The Seed Investing Framework | The Acquirer's Multiple®

During his recent interview with Tobias, Alex Rubalcava, Co-Founder And Managing Partner at Stage Venture Partners, discussed the seed investing framework. Here’s an excerpt from the interview:

Tobias Carlisle:
So given that you have this long right tale of returns, how then do you go about constructing a portfolio?

Alex Rubalcava:
So you construct a portfolio from a few different ways. Number one, you have to think about what’s your valuation when you’re getting in? What percentage ownership of a company you’re buying, number two. Number three, you have to be thinking about how much money do you put in up front and how much do you reserve for follow on and then where and how do you deploy your follow on reserves? Everyone wants to use their follow ons for Perrata when you have a company that you did the seed round in and then the Series A is led by Kleiner Perkins or Sequoia and you have all of the social validation that comes with that. But that will happen some of the time. Some of the time, you’ll also need to deploy your reserves to help a company where it took a little bit longer to get to product market fit than you had hoped and you need to give them another six months of runway in order to get there.

Alex Rubalcava:
Sometimes you need to use your reserves to bridge a company through a downturn. Downturns do come from time to time. It’s been a while, but we will have those. Sometimes you need to think about using your reserves another way, and so portfolio management for venture is largely a question of reserve management and it’s very different from public market investing, where you get to visit and revisit that decision every single day, where you have a high degree of reversibility, and you have the liquidity that’s available in anything other than the most liquid microcaps to make high resolution decisions. Decisions in venture are largely irreversible. They are very low resolution, in the sense that you only get a few chances to do it, and often the decisions are binary and have a social pressure that come along with them. They’re infrequent and unpredictable.

Tobias Carlisle:
Let’s just back up a little bit and talk about what are reserves and what do you mean by follow on? Let me just ask a little bit more detail.

Alex Rubalcava:
Sure.

Tobias Carlisle:
When you’re making your initial investment, you’re assuming that there will be some follow on or some reserve investment, and so what portion of your anticipated total investment are you making at that first stage?

Alex Rubalcava:
So at the first stage, I’m probably putting somewhere between 35% and 50% of the total amount of money that I expect to invest into that company to work. I am holding back the rest of it to invest in the company at some later time. You do that for a few reasons. You do that because you want to maintain your ownership when a company raises future capital and you can use your right to invest in that round. That’s called your pro rata rights.

Alex Rubalcava:
You also use it because you get more information as you go farther along in time. When I’m investing in a company that is … the youngest company I have ever invested in, I met when they were three weeks post-incorporation, and that was a team of four people. They had a logo and a deck and some early customers that they were talking to, but there was very little information there. When I’m looking at a company like that, a year or a year and a half or two years from now when the next round comes up, I’m going to know a lot more about how well they went about the big things that a startup has to do. How well did they hire? How well did they ship product and how quickly and efficiently did they ship product? Did pricing come in on the software anywhere near what we expected it to? What did customer acquisition look like? All of these questions, I’m going to have far more answers to and far more information about in the next round. So usually that means I am probably paying a higher price per share for the shares, but the upside is still so large that it’s a good decision to hold back some amount. How much you hold back is one of these questions that there’s endless debate about in venture and theses go back and forth, on blog posts and on Twitter, debating this kind of stuff endlessly.

Tobias Carlisle:
What’s your ideal target look like?

Alex Rubalcava:
In terms of what? In terms of characteristics of the company or return characteristics or?

Tobias Carlisle:
Yeah, in terms of the characteristics of the company. What are you looking for when you’re first making these investments? What stage should they be at? What should they have done?

Alex Rubalcava:
So some of the companies I invest in are pre-revenue and pre-product. When I invest in a company that has not yet shipped a product and generated revenue, I am typically looking for a team that has substantial domain experience. I’m looking for customers who have said in writing that as soon as this product is ready, we’re going to use it and we’re going to spend money on it, within a reasonable bound that is up for negotiation, that are willing to get on the phone and talk with me to verify that. I’m looking for some sense that the market is big enough to support the return expectations that I have for my fund.

Alex Rubalcava:
When a company is in revenue and has some early customers, I want to be able to talk to those customers, understand why they’re using it. I want to look at how those customers were acquired and whether that says anything about how we will be able to acquire customers going forward. You know, a lot of startups acquire the first customers from their relationships and that’s fine, but if your first customer is your father-in-law’s company, I need to know how you’re going to get beyond your father-in-law’s company. Getting corporate cookie delivery is a great way to retain and make new customers.

Tobias Carlisle: Do you have any preference for very big ticket items and fewer of them, or lots of smaller investments? Is there any guideline for which of those is a better investment opportunity?

Alex Rubalcava:
In terms of the price of the software that we’re talking about or the size of the investments I make?

Tobias Carlisle:
I’m asking you if 100 duck sized horses will defeat one horse sized duck.

Alex Rubalcava:
I tend to be moderately concentrated in terms of investments, so per fund, I’m going to make 20 to 25 investments. In my Fund Two, which I fully deployed into 20 companies, and my current Fund Three, I’m planning on about 25. when it comes the question of who these folks are selling to, my portfolio companies are tending to sell software that is pretty expensive that solves very critical business needs and as a result, is not software that’s selling for $9.95 per month. It’s often software that is $10 to $50 thousand for point software then for systems of record or systems of engagement. It’s software at $100 thousand plus, per year.

You can find out more about Tobias’ podcast here – The Acquirers Podcast. You can also listen to the podcast on your favorite podcast platforms here:

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