Thursday, June 28, 2018

Preemptive Rounds

One of the biggest shifts of the last 6 months is the degree to which pre-emptive funding rounds have become the new normal in Silicon Valley. While pre-emptive rounds used to be reserved for celebrity or serial entrepreneur founders, they have recently become almost the default for a subset of companies. I have seen multiple seed companies receive pre-emptive series A fundings in the last few months without any specific milestones hit. Similarly, late stage companies like Bird have seen their valuations skyrocket in the course of months or even weeks. Why all the fuss to pre-empt?

Traditional venture rounds track progress
In a typical venture financing the money is invested behind a big company milestone, or due to an ongoing business ramp. The later the round of funding, the more likely it is to reflect updated progress of a company hitting its user or revenue goals.

As an example, Instagram's March 2010 $500K seed round was at a valuation in the low millions. The investment was behind a team without a launched product.

Instagram's February 2011 series A with Benchmark was in the mid-20 millions market cap which reflected a rapidly scaling, but newly launched, consumer product that had just launched. The launch of the product and early customer traction created a big step up in valuation from the seed round, which was an investment in a team.

Sequoia's April 2012 $50M series B investment in Instagram at a $500M valuation was in a company that had continued to scale its userbase exponentially and whose growth was actually accelerating with scale. Future rounds for Instagram, had it not been bought by Facebook, would likely have tracked this exponential growth.

Preemptive rounds are investments without a catalyst
In each financing round example above for Instagram, there was a clear change in progress or major milestone hit between rounds. In a pre-emptive round, there is no material change in progress between rounds. Rather, the investor is so excited to invest, or believes the company valuation should be much higher than the last investment, that she is willing to push up the company valuation without any new progress or information.

Bird's latest rounds is a good example of pre-emption. While Sequoia led an investment in Bird at a $1 billion valuation, it is rumored Bird is closing another round at $2 billion just a few weeks later.

Why more pre-emption?
The trend to pre-emption is driven by a few factors:

  • Outcomes are bigger then ever before. Technology companies can now get bigger faster and reach billions of online customers faster then ever before. As outcomes get larger, a subset of later stage rounds remain attractive from a return or cash on cash multiple perspective.
  • "Greed" worked.  Alongside outcomes that are bigger then ever, a few VCs also continued to re-up or invest large checks in companies they backed. Investors realized that Airbnb at a $5 billion valuation was actually still a great investment, so why cede that round to new investors? Public successes like Sequoia with Whatsapp and A16Z with Github showed that doubling down on the same companies can lead to outsized returns. This has led some venture funds to take the stance that they want to keep funding their winners the whole way, when before many funds stopped at the series B or C.
  • Bigger funds. More VCs are raising funds over $1 billion in size including Sequoia, General Catalyst and others. Softbank's $100 billion fund is of course the extreme of this. With bigger funds two things happen: (i) VCs want to buy more of the companies they own as they need to own a bigger proportion of the best outcomes to make money on their funds and (ii) a $10 million check from a $1 billion fund is equivalent to a $3M check from a $300 million fund. In other words, a "small check that gives you optionality" is quite large for a megafund.
  • Fewer high quality companies. The ratio of great to so-so companies has been on a negative slope from a qualitative perspective. If you ask the average investor today what are the new break out companies few would have a long list. This is particularly true of consumer where investors will quickly throw money at anything with a heartbeat and a handful of teenaged users. A lot of money is now chasing a few companies. 

While some venture funds are pre-empting gracefully, others seem to be throwing money haphazardly at companies with the hope that if they pre-empt the next Uber, the other investments won't matter. Some funds will do extremely well due to pre-emption while others will see a big negative impact to their returns. Picking, as always, matters. Picking without more data is hard.

From an entrepreneur's perspective, fast, cheap, and easy money with an investor you already know tends to be a good thing. In general, there are few negatives to a pre-emptive round from a founders perspective.

However, if it is the same firm that has led one or more rounds in the past, there are deeper implications.

A founder's plusses of a pre-emptive round may include:
  • Can stay focused on building a company. Without having to go out to fundraise, founders can keep focused on building.
  • Board & investor stability. Typically, pre-emptive rounds do not include a change in your board of directors. Often a founder will take a preemptive round from an investor they already know and trust. In some cases, this will lead to a new board seat (e.g. when going from a seed to a series A) but it will be with someone the founder already wants to work with.
A founder's negatives of a pre-emptive round with an existing investor may include:
  • Investor diversity. Investors are there to help you build your company. If you do not add more investors, you will have a more limited network for hiring, future fundraises, or customer introductions.
  • Investor control. As investors buy more of a company, they may effectively end up with control of multiple rounds of preferred of the company. Depending on the rights you give with each round, it might either benefit or harm the company to have control concentrated.
  • Fewer voices. In general, keeping private boards small tends to be a good idea. If done right, you spend less time on board management and more time on building a company. However, having multiple board members and major investors sometimes leads to stronger discussion and richer ideas for the path a company should be on. Investors may end up balancing each other out with different voices optimizing for different approaches. Having a single large investor may negatively impact this positive dynamic if carried along for too many rounds.
  • Non-competitive round. In general I would suggest a founder take terms that are good enough with investors they would be happy to work with for the next 10 years. Optimizing on valuation doesn't always yield the best outcomes. Pre-emptive rounds are definitionally non-competitive, so as a founder you may or may not get the best price for your round.
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