Once per quarter I write a letter to all of the limited partners (investors) in the fund to tell them a bit about how things are going and what’s on my mind. To date, I have not shared these outside of the investors in the fund but wanted to experiment with sharing a redacted version. I’ve gone through and removed any of the company-specific data but have left all of the other content as it was when I sent it out to them earlier this week. I’ve pasted the letter below, feel free to provide feedback!
Precursor Fund I Q4 2017 LP Letter
I find that the end of the year is always a good time to pause and reflect on what’s happening in the early-stage investing ecosystem and what it means for Precursor and our portfolio. There is a lot happening in our part of the venture landscape and I think it has important implications for our work here at Precursor.
As we do every quarter, I wanted to give you a consolidated view on how the portfolio changed. In general, Q4 was a fairly quiet quarter, with one more small acquisition and a few companies that closed new rounds.
While Q4 was quiet, with one company raising an institutional seed round and one getting acquired, I expect a lot of activity in Q1 2018 as a number of companies in the portfolio are out raising new rounds that I expect to close in the new year.
The Atomization of Early Stage Investing
One topic that has been top of mind for me has been what I call the atomization of early-stage investing. When I think about the current state of early-stage venture capital investing, raising money prior to Series A has become really atomized. We have angel and friend & family rounds, pre-seed rounds, accelerators, institutional seed rounds, Seed II / seed extension rounds and other intermediate rounds of financing along the way. When I talk to founders about the dilution they can expect prior to Series A, I often walk them through a model similar to the one below:
The reason I spend so much time thinking about this is that we have gotten to a place where investors prior to Series A are buying an awful lot of ownership across multiple rounds and founders are ending up fairly diluted by the time they get to Series A. Even if you assume that the seed round is the new Series A round, that is a lot of potential dilution to take in 24–36 months. This model also doesn’t include any bridges, extensions or other interim financings along the way. Including those would make the picture even more dilutive to founders.
I wonder if this is a long-term sustainable equilibrium. Even without an extension following the seed round, we have reached a point where the pre Series A investors are buying a pretty large chunk of the ownership in companies across multiple rounds. Given that most institutional funds at the pre-seed and seed stage are getting larger and not smaller, I expect this pressure on pre Series A ownership to increase as more funds feel like they need to own more to make their returns models work.
Life as a Pre-Seed Fund in the Era of $100M+ Seed Funds
One other thing I have been tracking is the growth in institutional seed funds who are approaching or exceeding $100 million in fund size. Not every seed fund that we work with has adapted to this larger fund size in the same way. Some firms have decided to react by increasing their expectations around revenue and product traction, moving their expectations from $10–25K in monthly revenue to something much greater, in some cases to $50K or more in monthly recurring revenue. In general, most of the lead-oriented institutional seed funds have increased their target check size to something in the range of $1–1.5 million and are targeting 10–15% ownership in the companies they back. In addition to writing larger checks, they are writing fewer checks as well.
In addition to the seed rounds getting much larger (we typically see $2.5 to $3.5 million in new capital as the norm), we have started to see some of the mid-size Series A firms come down and look to do $4–6 million “small” Series A rounds in lieu of waiting until companies are far enough along to warrant the $8–10 million (or greater) Series A rounds. In late Q4 2017 and early Q1 2018 we started getting focused outreach from some Series A firms signaling to us that they were open to doing these smaller Series A rounds in addition to or as a substitute to institutional seed rounds. It is too early to tell how deep this trend is, but if it plays out the way I think it will we will be in a world where I think these small Series A rounds could compete with these large seed rounds as the next round that the companies we back at pre-seed ultimately raise.
Lastly, it has become really clear to me that there is a fairly small circle of 15–20 high-quality seed funds that are consistently open to leading rounds in the companies we back. Toward the end of Q4 we started a pilot program to spend more time with those firms and give them more insight into the current portfolio as well as newly-added companies that we want to put on their radar screen. It’s too early to know what the results of this exercise will be, but it feels like a good use of our time.
Pre-seed is neither collaborative nor competitive
One other theme that I wanted to touch upon is the nature of pre-seed investing. I’ve had a lot of prospective LPs and journalists ask me about how competitive pre-seed is. The short answer that I have for anyone who asks is that pre-seed investing is neither collaborative nor competitive. For the most part, there is a very small set of firms that are comfortable leading pre-seed rounds. I would put Notation, Precursor, Bee Partners, Bloomberg Beta, Afore, Wonder and maybe a few other firms in the group of pre-seed firms that will regularly lead a round of $1 million or less. Given the relatively small number of pre-seed firms that are open to leading, there is certainly room for us to work together if we find an opportunity that we all find interesting. To date, though, this hasn’t really happened. Whether due to our varied interests in terms of geography, focus areas, or levels of traction, we just don’t end up investing together very often.
Pre-Seed and Seed Are Diverging, Not Converging
When I started Precursor, it was unclear to me whether pre-seed and seed rounds would ultimately converge or diverge. Given the increased size of seed funds and seed rounds, I feel pretty confident that the worlds of pre-seed and seed investing are diverging as opposed to converging. The gap between companies that are really in the pre-seed stage and those that are ready for seed financing continues to grow, not shrink.
As a practical matter, I think this means that we, as a pre-seed firm, are going to have to be willing and able to support our pre-seed investments for a longer period of time. We are fundamentally in the judgment business as we are investing in companies prior to much evidence of traction. Given the increasing gap between pre-seed and seed rounds, I fully expect that we will have to write two, and in some cases three, checks before the companies we backed have cleared the necessary hurdles to unlock the next round.
In the end, I am okay with this. It means that we will have more opportunities to accumulate ownership in some of the companies we really like without having to write larger checks for our initial investment. It means that when we are right about a company and have conviction, we’ll end up owning more and have a chance to have a strong contribution to our returns. It also means that the cost of being wrong could be substantially greater.
Reflecting on the Difference Between Rules and Principles
One other area where I have spent some time reflecting is on where the firm can improve. I have long been a believer that it’s easier to follow a rule 100% of the time than 99% of the time. But there are a few areas where I think the desire to hold fast to a rule or principle caused us to miss out on a few really great opportunities. There are two specific cases where I believe that to be the case. There are two cases where I wish we had revisited the underlying nature of the rule and why we follow it:
- Having a blanket “no” to certain market sectors — There are two markets where we have had a pretty hard and fast rule for not investing. Those two areas are e-commerce and games. In thinking about my aversion to games, it was driven by the challenges I have in making objective assessments on games companies given some of my past experiences. That aversion to games caused me to not pay enough attention to eSports as an opportunity. Looking back on that decision, I wish I had been more open to revisiting games and thinking about the differences between eSports and games.
- Refusing to participate in uncapped notes — For a long time, I’ve had a blanket ban on uncapped notes. As a small fund, the structure of uncapped notes generally doesn’t make sense as we don’t have a sense for what we will own on conversion. We passed on two chances to invest in existing portfolio companies that were doing well but where the investment was done as an uncapped note. In retrospect, both of those companies were using uncapped notes for a good reason; the companies were growing well and were in between their last round and next round. The uncapped note made sense as they didn’t want to signal a price, high or low, via the cap. We passed in each case more due to an aversion to the structure than the underlying facts. Going forward I think we are going to rethink our views on when and if uncapped notes are appropriate for us.
Getting Leverage from Writing Guides
With a large and growing portfolio, we get a fairly common set of questions around some key topics, including how to raise a seed round and how to best work with Precursor Ventures. In the last quarter we launched our Precursor Seed Round Financing Guide, which distills much of the advice around seed round financing I give our portfolio companies into a consolidated guide. It’s not meant to be a substitute for conversation and advice, but it does mean that we can share our thoughts around what we think does and does not work as a reference for founders who have questions. So far the reception has been great, as it gives the founders we back some perspective on what we think matters when it comes to fundraising and saves us some back and forth on basic questions. We are working on our next guide, the Precursor How We Work Guide, right now and will have more to say on that next quarter.