Alpha, beta, and an inverted venture risk curve
Making sense of a momentum market
Private conversations between early-stage VC are getting weirder and weirder by the day. Specifically, I’m hearing of case after case of large Series A+ VCs literally fighting to stick big checks into very early-stage companies I’m not comfortable putting small checks into. This market is . . . interesting.
Assuming both the Series A+ guys and I am acting rationally and with some skill — what is going on? What explains the inverted risk curve of the VC market? After all, as a small first-check firm, we are supposed to be taking MORE risk than they are…..
A momentum market. I think what has happened is that we have moved wholesale into a momentum market. What’s a momentum market? The more money you raise, the more money you will raise. Because there is so much money looking for a home.
These numbers are off, but they illustrate the point: it used to be that VCs saw about a 50% drop off rate for each round of investment. Roughly half the pre-seeds converted to seed, half the seeds to A, half the A to B, etc.
The drop-off rates have shifted. In today’s environment, this pattern has shifted. There is so much money seeking exposure to private companies that the drop-off rate is diminishing. If 50% of pre-seeds convert to seed, 60% of seeds convert to A, 70% of the A convert to B, 80% of the B convert to C, etc. We see this clearly in the shift towards later stage deals, as reported by CBInsights.
As a first check VC investing in deeply contrarian (cliche, but true and I can prove it!) companies, I still see roughly the same risk (of company death) as I saw in 2010 and roughly the same valuations. For context, we’ve historically seen a very low write-off rate and, consequently, a very high follow-on rate. The point here, however, is that these rates haven’t changed much despite the market froth. We still take what we believe is a ton of early-stage risk, and both the hit rate, and very strong returns continue to justify it.
But the investors after us are living in (what appears to me, at least, to be) a vastly different world. There are so many new Series A, B, and late-stage players that the odds of a follow-on round are just MUCH higher than ever before. Valuations at these stages reflect this. There is simply so much capital waiting to follow a “Series A” that the Series A round itself is just legit less risky than before — and the bigger and more expensive the Series A is, the more likely it is that big follow-on dollars flow in and the less risky the Series A appears. Key point: This effect is independent of the actual true quality of the underlying company. (One obvious side effect of this: more paper unicorns than ever. Here’s the data from CBInsights.)
First check versus everything else. So we at first check are seeing roughly the same valuations and risk profile that we saw before, but with (1) vastly bigger outcomes for winners (Synk! JFrog! Aquant! Firebolt! Dust!) and (2) much higher follow-on valuations that come faster than ever.
The funds after us (late seed, Series A) are seeing MUCH higher valuations, lower risk of failure, and self-fulfilling prophecies. The rounds they do seem to trigger the next one almost automatically.
What happens next? As long as public market multiples hold up and exit values stay high — it’s all good. All VCs stand to benefit. At some point, however, returns may diverge. Selective specialist first-check firms should outperform later-stage momentum indexers.
If you raise your entry prices by 5–10x, you better see 5–10x better exit valuations on average (doubtful) or have gotten 5–10x smarter just to keep performance constant. For us, however, 2x higher exit prices have huge positive impact even if we’re no smarter than before.
But I think this explains the phenomenon we’re witnessing of an inversion of the implied risk tolerance curve: with paradoxically more risky-looking behavior as you move downstream.
Commitment relative to fund size is another measure of risk tolerance. Another thing that is worthy of emphasis is that a $2M check from a fund like Angular is 5% of the fund. But by the same measure, $10M from a $2B AUM firm is only 0.5%! Many of the venture funds that are doing these oversized first checks are oversized to the point where they don’t feel risk on a specific exposure. On a portfolio-wide basis, the risk is — in fact — reduced. But on a single asset basis (and let’s face it, entrepreneurs live in a single-asset world) the risk has actually gone up.
Alpha, beta, and fundamentals. It’s critical to point out that all of this is divorced from fundamentals. Early-stage VC can do one of two things: Either (1) they can write a ton more checks with a lot less diligence — or (2) insist on careful deal selection and a very concentrated portfolio of super high-conviction investments. I’d argue that because the first check VCs see more real and perceived risk, we should be more fundamental-driven. In my view, we have no choice. That’s the job. At Angular, we remain solidly in the sniper-rifle camp of early-stage venture — it’s what we love to do, and it’s worked very well historically in all kinds of market conditions.
Here’s the key insight I’ve come to: Later-stage venture capital which was previously all about fundamentals and deep analysis, has morphed into being largely about momentum (will the next round happen? Yes!), indexing (given that the next round always happens, let’s do everything!), and speed (since we’re going to do everything, what are we waiting for?).
This makes the risk to late-stage VC (or early-stage VCs that are indexing) much more systemic (beta!) and the risk to early-stage VC much more idiosyncratic (alpha!). Over the long run, we’re in the alpha business. ;)
