Chasing Markups

Yesterday, I attended a lunch presentation that my friend Bryce Roberts gave while he was in NY. It was mainly an update on what he’s been doing at Indie.VC and an overview of the early success and learnings from their model. Bryce is an OG in the seed VC space — he was one of the first to identify the seed investing strategy as a distinct opportunity, and so I always pay very careful attention to what he is doing.

One thing he brought up was how the VC industry has slipped into an obsession with “IRR over ROI”. In other words, much more focus on being able to show quick appreciation of a portfolio’s unrealized value vs. maximizing the ultimate value of a portfolio.

If I were to put it a bit differently, there is a general temptation in VC to be hyper focused on chasing markups. A markup happens when VC B invests in a portfolio company of VC A at a higher price that the company’s last round. This allows VC A to show that their holdings have increased in value, and generally makes the VC and their LPs happy.

The reason this happens is because everyone in our industry is desperate for intermediate measures of progress and success. It takes a long time for a VC investment to work out, and everyone wants market validation that things are progressing on the right track. And in a world where late stage capital is plentiful and exits are few, many VC funds have been able to raise larger and larger funds very quickly based on these unrealized gains.

Regardless of whether these valuations are right or wrong on average, this incentive to chase markups leads to some really sub-optimal behavior.

First, companies will be pushed to raise more money sooner than they really should. Raising money when it is available can be a good thing. But more money almost always leads to much less scrutiny and financial discipline. If there is something fundamentally flawed about a company’s business model, more money will usually magnify this problem, and the bigger a company gets, the harder it is to course correct.

Second, focusing on markups tends to lead to short-term and non-contrarian thinking. If you are focused on finding a markup for the next financing round, you will be focusing your own investment on companies that you believe the broader market will appreciate with 8–12 months more growth. Not that much changes in that time, so investors are less likely to go out on a limb if they feel like the company will be exposed to financing risk in a year because what they are doing is so new or unusual. This focus also leads to a preference for companies with easily understood signals of progress and traction. This can lead to a preference for achieving short term goals at the detriment of longer term strategy.

Third, for very large funds, desiring a third party to mark-up your investment is actually contrary to maximizing returns. If a portfolio company is performing extraordinarily well, and investor should want to invest as much as possible in the next round, and increase their ownership rather than just doing their pro rata to maintain ownership. This isn’t usually practical for smaller funds, but I’m often surprised how rarely much larger funds don’t just lead their own follow-on rounds and not have companies seek external funding. Some of the best investors in the world do this, but it’s actually the minority of firms that take this approach. Part of the reason is that it’s harder for an investor to justify a markup if they priced the round themselves, vs. a new investor setting a new price.

I don’t bring these problems up to say that the entire ecosystem is broken because of a focus on markups. But it is interesting to think about how the focus on markups drives sub-optimal behavior all around. These incentives are always present in early stage VC, but in a capital rich environment, I think this has been magnified and has persisted longer than would be allowed in a normal market environment.