If you’ve been following me on Twitter recently, you might have noticed I’m working on a new blogpost for the emerging LP. One that I’m poorly equipped personally to talk about, but one that I know many LPs are not. Hence, I’ve had the opportunity to sit down with a number of LPs (limited partners – people who invest in venture funds) and talk about what is the big question GPs need to answer to get LP money, specifically institutional LP money.
And it boils down to this question:
Why does the world need another venture fund?
Most LPs think it doesn’t. And it is up to the GP to convince those LPs why they should exist. For most institutional LPs, even those who mean to back emerging managers, to invest in a new manager, they have to say no to an existing manager. While data has historically shown that new managers and small funds often outperform larger, more established funds on TVPI, DPI, and IRR, when institutional LPs invest in a Fund I, it’s not just about the Fund I, but also the Fund II and Fund III.
For those who reading who are unfamiliar with those terms, TVPI is the total value to paid-in capital. In other words, paper returns and the actual distributions you give back to LPs. DPI, distributions to paid-in capital, is just the latter – the actual returns LPs get in hand. IRR, internal rate of return, is the time value of money – how much an LP’s capital appreciates every year.
It’s a long-term relationship. Assuming that you fully deploy a fund every three years, that’s a 19-year relationship for three funds. Three years times three funds, with each fund lasting ten years long. If you ask for extensions, that could mean an even longer relationship.
But the thing is… it’s not just about returns. After all, when you’re fundraising for a Fund I, you don’t have much of a track record as a fund manager to go on. Even if you were an active angel and/or syndicate lead, most have about 5-6 years of deals they’ve invested in. Most of which have yet to realize.
So, instead, it’s about the story. A narrative backed by numbers of what you see that others don’t see. Many institutional LPs who invest in emerging managers also invest directly into startups. I’ve seen anywhere from 50-50 to 80-20 (startups to funds). And as such, they want to learn and grow and stay ahead of the market. They know that the top firms a decade ago were not the top firms that are around today. In fact, a16z was an emerging fund once upon a time back in 2009.
Of course, anecdotally, from about 15-ish conversations with institutional LPs, they still want a 4-5x TVPI in your angel investing track record as table stakes, before they even consider your story.
The DGQ series is a series dedicated to my process of question discovery and execution. When curiosity is the why, DGQ is the how. It’s an inside scoop of what goes on in my noggin’. My hope is that it offers some illumination to you, my readers, so you can tackle the world and build relationships with my best tools at your disposal. It also happens to stand for damn good questions, or dumb and garbled questions. I’ll let you decide which it falls under.
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Any views expressed on this blog are mine and mine alone. They are not a representation of values held by On Deck, DECODE, or any other entity I am or have been associated with. They are for informational and entertainment purposes only. None of this is legal, investment, business, or tax advice. Please do your own diligence before investing in startups and consult your own adviser before making any investments.
A founder recently asked me how investors would perceive her going through two different accelerator programs. Specifically, what would investors think if she took dilutive capital from two investors who care about ownership targets, yet have similar, if not the same, value adds to her business?
How each type of investor thinks about dilution
It’s a great question. Unsurprisingly, a nuanced one as well.
Honestly, a “messy” cap table or early dilution is an excuse investors give when they’re not sold on you or the business. Investors regress to the “why this”, or otherwise known as, traction, when you haven’t convinced them on “why you.”
Investors want to be excited about you. They want to brag about you to their partnership, colleagues and friends. But if you don’t give them a strong reason to, they’re going to regress to what they know will return them capital. Predictability. And that comes in the form of traction. But I digress.
If Max Levchin or Phil Libin or Elon Musk or Justin Kan – pick your favorite serial entrepreneur with unicorn exits under their belt – wanted to raise for a new startup, no matter what it is or how early, people are gonna jump on the opportunity to regardless of how saturated the cap table is.
Let’s stand in the shoes of an investor for a second. Of which there are three main kinds of early investors.
Angels
Non-lead VCs and syndicate leads
VCs who lead rounds
For individual angels, ownership targets don’t matter. They just want a piece of the action. In fact, multiple sources of signal and validation give them more confidence to invest. Especially if you’ve taken previous or current checks from your small handful of top tier VCs. These angels’ check sizes are negligible on the cap table, so they won’t end up crowding anyone else out.
On the other hand, notice how I bucketed non-lead VCs and syndicate leads into the same category. Why? These investors are writing bigger checks. They won’t price the round. And they move a lot faster if someone with a great track record is leading the round. Once again, ownership also doesn’t matter, but great co-investors do. As long as ownership targets don’t matter, the excuse of dilution is merely lip service. The story here is “I just need to get in the best deals, so I can raise my next fund from LPs.” Or “I need build my track record as an investor, so I can raise a fund one day.” I’m going to generalize here really quickly. While it doesn’t apply to every non-lead investor, it does apply to the vast majority. I dare say, 90% of them. These investors move on the combination of three levers:
Great traction
Great team,
And great co-investors – the last of which is often the most important.
The more of the above levers you have as a founder, the faster you’ll get a check from the above individuals and institutions. Why do great co-investors matter so much? Outside of branding and social rapport, their investors – their LPs – also want to invest in these top deals led by these funds, but often can’t invest into these top-tier funds since everyone wants to get into a16z or Sequoia. In fact, for many of these top-tier funds, there’s a massive waitlist of LPs.
Finally, lead VCs. Ownership does matter. Really, this is the only audience you need to worry about when it comes to the topic of early dilution. While you as a founder should be dilution-preserving, sometimes, taking the capital (and subsequently, the dilution) is the best option. Maybe you really need something from an accelerator or an early investor that would be hard to get for you yourself. At that point, their capital becomes optimization capital. Early checks can get you from A to B faster, with less burn potentially, and with less detours.
So, the question you have to figure out if you take subsequent capital injections is that each time you dilute the cap table, did you reach an important milestone? What’s worrying is if you keep diluting your cap table without making meaningful progress each time. Think in the framework of milestone-based financing. Raise what you need, while giving you and your team an appropriate margin of error.
In closing
As a footnote, it’s also important to consider how much equity you as the founder will have left upon exit. If you’re going through large amounts of early dilution, you’re going to have very little upside unless you go through a massive exit. Unlike investors who invest in many businesses and have diversified their risk appetite, you, the founder, have put all your eggs in one basket. So if you care about the upside, you want to reduce dilution unless there is an absolute necessity to raise capital.
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Seemingly, everyone these days – from Twitter to podcasts to blogposts (including mine) – talk about buying and investing in startups. What are best practices for investment theses? How do I pick the best companies to invest in? Conversely, how do I get picked or get allocation into hot startups? But people rarely seem to be talking about selling positions. So, if you know me, I hit up two of the smartest people I know – one early-stage, the other growth-stage. Both of whom might be familiar faces on this blog. So I asked them:
How do you think about selling a position? How much does DPI matter for your investors?
The below insights include minor edits for clarity.
The notice that you’ve all seen a million times
None of this is investment advice. This content is for informational purposes only, and should not be relied upon as legal, business, investment, or tax advice. Please consult your own adviser before making any investments.
Shawn Merani (Parade Ventures)
Shawn was instrumental in my early career growth in venture. When I met him years ago, he was still running Flight Ventures, where he wrote early checks into Dollar Shave Club and Cruise Automation and was one of the first syndicates on AngelList. There he led a network-based model of syndicate leads, which I’ve heard been described by others as a “venture partner program on steroids.” Now he’s the solo GP at Parade Ventures, a seed stage venture fund investing in enterprise-themed companies.
“I would preface all of this with the fact we have never fully exited a position before a traditional liquidity event, but more so, have managed our position given the duration of our ownership and to generate returns for our LPs and manage risk.
“We talk to founders all the time, and foster a relationship that grows. When I was writing check sizes for 1-5% of ownership, my engagement then is very different from my engagement with founders now, where we take more concentrated bets.
“When it comes to selling, it’s about influence and information. The larger our ownership, the more information we have access to. And if a company is doing well, we don’t think about selling. In fact, it’s the exact opposite; we buy more. If things are working, we take our pro rata. In some cases, we take more than my ownership target. And founders are willing since we’ve been helping them from the beginning. We know when there’s going to be a 3-4x uptick every 12-18 months. Compounding is powerful.
“Our investors back the fund because they trust us. They don’t talk to the founders as often as we do. They trust our decision when we say we should buy more or keep our shares. There are two ways to talk about DPI:
1. Making money for your current investors, and 2. Telling the story.
“Selling is really a case-by-case scenario, and it really depends on my relationship with the founder. All the equity in which I sold so far has been before Parade. But if we know the company is doing well, we buy more. There are also holding periods to consider under QSBS, which has huge tax benefits.”
For those that are unfamiliar with the terminology, DPI means distributions to paid-in capital. Effectively, how much money you actually return to your investors versus “paper returns”. QSBS, or qualified small business stock, tax exemption allows investors in qualified businesses to avoid 100% of the capital gains tax incurred if they hold their stock for more than 5 years.
Ratan Singh (Fort Ross Ventures)
I posed the same question to someone I’ve been a huge fan of the day I met him – Ratan Singh, Partner at Fort Ross Ventures. He’s an investor in some of the most recognizable businesses today, including the likes of Rescale and Clearcover, as well as holds board seats at Blueshift and Ridecell. You may remember Ratan from a previous essay about speed as a competitive advantage for investors. And you’ll likely see him a lot more on this blog. He summed it up best in our chat when he said, “There are two reasons why an investor needs to care about DPI: time horizon and fund strategy.” Both of which are variables, not constants, between early- and growth-stage investments.
“The true metric at the end of the day is DPI. DPI is turning in money to your investors. And there are two reasons why an investor needs to care about DPI: time horizon and fund strategy.
“Let’s start with time horizon. For a seed stage fund, as you get close to the end of your fund cycle, that’s when DPI matters. What type of vintage is the fund in? In 2021, it’s going to be the 2010 and 2011 funds.
“For the majority of the time, you want to ride your winners. At the end of your time horizon, ask for a one- to two-year extension. Usually LPs want more money or their shares distributed. They’ve already waited 10 years. Two more won’t make a difference, especially if you have some big fund returners in the making.
“For fund strategy, did you meet the objectives for your LPs already? If you have, and you want to sell some of your winnable deals in your portfolio to help raise your Fund II because those are the same LPs that would re-up in your next fund, then you might consider selling.
“The worst reason to sell is that you want to take the wins you currently have since you think the market is overvalued. ‘I’m at the peak.’ Or ‘I want to take chips off the table because there’s something bad that will happen, but that is very hard to predict.’
“There were a bunch of funds at the beginning of this year that sold their entire positions. They were desperate to lock in a win. They sold because they thought the market was at the top. And, they were wrong. I’m against it. Selling early doesn’t fully realize the strategy you have put forth. For us, at the growth stage, we shoot for 48 months to an exit. If it takes longer, did we underwrite it wrong? But even if it does, the case may be that the company is growing a little slower than expected.
“At the early stage, all funds will say 2 to 3x cash-on-cash in the LP presentation. Most funds return 1 to 1.5x, on average, with most funds total DPI at 1.2 to 1.5x, which barely returns the fund. Before your time horizon, everyone likes to cite unrealized gains and mark ups because TVPI’s all they have.
“DPI matters most for funds in the top quartile – the top returners, funds with more than $500 million, or nowadays, $1 billion mega-funds. For the bottom majority of funds, early DPI won’t matter. They would be limiting their upside.
Author’s Note: Notice that 65% of financings lost money for their investors. Source: Correlation Ventures
“The new interesting commentary is that – where the job is getting harder – a lot of crossover funds are making binary bets. Finding the one deal that’s the next Salesforce – the next industry-defining company. And putting a lot of capital to find that one or two companies. Tiger and Coatue, still maintain that 10-12% IRR, but spend a lot to find the company that’ll be the next Databricks. Every generation has their industry-defining companies. And, they’re willing to lose it all to find that one.
“You usually don’t see this at the growth stage. It’s bad for innovation. Everyone is trying to find investments that are scaling. 1000 investments in the past year became unicorns. And there are 3000+ unicorns. Yet, the top five to seven companies are still undercapitalized.”
In closing
As we closed the selling part of our conversation, Ratan shared a great quote from an Economist article:
“Flush with cash amid a deal frenzy, what is the industry to do? One option would be to liquidate portfolios, that is, to sell more assets than it buys, in effect trying to cash in some chips when prices are high. As yet, however, this does not seem to be happening. Take the figures for three big managers, Blackstone, Carlyle and KKR. So far this year for every $1 of assets, in aggregate, that they have sold, they have bought $1.30. Although Carlyle is being more cautious than the other two firms, these figures indicate that the industry overall thinks the good times will roll on.”
In fairness, as the saying goes, the high risk, high reward. Data does show that the funds with the greatest track records have more deals that lose money than those make them more money than they invested.
Interestingly enough, there’s also a huge differential between the world’s most valuable and most funded startups. According to Founder Collective, “the most valuable companies raised half as much capital and produced nearly 4X the value!” All of which echo Ratan’s words. “The top five to seven companies are still undercapitalized.”
The public often looks towards invested capital as a proxy of startup performance. But the data suggests that isn’t the case. In the words of the team at Founder Collective, “capital has no insights.” One of my favorite lines from Ashmeet Sidana of Engineering Capitalframes it is still: “A company’s success makes a VC’s reputation; a VC’s success does not make a company’s reputation.”
But when DPI boils down to selling on multiples at the end of the day, I often reference Samir Kaji‘s tweet on the return hurdles expected of different stages of investors. As you might guess, the return expectations of each type of fund varies based on fund strategy.
Since it was asked, return hurdles for LPs are for different types of funds:
Nano-Fund (<$20MM)- 5-7X+ Traditional Seed Fund – 3-5X+ Series A: 3X+ Growth – 2-2.5X+ Crossover/late growth – IRR driven – 10-12%+
As all things in the world, exiting is just as nuanced and complicated as entering. Hopefully, the above insights will be another set of tools for your toolkit.
If this essay has inspired more questions, here are some further reading materials, courtesy of Ratan:
Thank you Shawn and Ratan for reading over early drafts.
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I want to preface this piece by first saying, though I have LP (limited partner) friends, I’ve never been an LP. So take everything with a grain of salt. For that matter, even I have been an LP, still take this with a grain of salt. After all it’s just my one perspective on the world. Nevertheless, I hope this perspective helps to provide some context around the venture space. As it did for me.
For years, I’ve recommended my friends who were looking at startup job opportunities to think like a VC. And having chatted a number of firms over the years about scout, associate/analyst, venture partner roles, I’ve come to a new revelation. Or rather one that I’ve practiced for a while, but haven’t connected the dots until recently.
When you’re looking for VC job opportunities, think like an LP. I’ve written about the LP calculus a few times before, like:
The bull and bear case of rolling funds, and how the emerging fund manager can win in this saturated market
How have you thought about your own differentiation that gets you access to some of the uniquely fund-defining opportunities you have?
What are the startups in your anti-portfolio? And what have you learned since from them?
[if their funds are wildly different in fund size (i.e. Fund I – $20M, Fund II – $100M)] How do you think about fund strategy now versus Fund [t_now-1]?
For context, usually each subsequent fund doubles in size. i.e. Fund I $20M, Fund II $40-50M, Fund III $80-100M
[If they have fund advisors, EIRs, and/or scouts] How do you pick advisors? What is your mental model for picking scouts?
Or one of my favorite phrasings: How do you differentiate the good from the great [advisors/scouts]?
Over the weekend, my friend sent me a great podcast for me to unwind. In it, I found an unlikely hero soundbite. “Your library holds a lot of value that you may not know until the story arrives. […] No one’s selling characters ’cause they’re one story away from this character becoming a hit.” While its context is related to why Marvel won’t sell any of its superheroes, Alex Segura‘s, co-president of Archie Comic Publications, anecdote proves just as insightful to the world of venture.
Discovering first-time early-stage founders is hard. The same is true for finding the next killer GP or venture firm. AngelList’s Rolling Funds are democratizing access to capital, lowering the barrier to entry for emerging fund managers. And really the success of a fund is determined by its MOIC – multiple on invested capital. 5x and up would be ideal. And that, like I mentioned in my last blogpost, boils down to the fund’s top one or two winners. Loosely analogized to a fund’s unicorn rate (percent of portfolio that are unicorns). In other words, the “one [investment] away from this [fund] becoming a hit.”
To see if a fund can consistently find those stories boils down to its systems. Often times, you’re joining a fund that has yet to have a runaway success. Or a fund that has a fund returner. So, instead, you’re looking at their thesis and if their thesis allows them to be:
The best dollar on the cap table of a startup in their scope
Forward-thinking enough to see where the market is heading, rather than where it’s been
And by definition of being forward-thinking, taking bets/risks that few other VCs would, yet calculated enough to make logical sense given the trajectory of the market. In other words, is the thesis grounded on first principles, yet able to capture their second-order effects?
That, in turn, requires you as a VC applicant to have decent literacy in the market the firm is betting in.
As James Clear, author of Atomic Habits, wrote, “You do not rise to the level of your goals. You fall to the level of your systems.” What are their mental models? Fund strategy? How do they think about portfolio construction? About capital allocation? And more importantly, time allocation?
If you’re looking to learn more about GP-LP dynamics, I highly recommend Samir Kaji’s Venture Unlocked podcast and Notation Capital’s Origins podcast.
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One of my buddies and his team recently successfully raised their Fund I, luckily before this recent downturn. Moreover, their fund is geared towards investments into frontier tech. And the Curious George in me couldn’t help but ask about his findings and learnings. In the scope of mega versus micro-funds, our conversation also spiraled into:
the current state of private markets,
VC-LP dynamics,
and, operators-turned VCs.
Here’s a snapshot of our conversation, which could act as a cognitive passport for newly-minted and aspiring VCs. For the purpose of this blog, I’ll call him Noah.
The Snapshot
David: How do you think the private markets will change in this pandemic?
Noah: In a way starting a fund is a lot like starting a company. It’s definitely a humbling process to be on the ‘other side’ of the table and feel what it’s like to be an ‘entrepreneur’ and fundraise.
Yeah the impact on the private market side is something i’m trying to figure out yet. I think it’s still a little early to denote the true extent of the impact. But nonetheless, in the short term, funding activity is bound to go down, people are speculating the duration of this event and waiting for prices to come down. We’re lucky to have closed some money before this happened but it’ll be extremely tricky for the next wave of new fund managers to raise their funds.
It’ll be an especially rough time for founders especially if it goes on for long enough, most VCs will probably try to cut losses by dedicating their attention to portfolios that have the highest chance of survival. This crisis is also different in the sense that it’s a virus which prevents people from regrouping quickly if it carries on.
David: And it’s partly due to a recent function of LPs under-allocating towards the VC asset class as a whole, with longer fund cycles (10 years [6-7 years now] + 2-year extensions). Before all this, the market had been performing rather well in the past few years (a solid 17-18% return YoY on the public markets, or these self-imposed liquidity events, versus venture where only the top quartile of VCs make better than market return). I believe the 2018 number for the top quartile annual IRR was 24.98%, which is, what, 3x in 5 years, but even then, its not enough to convince many LPs.
Although you have the rise in a new sort of private investor in both the secondary markets, as well as VC-LP functions, where firms LPs either invest directly, or VCs are now investing in other micro-funds, like Sapphire. With VCs writing more discovery checks, and so many recent exits in tech, syndicates, via SPVs (special purpose vehicles), has helped them develop relationships with founders early on and relatively no strings attached.
Noah: I think one metric that really stands out that everyone is thinking about is in terms of liquidity. Not only are companies staying private for longer, more and more new alternative asset classes are rising. Interestingly enough, a lot of the endowments or larger institutions we’ve talked to are over allocated in venture. For example, Duke has nearly 1/3 of their money allocated to VCs. One obvious way that VCs are tackling this is in the secondaries market, selling off equity earlier and earlier, so lower potential return profile but LPs generally love early indications of a good DPI.
And yep, microfunds is definitely a big trend as well. It’s simply not sustainable for half a bill/billion dollar early stage funds to exist. Some of the returns of these mega funds have been made public and they’re not looking too great, even if it’s still early for them. On the flip side, smaller funds are a lot easier to return and generally where the best performing vehicles can be found. Moreover, the traditional endowments and institutions have locked in to the Sequoias and Andreessens already, so new FoFs (fund of funds) and relatively newer endowments are always looking for who are the next best alternatives. It just so happened that we’re also seeing a wave of ex-operators coming into the world of VCs and starting new funds. They might not have the acumen to build a long-standing mega fund yet, but their technical expertise makes them a good candidate for more verticalized funds.
David: I totally agree with your sentiment that operators should go do specialized funds, that could be vertically aligned, or could be functionally aligned (i.e. marketing, growth, dev, design, etc.). I’ve had this long standing belief, and let me know what you think. If you’re a great VC, run a mega fund. But if you’re a good-to-okay VC, run a micro fund or an alternative funding vehicle.
As someone who’s good-to-okay, it’s more important to (1) hedge your bets, aka diversify your portfolio, and (2) collect data. Most newly-minted VCs don’t have the experience, like you said, on the other side of the table. Just because you’ve been a good student doesn’t mean you’ll be a good teacher. As someone starting off or just don’t have a stable track record for doing well (aka one shot wonders or the lagging 75% if not more, of the industry), you gotta collect data, to do better cohort/portfolio/deal flow analysis.
Whereas if you’re a great VC, you need the capital to commit to the best investments of your portfolio. So megafunds, plus growth funds, make sense. Although, admittedly great VCs are far and few between.
Noah: My two cents is that the trend of larger and larger fund sizes is ultimately the result of VCs becoming too competitive. It’s no longer enough that VCs have a platform team to help support portfolio companies because more and more other VCs are amassing large support teams too. Therefore as you mentioned, the true way for them to stand out is to have a multi-billion dollar fund that spans across multiple stages. So unlike an early stage fund that can only guarantee committing maybe up to, let’s say, $10MM in capital during their seed and series A, these new beasts can support you in the growth rounds as well, all the way to IPO, and more and more VCs are doing so.
The problem is that this is a recent trend that happened within the past decade, and it’s still quite early to judge the capabilities of some of these new mega funds and whether they’re qualified to manage such a large fund. Nonetheless, you do still see that some of the best funds out there are very disciplined in keeping a consistent fund size (e.g. USV, Benchmark, First round, etc.) simply because it’s so much harder to return a billion dollar fund versus a $250MM vehicle. Microfunds is another interesting trend. On one hand a lot of these newly-minted VCs simply don’t have the capability to raise a >$100MM+ fund in the first place. But there are also cases where the GPs are more than capable but still choose to keep it at a <$100MM vehicle. I’m guessing a lot has to do with the competitive environment we’re in nowadays. When you don’t have as high ownership targets because of your smaller fund, you’re more flexible with minority stakes and can thus co-invest and get into better deals.
What does this mean for founders?
In these trying times, the public discourse around venture financing has been that there’s still quite a bit of capital that has yet to be deployed and that investors are still looking to invest. Yet it is neither entirely true nor entirely false. There are still financings going on today. Admittedly, most of these started their conversations 2-3 months ago.
The goal is cash preservation over growth for many verticals and companies, and it’s no less true for private companies. In that theme, most investors’ first foremost focus is the wellbeing of their portfolio. And because of that priority, many investors are slowing their investing schedule for now. This is especially true for megafunds, where, as ‘Noah’ mentioned, requires much more to return the fund, much less make a profit.
On the flip side, I’ve seen smaller funds and angel syndicates still actively deploying in this climate. I’ve also heard concerns where this pandemic and downturn is going to affect their fundraising schedule for Fund II and Fund III, so they’re pressured with making bets now from their LPs.
Anecdotally, it shouldn’t be harder to raise funding now than before. Some of the greatest companies came out of the past few downturns (2000 and ’08). A caveat would be if you overvalued in a previous round and are still looking to maintain the valuation trajectory (up round over down round).
So keep hacking! Measure well! And stay safe!
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