Will Focus on LP Distributions Lead to More M&A in 2023?
I listened to a fund of funds investor give her perspective on how her team and other large institutions have changed how they evaluate venture fund managers. Their focus has shifted from increasing portfolio valuation (i.e., markups on start-ups) to distributions (i.e., cash returned by exiting start-ups). Part of the reasoning was around private market valuations’ lag in correcting and its impact on portfolio allocation.
Venture capital investments are private investments, so finding their correct market price usually happens when new funding rounds happen. If a company last raised in 2021, the company’s valuation is usually marked at the 2021 fundraising-round price. Public companies’ valuations are adjusted in the public markets every day, and many have been on a downtrend in 2022. Because venture investments are slower to be marked down, some institutions are over-allocated to venture capital relative to their entire investment portfolio.
For example, venture capital might have accounted for 8% of an investment portfolio in fall 2021 when valuations were high. The max allocation for venture capital in the investment portfolio is 10%, so that 8% allocation was below the limit. As the public equities in the portfolio decreased in value in 2022, venture capital values remained flat (they continued to be marked to their 2021 level because companies are avoiding raising in this environment). That means venture capital might now account for 12% of the overall investment portfolio, which is above the max allocation.
Given this dynamic, the fund-of-funds investor said her team is now more focused on distributions: how much capital have fund managers returned to their limited partners (LPs). For those overallocated in venture capital, distributions are an ideal way to increase cash allocation and reduce their venture capital allocation. Managers who have returned or are returning cash are viewed in a positive light.
She mentioned that part of a venture fund manager’s job is to know when to sell. Given the rich valuations in 2020 and 2021, her team is looking closely at 2017 or older fund vintages that didn’t use the rich valuations as an opportunity to distribute capital back to LPs.
Very interesting how the LP focus has changed from valuations/markups to cash returns. I suspect this focus will be top of mind for more venture fund managers and trickle down to CEOs of their portfolio companies. This, combined with a tough IPO market and other variables, could make 2023 an active year for acquisitions.
If You Must Deal with the Unexpected, Be Action Oriented
I talked to a founder friend who’s been working on a project for over a year. Part of the project’s economic viability centers on reimbursement from a project sponsor organization. My friend has been keeping the project sponsor up to date and is in regular communication with them. The project is now in its final phase and should finalize before year-end. The last part is to be reimbursed and close everything out.
My friend just learned of staffing changes at the sponsor organization. The organization isn’t sure if it’s going to reimburse him (and others) as agreed because of lack of protocol adherence by the dismissed staffer. The staff change is out of his control, but it’s materially affecting him and the cash flow of his business. My friend is in a tough spot. He spent six figures of capital out of his company coffers (a significant amount for a company of its size) in anticipation of being reimbursed by a certain date. That won’t happen now, and the reimbursement might not ever come through.
When I talked to my friend, he was taking it in stride. He realizes the precarious situation he’s in and is actively trying to figure out how to resolve it. I noticed that he’s not letting the situation paralyze him—he’s taking whatever action he can in hopes of resolving it. My gut tells me that his action-focused approach will help him find an acceptable resolution to this sticky situation.
Part of being a founder is dealing with the unexpected. The key is to continue taking action to move toward the desired outcome, whatever curveballs come your way.
You Don’t Need to Reinvent the Wheel
I’ve spent time thinking about how to create a solution to a problem I see. There are a few points I’m not quite sure how to resolve. I learned about some solutions close to, but not the same as, what I envision and was able to get connected with someone who helped create some of them. He’s familiar with the points I’m struggling with. Based on his experience, he laid out some possible paths and explained the pros and cons of each. That conversation was a huge time saver. It filled my knowledge gap and helped me understand what my next steps are.
My takeaway is that when I’m trying to do something, I should find out if others have done something similar and try to learn from their experiences. I don’t need to reinvent the wheel.
Meeting Companies at the Earliest Stages of Their Formation
One of the patterns I see in venture capital is fund managers, especially emerging managers, drifting downstream to invest at a later stage as they have success. Managers naturally invest at a later stage as they raise larger funds. More on that here and here. I understand venture fund managers' desire to raise larger funds, but I see things differently.
Meeting companies at the earliest stages of their formation is a massive opportunity for outsize impact and financial returns. It helps accelerate the success of founders, whose solutions can have a positive impact on society and address overlooked problems. When investments at the time of company formation are successful, they generate outsize returns for founders, employees, and fund managers and their limited partners. Those returns are, hopefully, recycled into other early-stage investments.
Raising larger funds and benefiting from the additional resources generated from increased management fees makes sense, but I think that doing so must be balanced with the risk of not being at the fountainhead of company formation.
Focus Relentlessly to Grow Quickly
I listened to an early-stage founder pitch his company this week. He’s passionate about his space, has founder–market fit, has built a great solution, and has acquired a material number of paying customers. I assumed he was positioned for rapid growth. But then I realized that may not be the case.
The founder’s core product is software that solves a specific problem for a specific type of organization. In his pitch, he explained that he’s branching out into other types of offerings to support his target customer: professional services, coworking, and a variety of other unrelated business lines. Each of these non-software business lines will require a different skill set that this founder will have to learn or hire for. He’ll also have to devote resources to incubating and growing each of them. If he executes on all of them, he and his team will likely be spread thin. And the core software solution won’t grow as fast as it could.
The key to success is to focus. Do one thing extremely well. Once you’ve achieved outsize success, then you’ll have the resources (and time) to diversify into other areas.
Regardless of the path this founder takes, I have no doubt that he’ll be successful. If he chooses to focus, I think he’ll turbocharge his path to success.
Weekly Reflection: Week One Hundred Forty
Today marks the end of my one-hundred-fortieth week of working from home (mostly). Here are my takeaways from week one hundred forty:
- Investor perspective – Investors view the world and founders through different lenses. I participated in an event where a group of investors provided feedback on a few founders. It was interesting to see how each investor’s perspective informed their analysis of each founder and their market. Sometimes substance was overshadowed by other things; conversely, sometimes lack of substance was overshadowed. External validation also swayed some investors’ analysis of a founder, although I believe that wasn’t intentional.
- Home stretch – We’re in the final weeks of 2022. The year has gone by quickly. I want to make these last few weeks in the year count.
Week one hundred forty was a busy week. Looking forward to next week!
High Valuations Can Come Back to Bite You
Some founders optimize for minimal dilution in the current round when they raise capital from venture capital firms. They do this by setting high valuations. For example, a company raising $1 million that wants only 5% dilution will have a $20 million post-money valuation. If they accepted 15% dilution on that same $1 million, they’d have a $6.66 million post-money valuation. The difference is large. In isolation, the 5% dilution at $20 million post-money makes the most sense to the founder.
If a founder considers the next financing round, things look different. Investors in the next round might be willing to value the company at or above the $20 million assigned in the first round only if there is a significant amount of traction. Otherwise, the founder could face many bad options (assuming they haven’t reached breakeven). They could run out of cash and close the business. They could raise at a valuation lower than $20 million. I won’t get into all the math, but depending on the terms of the first round, investors from the first round could receive additional ownership when the second round of financing is complete. Depending on how little leverage and runway the founder has, the dilution could be massive.
To avoid all this, founders raising capital should agree to reasonable valuations that won’t give investors in later rounds heartburn or force the dreaded down round.
One Conversation Changed This Engineer’s Life
Today I caught up with an aspiring founder. He’s been working as an engineer for a growth-stage start-up for the last four years. He’s fully vested and thinking about starting his own company. I always like to understand people’s journey, so I asked about his—specifically, about choosing to get his master’s in computer engineering from Carnegie Mellon.
He told me he didn’t even know what Carnegie Mellon was and ended up at the school by chance. He joined the National Society of Black Engineers (NSBE) as an undergrad and attended their conference. During the conference, he got what he thought was a spam email about Carnegie Mellon and its master’s program. Having never heard of the school, he asked an advisor about it. He learned it was one of the top engineering schools in the country. He decided to stop by the Carnegie Mellon booth to learn more. Talking with the admissions staff, he learned that he perfectly matched the profile they were looking for and that the master’s program was a perfect match for what he was looking for. He was basically admitted on the spot. He accepted and excelled in that program . . . and the rest is history.
Matching is critical at the earliest stages of entrepreneurship and your career. The right conversation can literally change your life trajectory. You must be in the right networks for matching with the right people and resources to occur. This engineer was under-networked and didn’t know what he didn’t know. He didn’t even know that Carnegie Mellon existed, let alone that he should apply. Carnegie Mellon didn’t know he existed, so it couldn’t recruit him. The NSBE was the conduit that allowed him to be matched to Carnegie Mellon. The NSBE played the critical role of finding this engineer by meeting him in his existing network/community. It then connected him with people, companies, and schools in other networks he wasn’t aware of.
This engineer is smart and scrappy, and he has a chip on his shoulder. He’s what I call a high-potential, nonobvious founder (or he will be, when he starts his company). These are the kind of founders I like to bet on. Nothing was handed to them. They earned everything they have by climbing mountains. They’re a little different, so people can’t relate to them, but they’re going to win because they want to prove everyone wrong.
These nonobvious, talented people will drive the next wave of entrepreneurship. Sadly, the current seed-stage venture capital model isn’t set up to find and support these types of founders. I think there’s a massive opportunity to support more nonobvious founders outside the traditional venture capital network, and it’s an area I’d like to focus on.
Compounding Equity: A Powerful Force
I chatted with a founder about his plans for his company. His goal is generational wealth for his family. He’s aiming to sell the company in an all-cash deal. I thought the focus on an all-cash deal was interesting given his company’s trajectory. It’s growing quickly, and I believe it has the potential to be worth a billion or even ten billion dollars one day.
Compounding is a powerful force that many—including founders—don’t grasp. If you own equity for a long time in a company with a healthy growth rate, the value of the equity compounds over time and can end up being massive. If accumulating wealth is a priority, owning equity in a great, growing company is the way to accomplish it. The families that understand this concept have continued to own significant equity for decades in the company their patriarch or matriarch started. Their wealth has compounded over that time into massive fortunes. Think Walton family and Walmart. Jim, Alice, and Sam Walton are worth close to $200 billion because of their decades-long ownership in Walmart. Even some of the recent entrepreneurs who’ve accumulated immense wealth did so because of the compounding value of the equity they owned in their company. Think Bernard Arnault, Jeff Bezos, and Elon Musk.
Founders (and everyone for that matter) should be keenly aware of the power of compounding when they’re thinking about financial security.
Setting Your Valuation Could Work Against You
Founders who decide to raise venture capital sometimes do things unwittingly that could cause a venture fund to opt out prematurely. The most common is setting the valuation before chatting with VCs. Founders decide the amount of capital they want to raise, pick a valuation, and put all that info in their pitch deck. This can be OK in raising from angels, friends, or family, but it’s not advisable when you’re seeking to raise a round of capital from venture funds.
Founders usually don’t have as good a grasp of valuations in venture markets as venture funds do. Funds usually see a constant flow of deals, which helps them keep a finger on the pulse of market valuation for companies at a particular stage. Founders are usually relying on conversations with other founders or data they find online. While helpful, these sources of information may not reflect current market conditions or may not give founders enough data points to really understand market conditions. A fund could be interested but decline to meet the company because the valuation is unrealistic.
Another variable founders should be aware of is a venture fund’s portfolio construction. I won’t get into the details of it, but when a fund is raised, the general partner(s) communicate to limited partners how many companies the fund will invest in, the average check size of each investment, and how much of each company the fund plans to own. These and other factors help create the hypothetical portfolio of companies the fund will own and the hypothetical portfolio return (i.e., how the fund will return a profit to limited partners). If a venture fund receives a pitch deck with a valuation that’s too far high, they’ll be more inclined to pass on the company. A high valuation can mean a lower share of ownership in a company, which can throw off the portfolio construction. If general partners deviate too much from the portfolio construction they communicated to limited partners, they have to explain why. These kinds of conversations can cause some limited partners to decline to invest in future funds. Of course, founders usually don’t know a fund’s portfolio construction, so they’re at an information disadvantage when they set a valuation.
So, what can founders do when they’re raising a round of venture capital? Simple: leave the valuation out of your deck. Include the amount of capital you’re raising and figure out the valuation as you chat with venture funds. These questions can help you figure out the right valuation and evaluate funds:
- Ask VCs what the current market valuation is for companies at your stage. If you talk to enough funds, you’ll have your finger on the pulse of the market.
- Ask VCs what their average initial check size is and if they have an ownership target. If a fund says they write $1 million initial checks and aim for 10% ownership, you know they’re likely in the $10 million post-valuation range.
Figuring out valuation for an early-stage company is part art, part science, and part negotiation. I hope this will help founders go into their fund raises better prepared.