On Getting An Outside Lead

There are some “truths” in the venture capital business that I have been hearing since I got into this game in the mid 80s. One of them is that getting “third party validation” by going outside of the current investor syndicate to find a new lead is good for the investors. I have come to believe this “wisdom” is nothing more than lack of conviction on the investor’s part.

What “super powers” do VCs have that allow them produce above average returns year after year after year? Well you could argue that some of us have the ability to see things before others see them. That might be true but it is hard to sustain that for a long time. You might argue that some of us have brands that allow us to get into the conversations with the best entrepreneurs when others can’t. That is most certainly true. You could argue that some of us have a tight focus on an investment strategy and work it tirelessly and don’t veer from it. That is most certainly true.

But short of those three things, I am not aware of a sustainable model that produces above average returns on investing in “new names”. However, there are two “super powers” that VCs have at their disposal that can produce above average returns year after year if they use them correctly. Those are the right to a board seat and the right to invest in round after round after round. I talked a bit about the latter one last week.

Taken together, these two rights put VCs in a position to intelligently invest in their existing portfolio companies. I believe that you can turn an average portfolio producing average returns into an average portfolio producing above average returns by intelligently investing in your existing portfolio companies.

It is one thing to take your pro-rata, and I talked a lot about that last week. But it is another thing to lead the next round and increase your ownership. It’s this latter move that I think many of us in the VC business instinctively avoid for fear that we are “falling in love with our companies.” Anyone who has been in the VC business for a long time has made the mistake of believing too much in a portfolio company and supporting it beyond when you rationally should. I have made that mistake so many times I can’t count them on two hands. It is my signature failure and I have not been able to stop doing it.

But, I would argue, the worse mistake is to know you’ve got a winner in your portfolio long before anyone else knows it and you allow a new investor to come in and lead the next round when you easily could and should. The upside on your best investments is the thing that allows an early stage VC to take so much risk and lose money on so many investments. Increasing the upside on the best investments is a rational move in light of the distribution of outcomes in a VC fund.

I would caveat all of this with a few things:

1) You have to let the entrepreneur do what they think is best for them and their company. If they want an outside lead, then by all means you should support that and work as hard as you can to make it happen.

2) You have to think about the amount of “dry powder” the current syndicate has and make sure that you aren’t using all of it up by leading a round when you should really be bringing in a new investor.

3) If an insider is leading a round, you should put a very fair deal on the table for the entrepreneur and the company. An inside lead is not about getting a “sweetheart” deal. It is about putting in place a fair deal for everyone.

4) If the valuation expectations of the founder and the company are unrealistic, then you should suggest that they go test the market. If there is a better offer out there at a better price than you would pay, that is always a good outcome for everyone.

There is a lot of signaling risk in all of this. If you are known to be aggressive in offering to lead inside rounds, and you don’t make that offer, then that puts the entrepreneur in a tricky spot. Of course the entrepreneur can say that they don’t want an inside lead and they want to expand the investor base. But even so, smart investors may know. Truth be told, there is signaling risk in everything that the existing investors do and anyone who thinks otherwise is just not seeing straight.

Two of my favorite examples of this strategy are YouTube and our portfolio company Etsy. At YouTube, Sequoia led the Series A and as far as I can tell (I’m not 100% sure), they led every round after that until the company sold to Google. That allowed Sequoia to allocate more and more capital to what was an incredibly great company and investment and get a massive return on a sale that sure felt like a monster at the time. At Etsy, USV participated in the seed round with some angel investors. We led the Series A and the Series B and increased our ownership substantially by doing that. On the Series C, Rob Kalin decided to get an outside lead and we were totally supportive of that decision. In both cases, I expect (or know) that the VCs had a better idea of how things were going (well!!!!) than anyone outside of the company.

There was a meme in the comment thread on my post last week (104 comments) about “insider trading”. I’d like to say something about that without getting legal or technical. In my view, insider trading is taking advantage of someone buying a stock from you or someone selling stock to you when you know something that they do not. It is illegal and should be. Purchasing stock from a portfolio company is unlikely to be insider trading because how can anyone suggest that you know more about a company than the company knows about itself? I guess that’s possible, but it’s a hard argument to make with a straight face. So while this insider lead thing may smell to some as insider trading, I am very confident it is nothing of the sort.

So in summary, when you have conviction that one of your investments is doing really well, you should have the courage to offer to lead an inside round (assuming you have sufficient capital including future reserves to do that). You should make the case to the entrepreneur and the board why that is a good idea. And if they decide to go outside and find a new lead, you should support that decision and do everything you can to make that strategy a success. I don’t think enough VCs do this and I think they should.

#VC & Technology

Comments (Archived):

  1. Tom Labus

    I’ve backed off increasing an investment in a stock even when I knew I was on the right track for fear of “over weighting” And kicked myself alter. I’ve also gone right ahead and did it and was pounded, It’s hard to tell Sometimes you get it right. Feels good.A good AVC post would be “When to sell”

  2. pointsnfigures

    Leading a round on a privately held company is NOT insider trading. Your points about investing are correct-but academically the only way to beat the market is by being able to invest meaningful dollars when you have more information than the rest of the market. (Fama-Efficient Market Hypothesis). By definition, a VC that does excellent due diligence and has more information than the rest of the market should be able to beat the market and get out size returns. Because of the Beta risk VC’s take, they get outsize returns.One of the facets of leading after investing that you touched on was transparency. Being transparent to the entrepreneur and syndicate gives the VC credibility, and freedom. Sometimes you’ll lead and sometimes you won’t. As long as the VC is a stand up firm; then whether they are leading or not doesn’t matter for the future success of the firm.I remember trading and sometimes, you’d just know that the market was going your way. You’d try to buy/sell all you could-and if you stopped, other traders might ask why. The reasons were the same-capital constraints, risk constraints, things change as the market progresses. The traders that didn’t have conviction and purely followed never lasted. The ones that had the courage to lead survived.

    1. ShanaC

      I think this comment really deserve a chart. It makes sense, but would be even clearer with a chart about why this is impossible.

  3. JimHirshfield

    Doesn’t this…4) If the valuation expectations of the founder and the company are unrealistic, then you should suggest that they go test the market. If there is a better offer out there at a better price than you would pay, that is always a good outcome for everyone….contradict the “myth” referenced in the post title? Surely, there’s no other way for the founders to know what their company is worth, right?

    1. pointsnfigures

      The founders are in a bubble. They don’t see the deal flow VCs see. Founders probably should test the market a little anyway just to put them in a better negotiating stance with the VC that continues to lead

      1. JimHirshfield

        Sure. I wasn’t refuting Fred’s principle of keeping it an inside round. Just think every founder is going to go for outside validation most of the time.

      2. JamesHRH

        trust is the issue there.

        1. JLM

          .Is it trust or information?As my favorite President used to say: “Trust but verify!”JLM.

          1. JamesHRH

            The Transaction Trinity – Trust, Information & Judgement.

          2. JLM

            .Talk about a crisis level of shortage, eh?JLM.

    2. fredwilson

      Yes. Great point. Bad title. I was referring to the myth inside the VC business. Founders should test the market whenever they feel they need to I am going to change the title

      1. JimHirshfield

        New title is short and sweet. +1

        1. JamesHRH

          It also uses the most tried & true structure ever.

          1. JimHirshfield

            You refer to “On…” ?

          2. JamesHRH

            Yyeeeeeeesssssss. 😀

      2. ShanaC

        I like the title. See, this is why testing titles makes sense. Outside validation (ha, I’m joking)

  4. Anne Libby

    “Signature failure.” So much yes.

    1. JimHirshfield

      “Don’t stop believing…” ♬♬♬♬Well, maybe sometimes.

      1. ShanaC

        We should do AVC karoke night.

        1. JimHirshfield

          Intriguing. And awkward.

          1. Anne Libby

            Way too awkward.

  5. bsiscovick

    I found this topic to be one of the most commonly discussed and debated during my tenure at IA. We often went back and forth on the pros and cons and discovered, through countless conversations with other GPs, the full gamut of opinions and approaches on the matter.The only cautionary note I would add is that USV is so damn good, smart and experienced that you guys have an incredibly finely tuned radar to identify when pushing harder makes sense and when it doesn’t. I think it takes years, and lots of mistakes, to tune this radar. As a startup fund, IA made mistakes both ways on this topic – at times we led subsequent rounds when we probably should not have (failure of falling in love) and we missed opportunities to lead follow on rounds when we absolutely should have (failure to use our information and access advantage). These were costly mistakes.That said, it is clear to me that many (if not most) of the best investors employ the strategy outlined in Fred’s post so I postulate that one of the critical, and most difficult, learning curves to ascend as new a GP and firm is to figure out how to deploy effective follow on/buying up strategy.

    1. JimHirshfield

      Trust your instincts?

      1. bsiscovick

        If only it were that easy. Instinct as informed by experience, maybe…

        1. JimHirshfield

          Instinct can’t help but be informed by experience….so, yeah.

    2. fredwilson

      As an LP in IA, it seems to me that the mistakes were not fatal and that there were many good decisions too

      1. JimHirshfield

        Wait….how many other VC funds are you an LP in? Does that mitigate risk or increase it relative to your piece of USV? On the surface of it, sounds like you could be an investor in many startups that USV passed on.

        1. fredwilson

          A lot. I like to invest in VC. I believe in the asset class

          1. JimHirshfield

            I’d be concerned if you didn’t believe in VC.

        2. LE

          Does that mitigate risk or increase it relative to your piece of USVHe has superior information and feel as far as what players to invest in. Consequently instead of “diversifying” into some other risky venture it actually is a good strategy.While normally diversification makes sense (say for an attorney or doctor who doesn’t have complete information or knows jack squat) if you are in a particular business already it wouldn’t make as much sense generally to diversify into other risky things just for the sake of diversification.Fred I believe also invests in real estate (and w/Joanne angel investments) and I believe that real estate is in the neighborhood that he is in and he knows very well. So that is something that would be diversifying but in something he has a better idea of than someone who is not in that area. (My dad did this in the 70’s and it worked out well, way better than real estate from that time period until now).

      2. bsiscovick

        100%

  6. jason wright

    do venture capital firms get investigated by regulators?hedge funds seem to sail very close to the wind.

    1. fredwilson

      I sure hope not!!!!!

      1. JimHirshfield

        Ah, come on, you’ve nothing to hide…or do you? Hard to tell by that comment. 😉

  7. WA

    There is a continuing portfolio lesson (private or public) for the good old dollar cost averaging philosophy & keeping the powder dry approach. Simplexity at its best Fred.

  8. LIAD

    “on a sale that sure felt like a monster at the time”Youtube’s $1.65bn sale felt like an earthquake.Instagram’s $1bn too.By the time of Tumblr’s $1bn – the big billion stopped having that impact.Whatsapp’s $19bn was like, whatever. sure.Twitch.tv’s $1bn sale hardly raised a murmur.amazing how quickly things change

    1. JimHirshfield

      3 “b”s and u almost spell bubble.

    2. fredwilson

      Yup

    3. JimHirshfield

      This…Zillow to Acquire Trulia for $3.5 Billionhttp://dealbook.nytimes.com…

      1. Elia Freedman

        At least it made news. Twitch… Not certain I even heard that one until LIAD’s earlier comment.

        1. JimHirshfield

          The Twitch news definitely hit Techmeme…that’s where I saw it.

          1. ErikSchwartz

            Has it actually finally happened and been announced? It’s been a badly kept secret for months.

          2. JimHirshfield

            widely widely, and then widely reported.

          3. ErikSchwartz

            Oh yes, look at that. Thanks. I’ve been totally heads down for the last week or so. AVC is the only website I’ve seen recently.

      2. Drew Meyers

        A bold, bold move by Zillow (my former employer).

    4. JamesHRH

      Read Benedict Evans graphs on scope of mobile v PC. Makes sense very quickly.

      1. LIAD

        was a great post. couldn’t open Xcode quick enough

  9. Adam Kearney

    Funny, I literally was reading Chris Dixon’s “Inside versus outside financings: the nightclub effect” as this post went up.”You think your date isn’t that attractive until you bring him/her to a nightclub and everyone in the club hits on him/her. Consequently, you now think your date is really attractive.Now the inside investors have 3 choices: 1) Lead the financing themselves. This makes the CEO look like a jerk that used the outsiders as stalking horses. It might also prevent the company from getting a helpful, new VC involved. 2) Do pro-rata (normally defined as: X% of round where X is the % ownership prior to round). This is theoretically the best choice, although often in real life the math doesn’t work since a top-tier new VC will demand owning 15-20% of the company which is often impossible without raising a far bigger round than the company needs. (When you see head-scratchingly large Series B rounds, this is often the cause). 3) Do less than pro-rata. VCs hate this because they view pro-rata as an option they paid for and especially when the company is “hot” they want to exercise that right. The only way to get them down in this case is for management to wage an all out war to force them to. This can get quite ugly.I’ve come to think that the best solution to this is to get the insiders to explicitly commit ahead of time to either leading the round or being willing to back down from their pro-rata rights for the right new investor. This lets the CEO go out and find new investors in good faith without using them as stalking horses and without wasting everyone’s time.”-Chris Dixon http://cdixon.org/2010/06/0

    1. fredwilson

      Shit. I missed that post from Chris. Heading there now. Thanks!

    2. LE

      You think your date isn’t that attractive until you bring him/her to a nightclub and everyone in the club hits on him/her. Consequently, you now think your date is really attractive.That’s fear of loss crossing with people wanting what they can’t have and creating a halo. The question is one week after the nightclub incident what do you think of the person’s looks.

  10. Brad Harrison

    These are critical points to being able to drive exceptional returns especially knowing when to increase your stake in a winnerI also agree with Ben, USV is very good and Fred has a ton of experience so they combine for strong decision making and producing great results

  11. Twain Twain

    Founders interested in “smart money” would prefer to have investors who commit to follow-on rounds. Which investor gets the board seat comes down to personal chemistry and trust.When that’s aligned between founder-investor, the synergy and value creation that happens exceeds the sum of their parts.

  12. Liban Mahamed

    A great thesis here; but I wonder how would this work in an environment of inflated valuation.Let’s assume the industry insiders had a great run for several years and feel invincible, they have a dose of irrational exuberance.I say this because of Ubber and 17 billion valuation.The entire taxi industry in the US has a total revenue of 15 billion US dollars, that is before any expenses , from insurance, car payment, driver pay etc.In essence, if Ubber replaces every cab in the US they may make a gross profit of 1 billion a year.Very unlikely scenario, still insiders valued Ubber beyond reason.Fred, few people maybe able to exercise restraint and do dry, sober analysis, but most will overshoot and overvalue due to attachment to the company.In my view, fresh set of eyes with different perspective will help and diversify the thinking of the board.

    1. Nick Grossman

      On Uber’s valuation, I would suggest reading Bill Gurley’s post (http://abovethecrowd.com/20… ) which gives a different view (that i agree with) on how to size the potential market

      1. Liban Mahamed

        I did, still I believe Ubber is not worth that valuation. In addition, Ubber has huge regulatory and insurance poblems.The cars used in Ubber fleet have only private insurance coupled with Ubber commercial coverage. By law insurance companies do not allow using private cars for business purposes. Technically all Ubber cars are operating illegally. They are breaking their insurance policy terms. Ubber does not even acknowledge it is a taxi or transportation company. The regulatory environment surrounding Ubber is very messy and not sustainable.I have some experience in this industry, I manage a company that leases trucks and taxi vehicles.Ubber has a very good dispatching system nothing more than that.I like Hallo and Flywheel among the new companies in the transportation sector.In my view Ubber is the first shot in the battle to innovate the transportation sector. It is just the beginning, eventually there will be cars with no drivers, maybe a fleet of Tesla etc.

        1. LE

          Yeah it’s hard to believe that the insurers aren’t going to put in policy riders that specifically exclude using cars in this manner.Right now it’s under the radar. Clearly that’s not the intent of a personal auto policy.That said isn’t Uber commercial coverage primary on this anyway? I would think it would have to be.

      2. PhilipSugar

        The article was very well written, thank you.It points out how you can miss use cases. I remember talking to an NTT executive in the 1980’s and he said cell phones would never be widely adopted in Japan. There were simply too many pay phones and Japan was a small place not like the U.S.Having just been in Boston and seeing how well Uber works there and realizing my fraternity brother had gotten rid of his car, I can see the use cases. He also cites an Article Increasing Returns which is also well written.Both are good articles regardless of what you think about Uber’s valuation.

  13. Aaron Klein

    There’s no question it isn’t insider trading. I just have to laugh at the handwringers who are worried about the “ethics” of doing what Warren Buffett has advocated for years and Andy Swan’s LikeFolio has opened up for average investors: “investing in what you know.”

  14. zackmansfield

    Conviction and courage, balanced with the ability to work with the entrepreneur to find a common ground and the ability to step back and support a decision to go with an outside lead if that’s where he/she & the board decide to go. It is simple in that breakdown (and beautiful, and true) and yet so difficult in its complexity in actuality. Just the conviction and courage part – sure, you have better information than anyone else but still a multitude of variables with unknowns not yet solved for – is a challenge enough. Then getting to a place of partnership where everyone feels that this (an inside led round) is the best way forward can be another mountain to climb. Wise words though and I agree that ability to scale these challenges successfully (being right, having the courage to act, then getting a deal done) can lead to superhero returns. Great post Fred.

  15. JamesHRH

    This is great stuff.I am very pleased to hear that you believe in signalling. The old adage: small minds / people; middling minds / events; large minds / ideas is universal, which means that a large swath of VCs just read other people’s actions (events and ideas too tough for them).Is this the toughest ‘gut check’ point in VC investing? (assuming the big three are 1) getting in 2) allocating during the ride 3) pricing a sale…..As an aside, like all great writing, your best stuff stems from personal experience.

  16. Dave

    #3 always seems the difficult one (fair deal, not about getting a sweetheart), particularly for companies that are doing really well but are not YouTube. Management will often think that the VCs are trying to screw them; unfortunately management often starts to think this about 2 months after the round closes and it can lead to long-term relationship damage.

  17. Alan Warms

    Great post. It’s this exact point, and the earlier post you had on dilution, which are exactly the reasons that I don’t believe angel investing without pro rata and real connection to CEO can be successful over long term. USV has the focus, time, seat at the table, and capital to maximize returns. Angel syndicates have none. Much rather be an LP in great VC funds.

    1. Joah Spearman

      “real connection to CEO” is so critical and undervalued

  18. Richard

    2) You have to think about the amount of “dry powder” the current syndicate has and make sure that you aren’t using all of it up by leading a round when you should really be bringing in a new investorThis seems like a problem where a SWAP agreement could offer a solution, e.g., a SWAP of part of the potential future return for a fixed return.

  19. Evan Van Ness

    Great post. It seems to me that tomes could be written about the signaling risk. You could probably write those, but it probably isn’t in your interest to do so.re: “my signature failure”It might also be the source of your edge in closing hot deals.

  20. Liban mahamed

    In valuing non public companies how prominent is the role of profits/earnings?Most of the prominent tech companies all have very high valuations with really no profits at all.Even some that went public have extremely have p/e ratio, I wonder at what point does a company need to become profitable, at least show profit in current operations excluding investments, etc.Sometimes it seems no of users etc are the most important valuation factors .

  21. ShanaC

    I find the love thing a weird metaphor. If you are ratonal, you are not falling in love – you are being smart to follow on – so why is there a fear of being smart?If these are long options (effectively speaking) you know this up front – what is there to love?

    1. pointsnfigures

      Investing is emotion.

  22. ErikSchwartz

    Courage is not a word I associate with many VCs.”We’re definitely interested once you get a lead” — How many times have I heard that? The pathetic thing is that once you get a lead they all call back wanting in on the deal

    1. LE

      All that sucks of course but this is business. Nobody is doing anybody favors unless there is a benefit to them. As in life the good looking girl doesn’t want or need you unless you have something to offer her (looks, money, personality) But guess what? It’s not like the guy (said rejected guy that is) is pursuing girls that don’t provide some tangible benefit to them in a way that puts a smile on his face…. People in glass houses and all.

      1. ErikSchwartz

        Business is business but we keep hearing as an asset class as a whole venture capital loses money. So maybe it’s not GOOD business.

        1. LE

          Why does it matter what the entire asset class does at all?That’s the type of thing that business journalism cares about or business school professors and analysts care about. Or people reading shit on the internet thinking they can get a leg up. I see business as nuance and degrees not absolutes like “bad as an asset class”.If I was a limited partner in a VC fund (I’m not) all I would care about is whether I think the particular VC or VC’s that I give money to can get the job done. Not how the how class did. Do I have confidence that this firm can make the best bets and do they seem to have their act together?Here is the way I look at investing or really anything where built up knowledge gives someone an edge. You always pay someone to do something where they have an advantage over you or other alternatives. And time is short and there is downside risk to making a mistake. My mother is using an adviser to invest some of her money. The adviser charges a percentage of what he invests depending on what he invests in. To me the fee is trivial because there is no way I’m going to be able to duplicate what he does as a full time job and to me it’s actually a bargain. I don’t care about how other people view using people like this since this is the best decision to be made in this particular situation given the participants and what they want to achieve

          1. sigmaalgebra

            Sure: As an LP you would be looking not just at the probability of success of the ‘VC asset class’ but the ‘conditional probability’ of success given the particular VC firm. It’s quite possible for the probability to be quite low but the conditional probability to be high, even 1.You are using the ‘information’ of knowing about the particular VC firm, and quite broadly the best way to make use of information is to take the conditional probability given that information. So, that’s what you are doing intuitively, and it’s the right thing to do. If you had more data, then it would be still more the right thing to do.Of course the asset class sucks: Enough poor players get in until the ‘class’ sucks. Then the LPs have to take seriously actually doing their jobs, which they are reluctant to do. They’d rather just invest in the asset class, if it made a lot of money. But there’s no such thing as a free lunch, and, as soon as a broad asset class makes especially large returns, that class will be over subscribed until the returns fall, which is just what happened.

          2. LE

            Then the LPs have to take seriously actually doing their jobsThe key to most things is luck and hard work.I did really really well at online dating while most people simply whine about that “class” and method of finding love (or just getting a date).that class will be over subscribed until the returns fallEverybody and their uncle as the saying goes.

    2. sigmaalgebra

      Ah, it’s simple: They just want to get on the airplane after it has already left the ground!Really, they know that they are “not for everyone”. So, who are they for? Maybe they suspect that often the guys, a team with a lot of mouths to feed, have long since been on bread and water with maxed out credit cards and will be desperate to sign a bad business deal.

  23. Brandon Burns

    “signature failure”Everyone has one (or several), but few admit it. Great to see you identify yours. I’m still trying to figure out what mine is. Its hard to see your own flaws with clear vision.

  24. William Mougayar

    Also, if you keep getting new leads at each subsequent round, doesn’t having too many VCs by the time you’re at a Series D create a relationship management nightmare? Who wants to manage 8 hot headed VCs who often see things differently amongst each other?Fred- not sure if you have written about that, but could be a great post about how you work with other VCs inside companies, whether you’re all on the board or not.

    1. JimHirshfield

      “Hot headed VCs”…hahahaha

      1. William Mougayar

        I haven’t met a good one that wasn’t 🙂

    2. awaldstein

      I’ve never been involved in anything passed a C round in my entire career.Am I the corner case here?

      1. William Mougayar

        Even at the C, you could easily end-up with 7-8 VCs.

        1. awaldstein

          Next time I’m locked in space on a plane I’ll figure out even how many Cs I’ve done.But yes, i’ve had many cases of 5 and regardless of the alphabetical #, it’s a challenge.

  25. Gennady Shenker

    Fred, you made me think about an improvement to your model. VC should structure board seat not for an individual but for the VC. Then, rotating partners on the board after certain time periods may provide a fresh look and enhance VC’s ability/confidence/comfort in continued investment.

    1. JamesHRH

      Tough call on that idea. Continuity provides depth of information that a rotation would lose.

  26. LE

    One of them is that getting “third party validation” by going outside of the current investor syndicate to find a new lead is good for the investors. I have come to believe this “wisdom” is nothing more than lack of conviction on the investor’s part.Maybe not, and I think what you said below supports that! The above statement actually seems to prove this is possibly happening, your signature failure:Anyone who has been in the VC business for a long time has made the mistake of believing too much in a portfolio company and supporting it beyond when you rationally should. I have made that mistake so many times I can’t count them on two hands. It is my signature failure and I have not been able to stop doing it.Conclusion: Reason for third party validation!I’ll tell the story again about “the lender”. The lender was the guy at the bank who just dealt with the cold hard facts. He wasn’t susceptible to the magic of the “dog and pony” show put on by the entrepreneurs. God did we snooker those guys with all our enthusiasm and bull shit.Back in the day when there were things called bank loans that you paid 15% interest on the local regional business banker would come out and be wowed by the show you put on for him. [1] You would totally “confidence” him he left dazzled by how much potential you had if you got more money from the bank. He was impressed by the nice car you drove and thought that meant you were making money (have a theory on this for another time). You were busy. [1] He then left with the figures and facts but then “the lender”, some guy in a room who only crunched numbers, took a look and either passed or failed the loan. The purpose of the lender was similar to the purpose of “third party validation”. Someone who isn’t emotionally attached or conned into doing a deal. Just able to look at things more rationally.Oh and one other thing third party validators aren’t looking to justify something they did previously by throwing more good money after bad. Well known fact (that I’ve observed and I believe is well known and have definitely used it to my benefit) that people are more likely to stick with something that they’ve invested so much time in. That’s at least two of the reasons you have this “signature failure”.[1] When said person visits, make sure there is plenty of activity, full staff working and very busy, and a certain hum the office and “factory” floor. Don’t take to much time, make sure someone else shows up and you have to end the meeting early. And so on.

  27. sigmaalgebra

    > But short of those three things, I am not aware of a sustainable model that produces above average returns on investing in “new names”.Well, for such a “model” we can mention two steps:(1) Pick a big problem where the first good or a much better solution stands to be a “must have” or at least very popular and, thus, very valuable.(2) For this problem, get the first good or a much better solution, one that in its technical internals is difficult to duplicate or equal and, thus, provides a technological barrier to entry.For step (2), the technical part, the US DoD is fully “aware” and has been back to the beginning of the Manhattan Project and forward through jet engines, the U-2, the SR-71, the F-117, Sosus (sea floor hydrophones), passive sonar, synthetic aperture radar, spread spectrum radar, both radar and sonar phased arrays, sometimes with adaptive beam forming, Keyhole (apparently Hubble is essentially a Keyhole but aimed in the opposite direction), GPS, and much more.But the Manhattan Project had low return on investment? Not really: As I recall, in one of the books by Richard Rhodes is explained that (1) the project cost about $3 billion but (2) likely saved 1 million US casualties that invasion of Japan would have caused. So, we’re talking $3000 per US casualty, which was great return on the investment, one that a poor GI who had to walk ashore onto a hostile Japan would have understood.”Sustainable”? The Manhattan Project started, what, about 72 years ago? Likely the last 72 years of the US DoD had been by a wide margin the most successful progress in technology, especially information technology, in all of history. Oh, yes, one little side effect was a place called Silicon Valley — Dean Terman, Varian, Fairchild, etc. Those airplanes and missiles needed a lot of rugged electronics.My experience in DoD work tells me that the ‘hit rate’ of such DoD work, including on projects as challenging as Keyhole and GPS, has long been significantly higher than that of information technology via Silicon Valley and/or venture capital.Indeed, with some irony, followinghttps://www.usv.com/posts/r…tohttp://www.rollingstone.com…that is, the recent Bill Gates interview on ‘Rolling Stone’, yields in part> Progress depends on such simple things – like functioning toilets.> We take things like TV or Internet or a microwave or a refrigerator for granted, but moving people from basic lives to decent lives requires a lot less than that. You know, development sometimes is viewed as a project in which you give people things and nothing much happens, which is perfectly valid, but if you just focus on that, then you’d also have to say that venture capital is pretty stupid, too. Its hit rate is pathetic. But occasionally, you get successes, you fund a Google or something, and suddenly venture capital is vaunted as the most amazing field of all time. Our hit rate in development is better than theirs, but we should strive to make it better.That is, it should be possible to raise the hit rate of venture funded information technology startups.How does the US DoD do it? For one difference, the DoD problem sponsors are quite ready, willing, able, and eager actually to read and/or review technical papers on the crucial, core technical material, that is, for step (2) above, and to fund a project based largely just on such a paper. So are the NSF and NIH. Such reviews can be done and can lead to a high ‘hit rate’. E.g., GPS? The first version was for the US Navy for its missile firing submarines and was first proposed on the back of a napkin by some physicists at the Johns Hopkins Applied Physics Laboratory. From the napkin, there wasn’t much doubt. Soon, there was a good project with very little doubt. Soon, there was an antenna on the roof that routinely navigated itself to within 1 foot. It worked great, and that result was quite clear quite early on.In the commercial world, to use this DoD experience to make money, go back to the beginning where a much better solution stands to be a “must have” or at least very popular and, thus, very valuable.> not aware of a sustainable modelWell, not in information technology venture capital. It took me a while to conclude that such venture capital just would not, Not, NOT even read or review anything technical. It was tough to believe, but likely and apparently for nearly all of information technology venture capital for at least 10 years that has been the situation. What, the MBA LPs all get together and insist on their GPs never considering anything technical?On evaluating technical material, the US DoD, NSF, and NIH, that is, ‘big government’, blows information technology venture capital out of the water like a sixteen inch shell from the battleship Missouri hitting a row boat. The situation is one of the grand tragedies of our economy and our time.The US DoD and the US Congress both quickly understood the importance of advanced technology, and associated research, for US national security, and one result was research funding that long was one of the main sources of funding for the top few dozen US research universities.Congress was correct. E.g., praise from an adversary is especially welcome: During Gulf War I, at one point there was an Iraqi tank hidden tightly between two buildings. Then a US airplane sent a missile that hit the tank and destroyed it and mostly didn’t hurt the buildings. An Iraqi officer claimed, “US military technology is beyond belief.”.Right, and much of that technology came from funding of the US Congress through MIT, Harvard, Yale, Princeton, Johns Hopkins, Carnegie-Mellon, Georgia Tech, University of Chicago, University of Washington, Berkley, Stanford, Cal Tech, etc. E.g., I got a relatively good undergraduate physics education in part because the USAF wrote a research contract with my main physics prof that read “To further the technology of the infrared.”. Has good work with infrared since helped US national security? Do we have to make a list?Now that Congress has paid for the basic work and a lot of military applications, the commercial exploitation is just sitting there, largely neglected by VC.Yes, I can expect that the GPs rarely get anything very technical and promising as a business in their e-mail inboxes. But as I recall once Marc Andreessen claimed that each year there are only about 15 deals worth of a Series A. And, as we look back over the last 15 years, get another Google, Facebook, or Twitter only once each several years. So, net, just a few really good deals a year could totally change the world of venture capital. For such deals, with powerful technical internals, entrepreneurs have long very much not been welcome at all at the VC firms; so, maybe mostly the entrepreneurs gave up.Yes, yes, yes, I know; I know: The venture partners are “the smartest guys in the room”. Alas, on technical material, apparently nearly none of them can read or even direct reviews! They should hang their heads in embarrassment, shame, guilt, and humiliation. Gee, smartest guys but can’t read!Not all the GPs can want to be like that; there has to be an explanation somewhere, maybe from the MBA LPs getting together.

  28. LE

    Purchasing stock from a portfolio company is unlikely to be insider trading because how can anyone suggest that you know more about a company than the company knows about itself?Consider this though. As far as “how can anyone suggest that you know more about a company” I could say that it is quite possible that you knew and had discussions with others in the industry that a potential buyout offer was either in the works or very possible. Maybe you are even a part of making that happen?Here’s an example from today. I’m working on something right now where I know something that is not known by either buyer or seller. I know what the seller thinks and I know what the buyer thinks and what both of their positions are. Consequently I can assess the likelihood of a particular event happening that both buyer and seller can’t since I am the one who is dealing with both parties. [1] QED I know more than the company does about the future and the prospects.[1] How about that Mr. Fung? (OJ trial..)

  29. Seth DeGroot

    It’s this latter move that I think many of us in the VC business instinctively avoid for fear that we are “falling in love with our companies.”I think many VCs have a (justifiable) fear of “drinking the Kool-aid” and falling in love with a portfolio company. That said, I believe there are performance metrics that can be used as reality checks to help avoid this. The metrics change depending on the sector, but taking a SaaS company as an example, one could look to MRR growth, monthly app session growth, growth in # of client accounts, penetration of existing client accounts (i.e. they liked the product enough to keep buying it), and cash management/monthly burn rate.I think it’s also important to run a detailed IRR analysis when making the pro-rata investment. Again using a SaaS company as an example- what does the investment do to fuel top line growth? What does the resulting top line growth due to valuation? Is there another follow-on capital raise, or does the current round likely get the company to an exit event? In the event of an exit, who are the likely acquirers, and what kind of multiples are they paying?There’s still an important intuition/gut-feel aspect of the pro-rata decision, but I think there are tools/metrics that can provide reality touchstones, to mitigate the risk of falling in love with a portfolio co.

  30. Jason Crawford

    Thanks Fred. Your caveat #3 is the one I have always heard as the reason why you would get a new lead for each round—there is a built-in conflict of interest. But if the investor is willing to put an obviously good, fair deal on the table, then this makes sense.

  31. Harry DeMott

    Best post in a long time in my opinion.Of course, I’m living with both sides of this coin everyday: madly in love with companies and concepts, and at the same time thinking about how to allocate scarce investment capital.It’s all a game of poker – you want to get all of your chips into the center of the table when you have absolute conviction of a win, all the while knowing that you have a finite stack – so you better be right when you push in.Interestingly when you lead inside rounds – or continue to invest pro-rata or even sub pro-rata, there comes a time when you own so much of the company that you are in essence diluting yourself, and then it really becomes not about % ownership, but gross dollar return relative to capital invested – which is a subtlety lost on many.In any investment portfolio (VC or otherwise) you only get so many high conviction ideas – key is to recognize them when they come along, have the courage of your convictions, and step up.

    1. fredwilson

      the reason we have two funds is one is focused on ownership and the other is gross dollarsit’s a subtle distinction but an important one

  32. Alex Dunsdon

    Agree. Fred, what do you think about angels – who take the most risk – getting squeezed in later rounds and getting pre-emption taken away. Happens loads with successful companies (has happened to me). May be a naive view but doesn’t seem right, right?

    1. fredwilson

      my wife is an angel and she won’t do an investment without pro-rata rights. the only way to protect your ownership is to continue to invest

  33. JLM

    .This subject touches on one of my favorite considerations — an entrepreneurs relationship with “the” money and money in general. Entrepreneurs/founders/CEOs have a tendency to see raising money as a moon shot — you blast off, get the money and land.It is in fact a long distance intergalactic flight in which you blast off, fly for a long time, refuel and keep on flying.I preach — “Never get mad at the money, it will change its mind.”Entrepreneurs have to develop and maintain a good relationship — continuous relationship — with the money and know what the money is thinking at all times. This is different than running the company which is the work a day responsibility of the entrepreneur/founder/CEO.By having a good relationship with the money I mean a two way dialogue in which the consumer of the money (entrepreneur) and the warehouser of money (VC) are in constant dialogue as to market, economy, business driven short/mid/long term funding requirements and the current price of money.Simultaneously, the entrepreneur/founder/CEO should know others in the business as a simple diversification of potential funding sources. If you are hunting for fuel on the Interstate as the fuel gauge trends toward EMPTY you really don’t care whose name is on the gas station. There is no reason to allow that to happen but it does sometimes.Don’t let some VC “come lately” to eat from your chili bowl. That’s your chili, Hoss.As to the actually doing of a deal — you don’t get what you deserve, you get what you negotiate. “Fair” is a wonderful concept but it rarely figures into the final resolution of many things of great portent — rather you negotiate a deal which is “acceptable” to both parties.VCs are silly to allow their own portfolio go looking for money elsewhere. They have invested a ton of “real” money but they have also invested considerable personal time, expertise and other qualitative capital in the relationship.VCs should be like the Pied Piper drawing their portfolio along to the promised land and making the journey wonderful along the way.I don’t know many deals that make it to the pay window that do NOT celebrate their successful journey. Very few relationships celebrate the painful journey while on the way.We should celebrate Christmas in July. How about tom’w? Couldn’t we all and the world use a bit of Christmas tom’w?Never get mad at the money, it will change its mind. Smart entrepreneurs/founders/CEOs will give VCs room and space to make the required changes. Smart VCs will maintain the kind of relationship that will seduce the entrepreneurs.Long term relationships require living through the tough times.JLM.

    1. PhilipSugar

      “If you are hunting for fuel on the Interstate as the fuel gauge trends toward EMPTY you really don’t care whose name is on the gas station. There is no reason to allow that to happen but it does sometimes.”Stolen. I love that line.

  34. Jonathan Friedman

    Excellent article! Glad to see you are back to writing more in depth about the VC business like you were in the past.One suggestion: “You have to think about the amount of “dry powder” the current syndicate has and make sure that you aren’t using all of it up by leading a round when you should really be bringing in a new investor.”Figuring out the amount of “dry powder” needed could be a good topic for a future post 🙂

  35. shenborn216

    If you are hunting for fuel on the Interstate as the fuel gauge trends toward EMPTY you really don’t care whose name is on the gas station. There is no reason to allow that to happen but it does sometimes.”Stolen. I love that line

  36. Josh Hannah

    Great points!Re: Signalling risk, you say: “There is a lot of signaling risk in all of this. If you are known to be aggressive in offering to lead inside rounds, and you don’t make that offer, then that puts the entrepreneur in a tricky spot. Of course the entrepreneur can say that they don’t want an inside lead and they want to expand the investor base. But even so, smart investors may know. Truth be told, there is signaling risk in everything that the existing investors do and anyone who thinks otherwise is just not seeing straight.”I think this, to some extent, glosses over a real problem with this strategy. There is clearly much less signaling risk in the traditional model: we always look for an outside lead in the next round, and modulate our participation down as the rounds get bigger. That strategy, faithfully followed, could effectively modulate most of the signaling risk to a new investor (and was likely a part of why it was adopted so widely, in addition to lack of conviction and poor judgment about your children).”I’m going to lean in to my Etsy’s and Twitters” has, as you point out, the benefit of allowing you to consistently make more money, but it has to be at the cost of your middling companies, where the new investor can clearly see you are not leaning in. If you never leaned in to winners, that signaling risk would be much less.It’s one of those areas where your interests diverge from your portfolio, and you need to make a judgment as to whether the returns to doing it outweigh the cost. I happen to think we’ve been in an environment where the cost has felt artificially low, and it will be interesting to see how this changes if later stage financing gets tougher.YC confronts this same issue, as they clearly want to deploy more capital in their winners, and frequently blog about how they have no clue who the winners and losers are, which may be true but also has the handy benefit of hoping to persuade investors not to view their activity as signaling.

  37. Hamish Eady

    All that absorbs of course but this is company. Nobody is doing anybody prefers unless there is a advantage to them. As in lifestyle the excellent looking lady does not want or need you unless you have something to offer her (looks, cash, personality) But think what? It’s not like the guy (said refused guy that is) is seeking ladies that don’t offer some concrete advantage to them in a way that places a grin on his experience…. Individuals in cup homes and all.Incinerador de Grasa