One of the things I love about the work that I do as a VC is the strategic aspect of investing. It’s easy to think that managing a fund is simply looking for good entrepreneurs with good ideas to invest in. The reality is that fund strategy is something that general partners have to spend a lot of time thinking about if they want to stay in the job for long. The strategic decisions investors make have a significant impact on their fund performance beyond the success of the companies they invest in.
One of these decisions is the size of the first check a fund writes to a company. This is not a trivial decision. It has implications on total fund returns and can make the difference between having an average or a top-performing fund. If a fund is to succeed in the venture game, the returns from its winners will more than make up for the failures of its losers. Making larger initial investments is one of the things a venture fund can do to maximize its return potential, yet this isn’t what most venture funds do in practice.
The dynamic at play is one of risk vs reward. The greater the check a fund writes initially, the larger the potential reward the investor will receive if that company is successful. At the same time, the larger the initial check, the larger risk the fund takes while the company is still early in its development and not a lot of information exists on its growth prospects.
There are many factors that will influence the strategic decision of initial check size for a VC fund. Among those are the following:
- Market conditions might determine that larger checks are required during particularly difficult times. For example, COVID has brought about higher uncertainty to companies. These days, it would be prudent to assume a longer-than-average time required between rounds for early stage companies because of a challenging customer acquisition environment.
- The stage of company development plays a big role on the amount of uncertainty involved and the potential check size an investor should write. Pre-revenue companies, for example, will require more patience than revenue generating companies.
- A good investor syndicate is always important to the success of a startup. Strong syndicates help companies by providing support and making future funding easier. Syndicating deals provides validation to investors and helps reduce deal risk. Conversely, when a deal isn’t appropriately syndicated an investor may be forced to invest an amount that isn’t appropriate for that fund.
One general rule frequently followed by early stage funds is to set aside $2 for future investing for every $1 initially deployed in a company. This is done to try to maintain pro-rata participation for several future rounds. This strategy achieves early participation, but it also preserves most of the money for future investing, when risk is reduced. It’s a compromise between maximizing investment potential and minimizing investment risk.
We at IDEA Fund Partners believe that, for the benefit of our fund and the benefit of our portfolio companies, a better approach is to write as big an initial check as we can without setting aside any guaranteed dry powder for each company. This means larger initial check sizes than average in relation to the size of our fund. With larger initial checks we are taking greater risk in each initial investment that we make, but it also means we are maximizing the potential returns from each of our portfolio investments. This strategy requires clear communication of expectations between the investor and the company, as it is not the norm for most investors.
While we advocate for a large initial check, we also think it’s important to have a pool of funds set aside to help companies during troubled times. This is different than automatically allocating a follow-on investment amount for each new company. This pool is intended to be there for when companies show promise but hit rough patches. However, this should not be an automatic check, but rather a case by case investment pool that takes into account both company potential and deal price. It considers each new deal independently of previous investments.
Maximizing the size of our initial investments is not a strategy we decided on lightly. It took us 2 funds and more than 100 transactions to arrive at this conclusion. We analyzed our history of investing and realized that if we had maximized our initial investment from the very beginning of our fund’s existence, our performance would have been better. Our losses may have been larger for a few companies that did not make it, but these losses would have been more than offset by the gains from our successful investments.
The basic argument is fairly simple to understand. If a fund is good at finding great companies to invest in, it will be better off making that initial check as large as it can. After all, prices are almost always lowest during that initial round. If a fund isn’t very good at finding companies with great potential, no amount of risk mitigation will help.
The key point to consider here is that this is a portfolio strategy, not a one company investment strategy. One should always look at investing in startups with the notion of building a portfolio. Successful portfolios are not made up of a lot of mediocre outcomes. They are made up of a few very large successes. Maximizing the returns of the successful companies in a portfolio is heavily dependent on the size of that initial check.
Not surprisingly, there are three basic types of paths that very young companies typically traverse:
- Early success: Companies are sometimes successful from the very beginning, growing revenues quickly with valuations up and to the right after initial funding. That is what investors always hope for. Kauffman Foundation research suggests that this is the kind of growth pattern exhibited by the majority of very successful startups, and what makes up the majority of venture returns. Under this scenario the best price to pay for stock in a company will clearly be the price of the first round. Valuations will always go up from there. So, it’s in the investors’ best interest to make that first check be the biggest and, by implication, the only check for that company, maximizing the potential returns.
- Early struggle: Other times companies can struggle to take off and fail to get traction. Failing is not something that anybody wants, but in entrepreneurship, quick failure is not bad. It is preferable to slow and protracted failure. Not every company is able to notice the signals that things aren’t working out as expected, but if they are then both investors and entrepreneurs are better off moving on to their next venture. Under this scenario, it also doesn’t make sense to write more than one check.
- Up and down performance: The third scenario is where companies experience a series of ups and downs, showing promise but taking longer to demonstrate greatness or failure. This case is more difficult to manage than the previous two. Sometimes we end up there because we do not recognize the signals that things aren’t working out. Sometimes things just take longer than expected. Either way, companies often need more runway than initially thought and require more money to achieve their potential. This is the scenario where a second early check is justified, and a “trouble time” pool of funds comes into play. However, each investment should be considered independently of previous investments. We should only invest again if the reasons that made the company attractive in the first place are still there. If that is not the case, then maybe we are not reading the signals appropriately.
Three general investment principles to keep in mind supporting the case for larger initial checks are the following:
Larger initial checks lead to better alignment between company’s and investor’s interest. A “dip of the toes” by an investor in a new company as a way to get a seat at the table is another way of saying “show me first”. It says: I like the idea, but I am not convinced by it enough to support it fully. This cuts both ways, and eventually entrepreneurs may find investors that are more committed. Entrepreneur and investor alignment is very important to the success of the company. Entrepreneurs have too many things to worry about. They do not need another one.
Underfunding companies is much worse than overfunding them. Both company performance as well as venture returns will suffer when startups are underfunded. If early stage funds do not maximize their initial checks, they run the risk of continuously underfunding their new portfolio companies. What we want to see early on is either fast growth or quick failure. We want to avoid the purgatory of mixed signals that make it difficult to tell if a company has potential. Underfunding obscures the signals, creates uncertainty, and doesn’t allow the potentially fast growers to demonstrate their traction. It provides a justification for underperformance.
Risk reduction should be pursued with deal syndication rather than underfunding. Venture Capital investors should only write checks for companies that they feel confident have enormous potential. Early on, it’s very difficult to tell which company in a portfolio will outperform. Because of that, early stage investors should treat each new company the same way and fully support each with a large initial check. Avoid hedging by writing smaller checks. Use syndication, not smaller initial investments, as a way to reduce risk.
Starting and building high growth companies is difficult. So is finding good investment opportunities. The risk involved is great, but so are the potential rewards. Early stage VC is an exercise in finding “big hits” as success does not come with good averages, it comes with home runs. Building a portfolio to mitigate risk is very important, but also important is writing large enough initial checks to make those home runs truly count.