Abe Othman writes: should seed investors follow on?

Steve Crossan
Unreasonable Effectiveness
3 min readNov 5, 2019

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I’ve been thinking about rational follow-on strategy for a long time, and how to use portfolio simulations to decide when to make follow-on bets. Abe Othman at AngelList has just published some really interesting work that moves the debate forward. Here’s my brief explainer of what he did.

Abe looked at a ‘universe’ of 1218 seed stage convertible investments from 2014 to 2017. He then imagined a pool of 10 randomly selected investments each year for a total of 40 investments in the pool, and simulated 10,000 random pools this way.

For each pool of 40, he then looked at the performance of 3 strategies:

  1. Never follow-on. Invest an equal amount of capital into each of the 40 startups.
  2. Always follow-on. For example, if a company you invested in in 2014 raises an upround in 2015, you invest the same amount of capital again in that company. Because he assumes a fixed amount of capital, each time you follow-on you forgo 1 opportunity to invest in a new company in 2015. The one you forgo is chosen at random from the 10 in the pool for that year.
  3. As 2, but only when the valuation doubles or more at conversion into the upround.

The final valuation of each portfolio is calculated 18 months after the end of the investment period, ie Summer 2019. It includes both realized and unrealized valuations.

Results

Cutting to the chase: Within this pool, never following is the best strategy most of the time, although the difference between the 3 strategies is not huge.

The exception is if you get into one of the top handful of companies in your ‘universe’ relatively early in your investing window.

Why? Because in the latter case the return on even the more expensive follow-ons can beat the expected return on the forgone new seed investment (at least for this dataset).

In a bit more detail:

  • Never following had the highest median outcome across 10,000 pools.
  • Within each pool, Never beat the other 2 strategies most of the time.
  • But, Always following has a higher mean — that is it is more skewed by the occasional outlier.

Clusters

The clustering diagram is really interesting, but took me a couple of passes to fathom:

Each point on the plot represents 1 pool of 40 possible investments, and the performance of 2 strategies (Never, and Always) on that pool. So for example the rightmost point represents a pool in which Never achieved about 5.5x portfolio return but Always achieved almost 10x.

The clusters are very interesting. The 2 outlier clusters towards the upper left and the upper right, represent performance on pools which contain the single best investment from the universe of 1218 startups. This is ‘outlier strategy’ writ large — as I’ve written elsewhere any portfolio that contains this investment will outperform every portfolio that does not.

But why does ‘Never’ sometimes outperform ‘Always’, even in portfolios containing that ‘universe winner’ (these portfolios are represented by the green circled cluster)? Surely if you follow on to that ‘universe winner’ you’ll always win.

The reason is that by having a strategy of always following on, you’ll sometimes miss the opportunity to invest in the ‘universe winner’. Remember that each dot represents a fixed pool of 40 companies, considered as 10 potential investments per year. The dots in the green circle represent times when the ‘Always’ strategy used up all its capital before it got to the ‘universe winner’, and thus missed out (presumably because a lot of the early bets converted). This is the ‘opportunity cost’ of doing follow on, and these are the cases when it didn’t work out.

Originally published at https://www.linkedin.com.

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Steve Crossan
Unreasonable Effectiveness

Research, investing & advising inc in AI & Deep Tech. Before: Product @ DeepMind. Founded Google Cultural Institute; Product @ Gmail, Maps, Search. Speak2Tweet.