I often speak with frustrated founders in the middle of a seed/pre-seed fundraising process, and they say something along the lines of “they [venture firm] have so much money, why can’t they just give me $50k!” Which seems on point when you look at the problem on the surface. General Catalyst for example, has something like $7bn assets under management (AUM), so wouldn’t it make sense for them to throw $50k-$100k seed checks out like confetti?
No, but yes, but really no.
There are a few forces at play when it comes to an investment from a venture firm, and those can be overly simplified to (1) time/opportunity cost, (2) prospectus, mandates and business model, and (3) firm/investor type. I’m going to go into each below to explain the balancing act of all three.
Time and opportunity cost.
This is the easiest one to explain, and I remember the first time someone told me, a lightbulb went off in my brain. I was 20 years old and I was so frustrated that a fund who had billions under management couldn’t just write a check for $50k and “see what happens.” Some of these super large funds will spin out a smaller vehicle for early stage investment and even brand it, but then comes the problem of the fact that you’ve suddenly got a whole new venture fund, (which I’ll touch on in the next section). But in this case, the problem is simply that if you’re a giant fund writing a $50k-$500k check into a small company, you can’t justify spending any time on that company if you have $30m into another one. Investors are people who only have so much time in a day, and so they have to be mindful of where they spend their time. As an investor, you also have a fiduciary duty to your limited partners (LPs) who are the people/entities who are giving the money to the VC firm to invest and make a return on. It’s not financially responsible to spend any time on an investment where so little is at stake, when you have 600x into another company.
In addition to the partner’s time, you also have the issue of back-office work (aka, the legal stuff to get the investment done). When it comes to making an investment, there are closing costs associated with it and it’s not impossible for the money spent on the back office to be more than the check itself, which is why we saw the rise in popularity of convertible notes and the infamous YC SAFE. The benefit of the SAFE (Simple Agreement for Future Equity) is that you avoid having to engage a legal team to execute a stock purchase agreement and do a full priced round. However there are other risks that come with SAFEs because the investor technically doesn’t “own” the stock at the point of signing.
Prospectuses, Mandates and Business Models.
There are literal books on venture capital business models, so I’m not going to go into any meaningful depth here, but I’m going to touch on a few areas that matter for this post. The important thing to remember is that Venture funds have to raise money too, and in order to do that they have to have a business model in which a mandate and a prospectus are established for each fund. One VC firm can/will have multiple funds that they invest into companies out of, and the partners have a financial interest in those funds. Generally a single fund (aka bucket of money) will have a 60/40 spit, where ~60% of the funds available are spent on new investments and the remaining ~40% is spent on pro rata, aka follow-on investments in subsequent rounds of financing of existing portfolio companies to maintain a certain ownership percentage.
Side note: if you want to learn more about pro rata rights, you can read my post on how to model ownership & dilution and how pro rata works.
When an investor raises a fund, they have to file a prospectus with the SEC, which details the investment security and the offering, aka how the fund will function and how investors will make money. Then funds will also establish a mandate, which determines how the money will be invested, and this mandate informs the decisions of the investment committee (IC).
For example, in 2020 a series A firm may have a business model that mandates they need to target 15-20% ownership in a company with an average check size of $5-6m investing out of a $300m fund, with up to $10m total into the company over the lifetime of the investment in order for the business model to make sense. So if you’re trying to raise a Series A on a pre-money of $60m, this investor is probably “priced out” of your round, because they can barely achieve 10% ownership which is too little for them to make a good return and against their investment mandate. On the flip side, if you’re raising $1m on a $5m valuation (aka seed), they definitely could get that 20% ownership target, but you run into the problem I outlined in the first section which is time and opportunity cost, as well as issues with the mandate that LPs bought into. If you invest outside of your mandate, you can run into legal problems with your LPs since partners of the fund have a fiduciary duty to their LPs, and that duty is all about risk management and returns. A seed investment has a different risk profile than a Series A.
Some funds have a single limited partner (LP) which is a business, and the fund is investing off the balance sheet of that business – aka the profits of the LP company. A good example of this is Amex Ventures – they are less valuation sensitive, and do have ownership targets, but the mandate for their fund is that they company needs to have specific strategic value to Amex in order to make the investment. Other investors have multiple LPs who are private family offices, university endowments, or pension funds, and these funds will generally have less flexibility in their mandates because it’s truly other people’s money. You also have mandates that indicate a specific vertical focus, such as marketplaces, or b2b SaaS.
One interesting example to highlight is that some funds will write in exceptions/additions into their prospectus/mandates for incubator programs like YC or 500 Startups where instead of their typical $5-6m check size with x% ownership, they set aside a % of their fund for $100k-$200k seed checks into YC/500 only companies. (One reason to do one of those incubator programs). Generally the fund partners won’t manage these companies/investments, the relationships will be managed by associates or principals. Another exception you’ll see are established funds writing a smaller check into a company they intend to then write a $5-6m check into in subsequent rounds because they have high conviction around a second time founder they’ve already worked with, or exceptional early-stage traction or strategic value. Often times this situation has language in the term sheet guaranteeing pro-rata rights, and/or aggressive liquidation preferences to mitigate the additional risk the fund is taking.
Firm / Investor Type.
The final case to consider is the actual firm type. An angel or a super angel can do literally whatever they want with their money, which is why founders are often encouraged to go the angel route for their first tranche of capital or are told “they’re raising too little” for an institutional investor (aka a VC firm) to care. The challenge is that Angel investors are active sporadically, so finding them or maintaining any sort of meaningful database of angel investors is a challenge.
Then there are firms/investment managers who are just starting out, and so they’re trying to build a track record to show that they can get into meaningful deals and make LPs money so they can go raise larger funds in the future. An example of this is a $10m fund getting into a a series B or C of a “brand name” or unicorn startup (think Lyft, Stripe, etc). It’s not about the actual dynamic of the investment at that point, it’s about establishing your track record as an investor, and showing that you have access to the good deals. The biggest challenge for an investor is getting access to good deals in the first place, and having the network connections so you don’t “get iced” from the growth rounds where investors have a lot more data to manage risk and therefore make a ton of money.
Hopefully this should help explain some of the driving factors behind why a large firm with tons of money can’t just write small checks to founders and smaller companies. But this should help you understand what questions you should be asking an investor when you meet with them to figure out if they can even invest in you in the first place. Those should be (1) What is your average check size, and what ownership target are you looking for? (2) What stages [seed/A/B] do you invest across?, (3) who are you LPs? Anything we should know about your investment mandate? (4) What is your investment committee process like? All of this information can help you formulate a strategy to work with a certain investor and close your round.
One response
Awesome article! Really informative and helpful.