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.