I spoke at an event the other week organised by Silicon Valley Bank and ADV, alongside Seedcamp, Episode 1 and my friend Volker Hirsch (angel investor whose sage advice I respect a lot)...
Anyhow, we were talking about seed rounds, when Volker asks:
âHow many founders in the room understand the business model of a VC?â
I didnât see *any*âââbut this is England, so you could have asked how many people were breathing and probably got the same response.
Venture capital lives by the âpower lawââââessentially that normal distribution doesnât apply in the venture world, but returns are governed by break-out companies achieving 10x+ returns, not a bunch of investments earning 10%.
This means VCs need to be skewed to backing companies capable of achieving returns way above the ÂŁ100m mark, therefore hitting big markets with super-bold innovation.
In Nassim Nicholas Talebâs languageâââVCs have to maximise their exposure to Black Swan events (unpredictable occurance with major effect, inappropriately rationalized with hindsight đ_)_. That doesnât happen from thinking small, so every bullet in a venture fundâs belt, has to be capable of hitting the target and returning their fund.
Start-ups have to optimise for this, or look elsewhere for cash.
This Andressen Horowitz chart illustrates the power-law pretty well, in that 6% of VC deals pay out 60% of the fund and 50% of them pay less than 5%.
https://twitter.com/BenedictEvans/status/1008038770396942336
If you want to take a closer look:
- @HomanVC has a good post on how VC maths works here
- Peter Thiel does a great job here
- Shane Parrish talks more generally about the power law here
What the Power Law means for startupsâŚ
Iâve put together close to 40 transactions in the seed/Series A space and itâs clear that start-ups donât just need to fit into a power-law modelâââto succeed, they need to make their own.
So, I try to do these things Iâve called âpower roundsââââthose deals that stack the odds hugely in favour of a companyâs breakout, and ultimate success.
To be clear, this isnât a definition of success or a guaranteeâââbut it can be a significant contributing factor. (I laboured the success point here.)
Not all money is equal
People talk about âsmart moneyâ, but I think thatâs only part of the story.
For me, smart money means that the investors make an active commitment in a company they understand that operates in a sector whose dynamics and development they have a deep knowledge of.
I guess the opposite is âdumb moneyââââwhere investors follow the crowd or use tax mitigation as an investment thesis exclusively.
The results arenât always what youâd expect.
Smart money sometimes gets impaired by âexpert biasâ. Dumb moneyâs success depends on an investors dealflow and spread.**_Power money is different ._**Stay with meâŚ
ITâS ALL ABOUT THEÂ BREAKOUT
The entire VC industry is fuelled by breakout companiesâââitâs those that allows investors to pay back their entire fund with one deal (ideally, a few times over).
For start-ups as well, breakout is a whole new world_â_ that point where youâre well defined in terms of product, model & strategy, in a strong revenue flow and youâve left a pack of competitors behind.
Think Revolutâs seed (and then Series A/B ) with Balderton & Index, or FiveAIâs seed round (followed by A/B) with Amadeus, Notion & Kindred, or more recently, Chargifiâs A round with HP, Intel, ADV and Firstminute.
Each of these rounds are enablers, not just to shake off funding risk and bring on a great board, set of expertise and network of investors to the tableâââbut to enable breakoutâŚ
âŚand itâs the breakout that gets you through the tipping point on the way to a meaningful market position and đ¤exit.
Breakout
BUT one startupâs power round is another startupâs nightmare.
Imagine being a deeptech start-up in slowly developing market, with the same growth-hungry seed shareholder base as Revolut. These guys only came in at the seed round to double down on growth and pile cash in at A and B rounds. If youâre ahead of your marketâââthatâs going to be a very uncomfortable place to sit.
Likewise, if youâve taken cash from a corporate investorâââthat could make or break your company depending on who you are and what your strategy is. Maybe itâs a great signal to the market, but constrains your exit. Maybe the corporate investor changes strategic focus away from supporting its portfolio (or just your area) and youâre stuck with a dormant investor who canât follow and gives a negative signal to everyone else.
Because breakout is such an individual thing, and no two power rounds look the same.
The challenge when it comes to fundraising, is to work out what your power round is and how to unlock itâââhow to build those critical investor relationships and make the VC model work for your company.
A couple of examples of a power round in actionâŚ
Taking funding risk off the table
A couple of years ago, the founders and I were putting together a large Series A for one of my portfolio. The company operated in an upcoming consumer space that wasnât without competitionâââ2 major, well funded incumbents and a bunch of smaller, less relevant companies. We needed relatively impatient capital with lots of ambition and deep pockets.
My guys had the skill and ambition to breakout here, and we were offered terms from one of the large US investorsâââthe sort of guys you want on your cap table.
I think it was a UK public holiday, so we took some time to think the offer over and gradually went sour on it:
- Weâre going to need to raise a Series Bâââwhat if these guys lose appetite for Europe and weâre left to fundraise from scratch?
- Are they going to be almost maxed out with us when it comes to Series B? Then weâll have a load of external raise to do.
- If they play in our space, arenât they just going to give local VCs appetite to build that thesis and invest in competitors?
- What value do they bring beyond money and brand?
- Is this just a âbetâ in the space and geography for them?
In short, they werenât our power round.
Who was?
A syndicate of top tier VCs with huge experience in consumer and a pretty good knowledge of our particular sector, who could commit now with a meaningful follow-on at B and maybe C, perhaps with some outside cash on top to set a price.
But isnât that anyoneâs power round? Nope.
Strategic positioning
I had a company early in my career that imported and sold e-cigarettesâââat this point the market was really in its infancy. Their plan was to re-engineer the product so that it didnât fail 95% of the time, and that led them to think about CE Mark and calling it a medical device.
We had offers from a number of VCsâââbut the power round? The guys that understood this was a regulation play, not a revenue spinner; and had the experience, money and patience to help us through that.
As it happens, it didnât take long⌠15 months after closing the round, the company got acquired.
Power round, init?