The “4-S's” of venture capital
Last quarter, we wrote about the effect of Softbank’s $100 billion Vision Fund on the venture capital ecosystem. Specifically, our view that it will cause later-stage funds to endeavor to raise ever-larger pools of capital while early-stage funds will continue to focus on smaller initial investments where the potential for high return multiples remains strong.
But fund size and average check size are far from the only attributes that differentiate early vs. late venture investing. We’ll utilize our simple “4-S” venture framework to illustrate the broader, and more fundamental differences, between the stages of investing.
The “4-Ss” of Venture Capital are Sourcing, Selecting, Shaping, and Selling:
For firms like Merus that invest in Seed and Series A rounds, deal sourcing is network-driven. Specifically, it’s the network of company founders, would-be founders, and technology executives that drives access to investment opportunities. This ecosystem of relationships is the lifeblood of an early-stage firm and often the basis for long-term competitive advantage as it affords firms a privileged view into potential investments at a nascent stage of development, before startups hit the radar of other investors, advisors or the media. For this type of investing, dealflow is almost 100% inbound.
By contrast, late-stage investing tends to be more outbound-oriented. A firm may have a team of associates whose job it is to reach out to companies for potential investment. Advisors and other investors also tend to be much more important sources of dealflow.
All firms, whether they be early- or late-stage investors, filter out the vast majority of opportunities that they evaluate. But how do these decision-making processes differ?
In general, a later-stage investor will examine existing trend lines and metrics like revenue growth, margin expansion, and demonstrated unit economics as well as consider structural deal protections like liquidation preferences, ratchets, or coupon rates.
While we at the early stage of course appreciate these attributes as well (to the extent they exist), our focus tends to be on the human element. In other words, do we believe that a founding team is capable of building a lasting, profitable business over the long term?
We analyze their domain expertise, the dynamic amongst the team, their ability to recruit others to their vision, and ultimately their passion and dedication to complete the challenging journey from idea to durable company.
We couple this with an analysis of the market opportunity. Specifically, we concern ourselves less with the “macro” or current market size and more with the “micro”, studying the magnitude of impact a product can have for a given customer.
When it comes to investment selection, you might say that a later-stage investor is trying to answer the question: What can go wrong? while at the early stage, we must ask: What can go right?
We use the word shaping to describe our role as a board member of our portfolio companies. It is intentionally an active word and we view our role as both dynamic and broadly defined. At the Series A stage, companies are still highly moldable. The ideal customer profile may not be clearly defined. There are often skill gaps in the management team. The right go-to-market model is likely still being tested, among other unknowns.
While this fluidity certainly suggests that risk exists in the business, it also means that a hands-on Series A investor can have enormous impact on the trajectory and ultimate value of the company.
Investing in a more mature, well-defined business has obvious advantages, but our view is that the opportunity for an investor to shape an outcome is significantly diminished at the later stage. In fact, we see this shifting dynamic in our own role as our portfolio companies mature from Series A to D.
This last “S” is where the two groups demonstrate fewer differences as both are focused on achieving the highest (and most certain) market-clearing price for their shares, whether it be through IPO or company sale. There is one structural difference whereby an early-stage investor may have multiple opportunities to sell with each round of fundraising along the company’s path to broader liquidity.
While the activity of investing may be quite different for early- and late-stage venture investors, both groups play a critical role in shepherding companies along the journey to success.