Advantages Early-Stage Investors Have for Producing Distributable Portfolio Returns

The ultimate goal for every investment firm in the world is to produce a higher-than-average portfolio return relative to the amount of risk incurred by the portfolio (Portfolio Alpha). Venture capital firms operate in the same fashion. Historically speaking, the two venture capital investment rounds responsible for the highest percentage returns on invested capital are Seed and Series A investments.

Numerous studies support the claim that early-stage investments generate the most DPI for venture capital firms. One study by Cambridge Associates found that seed-stage and Series A investments were the most successful venture capital investment stages in terms of net returns, with median net IRRs, over a 20-year period (1996–2015). Another study published by PitchBook found that seed-stage investments generated the highest median DPI multiples of any investment stage over a 10-year period (2011–2020), with a median DPI multiple of 4.5x.

DPI represents the cash returned to LPs after all fund management fees are removed from the portfolio’s value. DPI is a key performance indicator for venture capital fund managers that hope to raise multiple funds.

This report will highlight three advantages Seed and Series A investors have for producing higher portfolio returns and show what early-stage fund managers can do to maximize their DPI.

Advantage #1 — Valuation Growth Potential

Investing in early-stage companies comes with plenty of risks; however, the upside potential can be favorable because investors have more leverage to negotiate terms in exchange for taking on additional risk. Startups, like any business, are valued based on their potential for growth and profitability. Early-stage startups have less data and traction necessary to support higher valuations. As the business grows, relatively minor increases in business value can generate substantial book-value returns for investors.

Advantage #2 — Larger Ownership Percentage During Liquidity Events

Early-stage investors will purchase significant portions of each of their portfolio companies’ equity because they expect to participate in more dilutive rounds as the company grows. This is financially viable since these early-stage VCs are investing at lower valuations. In addition to having a more significant ownership percentage early in the investment lifecycle, most early-stage investors are given the first option for follow-on investment in later capital raises. This follow-on option is crucial to the Seed and Series A venture model because it allows fund managers to double down on their most successful investments. These factors result in a proportionally large return for the investors during a liquidity event.

Advantage #3 — Experience and Influence

Early-stage investors have greater control and influence over the direction of a startup. By investing early, these investors often have a seat on the board of directors and can provide guidance and support to the startup’s management team. This control and influence can help guide the startup and keep first-time founders on the right track. Seed and Series A funds should do everything they can to help the startup develop a solid business plan, build a strong team, establish key partnerships that can help drive growth and profitability, and ultimately lead to a successful exit.

Maximizing Returns as a Seed and Series A Investor

While being a seed and Series A investor has distinct advantages, early-stage fund managers must also be strategic to maximize their returns. Here are some tips for maximizing returns as a Seed and Series A investor:

1. Focus on high-growth potential startups with a clear path to profitability.
2. Build a diverse portfolio of startups to minimize risk.
3. Actively participate in the management of portfolio companies and provide guidance and support.
4. Stay up-to-date on trends and build a network of other investors and industry experts.
5. Utilize the secondary markets to liquidate matured investments and turn TVPI into DPI.

Conclusion

Someone once told me that the Venture Capital model is like playing baseball when the only options are hitting a Homerun or Striking Out. Being a seed and Series A investor offers distinct advantages for producing distributed profits (DPI) in venture capital. By investing at a lower valuation, accessing high-growth potential startups, and providing support and guidance throughout the startup’s growth trajectory, early-stage fund managers can maximize their returns and produce significant DPI for their limited partners.

Sources

“What is Venture Capital and when is it right for your early-stage business?“
— BGF Insights

“VC valuation trends in 7 charts“
— Pitchbook

“Distribution to Paid in Capital”
— Wallstreet Prep

“The State of Venture Capital in 2022”
— PitchBook

“Venture Capital Benchmarks”
— Cambridge Associates

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