Better predictions than #Blizzardof2015

I have always loved the fact that meteorologists do so much guessing with imperfect information in their forecasting, yet the public always yells and screams when some of that imperfect information ends up changing the course of the weather. It isn’t much different than investing, investors are making decisions with imperfect information and some do better than others at it.

My conclusion is…

As capital flows to the seed stage, the pool of investors are collectively asking for less risk. All the while assuming they’ll be able to get the same returns. If you’re trying to be the earliest investor in the next Facebook because the earliest investors made a handsome return, but you’re not taking the same risks as the earliest investors of Facebook, will you have the same returns (Do you deserve the same returns)?

Don’t believe me?

Like meteorologists, the natural inclination of investors is to add more information to the decision making process.This makes the decisions more likely to be accurate and is exactly what we’re seeing unfold in the startup investment space. Jason Calcanis talks about the changing definition of a seed round. Reading this post really pulled it all together for me, it simplified all the other posts that have been circling the internet about the changing nature of who is investing in which rounds and what information they need to make an investment decision at that round.

Jason is talking about the fact that seed round investments are rapidly taking on a new shape, investors are asking for entrepreneurs to reduce more risk before taking an investment. They are asking for more information that indicates the business will be a success and they are asking for it at an earlier stage than they used to in the past.

Pair that nugget of insight with the insights offered by Fred Wilson and USV’s increase in seed stage investments. CB Insights talks about this in a little more depth and illustrates the shift in capital going to micro-VCs who are all talking about their focus on the seed stage. CB Insights offers that there are 138 active seed stage venture investors which is a 105 firm increase from 2010. Many of these are established firms like USV, yet some are smaller or younger firms. This increase in the number of firms and independent angel investors trying to invest at the seed stage doesn’t necessarily mean that more deals are getting done. Mattermark offers that the number of seed deals actually declined a bit in Q4 of 2014.

How are these things related?

I’ll offer an explanation that accounts for all three of these, change in requirements for a seed stage deal, increase in number of investors wanting to do seed stage deals, and the high variability or decline in seed stage deals.

If you think carefully about the people behind the investments… no not the partners at the venture firms. Think about the analysts and limited partners. They’re contributing a lot to the puzzle and understanding their perspective is an important part of understanding the whole picture. The limited partner is allocating a small percentage of their portfolio to investing in startups and they want astronomical returns for taking such high risks. The media is covering those astronomical returns, nearly everyday in the media there is another story about unicorns (today’s is about Groupon and is brought to you by Dan Primack). As these LPs push for returns, investment teams start to plan how they can get into deals earlier and have a seat at the table for the next unicorn. Jason does some napkin math and estimates any investor has a .04% chance of investing in a unicorn so you can see why VCs are so interested in getting in the game earlier.

That explains why there is more investors interested in seed stage investments, why the capital is increasing at that level. Why the change in requirements? It is simply a factor of who is investing. As larger firms attempt to invest in the earliest of stages, good analysts at all those firms attempt to fit the seed investments into their fund models and they need more information. They aren’t confident in their guesses with the imperfect information usually offered at the seed stage and are asking entrepreneurs to take some of the risk off the table… while asking for returns that five years ago would only be possible if the risk was still on the table. The seed investors in businesses like WhatsApp, Facebook, and Uber all took more risk for their potential return than the seed stage investors of today are willing to accept. The economics of the firms and the fiduciary responsibility to limited partners is driving a change in behavior by these funds.Semil Shah talks about some of the other challenges facing MicroVCs that are forcing this behavior.

This is all fine and good so long as the entrepreneurs aren’t offering the same returns for less risk. We see that many entrepreneurs are taking some of those returns off the table by the increase in pre-money valuations and the increase in valuation caps. These increases (if everything goes well for the company) are shifting some of the returns back to the entrepreneurs. If things don’t go as planned (do they ever in a startup?), those higher valuations can hurt entrepreneurs though so they are in a way taking some risk back from investors in exchange for offering investors a slightly lower return.

For those companies unable or unwilling to take some of that risk off the table, they are stuck searching for one of those old school investors who is still willing to take on the risks that investors ten years ago thought was the norm. This behavior accounts for the new variability in the number of deals occurring.