pot of gold

We all know the obvious advantages of investing in the next Facebook or the next Google early. Namely, price. Each dollar buys you way more of the company. But there’s another huge advantage: Pro-rata rights. In layman’s terms, this means investors have the right to keep investing with each round. That used to be something all VCs did.

But two things have changed that dramatically in recent years. The first is that early rounds are increasingly being done by micro-VCs and super-angels, because the cost of forming a company is so much lower than ten years ago. While these small funds have enough wherewithal to get a company going, building a huge business still takes a shit ton of money and rarely do they have enough to keep investing in each round. And that brings us to the second dramatic change: Companies are staying private for way longer and thus raising more venture rounds at way higher valuations and in staggering amounts.

The result is a free and yet hugely valuable — and so far illiquid — commodity of those pro-rata rights. And as the pre-IPO $1 billion valuation club is rapidly becoming the $3 billion to $10 billion valuation club, everyone in the industry is trying to figure out a way to unlock those rights.

In an age of founder liquidity, secondary markets, and deal flow via AngelList, it may be the last piece of captive value of the early stage startup ecosystem that hasn’t been unlocked. And everyone in their right mind is salivating over it.

The last week has seen a rush of discussion over changes to the structure of the venture capital ecosystem. It’s a conversation that was sparked first by a detailed and thoughtful presentation by Upfront Ventures’ Mark Suster at the Pre-Money Conference and a subsequent blog post further exploring the topic.

Soon after Andreessen Horowitz partner Scott Kupor weighed in on why these structural changes matter. Then Union Square Ventures’ Fred Wilson outlined one practical strategy for smaller, early stage funds to more effectively compete in the increasingly top-heavy ecosystem, namely separate opportunity funds designed specifically to exercise a firm’s pro-rata rights in later stage rounds of its winning deals.

Wilson’s post is a more formalized version of another practice I’ve been observing with increasing frequency. Many smaller firms – typically those with funds of less than $100 million – are frequently creating one-off special purpose vehicles (SPV) to invest in or even lead follow-on rounds in their winners. In this scenario, firms offer their existing limited partner (LP) backers an opportunity to invest additional capital, outside of their existing fund commitment, in a single transaction. It’s a model that works best with more nimble LPs like high net worth individuals and family offices as opposed to slow-moving and often risk-adverse institutions like pension funds and endowments.

Typically, the general partners (GPs) wave or drastically reduce their management fee on this capital (the standard 1 to 2 percent firms charge charge against deployed capital) and in some cases even adjust the back-end carry (the 20 to 30 percent cut GPs take from winning deals) either up or down. Obviously the structures vary on a firm and deal basis, but the point is that these investments are typically structured differently than a firm’s existing venture funds.

I’ve spoken to a good half dozen firms that have employed this strategy, including most explicitly as part of their operating model Venture51 and Susa Ventures, and also seen angels like Kirsten Green (before she formed Forerunner) take a similar approach to leading opportunistic rounds.

The benefit from a VC perspective is obvious, and well articulated by Wilson, who writes:

Guess what? Early stage VC is a lot like poker. You want to go all in on your best hands. And if you make a seed or Series A investment, you get something called the pro-rata right. That means you get to invest an amount in every private round going forward that allows you to keep your ownership at the current level. A pro-rata right in Facebook, Twitter, Dropbox, Airbnb, Uber, ……….. is worth a lot. And early stage investors get those rights for free in the early stage rounds.

But with many early stage firms raising relatively small sized funds, it can be difficult to maintain a 5 to 20 percent ownership stake in a rocketship company as valuations predictably increase. Hence the need for alternative sources of capital, such as an opportunity fund or a deal-specific SPV.

For LPs, such a structure means increasing the (potential) impact of winning deals and the ability to put more capital to work with successful GPs, but at later stages when more data is available on which to make such a decision. As Susa’s Chad Byers told me recently, “There’s a huge amount of appetite among our LPs for these types of opportunities.”

For entrepreneurs, working with early stage funds that have access to this type of downstream capital can help maintain continuity with familiar investors and reduce the need to bring on potentially mercenary or simply unfamiliar shareholders. This is very much the reason Whatsapp reportedly stuck with Sequoia Capital through each of its venture-stage rounds (of course, with billions under management, Sequoia has access to all the capital that any startup could need). To play devils advocate, there’s arguably value (to all involved) in any deal to bringing additional resources and more smart people to the table.

Earlier today, I ran across yet another twist on this opportunity fund model. A new AngelList syndicate called the “Late stage Pre-IPO syndicate” was formed to pool the pro-rata rights of a group of as yet undefined angels. The Syndicate was created by former eBay VP and current Wikia CEO Gil Penchina, who claims to have participated in $25 billion in exits as an angel investor in 60 startups, including LinkedIn and PayPal, and who currently holds positions in AngelList, Wealthfront, IndieGoGo, Betable, Evite and Rally Software, among others.

The syndicate description reads:

We have banded together to pool our future pro-rata rights into a single fund. We sit on boards or have other ways to often get access to a $500k or $1mm allocation during later stage rounds, but can’t afford to take all of them.

And later:

All Partners in this fund will be committing to:

- allocate their pro-rata in deals where they are an angel

- hustle to get allocations in companies where they are on the board, or have connections

Our goal is to have a large group of partners who are all uber-angels and board members, in order to get access to the best later stage deals.

There’s no telling how effective such a structure will be or how much interest it will draw among backers – the still nascent concept has thus far attracted $130,000 in commitments from two approved backers. The minimum backer investment is $50,000 and syndicate manager will take a 25 percent carry on a deal by deal basis.

It should be obvious from these recent discussions and by the existence of these creative follow-on investment structures that the venture landscape is changing. No longer is it enough to simply pick winners early, or even to help them grow into mature businesses. The most successful investors will be ones that can find ways to maintain or even grow their positions in their best deals.

With the average time to liquidity and the extremes of private market valuations at an all time high, that’s a far more difficult proposition that it was in prior eras. There’s no single “right” answer to this riddle, but as the investors discussed above have shown, the only certain wrong answer may be to do nothing.