The story of these VCs usually goes like this:
“We’re starting to write very small checks much earlier. That way we can track company progress from the inside and are aware of any challenges or problems early on. We believe we can then also discern inflection points much earlier than other outside investors. We might be able to preempt the next round by two, three, or even four months! We will get in at a significant lower valuation and at lower risk, and only back companies with greater chances of success.”
I usually listen carefully. After all, I might learn something. Here’s the math. Let’s say you are a Series B investor (whatever that means these days… but that’s another blog post). And let’s say you go earlier — Series A — and thus you identify a breakout company with a recurring revenue model that just ended 2017 with $1.3M in revenue and you can reasonably underwrite revenue growth to $5.0M in 2018 and perhaps $14.2M in 2019 (as you might have guessed, this actually happened).
You might have modeled monthly ending revenue or you can estimate it:
Let’s assume you are looking at the next-twelve-month (NTM) revenue to get a rough idea about a possible valuation range. In October 2018, the NTM revenue will be about $10.7M. Per above reasoning, if you can get in two, three, or even four months earlier, you will get a 17% to 31% discount to the October 2018 revenue.
In your math, at a 10x NTM revenue multiple, you might be able to get your termsheet signed at a $75M valuation instead of a $100M valuation! Even better: What if, four months earlier, it is not at all clear to anybody else that this is a breakout company, and you can get a termsheet signed at 8x NTM revenue — now a $60M valuation instead of a $100M valuation, wouldn’t that be great?! That means a 40% discount = 40% less capital, or 40% more ownership, or 40% earlier exit at same return, or 40% higher return!
“As long as the early, small bets that fail cost us less than the upside and gains, we’re golden!”
“I get your math. But can you execute?”
- You are Series B investors. What makes you think you can select the right Series A investments? How do you suddenly get access and see all great Series A investment? What if the Series A investments you make are not the Series B investments you would make, what if these two groups do not match?
- What is your value proposition to Series A stage founders and CEOs that makes them select you over other, established Series A investment firms? Why is your current value proposition suddenly not only relevant for Series B stage startups, but also for earlier startups?
- How many Series A deals will you need to make to get to the right number of Series B deals? Do you have enough risk capacity in your fund? Do you have enough resources to tend to all your investments and execute on your value proposition?
- Will your “early, small check” be significant enough so you actually get any insight? Or will you watch from afar, unaware of any struggles or successes? What is it that will make founders and CEOs give you great insights and access? Can you get that access and manage all the information and communication for the now much greater number of Series A startups in your portfolio?
- What will the founders and CEOs think of your model? Will there be negative signaling risk for follow-on investments if you do not participate in follow-on rounds? Will other investors avoid you? Will you have to continue support even for companies that are not the breakout companies you identified but who still raise follow-on rounds?
- If you can identify the breakout companies, wouldn’t the founders or CEO also know that they are a breakout company? Why would they accept your termsheet earlier, perhaps even at a lower NTM revenue multiple? “Relatively easy, no hassle fundraising” is not quite the argument when the startup is breaking out and thus will have it relatively easy to raise the next round.
- Is it a good sign if the founders or CEO take your money early, unaware that they should have waited two or three months and run a process to create excitement and lose less equity? Is that the sort of founders or CEOs you would like to back? Will they be super-happy in the future once they realize what was going on? Will you be able to back their next startup?
- Will you need to make competitive investments: Usually, you selected adjacent Series B stage startups with a non-overlapping value proposition per specific sector. But now you need to invest in five (ten?) Series A stage startups per sector to find the break-out company, and they might develop competitive value propositions, or go after the same wallet share of their customers. How do you manage that potential conflict?
- Are the Limited Partners in your current fund OK with that change of strategy in your next fund? Will your LPs be OK with a much higher loss rate? Can your LPs stomach a greater amount of bad news as you have a greater number of investments that — due to their earlier stage — have a higher death-rate than before?