Doubling Down on Your Winners

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Hey friends đź‘‹ ,

Happy Tuesday and welcome to the fourth issue of Through the Noise!

I hope you all had a great weekend! We're a day late from a technical issue but without further ado it's time to strap in and enjoy.


Doubling Down on Your Winners

There is a central understanding within venture portfolio construction that the majority of a fund’s return will be generated by a very small number of portfolio companies. We know from the "Babe Ruth Effect" that if only a few investments become home runs, then a successful fund will identify this and double down on its winners to maximise the fund's return.

This is best highlighted by the esteemed venture capitalist Greg Wilson:

"One of the most common mistakes I see new “emerging VC managers” make is that they don’t sufficiently reserve for follow-on investments. They don’t go back for a new fund until they have invested 70 to 80% of their first fund and then they run out of money and can’t participate in follow-on rounds. They put too many companies into a portfolio and they can’t support them all. That hurts them because they get diluted by those rounds they can’t participate in. But it also hurts their portfolio companies because the founder and/or CEO has to explain why some of their VC investors aren’t participating in the financing round."

The best funds reserve capital for follow on rounds. This is not the case for angel investing or seed funds where a "spray and pray" strategy is largely employed. The opportunity cost of doubling down is high when the tradeoff is further exposure to new high-growth startups. However top VC funds will want their pro-rata share in future rounds to avoid their equity being diluted.

Let's look at what happens when you don't follow your winners...

Thefacebook & Thiel

Rewind to the start of 2005: Thefacebook raised a $12.7M Series A for 15% of the company. At the time, the company commanded what was considered an eye-watering $98M valuation. The round was led by Accel.

In 2006, off the back of high user growth and revenue numbers, now Facebook, raised its $27.5M Series B from firms including Accel, Greylock, Meritech Capital Partners and Founders Fund.

Even after selling $500M of equity in 2010, Accel's position was worth $9B upon Facebook's IPO in 2012. This made Accel's IX fund, which initially raised $440M, to become one of the best performing venture capital funds of all time. They doubled down and defended their position in Facebook.

This was also a bet that Peter Thiel, Facebook's first investor missed. Thiel invested $500K in the summer of 2004, originally in the form of a convertible note, to be converted to equity if Facebook reached 1.5M users by the end of 2004. Although Facebook narrowly missed the target, Thiel allowed the note to be converted. He said:

"I was comfortable with them pursuing their original vision. And it was a very reasonable valuation. I thought it was going to be a pretty safe investment."

When Facebook raised its Series A only 8 months later, Thiel did not participate in the round as he felt the company was overvalued. Many people underestimate how fast exponential value increases, known as the “exponential growth bias”. In Thiel's case, his behaviour had profound consequences. He would later miss out on Facebook's Series A which would serve as a serious lesson when perceiving "overvalued" companies. He wrote:

“Our general life experience is pretty linear. We vastly underestimate exponential things. . . When you have an up round with a big increase in valuation, many or even most VCs tend to believe that the step up is too big and they will thus underprice it.”

Thiel added that whenever a tech startup has a strong round led by a top-tier investor (in this case, Accel), it is generally still undervalued. The steeper the up round, the greater the undervaluation. Whilst last week's newsletter highlighted the pricey rounds of today's market causing companies like Instacart to slash their valuations and cope with prevailing market conditions, it raises the idea of conviction. A fund must have strong belief in their portfolio company to follow on when there is a steep rise in valuation to capture the future upside.

Wrapping It All Up

Fred Wilson's firm USV takes reserves very seriously. They reserve roughly half of a fund for follow-on investments and typically make four to six investments in a portfolio company over five to seven years.

Let's finish with some timeless wisdom:

"Most people think that VC is all about the initial portfolio construction, selecting the companies to invest in. But the truth is that is only half of it. What happens with the portfolio after you have selected it is the other half. That includes actively managing the portfolio (board work, adding value, etc) and it includes allocating capital to the portfolio in follow-on rounds, and it includes working to get exits. And it is that second part that is the harder part to learn how to do. The best VC firms do it incredibly well and they benefit enormously from it."


Through the Noise Podcast

Last week we recorded the fourth episode of the Through the Noise podcast.

Our guest was Josh Bonhotal, Vice President and part of the founding team at Future, a platform that brings human connection to digital personal training. Josh is also a Venture Partner at TXV Partners, an early-stage venture capital firm based in Austin, Texas, investing in the future of software and human performance.

This was a great one. We dived into what the future of human performance looks like and how to construct a portfolio around it.

Catch the episode on Spotify, Apple and Callin.


That's all for today friends!

As always feel free to reach out @thealexbanks as I'd love to hear your feedback.

Thanks for reading and I'll catch you next Monday.