People often think about venture capital as one homogeneous model. The reality, however, is that the way in which seed investors make money has been dramatically different from how late-stage VCs and growth-equity funds do.
Seed investors fundamentally must chase big hits. Because early-stage companies raise relatively small amounts of capital, to get big dollar returns, investors need enormous multiples on their successes to offset high failure rates and generate a good return.
Historically, later stage investors have run a very different model. They look for companies where they can deploy a lot of capital, get a meaningful, though not necessarily spectacular, return on that capital and have ample downside protection.
A 2X multiple on a $100 million investment returns a far greater amount of capital than a 200X on a $100,000 seed check.
But lately the dynamics have changed, and late-stage investing is looking more like seed-stage. The Whats-Insta-Snap-Uber-Pin-Air acquisitions and investments suggest a more radical change to the business models of the array of late stage investors and indicate that their math is converging with the binary-outcome mentality of the seed financiers.
Two things are driving this. Technology companies are having a real-world global impact. They’re taking in real revenue and profits; therefore the valuations placed on them by the public market and acquirers are skyrocketing.
Because of this, it is suddenly possible for later stage funds to plausibly assign a 100X stretch bull case on a $1 billion valuation company raising tens or hundreds of millions of dollars. Airbnb and Uber are great examples of this. Both companies have raised several $100M+ rounds of financing at multi-billion dollar valuations.
This means that bigger funds can at least fantasize about seed-stage style multiple returns, but with the massive benefit of being able to put far far more capital to work and therefore generate staggering real dollar returns. There is the possibility of having your cake and eating it too; the ceiling has been raised, and therefore the game changes.
Where historically later-stage investors needed to be more valuation sensitive than their seed stage counterparts to make their model work, they are all of a sudden willing to pay up on upfront valuations looking for massive multiples. Because the multiples on later stage companies can plausibly approach what seed stage financiers historically expected of a win, it becomes logical for later-stage players to not sweat the upfront price too much.
Loss of Protection
The second piece of the convergence with seed-stage is the loss of downside protection.
There are many people who would argue that because of liquidation preferences that promise investors their money back and the structure of later-stage VC deals, it is difficult for later-stage VCs to actually lose money unless a complete cataclysm strikes.
But as valuations grow, and companies raise more and more money, it now feels possible that you will see “successful,” even multi-billion dollar, companies where their financiers are washed out of their protection by later-stage capital that becomes necessary at depressed valuations as reality changes.
This is, in my mind, especially true where companies face regulatory risk which can quickly and dramatically readjust maximal bull cases.
So it feels to me like bigger and bigger funds are playing what feels like seed-style games. Meanwhile, in the seed-stage, the story continues to be more and more competition for deals. With more capital coming into a system where the outcomes are completely binary, it is natural for valuations to drift up meaningfully.
For late-stage investors, the convergence will likely generate some unbelievable windfalls where multiples line up with ability to deploy capital. It will probably also produce some huge losses at some point.
For investors who allocate capital into different types of venture funds, the question will be how they digest a world of greater late-stage fund volatility.