Too many first time funds simply follow on to rounds being done by more established VC firms. Another blog post I read today called these “proof of concept” funds started by successful angels, emerging managers or former operators turned investors. This is not a formula for creating outsized returns. This is a formula for indexing a top quartile of venture AT BEST and more commonly, being below average.
These funds are often between $5-$20M in size. If they invest in 30 companies they are likely writing $250,000 checks and reserving the same for a follow-on opportunity. If they are piling into larger seed rounds (at $6-$8M pre-money valuations) they are buying 2–4% of companies at most! Even with a few follow on checks in large series A rounds these firms may own 1–2% of their largest portfolio companies.
And to return a $15M fund 3x they need to fund companies that will end up creating $3B in market value! That is really, really hard! Especially when backing only 30 companies at the seed stage. (I’m assuming final ownership of 1.5%.
These funds should be investing with real conviction in rounds that are sized appropriately to their fund size. There are plenty of deals to be done that are between $500-$750k in size (remember when we all used to talked about how cheap it is to start a company?!) and at valuations closer to $3-$4M. A $300k check into these companies buys VC firms closer to 8% of a business and taking a super pro-rata in the next (much smaller and often “late seed”) round gets them closer to 10%. This means they need to invest in companies that create $750M after dilution in total market value, not $3B!
And investing one step earlier is not 4 times harder. (that’s $3B divided by $750M). The first reason is there’s less competition of sophisticated investors at that stage, the second is that’s one step of the hundreds it takes to build a real, profitable and scalable business.
But these new firms are seduced by the idea of investing with a top tier fund, de-risking the company by another 6 months etc. and “not getting fired for co-investing with XYZ fund.”
An obvious comment is “where are you finding deals that are raising at $3–4M?!
(1) not at YC demo day
(2) not in founders who have founded companies and exited at $50M+
(3) not in companies that have already build a product and are doing $20k in monthly rev
(4) not on Angel List
Other than ^^ those qualifiers — there are lots.
In my opinion, Notation, Brooklyn Bridge Ventures, Precursor, Arena VC, Nextview etc will all be in better positions to 3x their funds than their counterparts that are simply following on as minority investors. While this strategy doesn’t make raising the second fund way easier, it’ll make raising the 3rd, 4th and 5th easier.