The Achilles Heel of Startup Ecosystems

Across the world, various economic development organizations, government agencies, and non-profits are putting in admirable and well-intentioned efforts to develop startup ecosystems. They’re building campuses, districts, buildings, spaces, as well as running new educational efforts and contests—basically anything they can think of to foster the growth of new and innovative companies.

One thing they’re spending very little time on could wind up being the reason why all of these efforts dry up. Very little time and effort is spent helping professional, full time investors raise capital for venture funds. Everyone is excited when a new company gets funded in their ecosystem, but no one spends much time thinking about where the money comes from to fund that deal.

To care about this issue, you have to believe one thing—that the presence of full time, professional investors in an ecosystem catalyzes funding rounds better than a collection of part time angels, accelerators, and/or government entities that usually don’t lead deals. Accelerators can be great, but they’re not giving companies enough money to achieve the kind of escape velocity needed to get on the radar of national Series A firms that will invest anywhere. At some point, a real seed round needs to get raised—and it needs to get led by someone. Angels will often sit on the sidelines until someone comes in to set the terms and write a bigger check.

Take the example of goTenna, a thriving communications hardware startup located in Downtown Brooklyn that employees almost 50 people. I backed that company in 2013 when it was basically a table top science project, but the key was a series of connections that could have only been possible as a full time investor. I first met Daniela Perdomo, goTenna’s founder, at SXSW. So, number one is that I needed to be at least engaged enough as an investor to be out there attending gatherings of innovative people.

Second, I sought her out at that conference because I saw on SXSW’s intranet that she had listed NYC Resistor, a hardware hacking space and collective, on her bio. Resistor is a bit under the radar as a very cool community—and so being associated with it was a signal that I could have only known about if, again, I spent all of my efforts as a seed investor turning over every rock looking for opportunity. This isn’t the kind of thing your average high net worth individual who occasionally does a deal would know about.

This company would have had a much harder time getting a seed round together had it not been for the presence of professional seed fund investors—and my seed fund wouldn’t exist had it not been for the 50 different individuals and entities who participated in my first fund.

Yet, do you know how many of those investors came through intros made by those who have a strategic economic development interest in fostering the NYC ecosystem?

Zero.

Not a one—and through conversations with other seed funds I know, this is pretty widespread. A lot of these strategic entities have boards that are filled with some of the most successful high net worth individuals, family offices, foundations, etc. but the connections are not being made to support the funds that are supposed to be funding all these local startups.

I was talking with someone who worked for one of these entities recently and they gave me some insight as to why. This person told me that their group was worried about these folks “getting hit up all the time”.

This is exactly the wrong way to think about the economic opportunity presented by innovation. Innovation isn’t a charity—it’s a ticket to a very interesting and exciting future.

Wealthy people trade that wealth for interestingness—and the opportunity to economically participate in the upside of your local startup ecosystem is super interesting to many people. Not only that—these people are doing all sorts of different kinds of deals—and you don’t do deals without deal flow. No one has to say yes, but rather than this seeming like a bother, anyone with an investment mindset is going to welcome the opportunity to roll up their sleeves and dive into thinking about an opportunity.

Not only that, but for many in the real estate world, their economic upside is already tied to innovation. The growth of the local NYC startup community has been a huge moneymaker for many of those folks and can continue to be if the ecosystem continues to roll.

This won’t happen if all the seed funds become institutional, get larger, and stop writing the kinds of small checks that turn science projects into 50 person companies.

The other reason why development related entities that support startups should be making these introductions is because of some of the indirect roles VCs can play in the startup ecosystem. By being full time in the community—they can make connections to help market various programs and opportunities. They can help filter who these organizations should be focusing their time in supporting. They can also help generate interest across different types of wealth through their history of success. There’s no better way to get a room full of people who made money in real estate, manufacturing, or natural resources to care about tech startups than to have a professional investor up in front of a room sharing their approach, their wins and translating the enormous amounts of individual deal risk they appear to be taking into a sensible investment philosophy others can buy into.

Raising for a seed fund is exceptionally difficult. Institutions typically don’t participate until you’ve already got a few funds under your belt, and even when they do, their average check size is often too large for what you’re trying to put to work. That leaves seed funds out trying to gather a random mix of high net worth individuals and family offices, which is a bit like trying to find a needle in a haystack in a dark room with one hand tied behind your back.

It’s not exactly like anyone puts “willing venture fund investor” on their LinkedIn profile.

If you really want a solid startup ecosystem, you need multiple seed funds all coming at the community from different perspectives both funding a wide variety of companies but also working collaboratively together. It’s not just about having one dedicated fund—you need many funds coming together in a marketplace of ideas.

No one is asking the Mayor to tweet their fund prospectus, but hosting informal meetings with members of community economic development boards, looking into small baskets of endowment funding that can go into local early stage funds, and just generally being willing to help because they understand that we can’t fund your local startups unless someone funds us would be enormously helpful.

Three Exercises Every First Time Venture Fund Needs to Work Through

Some VCs peel off of other funds to start their own and they have the benefit of a track record from their previous firm to show. Obviously, that’s ideal, but that’s not where everyone starts.

If you’re lacking for track record as a firm, here’s three exercises you should walk through to help turn your pitch and due diligence meetings from guesswork into something more substantive.

The Fantasy Cash Flow Model

When I was an analyst at the General Motors pension fund, investing in VC funds, I had to build a model of how I thought they would perform. It started out with initial investment size, pricing, and outcome behavior for each deal and then it made a prediction around the distribution of outcomes.

It’s easy to say you’re going to be a 3x fund, but how does the math actually get you there. If you’re not actually modeling this out with a spreadsheet, I don’t know how you can look an LP in the face and say this. Build up your model of what you think the individual financial outcomes will be over time—layer that on with follow-on decisions, fees, carry, etc. I think the results will surprise you how hard it is to be successful.

A Time and Attention Model

How much time will you be spending on each portfolio company? Taking board seats? For how long? How long is your partner meeting going to be? Will you be going to the gym at all? Spending any time with family? How much do you sleep?

You give money away for a living—and so you’re going to get overloaded with requests. Once you do distribute the capital, you’re giving it to companies that will need a lot of help. How will you provide it across 30 investments? Will you have analysts? Partners? Will that increase the work?

Figuring out how you’ll spend your fully loaded time is something any LP will want to understand in order to know if you can handle going from just angel investing or doing whatever you were doing before to running a portfolio full time. Here’s what my model said.

The Backtesting Model

In the public markets world, when you start a new fund, you backtest it. You take your investment model and run it against the past to see if it would have worked. Want to only invest in diverse boards? Only companies with a certain contribution margin? Maybe you only care about growth. Whatever it is, could you have run that model successfully over the past five years? Not all prior performance is a guarantee—but it would be nice to know if this would have worked in the past.

I ask the same of new managers. Had you actually had your fund in the four years prior to today—which deals would you have legitimately been able to do? This is actually easily referenced.

For example, let’s say I had a more national fund. Because I had previously met Jack Dorsey through the Union Square Ventures network, in 2009 I was able to grab coffee with him before he launched Square. He demoed the product to me and I wound up being dollars #476 and #477 to be swiped on the very first Square prototype. I was blown away.

Had I had a fund, I could have said, “Hey, let me invest in this…” and maybe I could have squeezed $25k into the round. It’s at least plausible—versus being someone who had never met him at all who said they’re starting a fintech fund and Square is the kind of thing they would have invested in. It wasn’t likely that a fund who had no prior connection to him at all would have gotten in.

If you’re looking for more tips and advice on starting out as a first time fund manager, you should check out the webinar I’m putting on with Carta next week covering all the basics and stupid questions that aren’t so stupid.

You can RSVP here: https://www.eventbrite.com/e/best-practices-for-new-and-emerging-vc-funds-presented-by-carta-tickets-58679227148

Some Thoughts and Models Around Ownership Targets

You hear this from VC’s a lot: “We need to own X% of your company to make our returns.”

They back it up with sensible math—owning 20% of a billion dollar outcome returns a $200mm VC fund, and, of course, you’re trying to at least return the fund. So, no one really questions the ownership model.

Yet, when you buy shares of Apple or Facebook, you don’t even think about what percent of the company you own. How then, do you expect to make money when you’re buying on the public market?

Everyone knows the answer to that.

“Buy low, sell high.”

Seems like that should translate over to the venture world, too. After all, all we’re really doing as VCs is buying shares, aren’t we? How come VCs don’t think about it that way?

There are two reasons. First, price discipline doesn’t work in overly competitive markets. When there are too many funds in a market segment trying to do the same deals, keeping your entry price reasonable is going to get you shut out of a lot of deals. If you’re a first check lead VC for pre-seed rounds in New York, you can keep your head on when it comes to price, because you’re not going against that many other people.

If you’re in SF trying to fund AI companies from YC, good luck with your price discipline.

Second, you can only get so many dollars into “cheap” seed shares. If you raise $100mm, you can’t put it all to work upfront because the rounds aren’t big enough—so you have to deploy more capital later (and more expensively). Dilution becomes the enemy. You tell your investors that you don’t want to own a smaller and smaller percent of your “best” companies. You need to write bigger checks to maintain ownership.

What you’re not saying to your investors is that you’re buying more and more expensive shares at a lower return.

I guess that doesn’t have the same ring to it.

Of course, there are other non-financial reasons to follow-on. Brooklyn Bridge Ventures, my fund, does small follow-ons (10-20% of the original investment) that enable the founder to say that everyone is continuing to participate. That means you might get $400k upfront from me in your seed or pre-seed round when the money is hardest to get, plus a term sheet that helps wrangle everyone else, with a follow on of $50k in whatever comes next. The vast majority of founders are completely willing to get more money upfront when they haven’t proven much yet in exchange for less money later when there is enough risk off the table to get others to participate instead.

Also, funds that lead Series A, B, and C rounds have serious capital needs that extend over the life of a company. They’re not only leading larger rounds, but may need to bridge companies they’ve otherwise made large investments into that have higher burn rates. Sometimes, you’re the only one around the table who wants to do a Series B and that requires real cash.

That’s not what seed funds are doing. They don’t have enough cash to bridge a Series C round anyway.

Seed funds specialize in doing a lot of work for not a lot of money—and I suspect that’s why they’re getting larger. We do the work of sorting through the pitch decks of everyone and their mother, finding the diamonds in the rough, helping them turn an idea into something that looks like a company—and we do it for a fraction of the management fees of our later stage counterparts.

The incentive to want a larger fund is real—more staff, better office, better salaries—but the investment strategy of holding back your capital to pay up for pricier shares really doesn’t make much sense from a returns perspective if you ask me.

I took the time to model out some returns using share price as a basis—to figure out if the price you’re paying when you buy up is worth the difference in the outcomes.

Here’s a very plain vanilla model. It doesn’t take into consideration fees, carry, options, down rounds, or recaps. It’s just a model of the share price of a company going up and to the right smoothly until it exits for $300mm, and the outcomes for the shares purchased in each round of financing.

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Seed round investors get a tidy 18.2x return—which means in this model I’d return half my $15mm fund on one $300mm exit—since I front load most of my investment into the first round and write checks of $350-400k.

Later round investors who pay up get less, obviously.

Keeping fund size the same, they also wind up putting less into the first round of their winners while at the same time putting less into the losers. They hold their cash back until they have more data, and lean in as a company is outperforming.

That creates a tradeoff of paying up for more information.

How much do they hold back? This is the data of what your investment dollar distribution looks like if you’re doing the pro-rata of each of these rounds.

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Obviously, if you’re only doing the seed, you’re putting 100% of the fund into the seed. If you’re holding back to do your pro-rata in a seed+ round, you’re holding back about 32 cents on the dollar and putting 68 cents in upfront. Doing your pro-rata in the Series A? That means you’re only going to get 37 cents into the cheapest round and you’re holding back the other 63 cents for later, more expensive investing. That means your winners are giving you just under a 9x return, because, on average you’re paying twice as much.

At least you’re avoiding putting more of these dollars into the losers, through, right?

Yes, but you have to be really good at that to make it a better fund overall—like, REALLY good.

How good?

I created a few fund mix scenarios and estimated what the overall fund return would be given that mix.

Here are the following outcomes:

Big Winners: Exit at $300mm No downrounds

Solids: Exit at Series B Post No downrounds

Meh: Exit at Seed+ Post No downrounds

Capital Back: Capital Return

Wipeouts: No Return

I don’t like modeling things with billion dollar outcomes because they’re rare and you shouldn’t base your investing on getting one.

Then, I estimated a seed fund’s mix of dollars necessary to get a 3.3x return without follow-ons:

It’s not unlike what you hear a lot—that about 10% of the fund or so generates most of the returns. Throw in a couple more solid returners, a few singles and doubles, and you’ve paid for the fact that half your portfolio was a complete wipeout.

Some call it lucky. I call it disciplined—because you’re buying in cheap enough to make your winners return enough to make up for the duds.

If you keep on going through the seed+, you’ve got to be a bit better allocating your dollars. Only about a third of your dollars can go into the duds and you’re up closer to 15% of your dollars going into winners to get the same fund return.

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The pattern continues through the A. If you’re following on that far, you’ve got to be that much better in your dollar allocation to get the same returns:

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How much better? Well, now a quarter of your portfolio has to be invested into the big winners and only 15% can be in the duds. That’s actually kind of a problem—because, at seed, a lot of funds will admit that half your seed bets aren’t going to make it—but our math earlier gave us the following:

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This is the dollar distribution of your investments when you do pro-rata through the A. About 37% of your dollars will be in the seed rounds, and if half of them went bust, then you definitely invested more than 15% of your fund in those rounds. Not sure how you get around that math—unless somehow you’re able to know ahead of time they’ll be duds and you put less in them. It begs the question of why you invested in the first place.

Obviously, the math and estimates here are super variable, but the point of this is that we have walk right up to the edge of suspending reality to just get the same returns as in the no follow-on model. Imagine what the math needs to look like for this model to be demonstrably better by following on all the way through.

Keep buying up, and the pattern continues…

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Follow on all the way through a Series C and you’ve got to put in a full 90% of your dollars into your big winners to get in the ballpark of the no-follow model. Again, that’s going to be super hard to do, because if you invested through the A on all your companies, you put in about 15% of your dollars into the duds…

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Here’s how your dollar into a company shakes out if you’re doing pro-rata across rounds. In a one company model, it’s about 30%—but since half your seeds don’t make it to A, you cut the 14% A round follow in half. I don’t know how many seeds make it to seed+ or how many seed+’s there are, but the point is, you don’t have much margin for error if only 10% of your portfolio is allowed to be invested in the duds.

Following on is just really, really hard work if you’re going to get the same returns—and you can’t afford to follow on big into a company into the Series B, C, and beyond and not get a big outcome. That will sink a fund in a hurry.

The nice thing is that you don’t need the same returns, because you have more management fees and a bigger fund—so less carry on a larger base is still more money.

If you’re a larger LP, you don’t have much choice to put the money to work either. If you need to invest $25mm at a time, you’re still better off in venture capital than in the public market if you can access good managers. If you’re a smaller investor, however, and you can get your check size into any fund—the math points to trying to get into the fund buying in at the lowest average share price across its portfolio. It’s a lot easier to make a better multiple of return there—and if it’s all the same to you check-size-wise, then smaller seems better.

I’m sure someone else can build a much better model than I can, and throw in a lot more complexity around return expectations—but to even build a model at all probably makes me top quartile in terms of GP analytics. I’m absolutely stunned at how few managers, especially new ones, ever bother taking a shot at doing any fund cashflow models. Too many times I hear echos of what’s been talked and blogged about without any data behind the thinking. What might work for a larger fund may not hold true for a smaller one—so before you take someone else’s strategy as your own, take the time to do some math around it.

Also, we all need to play to our strengths. Some investors are better at dealing with more data—and others might be better “first pitch” hitters. What’s important is that you’ve thought through how good you need to be if the data says you need to be better than average to make your math work.

Why Investor Titles are Important

The other day, I generated a lot of buzz and feedback around my assertion that calling yourself an “angel investor” should require a little more than small syndicate investments:

Most people seemed to agree—some disagreed, but a few people were like “Why do you care? What does it matter as long as they’re out there writing checks?”

Some people thought it was a privileged way to enforce hierarchies and to equate money with value—and I understand where they’re coming from. The issue is that nomenclature creates a certain set of expectations that founders use to allocate the most precious of their resources—their time. They want to make sure that they can achieve fundraising goals as fast as possible and I am nothing if not a passionate defender of a founder’s time. That means deciding who to take 1:1 meetings with, who to travel for, or who to take 2nd or 3rd meetings with—and size of check has a major impact on that.

It used to be that the only people who could even get into angel rounds were high net worth individuals that could write at least $25,000 checks—so if someone said they were an angel investor, you could assume this was their minimum check size. With the advent of platforms like Angel List, now you could be investing with just $1000—which is great for the democratization of the asset class. Everyone should be able to access any investment—but it becomes confusing for founders to figure out where they should spend their time. It becomes even more confusing when they’re out going to conferences and reading articles that feature interviews with “angel investors” because they’re assuming these are folks with a certain type of experience that could be very different than reality. Crowd investing platforms allow anyone to be an investor even if they’ve never even interacted with the team—so you could have made two dozen investments and still have very little firsthand knowledge of what life is like at a startup or what early stage founders go through.

With new technology should come new terminology. I would propose that we call these types of investors “syndicate investors”—super useful folks who join with others to help rounds get raised on various crowd investing platforms. They could speak to this experience quite well if you were going that route and it would help differentiate from the kind of folks sought out for direct relationships and bigger checks. To me, an angel investor is someone who writes at least $10k checks (if not actually $25k) directly into company cap tables (as opposed to into syndicates or SPVs) and at least has some direct relationship with the founder. Other relationships can be very valuable and helpful, but I think we should call them something else.

A similar problem happens at venture firms—where no longer are you seeing clear cut terms like analyst, associate, and general partner. Now, everyone’s a partner, blurring the line around who can actually lead an investment and get a deal done. I was the first analyst at Union Square Ventures and so I get why this is done—because who wants to talk to the analyst? They don’t have pull and so founders try to go around them—defeating their purpose of screening for a partner.

Still, I think founders (and other VCs) who desire to make connections with investment professionals who have the “power of the purse” should be able to differentiate. When I was an analyst, I never took founder meetings on my own without either Fred Wilson or Brad Burnham because I didn’t feel experienced enough to vet the companies. When I wrote or spoke, I talked mostly about what I learned from the firm’s partners and what their actions were versus speaking authoritatively on my own. Today, the blurring of titles means that you have to go a few layers deeper in someone’s bio to understand what kind of experience they’re coming from and what kind of pull they might have in their firm—and I can’t see how this is better for founders trying to allocate their time and attention.

Partners, in my mind, should have carried interest (upside) in the fund and be able to lead deals and take board seats. They should be the kinds of key people that limited partners are basing their investment decisions on the fund itself on—not two to three year rotational employees. If you want to call someone else part of the “investment team”, that’s cool, let’s not try to make it seem like the person who just got their MBA has the same experience and pull as the person who started the firm. They’re an important teammate, but for founders, experience and influence is a meaningful signal on how to spend their time.

I feel the same way about someone who calls themselves a “VC”. You might work for a venture capital firm, but unless you’re an equity partner in that firm (and I would like to think a significant one) that writes checks, sits on boards, I wouldn’t consider you a “venture capitalist”. I believe the name creates a certain set of expectations and founders make assumptions about it enough that you should be a bit discerning about how you use it.

Call me old fashioned, but back in my day, I was happy working for a VC firm, but content to use my actual title of analyst so people didn’t think I was on the same level as the VCs who actually started the firm.

Five Questions for Vetting an Investment in a New or Emerging VC Fund

While most of the money that goes into VC funds comes from institutions that are highly experienced in the asset class, some family offices and high net worth individuals also invest in VC. They’re trying to get exposure and diversification at the same time, while potentially seeing co-investment deal flow.

A lot of VC fund pitches—and I know this because I used to vet VCs for a living as an institutional limited partner at a pension fund—sound the same. They all have great networks, above market performance and some special sauce that sounds nice but you’re not 100% clear it makes sense as a way to boost returns or get access to deals.

Here are five questions I would ask any new or emerging VC fund:

  1. In the five years before you had this fund (in case they have a short track record) what deals could you have legitimately gotten into that fit your strategy that would have been winners?

  2. Could you have led any of these deals?

  3. If every single fund at your size/stage/geography/strategy said yes to a deal, where are you in the order of preference for founders to accept a check from? (i.e. If you’re a Series A fund in NYC, and you, USV, Firstmark, RRE, etc all submit term sheets, who gets in and in what order?)

  4. Explain the math that gets you to a 2-3x net (after fees) return—how many deals, how much in each deal, at what valuation, what exit expectations, follow on or not, etc. If they haven’t done this math, they shouldn’t be managing your money.

  5. What risks have you taken that others haven’t—and why did you think they were worth taking?

If you want to learn more about how VC funds get evaluated and you’re either an accredited investor, a non-partner at a VC fund, or work on behalf of a family office, check out this event tomorrow. We are especially focused on bringing diverse attendees into the room. If you’re not sure if you qualify, e-mail me. No current non-accredited founders, please.