Over $200 million, forget it – they are locked in to the model. And the big funds are the ones that cause problems by investing in early-stage companies that they can later abandon without penalty.”
Lesson here kids, get funding from a stage appropriate firm. But don’t blame me…blame Rafer 😉
Image credit: CC by Studio Tdes