Ever since I’ve been in the venture business, some 20 years now, it’s been accepted wisdom that early stage, particularly seed stage, investing is inherently more risky than later stage investing. I guess it depends on how you measure risk. In the financial markets, risk is defined as tbe variation of returns around the expected return (the standard deviation from the mean). The more variability in the returns, the more risk there is. And from that perspective I am sure that early stage investing is more risky than later stage investing. But that’s largely the limited partner’s perspective.
My personal experience suggests something else. As a VC making direct investments in companies, I think we take on way more risk when we invest in a later stage company than an early stage company. Here’s three big reasons why:
1) You can’t play the poker game. I blogged this before so click on that link and read the whole post, but my basic point is in seed/early stage investing you ante a little, see your cards, decide if you want to invest more in your hand, see some more cards, etc, etc. You get to stage your risk capital as the investment shows itself to you over a number of years. You can manage all kinds of risk this way; management risk, valuation risk, technology risk; and market risk. Classic later stage investors want to be in the last venture round and in that scenario, you are putting all your chips on the table before you’ve really seen your cards.
2) Later stage investors can’t impact the development of the company. They have to accept the direction that has been put in place before they came in. We typically invest in pre-revenue companies. Usually they have the technology platform in place and in most cases, they have launched something with some success. But getting the business model and market entry strategy (the angle of attack) right is key. Is this going to be an enterpise software model, an advertising model, a commerce model, or something else? That’s as important a decision as any company can make. Later stage investors have to accept the direction of the company. It’s very unlikely that they can change it after their investment, and if they find themselves doing that, something has gone wrong with their investment.
3) Later stage investors take "past sins" risk. When you invest at or near the formation of the company, you are involved in all those decisions that can come back to bite you later on. You can impact the choice of the other investors, how the securities are structured, how the technology is protected, how the employees are compensated, how employees are let go, how the contracts with customers are structured, etc, etc. You can insure that its’ done right. That people are treated fairly and equitably so that nobody comes back to bite you in the rear end later on. When you invest in a later stage company, you can diligence this stuff, you can get indemnified, and you can try to protect yourself, but my experience is that when something comes back to bite a company, it bites everyone including the people who were not at the table when the mistakes were made.
When I go back over time and look at my personal portfolio, some 50+ companies, I see this fact so clearly. The returns are higher on the seed/first round investments I’ve made and the loss rates are significantly lower as well. I suppose that’s also an indication that I am better at seed/early stage investing and that there are others who are better at later stage investing than me. But I’d be curious if others in the venture business feel this way too.
