Deal Syndication in Micro VC Land

As part of my transition from angel to VC, one of the issues I’ve had to grapple with is that of syndicate construction. I have always been a huge proponent of syndicates, seeking to get parties around the table with the best mix of domain experience, contacts and attitude to help de-risk the investment. While there are myriad ecosystem benefits to taking this approach, e.g., playing well with others, sharing good deals, it is also highly rational. My friend David Beisel just wrote an interesting piece on deal-sharing in the Micro VC space, positing that the three biggest reasons for “large and friendly Micro VC syndicates” are: (1) being capital constrained; (2) as a vehicle for deal sourcing; and (3) due to the immaturity of the asset class. While I believe these reasons to largely be true, they don’t address perhaps the most important element of syndicate-building: the tactics around syndicate construction. To lead or to follow? When and how to build a syndicate? How do you work with the company on syndicate construction? How a Micro VC, or a VC, for that matter, deals with these questions can often determine the level at which an investor can play in a deal - if at all.

In general, I view the syndicate construction question in much the same way as I view the management of an early-stage company: one lead founder is fine; equal co-founders are great, provided that one is the CEO; more than two co-founders without a clear understanding of who is the CEO is bad. While there are exceptions to this rule I find it holds in most cases, and provides an accurate metaphor for how a Micro VC should view syndicate construction. I believe every deal benefits from a lead. Ambiguity around this issue can be costly, causing a firm to lose an investment opportunity because of distributed decision-making and slowness in getting a term sheet issued and signed. It is not simply a matter of capital provision but of deal leadership, serving as the primary point of contact during the deal negotiation/term sheet stage, being ultimately responsible for getting the deal done and advising management on the most value-added syndicate members. It is important for syndicate members to know their role in a deal.

I believe strongly in working closely with management to build the best syndicate. Sometimes more experienced entrepreneurs already have a wish-list of strategic angels they’d like to include in a round. This has to be respected and built into the syndicate sizing and composition discussion. One can have a reasoned discussion concerning capacity, etc., but fundamentally if an entrepreneur wants a particular investor in I am going to make room - period. Other times a first-time entrepreneur brings no investors to the table and is looking to me for guidance on building the best investor base, and that is fine, too. Either way, the entrepreneur is an essential part of the syndicate building process.

Bottom line: someone needs to own a deal. Coming to the table as a two- or three-headed syndicate beast without a clear leader is a big, big mistake. How many VCs like investing into situations where there is “management by committee?” Answer: zero. Why should syndicate-building be any different? You like the deal? Step up and issue a term sheet. You can get your BFFs in line afterward. I have played every syndicate role in my relatively short time as a VC: lead dog, strong #2 and a subordinate syndicate member. And each role is fine. Just make sure you know which role you want to play and by all means, if you want to own a deal, step up and make it happen. Otherwise, someone else will.

From Angel Investor to Venture Investor: A Process

For several years I invested exclusively for my own account. Now I manage a fund. This has given rise to a necessary change in strategy and approach to investing. I didn’t really appreciate the magnitude of the differences until I was in the middle of the transition. The net result is an investment approach and money management strategy of seed stage investing that I like a lot. Is it “right?” I don’t think there is a right answer, but it feels right to me and my partners. Will it evolve? Certainly yes, and it will change based upon dollars under management. Another important cultural and operational issue is moving into a position of fiduciary responsibility. Now I’ve run fiduciary investment vehicles before, most notably as CEO of the Registered Investment Adviser DB Advisors, so I am familiar with the nature and magnitude of the responsibility. But it is a change of which newbie fund managers should take note. While every angel starting a fund has to wrestle with these transitional issues themselves, hopefully by sharing a bit of my story it will both create a dialogue around optimal investment approach and be useful for those starting their own funds.

My life as an angel - smooth sailing

Prior to starting a fund, I had been an active angel investor and entrepreneur for over five years. I had seeded or incubated 40 businesses, established my presence as an active blogger, Tweeter and online denizen, and deployed a significant amount of personal capital in building a new career and life. I focused my investing in verticals I understood, where I perceived there to be plentiful and attractive investment opportunities, and where I felt my domain knowledge and suite of relationships would be most helpful in building businesses: digital media, advertising technology and financial technology. Notwithstanding my angel status, I felt as if I invested and was perceived as a sort of “mini-institution,” bringing capital, energy, engagement, relationships and know-how more akin to what I perceived a real venture capitalist to be. I prosecuted my strategy with initial check sizes ranged from $25k to $100k, with a median of $100k. I would generally take advantage of my pro rata rights where possible, and had cumulative investments of up to $250k in the companies with which I was most actively involved.

From angel to institution - doh!

However, it wasn’t until I raised a venture fund that I realized I was woefully inexperienced in areas with which I was intimately familiar during my years as a derivatives and trading professional - asset allocation, optimal bet size and bet types. As an individual I was focused principally on one thing - doing great deals in my areas of focus whenever they presented themselves - and it worked pretty well. Sure, I was conscious of investing in verticals I understood well and in which I perceived I had a competitive advantage. And I always invested with an eye towards creating ecosystems around my investment themes, enabling my companies to work together and to extract the network benefits inherent in such an approach. However, I never really thought about how many big vs. medium vs. small initial investments I should be making. I didn’t actively consider that if I was going to follow on, how much should I invest and how should I think about my long-term percentage ownership objectives. I also didn’t apply strict discipline in how I allocated my time across my investments. These shortcomings became apparent very rapidly after becoming an institution as my team was deluged with incredibly attractive investment opportunities, yet constrained by fund size and our lack of a detailed approach to capital and resource allocation. We intuitively knew the issues we needed to address, but at the beginning lacked the experience and data to develop a granular philosophy and approach to money management. Thankfully, this has changed.

The IA Ventures Approach to Investing

The first order of business was to take our core “Big Data” mission and to convert this into investment criteria. We spent a lot of time articulating the Big Data value stack as we see it on our website, and this was a healthy process for codifying our investment approach. At the end of the day we decided on three basic investment criteria:

Investment Criteria

1. Mission: We will invest in and incubate early-stage companies building tools and technologies to manage or extract value from Big Data. Companies focused on “extraction” are generally shorter-term plays. Firms focused on “management” tend to be longer-term plays. We will not stray from our mission.
2. People: We have to love the entrepreneur(s) to do the deal. Period.
3. Space: One of the IA Ventures’ partners has to be deeply passionate and excited about the space to do the deal.

Given these criteria, the question then becomes which kinds of bets to make and how many of them can be made given the firm’s capital base and the ability and desire to follow on. After considering our investment philosophy (heavy alpha generation leveraging our specialized skill sets, experiences and industry contacts across a more concentrated portfolio), we bucketed our bet types and are constructing our portfolio in the following manner:

Portfolio Construction

Concentrated bets: (~75% of capital; initial check up to $1mm; 2x reserve; 8-10 companies). This is the core of our portfolio. We will lead or co-lead the round, take a board seat and invest a significant amount of time per month helping with business development, recruiting, etc. These are investments where we believe our domain expertise, technology know-how and business development relationships make our money better than other investors’ money. Even so, we always take a syndicate-based approach to investing, working with top firms and individuals to create the strongest and most strategic investment group possible. We expect a single concentrated bet to return a significant share of the fund’s committed capital. Examples of concentrated bets in the current IA Ventures portfolio are MetaMarkets and The Trade Desk.

Opportunistic bets: (~20% of capital; initial check between $100-$250k; 1x reserve; 10-15 companies). These are companies that fit with the mission of the fund and where we love the entrepreneurs, but where we either don’t have sufficient investment capacity or don’t want the depth of involvement required by a concentrated bet. We don’t take board seats and take a “lightweight” approach to helping out, e.g., leveraging our networks for business development opportunities, recruiting, etc., but not on the heavy lifting required of board-level engagement. We might want to get close to the entrepreneur because this will be the first of many companies they found. We could be particularly interested in the company’s technology or area of focus, and view investment as strategic to the fund. And we always look for a bet to generate an attractive ROI and diversify our overall risk. Regardless, we see so many attractive deals that fit within the fund’s mission that we want the flexibility to do a larger number of smaller investments when particularly attractive opportunities present themselves. Examples of opportunistic bets include CrowdSpot and FluidInfo.

Incubation bets: (~5% of capital; milestone-based financing of up to $500k; 3 companies). Occasionally we run into outstanding talent with ideas that need nurturing, but also need help with building out the operational infrastructure associated with the idea, helping to identify key early employees and require only a modest amount of capital to achieve critical technical and product milestones. These are companies where IA Ventures is able to own a significant share of the company in exchange for a ton of work and some capital. It is expected that a single successful incubation bet could return a multiple of the firm’s total committed capital. An example of an incubation bet is TraceVector. From an investment perspective, the hope is that these ventures migrate from incubations to concentrated bets over time.

Larger incubation bets require the companies to be domiciled in New York City; the high-touch nature of these relationships cannot be supported remotely. If I run a larger fund after this one, I could see having some in-house incubation space in order to both support our companies and to extract the network effects of being around other smart, early-stage business builders. We are also exploring doing smaller project-oriented “explorations,” where a super smart entrepreneur working at a company has a relevant Big Data idea and wants to leave to pursue it single-mindedly. These deals would be in the $50-$75k range for a small piece of the company, enough for the entrepreneur to quit and to work full-time on their idea for 6-9 months. These are opportunities driven largely by personal relationship, where someone within our network is ready to make the move and we are “jonny-on-the-spot” to provide the early risk capital and support to the venture. Kind of like a seminar-of-one version of YCombinator/TechStars/SeedStart. Call it the IA Ventures Way.

In short, IA Ventures is seeking to most efficiently deploy its capital for the benefit of its LPs. This means not only investing in deals but building a real business, one which is well-known and respected for the value it drives to entrepreneurs and their businesses. It is this awareness and respect which creates the virtuous cycle of seeing great deals, having the opportunity to work with great business builders, helping them exit profitably and further reinforcing the reputation of being smart, supportive investors and partners. It also means playing an important role in the seed stage venture ecosystem, bringing together thought leaders and practitioners to help solve big, important problems of today. While IA Ventures is a small firm we take our roles and responsibilities very seriously, and strive to have an impact on business development, job creation and wealth building that far outstrips our modest capital base. This is how we roll.

[Addendum 6/29/2010 - What I gave up by becoming a fund manager]

During a breakfast meeting with my friend and High Peaks Capital VC Brad Svrluga it became clear that I had neglected to discuss a key aspect of my transition: what I’ve lost by becoming a very focused, thematic venture investor. Prior to the fund, I could invest in any deal that made sense to me. While I imposed a measure of vertical discipline on my angel investing activities, I had a far broader mandate than I do now as a fund manager focused on Big Data tools and technologies. I have extensive personal investments in social media, many of which would have been a “no go” for my fund but which fit my angel investment approach. Have I seen many of these deals go by that are getting done by friends and colleagues with broader investment mandates? Absolutely. And it is a bummer not being able to do them. However, I have unwavering passion and conviction for my fund’s area of focus, and feel that notwithstanding the give-up of flexibility it was a trade well worth making. But it is a trade that needs to be entered into eyes wide open. Being an angel and being a venture investor are not the same thing, with the only difference being a leveraged position in deals you would have done anyway. There must necessarily be a higher bar, both in terms of deal-specific thought process and due diligence and overall portfolio construction. Managing other people’s money is a big responsibility. It’s not just all about fees and carry.

Constructive Dialogue: Just Business, Not Personal

I have been an online denizen for some time, and have engaged in countless online debates both on this blog and elsewhere. At time those debates get pretty heated, as reasonable but opinionated people can disagree but do so with passion and intensity. Sometimes language can become snarky and sarcastic, as emotion and reason mix in an interesting and often entertaining brew. But when these dialogues devolve into personal attacks, where assumptions are made about people’s motives and character, the value of the entire discussion thread drops precipitously. And this is a shame, because often a lot of excellent thought is missed in the wake of judgment and hostility. And the online age has sharply increased the incidence of this kind of messaging, as the depersonalized nature of sending a comment into the ether has made it perilously easy to communicate things you’d never bring yourself to say to someone’s face. Yet this should be the check for whether something should be written as well.

While the catalyst for my message are the blog entries and tweets of Chris Dixon and Jim Robinson, this is an issue I’ve been thinking about for a long time. It’s just that Chris and Jim’s interaction, given the fact that I know them both and many of the others who have taken a stance in the carried interest taxation debate (e.g., @fredwilson, @bussgang, @pkedrosky), has made it much more real and personal. Chris and Jim are two exceptionally smart guys with strongly-held views. As it relates to the carried interest debate, they happen to be on opposite sides of the issue. Big deal; the often-snarky Mr. Kedrosky has more than a few times roasted me on issues where he and I disagree. And I have tossed it right back at him. But those exchanges are focused on the issues, not on either of our characters, motivations or integrity. Based upon Chris’s tweets in response to Jim’s strong but reasoned blog post, it is clear that he doesn’t know the Jim Robinson I know. No matter, the criterion for engaging in spirited but respectful debate should not be whether or not someone knows the commenter.

It should be that basic respect is afforded anyone who enters the debate in a respectful manner. Jim’s language is strong but not personal. It addresses Chris’s views and others who have staked out a similar position. But Chris’s response to Jim’s post was highly personal, not to mention uninformed. In my opinion it crossed the line and, in fact, much of the thread of “good versus evil” that has been taken up in this debate is neither intelligent nor helpful towards getting to a better perspective on the issues. Believe me, I understand the technique of “shock value” and taking a bold, hard-line stance. But to paint everyone who happens not to specifically agree with you as somehow morally bankrupt is absurd.

In other words, I am not arguing for a world where debates become some form of sanitized drivel. I am arguing for an approach where people can use colorful language to express their views with passion and intensity but with respect and in a de-personalized manner. I think people entering the fray need to take a deep breath, pause and consider their words before launching them onto Twitter, blogs or other forms of social media. Would you say these words to the person’s face? Would you want to be dealt with in this manner? If the answer is yes, then let it rip. If not, then resist the urge and re-cast the message. There are so many smart people with so much good stuff to say. It is shameful when so much good content is lost to poor form.