The signaling value of AngelList and YC’s new fund announcements

AngelList and YC both announced big new funds last week. AngelList announced that CSC Upshot raised a $400M fund to invest in startups on AngelList. YC announced that they raised $700M for their YC Continuity Fund, which will support YC companies into later rounds. The scale of these funds were enough to shock and awe the tech community.

These quotes from Naval Ravikant and Sam Altman struck a chord with me:

Naval: “Even the $400 million will be spread out over six to eight years.”

Sam Altman: “Finally, we look forward to being a very long-term focused investor in a sector where most players are not.”

It’s interesting to find that in both these announcements, they make sure to emphasize the long term nature of these funds. The signal that these funds are going to be around and investing over the next 6–8 years or longer have tremendous value for the tech ecosystem that not many people realize.

In economics, there is an argument that temporary tax cuts are ineffective. The purpose of tax cuts is to try jumpstart the economy by increasing consumption. But if consumers know that a tax cut is temporary, it won’t drive sustained increase in consumption because they know their bump in discretionary income is just a blip on the radar. However, if the tax cut is permanent, consumer will feel like they have a permanent increase in discretionary income and that will drive a long term increase in consumption.

Just like the power of permanent tax cuts that drive long run behavior change, these big announcements can drive behavior change in their ecosystems because they provide long term stability in an inherently cyclical industry.

These new funds can act as stabilizers for their respective platforms. Founders won’t have to worry about macroeconomic issues. They won’t need to go into hibernation mode. They won’t have to become completely risk averse to ride out the bad times.

Tech nuclear winters do not discriminate — they cause pain to the entire ecosystem. By raising a big later stage fund, YC can strengthen their platform and make sure YC founders building solid companies won’t have to worry about funding. Similarly, AngelList can make sure that the best startups on their platform continue to receive funding. The proverbial babies do not get thrown out with the bath water. These new funds add a big dash of antifragility into the YC and AngelList platforms, and that’s part I really appreciate with these developments.

The signaling value of AngelList and YC’s new fund announcements

Do Smaller Funds Perform Better?

In a report recently released from Mattermark, it is indicated that investment in startups from 2014 to probable year-end 2015 will eclipse all prior years, except for 2000. Now, ‘Unicorns’ are all the rage, leading many VC firms to raise bigger funds to target larger and later stage investments. But in the world of Venture Capital, bigger is not always better.

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A 2012 study by the Kaufman Foundation noted that in the years between 1997 and 2009, “only four of thirty venture capital funds with committed capital of more than $400 million delivered returns better than those available from a publicly traded small cap common stock index.” The solution, they propose, is to invest in smaller funds. In the study, Kaufman provides a number of reasons for this proposed realignment of investment allocations, the most notable being that smaller funds make their money from fund performance whereas larger funds tend to make money via fees. This pay-for-performance model makes sense intuitively, but is also far from a complete understanding of what is actually happening within the Venture Capital space.

Let’s try to break it down:

Smaller Funds have to return less capital

When a typical LP investor contributes to a late stage VC fund, they are probably doing so with an expectation to make three to five times their investment in total returns. On a $500 million fund, this means investors are likely targeting $1.5 billion – $2.5 billion in distributions at the end of the fund’s life. There’s a lot that has to go right in order to accumulate that much cash.

Small Funds don’t compete in the run-up in valuations

In the above case, the firm cannot realistically get all their money out the door by writing checks in $1 million increments; their ability to source enough quality deal flow and their ability to effectively monitor existing investments doesn’t scale that easily. They end up making large bets on relatively fewer later stage companies, effectively increasing their unsystematic risk which investment theory says they should diversify away. Compare the two charts below to see that Seed Investors make more investments but at very low average check sizes. This improves their risk return profile since they’re less reliant on one big winner.

Average Deal Size by Stage vs. Deal Volume

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You can clearly see above that in later rounds, relatively fewer numbers of deals are getting the majority of the funds. Jason Lemkin at SaaStr estimates as much as “75% of invested capital [is] trapped in private Unicorns,” indicating investors are increasingly driving up valuations of promising later stage rounds which Small Funds simply don’t get involved in.

Smaller Funds are company builders, not just company backers

Investing in a $1 billion Unicorn means investing in a company that is already performing well, firing on all cylinders and looking to scale quickly. In contrast, investing in a $10 million company means investing in a company that is looking to make one of its first few hires, even its first sales-person, which implies they’re preparing for, but haven’t actually experienced yet, a product-market-fit. In both cases, the investor is providing capital as a value-add, but in earlier stage investing – where Small Funds predominate – the investors are often also adding much needed outside support of a more intangible nature. Oftentimes, this comes in the form of the first outside board member, able to provide much needed guidance for best-practices to technical founders with minimal business experience, or plugging the startup into a larger network full of future investors, potential advisors and even customers – all of which the startup may have failed without.

Big funds may also provide these services – a16z is famous for it – but on the whole, they are more focused on getting dollars out the door rather than nurturing budding entrepreneurs through their growing pains and company pivots. By the time a smaller fund has shepherded a company through these early stages, they have effectively helped de-risk the investment, thereby making it an attractive target to a larger fund in a much more sizable subsequent round of financing. As an existing investor, Smaller Funds can participate in these follow-on rounds which helps improve Small Fund returns by concentrating capital in their all-stars. By doing this, Small Funds magnify the impact of outperformers on the fund’s overall performance in a way less available to Large Funds, who are participating in in the last few rounds of financing prior to an IPO or eventual sale.

Early investing is not without risks

We would be remiss if we didn’t point out the other side of the coin here. Investing in unproven companies means you are investing without the benefit of past performance and the failure rate among early stage companies is notoriously high. Furthermore the risk of dilution by inflated rounds of financing in Series A and beyond is something investors must be very cognizant of and should take steps to insulate themselves against this risk. Doubling down on winners is one of many ways to do this and many early stage investors would be wise to allocate a large proportion of their fund to follow-on investments. With all that said, investing in early stage companies can provide better cash-on-cash returns, provided you have the stomach for it.

Do Smaller Funds Perform Better?

Talking Tech With MeetAdvisors: Do VCs Read Business Plans?

This post was originally published by Brad Harrison at mayorbrad.com

I was recently invited over to MeetAdvisors for an interview with one of their hosts, Rachel Pollard. MeetAdvisors is a great platform where entrepreneurs can search for, find, and network with advisors and fellow entrepreneurs.
Rachel and I spoke about the recent history of startups, the genesis of Scout Ventures, how we view where technology is going, and about a very pressing question: do venture capitalists read or care about business plans?

Click here to watch the interview!

Talking Tech With MeetAdvisors: Do VCs Read Business Plans?

Three Things That Kill Early Stage Companies

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This post was originally published at Brad’s personal blog, mayorbrad.com

As a VC, we spend a lot of time thinking about where we want to invest our money.   Last night, I was with my friend Pedro Torres-Pincon who recently presented “How to Build an Investment Thesis”  providing good insight into determining how and where you decide to invest your money.

But writing the check is the easy part.    The real challenge in entrepreneurship is to build a meaningful and sustainable company.   To that end, one of the things we like to discuss at Scout with our founders is how to avoid the pitfalls that can kill an early stage company.

(1) Don’t run out of money.    I know this seems like a simple rule but it’s amazing how many entrepreneurs under estimate how much time and money they will need to build their business.   In most case, we see financial projections that too aggressively forecast revenue growth, while underestimating the cost of building a scalable product.    The other issue that tends to crush entrepreneurs is not allocating enough time to raise the next round of capital; fundraising is time consuming and requires a focused effort.    So beware – forecast more conservatively and budget more time to raise your next round of capital.

(2) Don’t make a bad critical hire.   We often invest very early in a company when they haven’t hired all their critical team members.  In many cases, our capital is being used to expand the team and help the founders grow their vision.  If the Company hires a rock star then everything will get much better, but if they hire a dud then the Company is sure to suffer.   The two areas that are most often affected are  technology and sales.    If the company is in the process of building a new product and their new CTO drops the ball, then it’s almost impossible for the company to meet any of their deadlines or achieve the metrics necessary to secure the next tranche of capital.    Likewise, if the Company hires a revenue generator like a VP of Sales and they fail to achieve their revenue goals, it’s often a devastating blow to the company’s forecasts and thus also hurts their ability to raise additional capital.

(3) Avoid bad investors.   The early stage landscape is much different today than it was when I started in this industry as there is more seed stage money than ever before.   Accredited investors are jumping into early stage investing with angel groups, accelerators, and equity crowd funding platforms like SeedInvest. This coupled with significantly lower barriers to entry means that it’s easier than ever to start a new company and raise a small amount of capital. The resulting increased competition among early stage companies has created a shortage of follow-on funding as described by Josh Kopelman of First Round Capital.    But more hazardous than the shortage of Series A capital, is the impact inexperienced investors, often from other industries who are looking to dabble in venture as an alternative asset class, can have on an early stage company.    The worst case scenario for a young entrepreneur is to get lured by an investor who is offering capital but wants to add terms and provisions inconsistent with standard early stage venture rounds.    These terms vary greatly but the most dangerous are the right to ask to get paid back, asking for too much control and/or the need for the investor to consent to future financing, etc.    It breaks my heart when a young team is crushing it only to have a disgruntled early investor call their $100,000 note – which represents a significant chunk of operating capital.    Smart money is always the best way to go.

Three Things That Kill Early Stage Companies

What is determining value in startups right now?

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Here’s a timeless quote from Bill Janeway on how value is determined in startups:

The value now is driven by supply and demand amongst speculators who have liquidity and will not have to stick around to find out what the fundamental value turns out to be over time.

The overall point of view is critical but the core idea to understand is that startup valuations are always supply and demand drive.  So what does this mean?

Because of this phenomenon of bubbles more risk will be taken, more capital will be mobilized than would be the case if investors were strictly investing based upon the net present value of the expected future cash flow, which as I began by saying cannot be determined in plausibly rigorous manner. Now having said all that, one of the laws of life is, as I used to tell my young colleagues, nothing ever sells for 50 times earnings for very long. So when it does, you, who are in a position of influence, have a positive obligation to raise all the cash you can as cheaply as you can, and then distribute as rapidly as you can the liquid securities, which you happened to own.

In other words, understand the context of the early stage tech environment and adapt to it as necessary.

Source:The Future of Venture Capital, Tech Valuations and the Fate of Tech Incumbents – Conversation with Bill Janeway

What is determining value in startups right now?