Is signaling risk dead?
As the venture market has become more competitive the most common tactic taken is to invest earlier. This can be quite a challenge for early stage funds that don’t have the capital to out-pay later stage counterparts. One defensive argument that early stage investors will use is “signaling risk”. For the unfamiliar, this is the idea that if a founder takes capital from a later stage fund and said fund does not invest in the subsequent round, it will effectively kill that CEO’s fundraising ability because any new investor would just assume that the company is shit. “Why would they forgo an investment, with all of their insider knowledge, unless they’re just not performing well? They know something that I don’t.“ I’ve seen this argument effectively used by many early stage funds in competitive rounds, I’ve even used it myself.
But with (stage) lines becoming blurred and many funds experimenting with their models (scout programs, discovery checks, etc.) , signaling risk isn’t what it used to be. There are a few reasons for this:
Conflict of Interest
Many funds won’t lead a the subsequent round because they don’t want to price it. This can be a bit wonky for non-investors but the basic idea is that you shouldn’t grade your own homework. All funds report their performance to their LPs based on the holding value of their portfolio vs. the entry price they’ve paid. Let’s say I invest $1 million at the seed round. 12 months later I lead that companies A round and my existing holding (note, not new invested cash) is worth $5 million. Do I really have a 5x markup or is this just very unsophisticated financial engineering? This can create a financial conflict of interest that some funds choose to avoid as a policy.
Out of Cash
With prices increasing as they have, many funds have had to invest more up front to secure the ownership they need. At a fund level this leaves less cash for reserves so it’s possible that a fund might want to lead a subsequent round but don’t have the capital to do so.
Ample Supply
There are more funds than ever before led by hungry new managers that want to make a name for themselves. This creates a more robust ecosystem with a range of investment strategies and risk appetites. I might pass on a seed deal because another fund invested before me, but there are a dozen other shops that will gladly step in. Venture used to be very cottage and zero sum but I see it increasingly mirroring public market dynamics - at least with respect to price discovery.
As Partner of a €53M fund, this isn’t great news. But willful ignorance isn’t going to help anyone and clinging on to outdate market frameworks is a quick path to mediocrity. My personal strategy for 2022 is to let go of this heuristic and judge every opportunity on it’s own. The question of “why isn’t Fund X leading this?” still needs to be asked, but ignoring this deal type completely, in my opinion, is a mistake.
For founders, this is a broadly good thing but while signaling risk may be diluted, the risk of an unsupportive lead is very much alive. Finding product market fit (PMF) is an art and requires a certain expertise. Investors that typically invest post PMF can be unhelpful if not value-destructive at the earliest stages - scaling too fast, pushing revenue too early, etc. I know dozens of founders who are less than pleased with their lead who promised a big game and didn’t deliver; even at top tier firms. If you’re looking for big brands and little engagement now is a great time to be raising. But if you’re looking for a true sparring partner at the earliest stages I highly, highly encourage you to reference your potential investor(s).
Thumbnail photo by Brian Wangenheim on Unsplash