Sramana Mitra: How do you process the current investment climate where capital is moving further and further upstream? Some of the funds that I’m sure you were involved in your previous life are becoming gigantic funds. As a result, they have to move upstream and deploy larger chunks of capital right away. How does a seed investor mitigate the Series A gap?
Charlie O’Donnell: For every fund that you’ve seen move up, you have some set of funds that fills in that space. The capital environment is pretty efficient. We certainly have Series A funds that insist on deploying $8 million to $20 million. It’s very hard to get a seed-funded company from their initial check to a position where they can take on a $10 million investment.
Sramana Mitra: That amount used to be a Series B or Series C kind of amount. Now that’s often the Series A amount.
Charlie O’Donnell: Exactly. However, you have a fair amount of larger seed funds who are more than willing to do a second seed or a seed plus. Somebody once told me that it was very hard to get a company to $100,000 MRR without spending MRR for enterprise SaaS. The reality is, most seed-funded startups in the enterprise space don’t get $3 million right off the bat. Somehow, you have to fill that.
For every fund like mine who might be willing to take a chance on a pre-seed investment and participate in a $750,000 or million dollar round, there are whole bunch of funds that have gotten to $100 million that are writing checks for a million dollars. They’re more than happy to do that for companies that have $50,000 in MRR and really getting to that Series A is more of a math problem than a technology risk.
Sramana Mitra: What is your strategy to maintain your position and not get diluted? You go into a deal like that. Let’s say it takes four rounds of financing before a real venture round. By the time your investment has gone to a full-fledged round, four years have passed and four rounds of funding have happened. Do you then sell at the Series A point or do you hold on?
Charlie O’Donnell: For a small fund, dilution doesn’t matter. The only thing that matters is, you’re going in lower than your exit price. Dilution only matters if you are an asset manager needing to put large amounts of capital to work. You have a larger fund and you just literally need to own a certain percentage of your winner to make your fund math work.
Sramana Mitra: Yes, but not every company is a winner. If you get buried under liquidation preferences, it will definitely matter.
Charlie O’Donnell: It matters to an extent. If you have an IPO, you would have loved to own more than you did if you’d only participated in the seed round. Just the math of the $15 million fund is that you roughly need to create a billion dollars of total enterprise value to return 3x to investors. You pull the math apart. The average M&A transaction for a tech company is about $250 million. The average win is not a unicorn.
The average win is a lot smaller than that. If 10% of your 30-deal portfolio drives most of your return, you’re talking about three winners that exit for the average, which is $250 million. That gets you $750 million right there. Maybe a handful of 50’s, a 20, and a 30. Then a couple of deals that return capital. Then half of the portfolio becomes a zero. That’s what gets you up to a billion dollars.
With that very reasonable math, you actually don’t need to do follow on investments and protect ownership. You can still return 3x to your investors which is something that most funds don’t do at all. It becomes a lot more difficult when you have a $500 million fund. Even if you had 20% ownership and you had two billion-dollar outcomes, you still haven’t even returned capital to your LPs. That economics on a small fund is very different.