Big rounds, big risks: some thoughts on the changing market environment for early-stage venture investors

There has been an enormous influx of later-stage capital in our market in recent years. Our meta-thesis says why: every industry is now a tech industry, every value chain is being reinvented from the perspective of the end user, software is eating the world.

In a world of zero interest rates and massive quantitative easing, tech has been the equity story of the last ten years. And so it's no wonder that capital has poured into our market "from the top."

For founders and early-stage tech investors around the world, this has been a boon. More competition around later-stage deals, higher prices, and ever larger investment sums. 

But as the pressure has mounted on later-stage firms to deploy capital, at the margins this is leading to some worrying behavior: investment decisions from the hip, low to no diligence, an extreme willingness to pay up that introduces significant asymmetric risk for founders, earlier investors, and companies as a whole.

Venture fund performance is driven by a fund's top outcomes. This pareto distribution, or power law, means that from the portfolio perspective an individual investment is "just an option", a "shot on goal." This is an awful way of thinking about VC investing, so bear with me. It's true from a portfolio perspective (it doesn't mean it should be true from an operational perspective). 

You build a portfolio of options and through gradual de-risking of the individual portfolio company, you identify the ones that are performing well. And then you allocate the rest of your fund's capital to those companies that look like they will be the biggest outcomes. We do this through a well-defined capital allocation model that gets updated at each quarterly portfolio review. 

A part of de-risking individual portfolio companies is whether they manage to raise an externally-led round, what the quality of that investor is, what valuation is put on the company. It's the moment of truth when the founders and you stop "drinking your own kool-aid" and get feedback not just from customers, but from the capital market.

But with the changes in later-stage investor behavior, raising follow-on rounds nowawadays feels less like de-risking and more like "kicking the can down the road." The new investor coming in has a risk-adjusted rate of return calculation that's much more similar to the earlier investor. And so a high valuation and a good sum of money may well be a false positive.

This is worrying not just from a perspective of founders who must meet some extreme growth targets. E.g. the Wired story on Revolut seems to me to ignore the incredible pressure that their founder must feel, having raised $300 million plus for a relatively early-stage business.

It's also worrying for earlier-stage investors who are sitting on a large amount of paper returns. This isn't quite RIP Good Times 3.0, but I have started to think about what that will look like. I think we'll be in for a significant number of restructurings that will involve non-traditional venture investors that may not exhibit best behavior. 

In the meantime, the best you can do is to focus on actual company building: execution quality, team quality, and making sure you're not fundraising at next year's valuation today. Think about what risk an outsized post-money means for you, your team, and your early supporters. By all means, negotiate the best deal that you can. But then take money from the people who are actually aligned with you and your goals.