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The evolving venture capital business

Before I got into the venture business, it seemed like there were a number of rules that many VCs held as sacred. 

I won’t go into all of the “rules” on this post, but the most typical one was the “20% rule.”

The idea was that VCs would tell founders (and their limited partners) that they always own 20% of the startup at the time of their initial investment.

The reality is that since we started Spark in 2005, we haven’t embraced that rule. (We try not to have too many rules actually).  Sometimes we own 20%, sometimes we own more and sometimes we own less. It depends on lots of things. 

And this approach has served us well. Many of our best investments have come from startups where we ended up owning less that 20% initially but either a) the startup radically increased it’s value over time and our position became worth tens or hundreds of millions or b) we were able to respectfully increase our ownership over time thru one or more inside rounds that were good for the company and good for us.

These days I see a lot of VCs also ignoring the 20% rule and it seems to come in four flavors. Some are more challenging than others – because of their nature and because of other things like fund size and team. It’s a complicated subject but I’ll try to be direct and hit the high notes. 

Scenario 1: VCs are leading Series A investments and because valuations are going up these days, VCs are owning less than 20% on a pre-revenue and/or early stage product. That’s just the reality today. Or the valuation isn’t that high but the founder is very dilution sensitive so the company raises less money. In any event the VC doesn’t own 20% and that can work as I mentioned earlier.  We’ve done this and will continue to do this. 

Scenario 2: Later stage deal where a VC invests tens of millions of dollars and buys less than 10% of the company. For a given a certain fund size, this can be a great investment from a cash on cash basis. I like and respect this more when it’s done in coordination and support of the company (thru primary or primary and secondary) vs a VC just buying shares on a secondary market where the company is blind to the transaction. It still may end up being a stellar investment but that’s my bias on this one. 

Scenario 3: Early stage deal where a company raises lets say $2M and there are 3-4 VCs in the syndicate. Sometimes all the VCs will split the deal evenly or there will be one lead VC and the others split up a minority interest. In the case of the latter, where a VC invests in a tiny fraction of the deal, it can be mathematically justified since they will most likely be passive and let the main VC do most of the work. I’ve heard some VCs call this an option on the company, or spray and pray or other things. I’m not super comfortable with the passive model for VCs and will come back to this point. 

Scenario 4: A new round comes together and there is a new lead VC which gets to buy the bigger piece of the round. And then another VC comes into the round and suggests to the company and the new VC to let them invest a small/tiny piece and in exchange for being active and providing value. The VC getting the smaller piece in this case convinces themselves that they want to be close & active to the company because they love the product/team and hopefully can increase their ownership in follow on rounds. The founders agree because they want the small VC to be involved. Sounds like it works for everyone, right?

Well the answer is messy at best. The reality is that the small VC may only own 1-2% of the company after such a round. And if they do that type of deal a few times and become involved, then you have a scaling problem (which is problematic because it’s hard to scale venture capital to begin with). 

The mathematical formula says that a VC should stay away from these types of deals or you should be passive. 

We have invested and will continue to lead investments in Scenario #1 and #2 (in addition to leading more traditional seed investments, etc). I don’t see us doing Scenario 3 as a small passive VC. I’ll never say never but I just don’t see it at the moment. 

So that brings us to Scenario 4. The math says we should only do it if we can be passive. But I don’t know how to be passive. And when I look around the table at our firm, I don’t see any of my partners being passive either. So that suggests we should just skip these rounds altogether. 

But I don’t think I can. If I love the product and company then I love the product & company. And I’m not gonna let the near term math tell me what to do. 

Interesting times for sure. It’s clear that this venture capital business is evolving.