PS#070: Why does stage matter?
Last week, we kicked off our series on how to choose a VC firm.
Today, we are going to dive into the first aspect of this decision – investment stage.
This is actually a big component of the decision and one that I’ve noticed most aspiring investors don’t fully understand. The stage where you invest will dictate a lot of the skills you learn and your overall development as an investor.
With that being said, it’s an important one to get right.
Let’s get started.
The different stages of venture capital investing.
There are generally four main investment stages for VC investors…
Pre-seed/seed
Early stage (Series A or B)
Growth stage (Series B and beyond)
Late stage (preparing for exit)
We’re going to focus on the first three stages. The last one blurs with both growth stage and private equity, so we’ll cover the key components there.
Each of these stages requires a different set of skills, frameworks, and routines as an investor. They are looking for different types of companies, underwriting completely different levels of risk, and expecting totally different types of return profiles, despite them all falling into the broad bucket of venture capital.
We’re going to take today’s issue and…
Define each stage
Identify the skills & learnings for each
Highlight some of the drawbacks of this stage vs. others
Note: When it comes to the skills, take a look at my 3-Step Guide to VC Interviews, where I discuss the skill sets for aspiring investors.
Alright, let’s get started.
1. Pre-seed / seed stage.
Definition
Pre-seed or seed stage investors provide funding to startups at the earliest stages of their development.
These investors are taking on the most risk in the VC ecosystem, because companies at this stage have the highest likelihood of failure. In most cases, investors are investing in a strong founder (or set of founders) that are tackling a big idea. There’s often little to no evidence that this idea has or will work, so the investors are banking on the founder(s) to make it happen.
Of course, alongside this risk, they also have the potential for high returns. Because they are investing at such an early stage (before much of the business has been proven out), these investors can invest at much lower valuations.
Skills & Learnings
Working at the pre-seed or seed stage will require and (develop) two things…
Sourcing
Evaluating
For the first component, a lot of your job as an investor will be similar to business development. You’ll be spending most of your time networking, reaching out to companies, building brand recognition, and meeting lots and lots of potential founders. The entire foundation of this model rests on being able to invest in the best and brightest founders for your firm’s investment mandate before they’ve proven that the business will work.
On the second point, you’ll learn a lot about evaluating the very early components of a business and what it takes to get it off the ground. That’s often the main focus for this stage of capital and where most venture-backed businesses fail. With that in mind, you’ll learn a lot about what it takes to get the many different functions of a business started (e.g., initial hiring, building MVPs, launching pilots, finding initial users, etc.).
Drawbacks
However, your day-to-day work will not be focused (as much) on the financial components of venture capital or businesses.
This is mainly a business development role. Your job is to find great founders tackling big problems. For the most part, these companies are so early that there is just a limitation of what you can learn and develop through the normal course of investing. When your diligence is focused on a founder and an idea, the skills developed are simply different.
2. Early stage (Series A or B)
Definition
Early stage investors are looking to find companies that have established product-market fit and are looking to scale their operations.
This is my favorite place to invest. You’ll often have a good amount of data that helps indicate product-market fit (i.e., users, customers, revenue, etc.) and a clearer plan for turning this into a big company. Investors at this stage are still underwriting a lot or risk and will often take a larger piece of the company (i.e., +/- 20%).
Similarly, early stage investors are still expecting high return profiles. While it may not be the same as pre-seed or seed stage potential return profiles, the company is often still early enough to drive large returns for the fund (especially when combined with higher ownership stakes).
Skills & Learnings
The early stage investor combines a lot of the skills of both pre-seed/seed and growth stage investors, including…
Sourcing
Evaluation
Diligencing
Investing
Personally, I think this is the best stage to learn venture capital. You’ll need to drive high sourcing volumes, build relationships with founders through the seed stage, be prepared to dig in on diligence, negotiate and structure investments, etc.. Further, this is where the financial engineering components of venture capital really start to come into play (i.e., structuring, cap tables, scenario planning, portfolio construction, etc.). Overall, it's a great place to start your career and build a well-rounded skill set.
Drawbacks
While I think highly of this stage, there are still drawbacks. The biggest drawback being the distortion of valuations and the large amount of capital currently being invested.
The current era of venture capital (with the high amounts of dry powder) has made this a tricky place to invest. Larger funds are coming down stream and putting significant amounts of capital into companies much earlier than historically. They are often combining the investments of early stage and growth stage into one financing round, making it hard for pure-play early-stage investors to find the right opportunities at the right price (to meet their return thresholds).
3. Growth stage (Series B & Beyond).
Definition
At this stage, investors are looking for companies that have significant traction in the market and are looking to accelerate their growth.
These investors are taking a lower risk profile (compared with the previous two stages). The capital provided is used to expand into new markets, further grow sales and marketing, build out additional products, and scale the operations to support an even bigger business. They are often putting in significant amounts of capital to help the company rapidly scale across these different aspects.
With that lower risk profile, they are also expecting a lower return profile. Ideally, these investors should benefit from participating in the later stage of the company's growth cycle, where there is less uncertainty. The lower uncertainty leads to higher valuations, reducing the potential for higher returns. Of course, when they hit on a category-defining company, they can still reach those high return profiles.
Skills & Learnings
At this stage, the skill set looks a bit different. You’ll be much more focused on thorough diligence vs. high volume sourcing. Some firms may not even have you working on any sort of sourcing, leaving that to the more senior investors. The skills developed include…
Evaluation
Diligencing
Investing
This stage is all about picking the right company. There are a lot less companies that make it to this stage, so there’s a lot less “volume” sourcing involved. Most of your time will be spent learning about the different components of diligence and developing a strong financial skill set for the venture industry. However, if you are involved in sourcing, it will be much more about building relationships with the smaller pool of companies to create a potential opportunity.
Finally, structuring the deal will be really important. Due to the higher valuations, you’ve got a lot less buffer for valuation or structured-based mistakes. This will be a critical component of making an investment at this stage and will teach you a lot about the deal-making process of venture capital.
Drawbacks
In an era where there is a lot of available capital, this space is highly competitive. Finding the right companies is step one, but step two (and the harder step) is earning the right to invest. Beyond the name-brand firms, it can be hard to demonstrate why your firm should earn this right. It’s a competitive space for the firms and investors competing at this level.
It also gives less insight into the early stages of company development. Since these companies tend to be at significant traction levels by this point, you won’t have as much exposure to the early days of building a company.
A few thoughts.
As I mentioned in the beginning, I think a lot of aspiring investors miss the point on this aspect when evaluating a VC firm or role.
In my opinion, most individuals seem to think you’ll learn it all wherever you go. While I admire that spirit, the work for each stage is quite different. You’ll learn different skills and be exposed to different aspects of this industry.
Depending on what you’re looking to do, I really encourage you to think through what stage is right for you. Even further, it may dictate what type of skills you’ll need before entering the space. For example, it’s hard to make a case for being a growth stage investor when you have little to no financial skill set.
Alongside stage, your role at a firm plays a big part in determining your experience in venture capital. In the next issue, we’ll discuss the main roles for aspiring investors.
