investing

Does “surface area” matter as a pre-seed investor?

/ Robert Pease / Leave a comment

TL;DR: Yes

To me, anyway. This is a simple question with many, many different variations of answers so I am simply sharing my opinion and thinking around this as it relates to my perspective, fund size and investment strategy. Your mileage may vary so don’t hate on me.

“Surface area” in this context represents the extent of the exposure you have across different investments, so maximizing the number of opportunities to find truly breakout companies that will provide outsized returns.

In venture capital, there are a few undeniable variables – entry price, company execution, and exit price. Wrapped around those things as an investor are ownership share, dilution, preferences (as discussed previously) and beyond.  As a pre-seed or early stage investor most, if not all, of those things are completely outside your control over the life of the company other than entry price – meaning the price you paid to invest be that as priced shares or some type of valuation cap on a convertible note or SAFE. And, sometimes, even that can be out of your control in subsequent rounds.

So, Robert, are you saying you should “spray and pray” as a pre-seed investor?  Of course not and that phrase gets slapped on any type of portfolio strategy that drifts north of 20-25 investments it seems. No, you should have a structured and methodical way to evaluate investments that you believe will deliver the risk adjusted returns you and your investors expect and invest enough in each company for it to matter. So factor in fund size, holding periods, estimated outcome potential and many other factors to get to what you think is a proper number of investments to hold.

What I am saying is that the startup journey has barely begun at the pre-seed stage and what is known and knowable is generally lacking. This is the core of the information asymmetry that exists at this stage and where the truly outsized returns (the “alpha”) resides. There are many, many reasons things don’t work out like the founders or investors thought they would. Sometimes for self-inflicted reasons, sometimes through no fault of anyone involved. It’s just part of the deal.

So balancing the risk you are taking on with the return you are seeking requires surface area because, in the famous words of screenwriter William Goldman “nobody knows anything.” 

You can certainly be informed, you can certainly be smart, you can even have what you believe is an edge in access or decision making but truly nobody knows.  That is why it is important to be disciplined about why you are making an investment and clearly articulate what you believe the “bet” is that you are making. Which is also the reason that I believe the most important thing in due diligence is figuring out if the founders will quit. There will be failures and going back to see what you believed needed to happen for success and why it didn’t is both humbling and instructive. 

How do you increase your surface area as a pre-seed investor?  Obviously through a larger portfolio of investments but getting there requires time, patience, process and, to a degree, creativity plus the capital to do it.  As an angel investor, things like AngelList and products like Sydecar let you build a portfolio for $5k or so per shot.  A broader (and I think, self servingly, better way) is through investing in a fund.  Yes, you pay a management fee but you are (hopefully) getting access to a larger, diversified portfolio with better deals, better terms, and dedicated management.

In my current fund, we are making direct investments in companies as well as select Limited Partner investments in stage and category aligned venture capital funds. That adds the holdings of those underlying funds to my fund’s surface area increasing the potential return profile.

Highly concentrated funds can and do work but at the later stages (late here meaning Series A and beyond) there is more known and more that can be analyzed and forecasted vs. the “first check” type of investor. This is a thoughtful write up on this topic “Should You Build a Concentrated Fund”

Being a pre-seed investor makes you a “believer” investor while later stage investors are more “spreadsheet” investors. As a founder, you should know and understand the difference because if you get in front of a spreadsheet investor too early, they will eat you alive.

So this is my opinion and approach formed by doing direct and fund investing for the last 15 years. Things I was convinced were winners, weren’t. Some that struggled, found success. Many failed. Some were great. Many, many surprises along the way.

Surface area matters.

The Crush of the Preference Stack

/ Robert Pease / Leave a comment

One of my very early angel investments made 12 years ago now taught me an essential lesson as an early stage investor.

What lesson is that?

The preference stack.

I would argue that you have not truly lived as an early stage investor until you have directly learned this lesson with your own money and experienced it first hand.

So, what is a preference stack?  In its simplest explanation, it is the rights and preferences that come along with each new equity round or bridge round a company raises.  When all is going swell, everyone wants to keep riding the wave and the company has significant leverage to negotiate the terms. If things aren’t or were and now there has been hiccup, that leverage shifts to the investors and, in many cases, the new investors who have not been on the cap table since the beginning.

How can this negatively impact you as an angel or pre-seed investor?  Well let’s just say you invested first check in on a company at a $5M valuation. Company executes and raises more money at a $10M valuation. On paper you are doing pretty good. Along comes a Series A based on even stronger performance at a $40M valuation. Everybody is feeling good and you are getting much sought after but not bankable markups.

And then a hiccup. Could be a missed quarter, a competitive shift in the market not in the company’s favor, whatever and it really doesn’t matter but it informs the next financing the company has to do be that a bridge (via convertible note likely b/c it is debt like) or equity of some sort. Either way these things can have liquidation preferences meaning that money gets paid 2-3x or whatever back first and/or participation rights meaning they get their preference money then get in line ahead of you and other shareholders to take more proceeds and/or some type of accruing dividend that builds up a cash payable to the investor(s) due upon sale. They can even re-price previous investors and force them to common shares via a recapitalization (that is a topic for another post).

So let’s just focus on the gnarly liquidation preferences and other things that puts the latest money in front of your first check in terms of payout.

This is the situation I experienced. Early check into a company in a small round. Things were going great, then not so great. A couple of rounds where the company was not dictating the terms and the preference stack was primed and ready to fall on not just preferred share investors but all the holders of common stock (ie, mostly founders and employees) who don’t have the rights and preferences that come along with preferred shares.

The company got acquired by a bigco in a cash deal about 6 years after my investment. Lots of buzz and coverage. High fives online, etc. Looked like a great deal and the purchase price was actually pretty strong.

However, I got crushed by the preference stack. The money that had come in at the Series B then Series B+ then a bridge note then several other things to keep the company funded all stood ahead of me at various liquidation and participation preferences.

I received zero. There was nothing left for my share class after all the other bites were taken out of the apple including nothing left for the common shareholders other than jobs for most employees with the acquiring company.

How do you stop this from happening?  Hard to do if you are an individual, a small fund, or only an early round (pre-seed, seed) investor. There are some things that can protect you a bit as a preferred shareholder to grant you the same rights as next issued shares but those can and frequently do evaporate as a company goes through subsequent rounds. 

Very much a golden rule model – those with the gold make the rules.

This “feature” of early stage investing reinforces the need for a sizable portfolio of investments if you are an angel or fund investing as a first check, pre-seed, or seed stage investor as well as the perspective that this is a possible path. If you aspire to angel invest, please pick more than one company and build a broad portfolio. Please.

As an early stage investor, you just cannot control what is happening positively or negatively to you in subsequent rounds especially if the company loses its leverage to dictate the terms of a financing. Yes, a board seat can put you closer to the decision but boards can and often do get re-defined with each round of funding.

With so many lofty valuations and ridiculous funding rounds being done these days in “hot” companies, I can only wonder what the preference stacks look like in those companies. A relatively newish fund manager I was chatting with recently who had a few of those hot names in their portfolio had no idea what the preference stack was or how it worked. It made me feel for him and, more importantly, his LPs.

It won’t matter if it all goes well but if it doesn’t, even for a short period of time, watch out below.