Why do VCs hunt in packs?

Lots has been written about WhatsApp’s sale to Facebook back in February this year. Plenty has also been written about how this is perhaps one of the best returning investments ever made by a venture capital investor. After all, WhatsApp’s backers Sequoia Capital are estimated to have received proceeds of about $3.4 billion for an investment of about $60 million.

One point that has been remarked upon in a bit less detail is the fact that Sequoia was the sole VC to invest in WhatsApp. Rob Go of NextView Ventures seems to have been the first to talk about this at any great length. He wrote:

I can almost guarantee that if any other fund was an investor in this company, the cap table would look very different by the time they exited. Well done.

Very true. Well done indeed. (Not that Sequoia is waiting for the rest of the industry to pat them on the back.)

Photo by Beau Considine

Rob explains why this sort of situation is very rare. In summary: it takes guts.

It also requires having a lot of dry powder, a VC partner who is willing to stick their head out without social proof, and the ability to convince a genuinely successful entrepreneur that they don’t need a different investor at the table in their next round of financing.

Dan Primack of Fortune asked whether Sequoia’s phenomenal success as the lone WhatsApp investor meant the death of social proof. Dan feels that social proof “deserves to be on the run” but also hints that it is unlikely to go away. Why? Because being the sole investor requires conviction.

CB Insights dug into their database to see how many other large VC-backed tech exits in the US had just one institutional investor and found that just 7 out of the 100 largest exits fell into this category. (I unfortunately don’t know which companies these 7 are.) Their conclusion? Leaning in requires conviction.

Conviction. Guts. Is that the #1 factor?

In the US, yes.

That’s probably because the US financial markets are the deepest and most sophisticated in the world. Not only do start-ups have access to the world’s largest and oldest venture capital industry, they also have access to other forms of financing, such as from wealthy individuals, the government, venture debt providers, banks, hedge funds and several other financial entities. All this makes the market incredibly competitive. A consequence of this is that consistently generating outsized returns is very hard. This implies that if a fund does have access to a high-return investment opportunity and they have strong conviction about it, they quite rationally should take a shot at being the sole investor. If they don’t, someone else in their highly competitive marketplace will happily jump in.

How does this play out in India and South-East Asia? Quite differently.

For purposes of this post, I will focus mainly on India because, although South-East Asia has seen a lot of early-stage venture capital activity in the recent three or four years, there still isn’t a large enough sample size and sufficient public data about large exits to be able to draw any broader conclusions. See the end of this post for a quick aside on SE Asia.

Between the years 2007 and 2012, there were 810 venture capital investments in India. I looked for companies for which large outcomes have been realised or at least rumoured, where I defined “large outcome” as exits or up-rounds at valuations at or above $100 million. That is a somewhat arbitrary number which I chose because it is a meaningfully large number in the Indian context.

To the best of my knowledge, of all these investments, not one had a sole investor at the time of exit. When I extended the time period further back a few years, I came across just one company that had a sole investor at the time of exit, which is the relatively unknown building technologies company iMetrex. iMetrex was founded in 1992 and bought in 2007 by Siemens for a rumoured $100 million. Its sole investor was IL&FS Investment Managers (IIML), which owned a 21% stake for an investment of Rupees 18 crore made, I estimate, around 2005 or so.

I should note that I don’t have data on all VC investments made prior to 2007 so my analysis is incomplete. That being said, the trend seems clear: solo investor-backed companies that achieve large outcomes are exceedingly rare, even more so than in the US.

There are several quite rational reasons for this.

Under-penetrated market for start-up financing

The Indian venture capital market is still underserved compared to its long-term potential. In the high-risk field of start-up investing, given the choice to keep doubling down on an investment from a very early stage all the way through to a large exit versus investing in several companies at once without facing the hyper-competition of the US, it makes sense to spread one’s bets and increase one’s expected (i.e., risk-adjusted) returns.

Sharing returns in return for sharing risk

Also related to risk, it makes a lot of sense to let another investor participate alongside oneself in the potential up-side of a given company in return for shouldering the burden of risk. This is also true of US VCs, as Rob Go pointed out in his piece, and I would argue an even more important point in an immature market where it is very hard to price risk.

Investor aptitude

Every investor would admit that it takes a particular set of skills, VC team profile, and fund size/structure to identify and back good seed-stage companies, and quite a different set of abilities to back late-stage opportunities. They’re just very different games. Witness how even our sole example IIML/iMetrex was of a late-stage investor investing in an established, cashflow-generating company, not one where an investor backed an early-stage start-up and then kept investing in subsequent expansion rounds nurturing it all the way to exit.

A few of our peers (e.g., Sequoia Capital India, SAIF Capital, Nexus Venture Partners and Accel India) do have the ability and inclination to write cheques all the way from seed stage through to the last pre-exit round. However, even these investors naturally prefer to focus on their specific areas of strength and have never been the sole investor in a company that has achieved a large exit.

Stick to your knitting please

Most venture capital funds operating in India have yet to go through a full ten-year cycle. Many first-time funds have yet to even complete their investment periods. This means that there is little scope for experimentation beyond the fund’s original mandate, whether that is early-stage, growth or late-stage investing.

Fund sizes

Back to Rob again, he estimates that Sequoia’s WhatsApp investment saw roughly 5% of their fund being invested in this one company, which he further extrapolated to point out that for a typical $300 million fund, this would translate to $15 million into a single company with no other co-investors.

In India, venture fund sizes range from as small as $10 million to several hundred million, with the average fund probably in the high tens of millions range.

If we were to apply the same 5% metric to India, that would mean at most $10 million or thereabouts coming from a sole investor. Could a company raising such a small amount in total funding achieve a $100 million exit? In theory, if all the stars aligned…

Implications for entrepreneurs?

Clearly, the biggest conclusion that an entrepreneur should draw is that it is very unlikely, no matter how large your first investor, that they will be able to back you single-handedly through to a large exit. I think this is obvious enough to all entrepreneurs.

This then implies that, if your company is growing quickly, you may find that fund-raising isn’t something that you can do once (or once in a while) and forget about it thereafter. The best start-up CEOs treat fund-raising as a fundamental part of their jobs and keep potential future investors regularly updated about their progress, making it easier for them to gather investors in subsequent fund-raising rounds and continue growing their companies.

For those of you who are curious about South-East Asia, notwithstanding the small sample size and inability to draw ironclad conclusions, the pattern is similar: there are less than 20 technology companies in South-East Asia valued at over $100 million today, of which 4 have achieved exits (although we see a robust pipeline of several more coming through in the next few years). Of all these companies worth over $100 million, not one has a sole institutional investor on its cap table.

This post first appeared on Ask(your)VC.