Part 3: Sacrifice Dilution for Diversity

“I’m not ashamed to come and plead to you baby
If pleadin’ keeps you from walkin’ out that door
Ain’t too proud to beg, you know it sweet darlin’ 
Please don’t leave me girl, don’t you go”
(“Ain’t too Proud to Beg” by the Temptations)
The Temptations were afraid of being diluted from something great, but early-stage micro-VCs don’t have to be.

This is part three of a four-part blog series, Smaller, Earlier VCs Should Invest Differently, that I began two weeks ago. The first post outlines why micro-VCs investing in early-stage startups should not follow the best practices of their larger, more traditional VC peers. Last week in the second post, I discussed a little-discussed metric — portfolio variance — and how that significantly impacts a smaller, earlier fund’s risk. The big takeaway? A larger portfolio size of 70 companies both increases the median fund return and decreases portfolio variance (i.e. risk) to match that of a 20-company-portfolio Series A fund. This week I’m bringing up a metric that is touted as a chief concern for investing in smaller, earlier VCs but I find it completely over-hyped: dilution. Turns out, it really doesn’t matter that much…

First, let’s dig into why large funds care a lot about ownership, control and dilution. It isn’t because they are irrational — it makes a lot of sense for their stage and size. With a lot of capital under management, these firms have to try and return ~3x of “a lot of capital”. Each year there are a limited amount of companies that can return tons of capital (i.e. the much vaunted unicorn) so investors need to own large stakes of these companies. To own a big chunk of the company, they avoid dilution, and hence have large amounts of cash reserves for earlier investments that start scaling. Because they own a large amount and have a lot of capital invested, they have to sit on the board — hence the number of companies in their portfolio is an equation: (# of partners) x (# of board seats a partner can take). For 3–4 partners taking 5–7 board seats a person, the portfolio size can be somewhere between 15–28. And one of those ~20 companies needs to return the entire fund.

But what can a smaller, earlier fund do? Getting in earlier gives these funds a lot of ownership at a relatively low price, but the funds don’t have enough cash to keep their percentages through the alphabet of fundraises. These funds care more about the return multiple (rather than simply the gross amount of cash) and their LPs expect a higher multiple than later stages in exchange for the risk taken. Deploying a huge percentage of their cash into later and later stage follow-on rounds will hurt their performance and paradoxically increase their risk. These micro-VCs need to have a different strategy that doesn’t depend on micro-managing ownership and shunning dilution.

To provide some more structure, I wanted to use math to demonstrate how focusing on follow-on hurts an early-stage fund’s performance in both risk and reward. I’ve outlined 3 different scenarios below and highlighted some key metrics. For those of you taking notes, I’ve simply added to the same model I used last time, which is based largely off data from Pitchbook and CB Insights.

Each of these examples starts with a 20-company seed-stage fund that is faced with a follow-on investment decision in a Series A company. They have roughly $5M to allocate.

Option A: Lead the round and invest all $5M in the company.

Option B: Keep your pro-rata (roughly $900K) and spend the remainder on 6 new seed investments

Option C: Don’t follow-on at all and spend the remainder on 7 new seed investments

Now, options A and C are each on the extreme edge but the spread of the scenarios will serve to demonstrate what happens as you choose between different follow-on strategies.

What happens in these scenarios? Well, Option A isn’t good. The expected value of your $5M is only 2x (compared to 2.6x for Option B and 2.7x for Option C). The median return is 15% less than Option C, and the 90% confidence interval range is much broader — 4.4x vs. 3.7x for Option C. The story for Option B is much better, but it still demonstrates a lower return and higher risk than the all-seed strategy of Option C. That being said, there could be some intangible aspects to doing a hybrid approach like Option B — it could be a bad signal to outside investors for the original investor not to participate, or it could help the firm attract founders by showing that it allocates some capital for follow-on investments.

But wait — the Temptations aren’t done yet! There are a lot of tempting reasons to keep investing in your existing, successful companies — and these temptations are incredibly alluring. Investors hold several commonly-held beliefs about follow-on investments — dominated by concerns about dilution and control — that logic and numbers demonstrate aren’t true. I’ll dissect some of the most common ones to hopefully convince you why it may not be best for an earlier, smaller VC to give into these temptations:

Temptation #1: Your company raising a follow-on round is one of your best companies that is now more likely to produce a successful outcome, so of course you want to follow-on!

If you’re a seed investor and you have a company raising a legitimate Series A round, it certainly is one of your better companies. According to our model, only a third (or less) of the typical seed fund’s investments make it to a $5M Series A raise, and they typically have to have some incredible stats. As a seed-investor, it will look like a great investment. But remember — you are a seed investor, so of course a company reaching the Series A checkpoint is going to look great! But now that this company is more successful, it also has a very different risk and reward for a new investment, and both are lower than your seed investments. Therefore ironically, a re-investment in your best companies will have a lower average expected value than new investments at an earlier stage.

And normally a Series A investment is less risky — but for your portfolio (and considering your tradeoffs), you actually increased your risk. How? First, by reinvesting you have added more capital to an asset that is 100% correlated with an existing asset (the seed investment in the same asset). If that asset fails, both investments fail, and if that investment succeeds, both investments succeed — they are no longer independently and identically distributed. Second, you’ve decreased your available cash that you can invest in other assets at the earlier-stage you invest in.

Temptation #2: Because you’ve been a part of this company for awhile, you have insider info on how the company is doing!

Earlier investors are constantly told they have a huge benefit because they can see how a company is doing and decide to invest. If it’s not doing well, they will supposedly back off. If it is doing well, they will pour capital in. Sounds pretty easy? Then why do early-stage investors repeatedly make less in their follow-on investments than deals where they don’t follow-on?

There are a few theories here, but two stand out the most. The first is that the only time an investor can actually make use of their insider info is to decide not to invest. If a company is doing well, it certainly knows it and will let other investors (inside AND outside the company) know it, and that information will be priced into the deal. If a company is going poorly, the inside investors are more likely to know it and have an opportunity to decide not to invest. The third option (a company doing well but not priced accordingly) doesn’t exist. Many investors think they have this option but have substituted genuine metrics of success with speculative or overly-optimistic information (“they will close this deal soon” or “this company will likely acquire them”). The second theory is that early-stage investors are naturally-optimistic and develop a strong familiarity bias with a company. Even when a company isn’t doing well and can’t raise outside capital, they continue to invest in the company for subjective reasons. Beliefs like “this founder can turn the company around” or “they only need a few more months until they close a big deal” are emblematic of this low-expected-value investment.

Temptation #3: Dilution sounds terrible — won’t owning less of a great asset generate worse returns?

Just as a founder sometimes has to be convinced that a smaller slice of a larger pie will result in a fuller stomach, VCs have to as well. Without a follow-on investment to keep your stake the same, your ownership will decrease — but if the company is doing well, your value will still increase. And it can still be incredibly positive — on a ~$500M exit with six up-round fundraises, a seed investor will on average own just 32% of their original position… but return nearly 40x the investment. Reinvesting will actually decrease your return multiples as you invest at a higher valuation — a Series A follow-on investment in the same company will only make 12.5x, and your blended return will be somewhere in the middle (much less than 40x…)

Temptation #4: All the great VCs return their fund with a single investment, so I need to keep my ownership to make the math work.

As discussed earlier, this is the tried-and-true math of a traditional, larger VC. But that is only true because their portfolio size is relatively small — and there are very few companies each year that could return their fund. In the 70-company portfolio we discussed last week, the average no-follow-on portfolio would include 1.3 companies returning 39x, 0.4 companies returning 26x, 1.1 companies returning 18x, 3.3 companies returning 10x and 4.0 companies returning 6x — or in other words, effectively a smorgasbord of exits between $28M-$500M. No reliance on unicorns or a single company returning the entire fund. Rather, a diversified strategy and unconcentrated ownership causes this portfolio to be successful.

Temptation #5: You want to keep control of your investment and have a great relationship with the founder, particularly so you can continue to invest.

This is tricky — relationships are involved and you may be giving up a board seat. And LPs may be expecting you to own a certain percentage of a company. That being said, as an earlier, smaller VC, you have to critically ask yourself if you are the best investor/fund for this company as it continues to scale. Should you continue to be taking a board seat when it might be able to attract more experienced, later-stage investors? Should you insist on taking a certain chunk of capital that could have been used to attract more investor talent to the table — and further help the company scale? Remember the larger pie — ultimately the wisest move might not be to grab a bigger slice. And I’ll continue to reiterate that an early-stage fund will decrease it’s performance by investing in subsequent rounds.

Ah, that’s a lot of Temptations!

It shouldn’t come as much of a surprise that follow-on investments will yield a riskier, lower-performing fund than if the fund had only invested at the initial, early-stage asset class. Follow-on investments combine the higher-yielding earlier investment with a lower-yielding later investment, while simultaneously removing capital that could have been used to make additional earlier investments. This further concentrates a portfolio into fewer, highly-correlated assets that could do great — or could do terribly. Either way you bought into this company at a higher combined price, meaning when they do return, they will return less of a multiple on your investment. Sure, by not continuing to invest you will sacrifice ownership in the company and your stake will be diluted — but if that increased ownership is bought at a higher price, it really should be evaluated as a completely new investment, with associated risk/reward tradeoffs. Your original investment is being diluted anyway, and now your choice is between doubling down at a high price or increasing your chances of a successful portfolio by investing in new, early-stage opportunities. It may be tempting to go with the familiar, but the numbers favor dilution.

This week, we started to see how the same amount of capital invested at a higher valuation can dramatically impact returns, no matter how impressive the company seems. We’ll investigate that topic further next week, when I discuss why valuation matters so much to earlier, smaller VCs.


General Assumptions:

On the model:

  • The model doesn’t take into account that the Series A investment is 100% correlated with the outcome of the corresponding Seed investment. Therefore, the actual returns for Options A and B would be riskier than presented here.
  • This model has each investment for a given stage as an equal-sized investment into an averaged valuation. In reality this will likely not be the case; just remember that the more you vary the size/valuation, the more portfolio variance will increase.
  • Please note that there is a round between Seed and Series A, called “Seed +” in our model, which averages $1.6M on $8M postmoney

A big “thank you” to fellow M25 director, Mike Asem, for his assistance crafting this series, providing feedback and help in editing.


About the Author

Victor Gutwein is the managing director of M25 Group, a VC firm he founded in 2015. Victor is a Kauffman Fellow (Class 22) and an active member and co-chair of the Consumer group at Hyde Park Angels. Previously he has worked in corporate strategy on a variety of new businesses in retail & ecommerce. Victor has a passionate history with startups, including a vending machine business and kick scooter company, along with being on the board of the University of Chicago’s first student-run venture fund.

Victor lives with his wife on the South Side of Chicago and loves staying active with backpacking, running, biking and most water sports. If he can’t convince you to workout with him though, he’ll usually succeed in getting you to try out a Euro-style board game (like Settlers of Catan) with his friends.

Twitter: @lalayak

About M25

M25 Group is one of the most active venture capital firms focused solely on early-stage investments in the Midwest. Their objective, analytical approach has helped support their thesis and craft what is known as an ‘index fund of Midwest startups.’ M25 has already invested in over forty companies since their inception in 2015, and continues to invest in over twenty companies each year. Their collaborative, forward-thinking approach and diverse array of investments across industries and business models throughout the region has quickly established them as a key node in the Midwest startup ecosystem.