Throttling

One of many reason LPs (rightfully) prefer to invest in new firms with “spinouts” (investors who have already been inside a VC firm) is because there is no Khan Academy online course for Fund Management. I am lucky because I have been at least exposed to how a handful of firms operate, but it still remains an elusive topic. The most recent fund management technique I’ve been learning about and applying to Haystack is “throttling” the flow of capital. We are talking small dollars here, but the mechanics matter — I wanted to look up the definition for myself — a “throttle” is a device which controls the flow of fuel to an engine, and “throttling” is the act of controlling said engine.

One of the most outspoken LPs, Chris Douvos, wrote last year, from the perspective of an LP, about how investing continuously in VC funds without seeing cash distributions affects the overall flow of capital. The logic is straightforward: If LPs don’t at some point get cash back, they may be reluctant to or simply physically unable to keep investing in those VC funds, which then of course could impact current portfolio companies and most certainly would affect the next crop of founders pitching those firms. Douvos writes, “So, entrepreneurs with visions of staying private forever: for the good of the ecosystem, let’s take a laxative and loosen that exit sphincter; let’s put the moolah in da coolah so that it can be recycled back into the startup world. Don’t just do it for us, the LPs, do it for your next company. Your future self is counting on you.”

The same principle may loosely apply to the gap between Seed and Series A that I wrote about a few days ago (see here). Please note this doesn’t necessarily apply across the entire seed stage, as it is very fund-dependent. I can only speak for myself here. When I began investing in 2013, it seemed like after every check I wrote, within 9-18 months, I’d get a phone call which said “Hey, good news! So-and-so VC firm is leading a round in Company X.” As 2016 nears a close, those phone calls are fewer and far in between. Now, that could be because my own selection hasn’t been as precise, or because I invested a smidge too early on the risk curve, or because the cost of capital and/or local inflation impacts how far a local dollar can stretch, or because it will take at least 2-3 years for seeds to mature to be ready for an A (I’m only 16 months into Fund III). We don’t know yet.

As a I result, my instinct has been to throttle a bit. Not a ton, but just a bit. In the same way an LP may be more cautious if the flow of fuel to the engine is interrupted, a seed investor may feel the same if the rate of portfolio companies which graduate to Series A slows down. That means more seed extensions, perhaps, or more explorations for alternative financings (more on this in another post), looking for exits (or something less savory), or just more time to get to the truth. We will see. While I can only speak for myself, I have to imagine other funds which participate in the earliest seed rounds with a higher throughput of investments may feel something similar. If it is a more widespread feeling, that may mean a slowing of the rounds a bit, which is overall a healthy thing.

Haystack is written by Semil Shah, and is published under a Creative Commons BY-NC-SA license. Copyright © 2017 Semil Shah.

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