Valuation vs Ownership
I am talking at the PreMoney conference today (via Skype) and I woke up thinking about the challenges facing the VC industry. I hope to talk a bit about this at the conference.
Some investors are ownership focused. They want to own 20% of the business but care less about the valuation. Let's take a hypothetical Series A round. An entrepreneur comes to USV and pitches us and we like what the company is doing and we offer $2mm at $8mm pre-money/$10mm post-money. The $2mm buys us 20%.
Another firm shows up, a firm that is less valuation oriented, and they offer $5mm for 20% of the business, which works out to $20mm pre/$25mm post. The entrepreneur suffers the same dilution but gets $3mm more to work with.
From the VC's perspective, there isn't that much difference. Let's say the company sells for $100mm at some point. The first deal would produce $20mm in proceeds at sale, an $18mm gain, and a $3.6mm carry if you charge 20% as we do at USV. The second deal would produce the same $20mm in proceeds, a $15mm gain, and a $3mm carry if the other firm charged 20% carry. If they charged 25%, as many do, then they make $3.75mm, which is more than the $3.6mm.
It's the limited partners who get screwed by this stuff. If they had money in both firms, one deal would have turned $2mm of their money into $16.4mm (8.2x), the other would have turned $5mm of their money into $17mm (3.4x).
And the firm offering $5mm for 20% will likely have a $500mm fund size (or more) and will be making $10mm or more per year in management fees.
This happens all the time in the VC business. And it is why USV is committed to small fund sizes, small rounds, and smaller valuations. We lose a lot of deals to firms who aren't committed to any of those things. But that's life. We have made our LPs a fair bit of money and we expect to make them a lot more in the coming years. We keep the fees low and try to produce big gains. That's our model.
We are also very much focused on what is in the best interest of the entrepreneur. You might ask "how can taking $2mm for 20% be better than taking $5mm for 20%?" and you'd be right asking that question. The answer is you can get the other $3mm later at an even higher price. That has been the history of many of our investments.
We recommend that entrepreneurs keep the funding amounts small in the early rounds when the valuations are lower and then scale up the amounts in the later rounds when it is a lot more clear how money can create value and when the valuations will be higher. This model has worked out pretty well. David Karp raised $600k, then $4mm, then 5mm, then $25mm, then $80mm (or something like that). And at the time of the sale to Yahoo!, he owned a very nice stake in the business even though he had raised well north of $100mm. He did that by keeping his rounds small in the early days and only scaling them when he had to and the valuations offered were much higher.
It's important to understand all of this if you are an entrepreneur. Understand what your investors are optimizing for. Many are optimizing for putting a lot of money out so they can get to their next fund and raise even more. It's a big money game of asset allocation. When you team up with VCs who are playing that game, you are playing that game. There are VCs out there who play a different game. If you want to play that different game, please knock on our door.