Alex Iskold
After making pre-seed investments for seven years, I have observed how different the pre-seed stage is from Series A and later-stage investing.
Today, I want to highlight four ideas that are true across different stages of investing.
Venture outcomes are driven by a power law
Power law is an immutable law of the universe. Examples include the distribution of population in cities, price of artwork, and unfortunately, wealth distribution. This law is also known as the Pareto principle, and colloquially known as the 80%-20% rule.
Venture capital is no exception and the outcomes of every venture portfolio will likely follow a power law distribution. There are two significant things to think about here:
One: Because most startups fail, the distribution is going to have a lot of zeros (or near zeros) in the long tail. The zeros are going to be followed by singles and doubles.
Two: The biggest winners, when they happen, tend to be huge. Unicorns were hard to come by when Aileen Lee penned her now-famous article in 2013. Today, unicorns are no longer as rare and top-tier firms are constructing their portfolio with the goal of funding a decacorn — a company valued at $10 billion or higher.
There is nothing mysterious about the power law dynamic in venture. Just like the rich get richer, the biggest companies get bigger.
A startup that reaches $10 million in revenue is much more likely to double, double again and then cruise by $100 million in revenue versus a startup at the $1 million mark now trying to get to $10 million.
At scale, everything is different — the resources, the possibilities and access to capital. Of course, even companies that reach very substantial scale may run into obstacles and eventually underperform. But that is not the point.
The point is that the ones that do end up winning and driving all the returns keep doubling and continue getting bigger and bigger.
Hence, the outcomes of the venture portfolio fit a power law curve.
The best managers in the business are distinguished by a few more at the very top of the curve.
The average manager faces a very real possibility of making no money at all because of how steep the power law curve is.
Your fund size is your strategy
There is a piece of feedback that fund of fund managers frequently give to GPs: Your fund size is your strategy.
What they are essentially saying is that a fund’s portfolio construction will depend on how much capital is under management, and vice versa. Why is that?
Let’s take two extreme examples — a manager of a $10 million fund and a manager of a $1 billion fund. Let’s assume that both managers want to lead rounds. If the first one decided to be a Series A fund, it would be extremely concentrated. It may be able to lead 1-2 rounds, but that’s it. Given the power law nature of outcomes, it would be extremely unlikely for this manager to generate a good return.
On the other hand, the manager who is managing a $1 billion fund has a very different problem. They have so much capital to deploy that they don’t bother with the super early stage. Investing in pre-seed and early-seed companies would rarely make sense as it would take 500 deals at a $2 million check size to deploy $1 billion. Even with 50% reserves, it would be 250 deals. So they can’t do that. Instead, they need to write large checks, and follow on as much as possible.
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Now another math complexity with a larger fund is ownership. To return $1 billion, the fund needs to own 10% of a company at a $10 billion level. This is a complex game where the manager needs to really think through their follow-on strategy to make sure they have enough ownership at the finish line.
From these two examples, it is clear that fund size and fund strategy are dependent. This is exactly why funds often specialize at a specific stage of investing:
- Less than $50 million fund — usually pre-seed and small seed.
- $150 million-$300 million fund — usually seed and small Series A.
- $500 million fund — usually Series A.
- $1 billion — usually stage agnostic, but typically no earlier than A, and more likely B+.
It’s worth noting that lately we have seen a trend of late-stage megafunds trying to get into companies as early as possible. For many, it’s an option check, with the intention of following on in a big way in future rounds.
Ownership matters
Many smaller pre-seed and seed-stage funds have been learning this very painful lesson: Ownership matters.
Let’s start with an example. Say you are running a $20 million pre-seed fund and invest $250,000 into a seed round at $10 million valuation. You own 2.5% of the business. If all goes extremely well and the company becomes a unicorn, how much will you own?
Assuming this very optimistic dilution sequence and unrealistic valuation ramp up:
- 30% dilution at Series A ($40 million valuation).
- 15% dilution at Series B ($125 million valuation).
- 10% dilution at Series C ($300 million valuation).
- 5% dilution at Series D ($1 billion valuation).
You will land on 1.27% — less than a half of your original ownership. The value of that stake would be $12.7 million, which is a lot, but still falls short of returning a $20 million fund. The solution here is to either take pro-rata — which small funds can’t really afford, or to increase check size and get more ownership up front.
Let’s look at another example — a $300 millino fund, buying 20% of the business during a $5 million-$7 million fundraise (which is now considered a large seed or a small Series A). Assuming the same dilution sequence as above, the fund will own 14.5% at the $1 billion mark, which is only a half of the fund size. The solution here is that the fund needs to follow on and maintain pro-rata, likely through Series C.
Whichever way you look at these equations, you realize three things:
Ownership matters — you need to be disciplined, and you need to get lucky.
The other realization that many managers have is that buying very little in hot deals doesn’t always work, but could work if this is the core strategy, and you get into a lot of hot deals. That is, if you can’t buy enough ownership in any one deal, you should try to get into as many of the absolute “best” deals as possible.
This strategy worked great for Ron Conway at SV Angel, who was known to be the first call in Silicon Valley. Such strategy takes a while to execute upon — you need to be in venture for a long time and build up a reputation.
Today, it is increasingly more difficult to run such a strategy because of the abundance of capital in the ecosystem. So, if you can’t get into all of the absolute best deals with a smaller check, you need to instead think really hard about ownership.
The venture business is hard to learn
There is a saying that venture is an apprenticeship business.
I dislike this saying because I think it is misleading. Of course, like in every business, having a great mentor or a great manager helps.
What the saying really means is that it takes a while to learn the craft of venture. Why is that? Well, like anything else, you can only learn venture by doing — actually investing. The problem is that this is an expensive form of learning.
Consider a $300 million fund that is focused on leading $5 million-$10 million rounds. A firm like this would do 5-7 deals a year and build a portfolio of 25-30 deals and have ~50% in reserves.
If you are a new investor joining this firm, lets say as an associate or a principal, you are unlikely to get any deals done in the first 9-18 months. Instead, you would focus on supporting a partner. In general, in firms like this, partners will have to make a final decision on all deals, because they are the ones who are ultimately accountable to LPs.
So how does a junior investment professional learn if they can’t make investments? It is like being in the passenger seat in the car, you kind of never know where you are going.
Ultimately, it takes years before a junior investor can make a few investments, and even those aren’t fully theirs.
The alternative routes to learn venture faster are to become an angel investor, to be a founder with a big exit or to go to a smaller, pre-seed stage fund.
If you can afford to, a great way to start getting into venture is through angel investing. However, this could be expensive and you will learn by making mistakes on your own dime, but if you commit to it for a few years, you will have a natural leg up.
Being a successful founder with a big exit instantly puts you into the VC orbit as a potential partner. Why? Your experience as a successful operator is attractive to the firm and will be very valuable to the founders you back.
Thank you to Zann Ali for editing this post.
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