As someone who has decided to build a venture investing firm for the long run, this is a question that weighs heavily on my mind. From my perspective, raising a pool of capital should have a huge amount of intention: exactly how do you intend to deploy that capital, and how much capital is sufficient to execute your strategy? While raising $10 million, $50 million or $500 million is great, without a clear view of portfolio construction and asset allocation going into it I can’t see how a manager could be comfortable deploying any amount of limited partner capital.
I see the question as revolving around two vectors: stage entry and persistence. The first issue deals with the character of the initial risk position, while the second addresses the philosophy of managing the dynamic risk position.
Stage entry
- Seed funds: Seed stage investors are willing to take maximum risk and are generally willing to get involved deeply in the business. They often invest before there is a salable product, and are heavily banking on the skill and ability of the founders to discover product/market fit, build a team and get the firm off the ground. These funds tend to be much smaller than either classic venture funds or growth funds as the capital required to do seed stage investing is much smaller than that required at later stages. Initial check sizes generally range from $50k-$500k.
- Classic venture funds: Generally enter at either the Series A or Series B stage, after a product has been shipped and the key challenge shifts from product/market fit to execution. While still in the early stages, the risk of these investments is of a dramatically different character than seed stage investments (leading to much higher valuations). Some classic venture firms do make seed stage investments, and some even prefer entering at the seed stage. Because of the higher levels of capital required for scaling a business (as compared with validating a business), these firms are necessarily larger than seed stage firms. Initial check sizes generally range from $500k for a seed stage investment to $10 million for a Series B investment.
- Growth capital funds and alternative investors: These firms generally play in the “alphabet rounds” – Series C, D, E… Investments are almost always made in successful firms with proven business models that warrant extreme investments to “step on the gas.” Groupon, Gilt Groupe and Buddy Media fall into this category. The issue in growth equity is not business failure risk, but how big a business can get and over what time frame. While target returns for growth equity are lower than those for seed stage and classic venture firms, the risk of achieving their targets are much lower than those of either of the earlier-stage venture asset classes. Investments can range from $10 million to $250 million and beyond.
Persistence
- No follow on: There are a number seed firms which pursue the approach of building broad, options-type portfolios, on the assumption that a few extreme wins will compensate for a large number of small dollar outcomes. Sometimes the reasoning is empirical, sometimes it is impacted by issues such as signaling, e.g., if I have a culture of not following on, nobody will question why I’m not following on. Neither classic venture firms nor growth capital firms follow this approach.
- Modest follow on: Several seed firms pursue this strategy as well. This assumes a reserve ratio (capital set aside for follow-ons relative to initial investment) of approximately 1:1. In these cases, some capital is set aside to protect ownership position as successful companies raise additional funds to finance growth. These investors are not terribly concerned about the signaling risk because of their small size, and they are interested in getting paid for some of the de-risking that took place with their capital and early company-building efforts.
- Heavy follow on: A few seed firms as well as almost all classic venture firms and growth capital firms ascribe to this philosophy. This generally means reserves relative to initial investments of 2-3x or even much more. Reserve levels are generally calibrated to the expected capital requirements of a particular business as well as fund size. For example, it is possible for a $500 million fund to make a $10 million Series A investment and reserve an additional $40 million for future funding rounds, on the expectation that successful execution of the growth plan will warrant this capital investment. Another word for classic venture firms that follow this methodology are “life cycle” firms, those who have assets to reserve the capital necessary to continue participating in funding a company’s growth throughout its life. Firms with assets of less than $250 million find it hard to go the distance, even in relatively capital-efficient businesses that are very successful.
While I am familiar with the policies of several other firms, I can only speak authoritatively with respect to IA Ventures. We perceive ourselves to be and act as life-cycle investors, albeit at the early part of the company’s life cycle. This is a constraint imposed by scale, where we are in a position to lead seed rounds, some Series A rounds and perhaps one or two Series B rounds. With $50 million, we feel we’ve optimized for both stage entry (seed) and persistence (heavy follow on) in light of our philosophy, skill and experience. Most importantly, we have a clear plan for how to build and manage a portfolio that meets our goals. And with the inevitable twists and turns of the seed stage venture business, having a beacon to guide us is a comforting thought, indeed.