How VC “optics” can drive behavior

I know this sounds strange, but investment firms can have an incentive not to support their companies in future rounds, particularly if there are deep-pocketed co-investors who can do so.  It may be part of that firm’s strategy, but also, it can make for some great optics.

For example, one of our companies raised a Series A money that was a near-3x share price increase from the Seed round.  Good stuff for Kepha, right?  However, the company is valued on our books for much less than the 3x.

Here’s why: we invest in follow on rounds.  In other words, since Kepha supports our companies in future rounds, we wrote a large Series A check which diluted the “value to cost” ratio on our books.

Here’s more detail but with made-up numbers:

  • Seed financing: Kepha invests $500K at $1.00 a share
  • Series A: new investor sets a price of $3.00 a share and Kepha invests another $2MM
  • Value of Kepha’s investment: $2MM in Series A + $1.5MM of value in the Seed (the seed dollars are up by 3x), or $3.5MM total
  • Cost of Kepha’s investment: $2MM in Series A + $500K in Seed, or $2.5MM total
  • Value to cost ratio: $3.5MM divided by $2.5MM, or 1.4x

A fellow co-investor of ours in the Seed round noted above invests only in one financing in each company.  They openly state that they invest in the first round and then do not thereafter.  In the above example, an investor like that can report a 3x value to cost ratio on their books while Kepha reports a 1.4x.  Great optics for them.

(Note: there’s a reason why firms like Kepha believe in being active and owning meaningful pieces of their companies, but that will be another blog post in the future).

Some investors want to make a lot of investments, not join Boards and not re-up in future rounds.  I call this the “one and done” investment model.  They invest in one financing round only.  The Kepha model is to make few investments, join Boards and continue to support the company in future rounds.  I call this the “venture building” investment model.  Don’t get me wrong.  We love valuation increases in our companies when a new investor comes in and sets a new price.  But, we value more who that new VC is and what ownership position we have in our companies.

Neither is better or worse for the entrepreneur, but both approaches are very different.  For example, doing a Seed round with a sole  “one and done” investor means you have to start over from scratch in the next financing; the Series A bucket is empty from the get-go.

This is another example of why entrepreneurs need to really understand how investors behave, and more important, why they do so.  The current boom in early-stage funding innovation is very promising.  Lots of choices.  But, the trade-offs to the entrepreneur are varied and real.

So, what should an entrepreneur do?  My 2 cents:

  • Ask that investment firm how much capital per investing partner they have. Firms with low-volume and high-commitment strategies have about $40MM per fund for each investor.
  • Just ask that firm what their strategy is.  It’s not true that VCs are out to lie, cheat and steal from entrepreneurs.  Nearly all will be very honest about their plans if you ask them.
  • Really understand what you want to accomplish in a Seed round and what team you need to help build success.  A high-volume and low-commitment investor may be a fit for you, or may not be.  You are the customer.  One size of VC no longer fits all.

Many thanks to Antonio Rodriguez for a stimulating lunch discussion on this topic.

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