Following On In The Land Of Plenty

Editor’s note: Nino Marakovic is CEO and managing director at Sapphire Ventures.

Charlie O’Donnell recently wrote a good post in which he questioned how easy it was for seed-stage investors to abide by the old adage: “follow on in your winners.” I agree with O’Donnell’s conclusion to call traditional thinking into question and believe it has applicability beyond the seed stage of investing.

O’Donnell’s blog also raised the question in my mind that even if you could tell which companies were your winners, at what point do you stop investing as valuations in each round spiral upward? My hunch is that in today’s market you should go against conventional wisdom and not chase your winners through all later rounds.

Given the influx of new talent that has poured into the venture capital industry and the extended length of feedback cycles, it’s not that surprising that VCs tend to stick to old norms even if they may not apply in today’s market. This “rule” about following-on in your winners has been informally handed down from one generation of VCs to the next – and indeed has solid grounding in historical best practices. But given the rapid pace of change in our business an investor needs to be aware of context to apply the rule properly.

My position as both a later-stage VC at Sapphire Ventures and as a limited partner via our fund investments – a program through which we invest in early-stage VCs – gives me a somewhat unique perspective on the question of follow-on investing.

Of course, early-stage VC managers have always faced the challenge that, on the one hand, they have the option to exercise their pro rata rights in follow-on rounds of their best investments, but on the other hand, they often lack the follow-on capital in their fund to allocate the full portion of their pro rata in every subsequent financing round. This dynamic has become especially acute in today’s environment, where the early-stage VC may have pro rata for a third, fourth or even greater round of financing and those rounds have become larger than ever before.

Today, I see more and more early-stage VCs interested in investing in their “winners” for much longer and more than has traditionally been the case. Consequently, early-stage VCs are raising larger and larger funds in order to make follow-on investments in their portfolios. Additionally, more early-stage managers are raising “overage” and “opportunity” funds to capture value in their later-stage winners.

Good late-stage VCs acquire a pattern recognition that’s built up over years of experience of meeting with, and investing in, later-stage companies.

Of course, venture capital is a hit-driven business so it is intuitive that a VC would want to put as much of their fund behind the few companies most likely to be winners. That is why early-stage VCs not only insist on pro rata rights but often seek to double down on their winners and even lead subsequent rounds to retain or increase their ownership.

But what if that next round is at twice or three times the price of the prior round? While upside may remain, the next dollar will yield half to a third of the return and the average dollar-weighted return of that investment will therefore go down. And think about the Series C and D rounds where the price is often four or eight times what the early-stage VC originally paid.

Moreover, companies tend to stay private longer in today’s markets and raise more money before going public – both because of lower public capital market appetite for small-cap IPOs and stronger private market appetite for late-stage quality companies. This further increases the averaging down over time as VCs continue to do their pro rata (or more) and forces early-stage investors to invest material portions of their funds at valuation levels where historically they were sellers.

Early-stage VCs who invest big pro rata dollars in their own later-stage companies are farther removed from public market conditions and from the M&A landscape than are dedicated late-stage VCs and likely haven’t had the benefit of meeting all competitors in a space. Moreover, good late-stage VCs acquire a pattern recognition that’s built up over years of experience of meeting with, and investing in, later-stage companies.

And even good early-stage VCs are, at best, constructing a portfolio of later-stage investments from a limited dataset (their own early-stage portfolio) versus picking the best-performing company from the wider universe of later-stage companies, as a dedicated later-stage investor would do.

So my two cents to early-stage VCs in the context of today’s capital markets: stick to your knitting. Focus on adding value at these early stages. Don’t focus on increasing your fund size or raising dedicated follow-on funds, which can lead to averaging down of returns and may distract you from your core expertise of backing the best early-stage entrepreneurs. My hypothesis is that the best-performing funds in this environment will be those with the confidence to find the next hot company at an appropriate early stage (and valuation) and get enough ownership upfront to avoid playing catch-up.

At Sapphire Ventures, we pride ourselves on being opportunistic rather than dogmatic in our own approach to later-stage investing. When we break our own rules, we do so with care and prudent attention paid to where to put the “burden of proof.” While there are always companies that have such spectacular outcome potential for which it’s worth breaking the rules, this should be the exception and is not a sound basis for a fund strategy in today’s context.