Do VCs have “Herd Mentality?” Yes and no.
For bad and good reasons.
1) Simple and Pure FOMO
There is no denying some VCs are looking for social proofing in order to invest. If a VC is not doing their own diligence but tagging along someone else’s investment or simply betting on the team should be telling signs for an entrepreneur. Having such a VC on your cap table is not inherently a bad thing, as long as you set your expectations accordingly.
If a large VC is investing into a very early-stage company they are very likely buying an option value. The entrepreneur should balance the benefits of a brand name with the signaling risk i.e. they decide for some reason not to invest later. Funds are getting increasingly creative around this by allocating separate seed funds, creating altogether new entities, or investing through someone they trust so the fund’s name is not officially on the cap table.
2) Mitigation of Risk
The most commonly stated reason since no investor wants to be the only one supporting the company in time of need. But it’s also in the interest of the entrepreneur to have a diversified cap table — you want to minimize investor risk (they might not be able to give as much time or run out of funds) and maximize benefits (expertise, network, help). When a VC asks who else is in, always put context around it — if they have or are doing their due diligence then they are probably asking this question for the right reasons.
3) Smaller Investors Need Larger Ones and Vice Versa
First principle — the limiting factor for a responsible VC is not capital, but time. Whether you are a $50M fund or a $500M fund, there are just so many companies that you can tend for, typically between 7 and 9.
Second principle — the structure and incentives are different based on stage and size of a fund. A $50M fund can get a 20% win by returning $60M i.e. $10M more in cash whereas a $500M needs to return $100M for the same win.
Third principle — the horizon for the return and the fact funds are optimized for 5–7 year windows. A small fund can sell its portion in a secondary offering to realize a gain but a larger fund will have to take a company to its full exit. So a small fund can come in early but a large fund has to come in later to still be within the 5–7 year window.
All this means that a small fund cannot do too many large deals lest it be too concentrated in its risk. And a larger fund cannot do too few small deals because a partner cannot disperse his / her time too widely. When they are looking for who else is in the deal, they are looking for signals that optimize the three principles above.
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Thank you to Apoorv Agrawal for inspiring this article. These are purposely short articles focused on practical insights (I call it gl;dr — good length; did read). I would be stoked if they get people interested enough in a topic to explore in further depth. I work for Samsung’s innovation unit called NEXT, focused on early-stage venture investments in software and services in deep tech, and all opinions expressed here are my own.
