To Follow On or Not to Follow On

I have figured out the ultimate VC fund strategy.

I swear, its totally foolproof--guaranteed to bring superior returns.  You can forget everything you've read everywhere else.  

Do what you're good at.

It's that simple.  

There are a lot of people that artificially group together performance metrics for venture, and try to extrapolate successful stratagies from it.  I know, because those people all used to pitch me as an institutional LP back in the day.  Reality is that venture is a bunch of individual stories, individual assessments of teams, unique products, and a whole lot of stars lining up for particular companies for success to happen.  The one thing that does effect them all is the cyclicality of funding and exit markets, but if you go back over the last 20 years, there's really only been a very short timeframe where you literally could not get a company funded.  Sure, when those periods hit, they hit bad, but most of the time, they hit the poorly prepared companies worse.  In the late 90's, it wasn't surprising that companies with no revenue that were funded at 100 million dollar valuations didn't survive.  That wasn't a bubble bursting issue--that was a poor financing strategy issue of people getting caught with their pants down, hands in the cookie jar, and all the metaphors you can think of at once.  That's why I constantly remind companies that when you do an outsized financing price or size-wise, you expose yourself to getting hit bad in a downtown unless you're conservative about how you use the money.  

So, the idea that it's a good or bad idea to follow on, or to play in certain stages versus others--honestly, it's a lot of marketing hype and anecdotal stories that really don't play out across the law of large numbers.  

Me?  I think I'm terrific at helping early stage teams by rolling up my sleeves and doing what's necessary--getting them hires, PR, product strategy help to find that market fit.  What I'm not good at--or, rather, simply haven't done yet, is sit on a board for seven years helping a company go from $20mm in revenue to $100 million in revenue.  I haven't negotiated to get my way into $18mm funding rounds with huge checks--so I'm simply not going to do that.  I'm sticking to what I know.

What I find most interesting is the response from people around the idea of following on or not--and this is where I find some pretty questionable logic.  Here are the top things I hear about follow ons and why they don't make a lot of sense to me:

1) You need to have follow on capital to protect your investments in case of a down round.

If you're a multi-stage investor, I get this.  Sometimes, over the life of a company, there are ups and downs and you might want to have a little extra cash to put in when there's revenues, a strong team, and a promise of better times ahead.  

But that's when you've actually proven this thing is a viable company and there's work worth protecting.  If you're doing seed deals, how often does a down round in a seed deal even happen?  Down from what?  If you're investing at pre-money valuations in the low to mid single digits, then how much worse can the next round even get?  If I invest at a 4 pre and the next round investor says, "I'll do this, but only at a 2 pre," then we're already effed and something went wrong.  

Sure, it *could* happen, but most seed rounds have more binary outcomes--you try to prove a simple hypothesis and you either make it or you don't.  I think the "near miss" scenario is totally overhyped.  I'm sure an entrepreneur would like to think that they came a lot closer than they did, but I think the reality is that if you're already into down rounds within the first year of your companies existance, your future is probably pretty bleak and the VCs seed money is probably best spent elsewhere.  Your time as an entrepreneur is probably best spent elsewhere as well--and that's the most valuable investment of all.

What's more likely to happen is a flat round, where everyone just tacks on a little bit more money to turn over another card to see if there's anything there or give you just a little more time--which is fine, but you don't have to "protect" from flat.  Sure, it might be a good buying opportunity, but if that's not what you do, then that's not what you do.

On top of that, I'm not 100% sure you can really know that much more about a company at that next round anyway.  VCs who tell you they "knew" that this company was a good company, even though no one else was willing to buy into the plan, are really betting on luck, which they often mistake for skill.  I've seen so many instances where these types of bets to "save" a company just wind up being a rabbit hole and a great way to punch a big gaping hole into your seed fund when the company blows up after a long delay.

If you like that team so much, bet on them again to start a new company and a new idea, based on what they learned from the last one.

Some of this thinking is also driven by folks who aren't well connected to the rest of the later stage venture community.  If anything, I've seen that later stage folks go to great strides to maintain relationships with people that are in the early stage business for the long term.  When the choice is "screw this seed fund and let's put the entrepreneur at odds with the people that were there for them first" or "Ok, fine, let's just do a flat to slight uptick round b/c the difference between a 3 and a 6 pre won't matter that much when we exit for 250", they'd usually rather go with the latter to maintain the relationship.  

The veterans are all saying "yeah, but when the bubble bursts, you get screwed."  Yes... we all do, pretty handily and pretty equally--so try not to invest in bubble deals.  

If you're an irregular angel or someone they're not counting on for future dealflow, then yes, perhaps you need to grease up--but this is an industry where relationships count unevenly.  

 

2) If you follow on, you have to follow on with everyone or you'll screw the company via signalling. 

Everyone who argues for this has totally seen it happen before, they'll tell you--except that I really do have to question the idea that there was this amazing company that you didn't want to back and for that reason alone, no one else wanted in either.  

So basically, all VCs are lemmings, and are willing to outsource decision making to other VCs.

Is it me, or aren't all VCs generally the kind of pompous, egotistical types who think they're smarter than everyone else?  Since when does someone else's "no" take them from a strong "yes" to a no?  I feel like they were never really that interested in the company in the first place, but maybe a lot of momentum would get them over the hump.

So, the rule about signalling is: "If you're a mediocre company that people are on the fence on, and none of the people who know you best seem to like you, other people probably won't go out of their way to fund you."

Try not to be a mediocre company that no one has a strong opinion on and you should be ok.  

 

3) It's good to have a deep pocket in your round just in case the company needs more money but can't raise again.

Some big VCs are awesome at seed, and to a lot of work to help their companies.  Google Ventures comes to mind.  Others genuinely suck at it and not only will ignore you for the most part, but occasionally drop in and give you bad advice because they don't understand the stage you're at.  I won't tell you who comes to mind here.  My general rule is that you should have people in your round who are good at working with companies at your stage--and don't expect anything from anyone unless you perform.  

Too often, you put a bigger VC in your round to be the deep pocket, but you never tell them they're the deep pocket or get a sense of their follow on strategy.  There's little to no interaction for nine months, you miss all your milestones, and then you want to know why they're not psyched about the next round.  You blame the signalling.  

You need to absolutely be certain of what the goals of your investors are when you let them in and weigh all the possibilities accordingly.  Some VCs just toss in seeds as options.  Others just want to stagger their risk over time but almost always follow through in several rounds.  You need to make sure you know which one it is.  

 

4) You should follow on as a VC because the only way to make money is to double down on your winners.

You know what most VCs aren't good at?  Picking winners based on more information.  Isn't that the trouble with the whole asset class?  I thought the numbers prove this--because big later stage underperforms small early stage.  

I'm not a big fan of strategies that require *more* intelligence on behalf of VCs.  I want to know how a VC can make money and be dumb all at the same time.  That's a winning strategy because then I don't have to count on anyone being smarter than the next person.

It's nearly impossible in the first two years of a company to be 100% certain you have a winner.  Sure, sometimes, you have a clear winner like a Kickstarter, but when *everyone* knows they're a winner, you're not going to get that next round on the cheap.  The only time you're going to be able to buy up is when you think the company is a winner, but other people won't--that's a smarter than the next guy strategy.  I think VCs tend to be wrong just as often than they're right in those cases.  How many companies looked red hot at one time--Hashable, Dailybooth, Digg--not to make it in the long term.  You definitely would have doubled down early there, while thinking that perhaps your investments in Burbn (Instagram) or Tote (Pinterest) were dogs right out of the gate.  

I'd rather think that I'm not very smart, but that, in general, if I pick solid ideas that match patterns of product success, with teams that match the challenge, I will do well in a portfolio by adding a lot of value early on.  I might not know which companies are going to generate my return, but on the whole I'll do fine.  I know I can work harder, but I'll be the first to admit that being smarter than the market is a fool's game, or just dumb luck.

So, yeah, I'll just stick with what I know, assume that it isn't a lot more than other people know, and try to spread my bets evenly.  You're welcome to do differently with your own fund or vehemently disagree in the comments.