Leading a Deal

Thought these tweets from Elizabeth Clarkson and Samir Kaji were interesting.

Very true. Main line of demarcation within seed fund market is lead/non-lead. Very small percentage of the former. https://t.co/1RNpnC9ts5

— samir kaji (@Samirkaji) November 27, 2018

So true. Thanks for the great article on seed funds who lead @robgo #openlp https://t.co/Bx8vSf9Pl2

— Elizabeth Clarkson (@Beezer232) December 2, 2018

I spent a month in Silicon Valley and San Francisco last February. I was talking to LPs, funds, and entrepreneurs. I was shocked at how many seed funds didn’t lead. I was also shocked that a lot of seed funds would invest small amounts in a deal, as little as $50k, just to have the deal on their tombstone even though they probably wouldn’t make money for their LPs.

If you are an angel group, it’s tough to lead a deal unless you have angels in the group that are experienced enough to do the negotiation. The other hard part is the diligence.

Negotiating with an entrepreneur over terms is relatively painless. Seed deals have become pretty standardized by now. There is always some small nuance from deal to deal where terms are slightly different but on the whole, they are pretty similar. That’s why you can just download a term sheet from a VC law firm or the NVCA and they all look the same.

Legal costs at seed should not break the bank.

The hard part is the diligence. As a lead, you will have to share your diligence with other members of the syndicate that you arrange.  Entrepreneurs can certainly feed you potential investors, but it’s up to the fund that is leading to bring them along.

There are two reasons for this.  First, shielding the entrepreneur and having one point of contact for diligence makes a lot of sense. It lets them execute the business and not be totally disrupted by fundraising.  Fundraising can be very disruptive.

The second is that the lead needs to build rapport and trust among the investor syndicate.  After all, the lead is going to take a board seat and lines of communication have to be strong between the investors.

The Angel Capital Association found that the more thorough the diligence, the better chance of success at investing. That’s why it’s important.

On the flip side, sharing diligence with other funds and investors exposes the lead.  They get to see a little bit of how the fund operates and goes about their business.  If the diligence is sloppy and unorganized, it’s likely the fund is that way. When you are an inexperienced investor, or new to doing deals, there is a fair amount of trepidation that goes into diligence and it is heightened when you share it with peers.

I cannot speak for other funds.  We are certainly on the smaller size, especially when you consider the size of funds in California and New York.  Our fund has made a very conscious decision around leading versus not leading.  At the initial institutional round, we really want to lead.  We want a board seat.  We want to write a meaningful check.  We want to help the entrepreneur herd the cats and we are very transparent about what we are doing.

Our philosophy is to write a check big enough so upon exit it pays for the entire fund.  Doing the math, a $500k check with a $1MM follow on needs to return $10-$13MM.  How much ownership we need and the potential exit value takes care of itself when that’s your philosophy.

Because of fund size and check size, we are pretty keen to have a very engaging discussion with entrepreneurs about valuation and their goals for the business prior to giving them a term sheet.  I think we have gotten a lot better at this as we have gone on.  Instead of assuming everyone understands the math around VC, we show them how we do it.  We also help them decipher the hidden messages around what other investors might actually be telling them.  A good meeting might not mean anymore that that.  It certainly doesn’t mean a check is coming.

We are also very committed to trying not to have commodity money in a deal.  Even if it’s an individual angel, we’d prefer that strategically they can help one part of the business move forward.  Dead money on a cap table is dangerous.

So far, it has proven out.  We have led 4/5 of the deals we are in.  We took board seats on 4/5.  We have written meaningful checks in all of them.

Once we are in, we work like hell to bring an unfair advantage to companies we are invested in, and we do all we can to help investors in our syndicate understand what’s going on and how they can be additive too.

We didn’t do this to ride on coattails.