“I don’t think the objective of investment should ever be to take a risk in order to get a return. I think the objective of shrewd investment should be to find opportunities which offer a larger return than the average, combined with adequate safety.” — Benjamin Graham
Venture Capital funds like Sequoia Capital follow a strategic investment criterion while evaluating each of the investments in their portfolio. For example, Sequoia passed on the Doordash investmentin the company’s seed round in September 2012. However, later in May 2014 the firm led the Series A round of USD$17.3mm, which would be the first of 6 investments in which Sequoia participated throughout the life of the company (Series B, Series C, Series D, Series F & Series G) for a total amount of between USD$217mm and USD$260mm At the time of the IPO in late 2020, Sequoia was estimated to have a 5.7% stake on the company, valuing its position at USD$9.55bn, at least a 36x return on the total invested amount.
Such as Sequoia Capital, Venture Capital funds around the world seek to mitigate risk in each of their investments by investing in different stages throughout the life of the startups. This strategy reduces the risk of the investment since it allows the VC fund to have visibility on the execution and traction of the startup. The investor also has the option of investing a lower amount at the beginning and increasing the amount of the investment over time. This leads to a strategic selection of the best companies in the portfolio, making small bets on a lot of multiple companies and increasing the risk only on those that have a prospect of success.
Some investment strategies done by stages are the following:
1.2-tranches way: This strategy allows you to invest a defined amount in a startup in two moments in time. It is usually used in times of high volatility and when there’s a need for liquidity by the startup, by allowing the investor to phase out its investment over time.
a. Advantages: For an investor it is a financial option since it manages the value of money over time; or an investment option if the VC fund has the right not to invest in the second tranche. The entrepreneur has the power to ensure this investment and future liquidity for the startup through a contract.
b. Disadvantages: Under normal market conditions, and considering that it is a quality startup, this investment strategy might not be available, since the startup could have a single closing with the leading investor. Sometimes having two tranches from the same investor could make it difficult to raise future capital and generate mistrust and uncertainty for new investors.
2. Follow-on strategy: Most of the Venture Capital funds include in their investment thesis to do follow-on investments in the startups of their portfolio. Typically, more than 50% of the fund is reserved for these investments. This allows fund managers to increase the stakes on those startups they have monitored and that have a winning profile.
a. Advantage: The fund has the option to continue to invest while maintaining or increasing its shareholding percentage and thus remain relevant in the capital structure of the company. In addition, the current investor of the company has privileged information that allows him to make better investment decisions unlike new investors (information asymmetry)
b. Disadvantage: It could be the case that in your initial portfolio of startups there were not good investments to be able to increase the capital in. It could also be the case that the fund took much more time than required to make those subsequent investments derived from the construction of the initial portfolio, or that is didn’t leave enough follow-on capital for the last companies that entered the portfolio.
3. Side car (SPV): On some occasions, fund managers find themselves in a scenario where they have the option of exercising their pro-rata right or even increasing their participation in startups, but they no longer have available capital from the fund with which the first investment was made. This leads to the raising of additional capital through an SPV (Special Purpose Vehicle) from current or new investors (LPs).
a. Advantage: Fund managers can create an ad-hoc vehicle where they continue to receive commissions and remain a relevant investor in the startup. Similarly, managers can use these vehicles as a method to begin building a relationship with potential future fund LPs.
b. Disadvantage: There is an additional workload for the fund manager. The entrepreneur would probably prefer that you invest from the fund with which the first investment was made.
4. Opportunity Fund: When a VC fund is confident that it has built a portfolio where it has multiple potential winners, the fund managers can make the decision to raise an investment vehicle dedicated to participating in the growth rounds of those winning startups. This allows the fund’s investors to increase their exposure to these startups and facilitates access to other investors seeking a more moderate risk-return profile.
a. Advantages: The investment process for the fund manager is much easier since it does not require the origination of new investment opportunities or running an exhaustive due diligence process.
b. Disadvantages: The fund is limited to portfolio companies that require the investment of larger tickets.
Investments in Venture Capital are risky; however, fund managers try to establish the strategy to mitigate or at least limit the risk of their investments. Whichever strategy is used, the fund manager must be selective in only increasing capital exposure to startups with the highest growth potential. Being an early-stage investor opens up the opportunity for you to invest in early stage startups and support them throughout their growth.
“Avoiding round trips and short-term devastation enables you to be around for the long term.” — Seth Klarman
ACV is an international Corporate Venture Capital (CVC) fund investing globally in Startups & VC funds.
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