Between Monday and Friday the week before the last, 6 technology startups and 1 UK biotech startup filed for IPO. Asana, Snowflake, Unity, Palantir, JFrog, Sumo Logic, and Compass Pathways all submitted their S-1s, marking one of the busiest week in history for SEC filings. With public equities closing the summer months in bullish defiance the covid-related disruption and Airbnb also gearing up for an upcoming IPO, it seems that the public markets are about to make cash rain on startups and the investors who backed them.
If you look at these companies, one thing you’ll notice is that they are, mostly, fairly old businesses. The youngest of the companies planning to go public —Compass — is 5 years old. Snowflake is 8 years old. Without the oldest and youngest outliers, Palantir and Compass, which were founded in 2003 and 2016 respectively, their average age is 10.5 years. When the median age of a US IPO company is seven years, you’ll be excused to think of this bunch as “old timers”.
Out of the whole lot, Compass is the one targeting the smallest raise (and the smallest valuation). Founded by George Goldsmith and Ekaterina Malievskaia at the end of 2015, Compass received initial fundings from Angermayer, a German entrepreneur, as well as Peter Thiel, an early backer of Facebook Inc. and cofounder of Palantir (busy IPO season for him indeed).
The initial funding round valued Compass at $16 million and the IPO will see the initial investors realising a multiple of over 10 times of their investment, according to Bloomberg. Between the two, only 2 rounds occurred (Series A and Series B).
Easy in, easy out.
As per everyone else, the story is a bit different.
Sequoia is just about to receive a big payout cheque.
VC investors have played a big role in all of these companies and, therefore, are about to receive a large payoff.
Sequoia Capital has a significant stakes in 2 out of the 7 companies who filed for IPO last week (Snowflake and Unity).
Sapphire Ventures has roughly 9% in JFrog and Sumo. Other VC and PE firms with sizeable stakes in the various companies include Benchmark, Accel, Founders Fund, and Silver Lake Partners.
In general, though, these stakes are not the result of a “lucky first bet” on these companies when they were fledgeling startups. At least, not only that.
The case of Sequoia with Unity, for example, can help us understand a bit better what I mean.
According to the docs, Sequoia’s total ownership of the company is roughly 24.1% today. The company was last valued at around $6 billion in mid-2019, and we will see how the shares perform with investors in the coming week. But owning nearly one-quarter of billions of dollars is a huge return for the venture capital firm.
To compare that with what founders and execs own, David Helgason, Unity’s founder and current board member, owns 4.4%, and John Riccitiello, Unity’s current CEO, owns 3.4%.
What’s interesting about Sequoia’s stake is how much it has grown over the years since the firm’s initial Series A investment into Unity more than a decade ago (back in 2009).
The importance of being there in the long run
Here is table I found on TechCrunch, breaking down which funds within the Sequoia brand, actually own what:
While Sequoia did indeed get in early with the video game platform, what’s been key for it over the years has been buying up additional shares through follow on investments and, later on, further growth investing from its late-stage funds. The firm also bought out common shares, presumably from earlier investors, employees and perhaps founders as well.
Its XIIth fund owns 10.28%, most probably acquired as series A and B, then its growth funds collectively own another 13.82%.
Although the overall multiple decreased, since the newly purchased shares were acquired at higher valuations, the fund will still obtain tremendous returns due to the likely size of the final exit.
How to capture the most out of a win
Unity has shown the ideal J-curve in value growth over the last 10 years. However, with a longer-than-average gap in funding between its Series B in 2011 and Series C in 2016, and 6 venture rounds, Sequoia’s final win is the result of a long-term game.
Even for the smallest (and fastest) IPO exits, such as European’s COMPASS Pathways, you can spot the J-curve in both the size and the valuation of subsequent fundraising rounds.
This presents VC investors like Sequoia an opportunity to double down on their bet, since they normally secure the right to re-invest with pro-rata and similar clauses. It also dilutes their previous stake, with new investors coming in sometimes asking for terms such as “pay-to-play” rights, which would cut out of the follow on game those that don’t want to keep investing.
Companies in hyper-growth raise larger and larger rounds and dilution does not improve much until at least series C, which is why investing in them early on can be a double-edged sward.
After spotting a company and making the first investment, the job of a skilled VC has only just begun.
Since most of the investments end up failing, a fund manager who wants high returns needs to maintain (or even build up) a substantial stake in that one or two outliers that can drive the portfolio returns.
The importance of capturing the “anomalies”
In venture capital you have two “main” school of thought. Those that want to back a few companies and help them out, so that at least one makes it big. Then those that believe “a few companies” are not enough to have a statistically strong chance of capturing that one or two hyper-growing superstars.
The likes of Sequoia’s managers and Peter Thiel fall into the first category. 500 Startups and other large-portfolio funds fall into the latter.
The first kind tend to build portfolios in the range of 15-30 companies, where they often take board seats and a fairly active role. The latter tend to back anywhere from 50 to several hundreds of startups (normally with smaller cheques), before moving on to raise a new fund and build a new portfolio.
The likes of 500 Startups believes they can find hundreds of companies with high enough growth rates to have a shot at being that outperformer. Thiel and the Sequoia guys think it’s not possible.
Both agree on something, though: VC returns follow a Power Law distribution. This means that the majority of the value generated by startup exits is disproportionately concentrated in a small number of companies (like Unity, JFrog and the likes).
This means that the returns of any given fund are mostly driven by those few outliers that generate anomalously big multiples on exit. It also means that most other investments will either go to zero or have a very small exit multiple.
Different investors may have different options about how to hunt down these champions. Once they find them, though, like in the case of Sequoia with Unity, it becomes extremely important for any investor to maximise the value he or she gets from those companies.
Winners at the VC game are those who find and exploit ‘dragons‘
In VC jargon, a “dragon” is a company that returns an entire fund — a “fund maker.” A dragon is 4x as rare as a unicorn (i.e. a “billion dollar” company).
According to data by Correlation Ventures, a lot of VC money ends up in companies that lose all the capital or barely returns it. Nearly 2/3rd to be exact.
Of course, since the data is about amount of capital invested, you might be forgiven to think that the ‘bad VCs’ are the ones that skew this upward, by wasting all of their cash in ‘bad apples’.
However, data from LP investor in VC Funds Horsley Bridge shows this is not exactly accurate.
If you ignore ‘terrible VCs’ (those who don’t even manage to return the capital back to investors and who do end up splashing money onto loads of money-losing companies) pretty much all VC funds lose money on 35-50% of the portfolio.
The difference between mediocre VC funds and top-performing ones (read ‘top quartile’ fund) is therefore not correlated to the number of failed investments. What matters is the other side of the coin: the home runs. And overwhelmingly so. Returning to the Horsley Bridge data, it is notable how returns of its best performing funds are mostly derived from a few select investments that end up producing outsized results.
In a nutshell: a successful venture capitalist should look to invest in those companies that display the potential for truly outsized results, and to not worry if they fail. As the investee companies grow and the best in the portfolio reveal themselves, the smart VC needs to ensure they bring the maximum benefit to the overall fund.
The importance of follow on capital for a VC’s winners
What Sequoia did with Unity is ‘following on’ on one of those early bets that proved to be a top-performer over time.
The importance of follow-ons was illustrated by Peter Thiel in his book, Zero to One. In it, he gives the following example:
“Andreessen Horowitz invested $250,000 in Instagram in 2010. When Facebook bought Instagram just two years later for $1 billion, Andreessen netted $78 million—a 312x return in less than two years. That’s a phenomenal return, befitting the firm’s reputation as one of the Valley’s best. But in a weird way it’s not nearly enough, because Andreessen Horowitz has a $1.5 billion fund: if they only wrote $250,000 checks, they would need to find 19 Instagrams just to break even. This is why investors typically put a lot more money into any company worth funding. (And to be fair, Andreessen would have invested more in Instagram’s later rounds had it not been conflicted out by a previous investment). VCs must find the handful of companies that will successfully go from 0 to 1 and then back them with every resource.”
— Peter Thiel
The example above demonstrates vividly the importance of follow-ons: if only a few investments end up being home runs, then a successful fund will identify that and double down on its winners to maximize the returns of the fund.
Entrepreneurs who enter the VC game should know what is expected of them is to shot for the stars, not “make a few bucks” – as the Americans say.
Investors entering the game should also be mindful of the maths behind it: you’re much better off having and end-stake of 20% in your Unity and lose most of your other companies, than have 2% in your Unity and a bunch of tiny exits. What the implications of this are I leave to you to make.
In real life, being able to distinguish between a “Unity” and a startup that’s not going it “make it big” is not an easy task. The Americal entrepreneur-turned-VC Mark Suster wrote a helpful post with some pointers on this, but the fact remains that the decision is not always a clear-cut one. But that is why I mentioned before that the job of a VC has only just begun when writing the “first cheque”.
Yet, despite these risks, following on actually presents opportune informational advantages to an investor. Unlike newcomers, who just have a pristine ten-slide deck, existing investors already know the business warts and all; the board minutes, the downside budgets, and the cultural dynamics.
It is not just Unity and Squoia
As I first learned by chatting with Hussein Kanji from Hoxton Ventures here in London, top-tier VC firms tend to keep around 60-66% of the total fund for follow on. A view which is widely shared by US top VCs.
Union Square Ventures’ 2010 Opportunity Fund, for example, had a calculated IRR of 60.59% (Pitchbook data as quoted in Medium), making it an extremely successful VC fund. CB Insights reported that USV 2010 had a pretty balanced profile between new investments and follow on, which are in line with the number above. They were therefore doubling down and the fund result shows that this was indeed a profitable strategy.
In the case of Unity, we don’t know what pushed Sequoia to double down so heavily on this particular company…. Looking at the upcoming IPO, though, it seems like it was the right decision to make.