The Game Theory of the Seed Stage = Pay Upp
Yesterday Hunter Walk published a post entitled: Seed Stage VCs Compete With Each Other But Not How You Imagine, which argued that in spite of the explosion of seed/MicroVC funds, the environment remains more collaborative than competitive. While, anecdotally, I agree with most of his thoughts, I do believe that from a game theory perspective the seed stage world should look far different. In addition to Hunter, Semil Shah recently reflected that he’s seeing increased downware pressure on seed valuations as investors (and LPs) tire of ballooned entry prices – especially with the lack of any material M&A.
If these trends are true, that top tier “branded” seed funds with institutional LPs will be increasingly subject to valuation discipline, it should (in a game theory optimal world) create an opening for a new generation of seed funds.
Here’s why –
Everyone Likes Storytime, Right?
In early 2015 I got extremely excited by a company involved with an exclusive group, that, well, rhymes with “I see.” I started speaking to this company about a week before their demo day via a referral from a founder in their class. As I recall they were trying to raise some money at a valuation cap of $5M.
It took me a few days to track down the people I wanted for diligence and we spoke the morning before demo day. They offered me an allocation at that moment but told me that after demo day, the entry valuation would double to $10M. I see this tactic a lot, and while I always find it a bit off-putting, I do respect their trying to incentivize closing some money early to build momentum.
For whatever reason, a few diligence points I was waiting on didn’t come in until later in the afternoon, but came back positive. I called the founders and told them I’d write them a check at the $10M valuation. They told me that they’d quickly filled their raise at $10M (and told me the rather seductive list of investors who’d joined at that price), but would be happy to have me at a $20M valuation. They wouldn’t budge.
Irrespective of whether this healthy or atrocious for the ecosystem, what would you do?
I passed citing “valuation discipline.” And in turn missed on one of the hottest companies I’ve seen this year. I later heard through the grapevine that the valuation ballooned as high as $30M for some investors. I sacrificed brand for valuation discipline.
Game Theory Optimal
Yesterday, Kauffman Fellow and all-star blogger/LP Samir Kaji responded to Hunter’s blog post asking if explosion in seed funds is lifting valuations?
@Samirkaji IMO multistage firms coming downstream causes more pricing pressure than lots of small investors. At least for our deals.
— Hunter Walk (@hunterwalk) August 4, 2015
What’s interesting to me about Hunter’s response is that it actually suggests that growth firms moving downstream understand the lifeblood of competing at the seed stage: Brand.
These growth firms want access to opportunities that founders aren’t traditionally considering them for. To become convincing they need to pay up. Upstart seed funds face the same dilemma.
Being branded affords certain advantages:
Theoretically it allows you to convince founders to take your money at lower valuations because you bring more value and more positive signaling.
It improves dealflow, thereby improving ultimate returns.
Your investments have more positive signaling associated with them, leading to less susceptibility towards the Series A crunch, and therefore improving returns.
If this is true, fund strategy should be largely centered around brand.
If I had to summarize what founders have told me they want in a Big VC Firm, it would be: 1. Brand name 2. Trust 3. Ability to follow-on
— Semil (@semil) July 23, 2015
In my mind, brand can be developed in a couple of ways: (a) A long track record of successful investments/exits (b) A more recent track record of well known investments alongside strong syndicates (c) Thought leadership/strong publicity/founder references. In my view, many entering seed funds – looking at A16z’s astronomical rise - believe that “services” are what matter most. Services are merely a means to building a brand - VC has always been a rolodex business, and services/help are pre-requisites to even compete in the game.
Here’s My Logic And the Cycle of Venture Disruption:
seedgametheory1
Venture has proved to be a Winners Take Most business where the top few funds in each category produce the outsized returns. In order to become a top decile fund, it is vital to find yourself in this category.
Becoming a top fund is a function of brand.
Brand is a function of several variables, some of which are long-term – returns – and others which can be influenced near-term: syndicate partners, relationships, marketing, founder testimonials.
Because quality of investments can be “influenced” by paying higher valuations for access, funds without brand equity should be willing to do so.
Because of the increased number of seed funds, this logic should cause considerable upward pricing pressure – forcing prior “branded” funds (now more return/institutional LP sensitive) to pass and exercise discipline.
After some duration of exercising discipline – and missing good opportunities – the first wave of funds will return to paying inflated prices to gain access but several from the second wave will have emerged.
Over time, unbranded funds or funds that exercise extreme discipline will lose access to top opportunities, not perform well and will die out.
Taking a very long term approach, as these funds die out, valuations will recede to lower levels as competition lessens and as branded funds are able to sell their “value” better than newer competitors.
It's using this logic that leads me to believe that as long as seed funds continue to enter the market at record pace - those who are fortune to be backed by LPs with a long term view of the world - will continue placing upward pressure on startup valuations - but may also emerge victorious and as powerful players in the still maturing seed environment.
If you're curious....
My logic assumes the following assumptions to be true (many of which are debatable). If you spot more, please let me know:
Markets are game theory optimal and rational (obviously untrue)
Venture stages operate similarly to WTA
Founders remain largely valuation sensitive and will mostly optimize valuation while fundraising.
Brand is a leading factor in access to top investment opportunities.
Paying higher prices correlates to better deals