In my role as a marketing strategist for Decile Group, I do a lot of case studies on emerging managers and LPs.
A lot of emerging managers talk about their abilities to squeeze into hot deals, because of their non-threatening check sizes, or the importance of getting into deals that are about to get a big mark-up, so that they can post a quick win.
You can see their logic. Emerging managers have a tight window to build a track record before they raise their next fund, and there are only so many variables you can control in the startup game. Stacking the deck with some near wins is understandable. And no one ever faulted anyone for investing alongside a Sequoia, a Benchmark, an Andreessen Horowitz.
However, argues Martin Tobias, that is not what your LP wants from you.
Martin has his own fund, and is an LP in 17 other funds. He was our guest for a recent virtual event and he sounded off about LPs who deviate from their thesis to invest like mega-funds.
$10 million funds cannot play the “YOLO game,” he argued.
“Your fund size is your strategy,” he said when I asked him about how to invest in markets with sky-high valuations like we’re seeing in AI right now. “As a $10 million fund, my check size isn’t big enough to own a company with a $30 million valuation at pre-seed. The people who can do those rounds are big funds. If you have a billion-dollar fund, you can write a $5 million check for an incredibly speculative deal because that’s a tiny single-digit percentage of your fund.”
There is no such thing as trying to buy your way into a “sure thing” in the venture space, he argued. Every single check needs to be aimed at finding an outlier who can return the fund; otherwise, you’ve wasted it.
“I have one investment that has a $2 million fund, and the first check he wrote was a Series B at a $125 million valuation. He put a $25,000 check in,” he said. “I said, ‘What the f— are you doing?’ He goes, ‘Well, I think it’s gonna go up 10x.’ But even if it goes up 10x, it doesn’t even return 10% of your fund. I told him, ‘You just wasted that check. I would rather you take ten of those $25,000 checks and give them to much earlier companies at a $5 million or $10 million valuation because those companies have a chance. Even if you are wrong.’”
Small funds, he argued, have to take more risk. He quoted Roeloff Botha of Sequoia saying that if you don’t have a 40% write-off rate as a small fund, you are not taking enough risk.
“A lot of first-time managers make the mistake of doing what they consider ‘lower-risk deals’ like investing next to Andreessen Horowitz or Index or one of the big funds,” he continued. “But as a small fund, they’re playing a completely different game. Don’t get caught in that.”
Instead, $10 million funds should focus on being the feeders to these funds. Tobias cited a company that he invested in when it was just two PhDs out of Berkeley, and it had a $6 million valuation. After he invested, they got into YC, and now they are raising money from the big funds with YOLO prices.
“Are they going to be successful?” he says. “I don’t know, but I’m happy being an investor at $6 million and allowing them to get the markup to $30 million, rather than me coming in at $30 million.”