Why we invest in seed and early stage companies
Another year, another post-DotCom record breaking activity in the world of venture capital. Yet again, the volume of venture capital flows is exceeding the industry expectations and continuing on a steep, upward trajectory. According to Crunchbase, the first half of 2018 has already seen inflows of approximately $175bn. To put this into perspective, the total amount invested by VCs in the whole of 2017 was $212bn.
This VC boom is a function of growing deal, dollar and fund volumes. The decade-long bull run in equities and low interest rate environment have forced investors to seek greater returns elsewhere, specifically in the private markets. As a result, a growing number of institutional investors, including historically risk-averse pension funds, have turned to venture capital.
Investor confidence in, previously feared, venture capital has been bolstered by strong performance of public tech stocks. Until recently they have been posting stellar results not seen since the dot com boom. The notorious FAANG (with the exception of Netflix), Microsoft and Alibaba replaced energy and telecom stocks in the top 10 largest companies by market cap. Unlike the early 2000s, the tech revolution has ensured that the new breed of tech companies is here to stay.
The mushroom growth of tech unicorns and ‘rags to riches’ stories got both institutional and retail investors excited about backing their ‘own’ unicorn and enjoying multiplied returns in the forever ever after.
One of the side effects of this VC craze is the launch of Softbank’s $100bn Vision Fund. It didn’t take long before Softbank’s deep pockets and powerful networks began to shake up the industry. Masayoshi Son’s creation has led to the emergence of mega funds, Silicon Valley’s answer to Vision fund. These are billion-dollar VC funds that have the ability to write multi-million-dollar checks at a drop of a hat. The magnitude of these funds and deals rivals those of the top private equity funds. A VC buyout is becoming a viable exit option for many founders.
Crunchbase reports that in the first half of 2018 alone there have been 268 mega rounds (defined as $100m investments) compared to 272 for the entire year in 2017. Given the size of these deals, it comes as no surprise that over 60% of the aforementioned venture capital flows are deployed into late stage companies. In short, most of the VC dollar growth comes from late stage deals. Funding seed and early stage companies with relatively small sums of cash is becoming increasing uneconomic for these funds. Instead they are supporting more mature (and therefore less risky) companies that require significant capital to propel them into multibillion dollar businesses.
This leaves many seed and early stage companies short of capital and, more crucially, professional support and mentorship. To keep up with the trend and to qualify for funding, a lot seed and early stage businesses have been forced to raise larger rounds. This is a treacherous path.
Firstly, raising large sums of capital early on is highly dilutive. Founders are often left with too little skin in the game. We have come across cases where at seed/Series A rounds founders own sub 20% of the company!
And secondly, having too much capital can often lead to poor decision making and overspending. As someone once said, startups don’t die of starvation, they die of indigestion. This holds very true from what we’ve seen in VC.
Seed and early stage stage investing is a double edged sword. They are by far the riskiest and yet, if successful, most rewarding investments. Our founder and CEO, Andrew Jenkins, was very lucky to have been involved with Mimecast. He was the lead financier and adviser to Mimecast in its first 5 years. Taking on the early stage risk paid off for Andrew and his angel group delivering returns in excess of 50x at the time of exit. For a later stage company to generate returns of this magnitude is hard, if not impossible.
The ingrained riskiness highlights the importance of having the right financier who believes in the product from the start. Seed and early stage companies require an angel or a VC that, in addition to providing the capital, can mentor, advise and be actively involved in the decision making.
At Conviction we believe that seed and early stage investing remains an underfunded sector in the European ecosystem. Therefore, our focus is primarily on seed and early stage, fast growing tech businesses that we believe have a unicorn potential. Every year we provide these businesses with the capital they require for the next 12 to 18 months of growth. Raising modest amounts of capital at increasing valuations helps to lower the equity dilution for founders and existing shareholders. We believe in active engagement with the management and, where possible, opt for executive board seats.
