Should You Lead or Follow?
I’ve been lucky to be given a lot of responsibility in my venture capital career. In the early 2000s, I was entrusted by the largest pension fund in the United States, CalPERS, to become a founding General Partner in a seed stage venture capital firm.
Joncarlo Mark, the founder of Upwelling Capital Group, was formerly a Senior Portfolio Manager in the Alternative Investment Management group at CalPERS, where he was responsible for the investment in my fund. From 2007 to 2010, he also served as chair of the Institutional Limited Partners Association (ILPA), whose 300 member organizations oversaw over $1 trillion of private equity capital. Before we closed the deal, I remember Joncarlo charging me to “deliver alpha” by finding my own deals, and not simply riding on the coattails of well-known Silicon Valley venture capital investors. He explicitly said that he expected our firm to lead deals, and not just follow. Today, he reflects:
“Being able to select new managers is critical to generating outperformance. Over my 12 year career at CalPERS, it was our ability to find groups that offered a differentiated strategy that helped us outperform our benchmarks. We sought out managers who were leaders within their strategy. We also selected groups that we determined had the best sourcing capabilities, were willing to be decisive about which deals to lead, and could truly add value to their portfolio companies.”
Choosing to lead can also be valuable to entrepreneurs seeking to catalyze their funding rounds. I’ve been approached by many founders who have attracted interested investors wanting to “follow” by participating in the round, in which case the CEO is “looking for a lead.”
But what is required to lead a deal in venture capital? Historically, leading has been defined two ways:
1. Write the term sheet and negotiate the deal with the entrepreneur
2. Put the most money in the round
While the technical definition of leading is structuring the deal and negotiating terms, the two definitions have become intertwined.
A round cannot occur without agreed upon terms. Someone has to step up to say “I am willing to fund on these terms and at this price.” Except in angel rounds where the startup provides the terms to investors with no negotiations, whoever takes responsibility for delivering the term sheet and set the terms of the deal is considered the lead.
In many cases, structuring terms does coincide with writing the largest check. The National Venture Capital Association’s 2020 “enhanced model term sheet” includes historical information detailing the percentage of each round purchased by lead investors. The data is remarkably consistent measuring rounds from Series Seed to Series D+, with averages ranging from 47.1% to 58.2%. In other words, in a typical round, the lead investor puts in about half the money. This would mean in a $10 million round, the lead investor would commit about $5 million.
My colleague Allison Goldberg formerly ran Time Warner Investments, where she preferred to invest at least 50% of the round when leading a venture deal:
“At Time Warner Investments, we acted as lead investor in about half of the deals we funded. That means we negotiated and issued term sheets, invested at least half the round, served on the board of directors, and often controlled the series of preferred stock that we held. The board seats were typically occupied by a member of our investment team, but sometimes one of the execs from one of our divisions would serve on the board if that would be more helpful to the portfolio company. Leading deals facilitated mutually beneficial relationships between us and the companies we invested in, and helped us achieve both our strategic and financial goals.”
However, there are multiple reasons why venture capital investors might decide not to lead a round:
- If you don’t have conviction about the deal, meaning you aren’t really sure you believe it’s a good investment. In my opinion, this is a bad reason not to lead, and has resulted in the stereotype that VCs are like lemmings who cannot make up their own minds.
- If you aren’t sufficiently expert at negotiating terms. This is one reason why convertible notes and SAFEs have become increasingly popular as new investors have entered the venture industry. These simple structures allow anyone get started, even if they are unsophisticated and haven’t been trained at venture capital.
- If you want to test whether the startup CEO can attract capital from other high quality sources besides your own fund. Being the largest check writer can be difficult when a startup returns for more capital every year. To manage the budgeting process for smaller funds, it’s sometimes prudent to let others take the lead for startups that will require steady capital infusions over multiple rounds. Many institutional venture funds have a diversification rule requiring no more than 10% of the fund be invested in any single portfolio company so each fund has its limit. As a result, a strong investor syndicate can be the difference between success and failure for a startup.
- If you don’t believe you will buy enough influence without putting in the most money. Many entrepreneurs believe they owe the most to those who put in the largest amount of capital. While technically speaking, each shareholder is owed the same duty, there’s some logic to the idea that startup management will be most responsive to those who have provided the most financial support.
- If you don’t perceive you have enough money to catalyze the round. In my experience, 50% often is a tipping point in any fund raising, including for non-profit campaigns. If you start with “anchor” investors committing $10 million, it’s reasonable to think you might get to $20 million, but probably not $50 million or $100 million.
What about corporate venture capitalists?
Corporate investors (CVCs) historically have not led deals primarily for the second reason above, which is lack of experience with venture capital terms. With the increasing sophistication of the CVC community, including external advisors who can provide deal structuring expertise, this is no longer a good excuse. As Allison Goldberg indicates, experienced CVCs can be comfortable leading when appropriate.
Whether to lead or follow is one of more than a dozen key decisions when starting and running a venture capital fund, whether that vehicle represents institutional capital, an angel fund, or a corporate program focused on strategic investing. Understanding what’s required to lead can help facilitate a logical strategy that helps the fund and its portfolio companies, too.
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