Masterclass The Art of Evaluating a Deal — Part 2

Lead Investor, Part 2

Written by

Mark D. Edwards

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3 min

In the second part of our Masterclass on The Art of Evaluating a Deal, we evaluate the lead investor in a venture round. In VC, a select group of firms consistently outperforms market indices — so as a value-add co-investor, we’re looking to invest alongside those leaders. Our checklist includes the firm’s quality, the lead partner’s sector, stage experience, and their conviction. We use a case study to bring the example to life and discuss the challenges in separating a firm’s performance from a lead partner’s.

In this series, we’re exploring the factors that impact our decision about if and how much to invest in a deal. As part of our Masterclass series, this addresses some of the basic questions our investors have about venture capital.

Last blog, we covered Deal Dynamics; you can find that exploration here. This time, we’re focusing on the lead investor. This is always a key consideration for a VC, but it’s especially important for AV. Due to the investing volumes involved in creating the diversification of most of our portfolios, we don’t lead deals. Instead, we co-invest alongside other well-known VCs who have expertise in the sector and / or stage.

Part 2: Lead Investor

It’s tough for portfolios of public equities to consistently outperform market indices. According to Business Insider, nearly 90% of actively managed investment funds fail to beat benchmarks like the S&P 500 over a 15-year period. The gravitational pull of the “market” is simply too strong for the overwhelming majority of public stockpickers to create separation between their fund and the overall market.

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    Firm Quality / Brand

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    Partner's Experience

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    Conviction

The same is NOT true of venture capital. There, a select group of firms do outperform. More importantly, the firms that outperform tend to do so consistently from year to year and over a lengthy period of time. And often the magnitude of outperformance can represent several hundred basis points of annual return — so the separation is significant.

We attribute this to the “Matthew effect” of accumulated advantage — which is essentially “the rich get richer, and the poor get poorer.” In short, top entrepreneurs tend to find their way to the most storied firms, like top international soccer players finding their way to Manchester City or Barcelona. At Alumni Ventures, we’re not trying to disrupt this market dynamic or even compete against it. Rather, we aim to embrace it as a value-added co-investor that chooses our partners deliberately.

Lead Investor Firm Quality / Brand

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    Investment Team's Score

    [X] out of 14

✔ 12-14: Exceptional; AV Target VC or top specialist VC for the company’s stage & sector

✔ 9-11: Good; well-established VC with a strong track record or highly relevant lead for the company

✔ 4-8: OK; well-capitalized VC (>$100M AUM) or well-regarded strategic investor

✔ 0-3: Weak; family office, regional, VC, or angle group

Our deal evaluation related to lead investors first prioritizes match points between the VC and the company. What are the target company’s industry focus, stage of development, and longer-term capital strategy? Are the VC’s track record and domain expertise a good match? What financial, strategic, and networking resources does the VC bring that will help the company grow?

To learn more, view our latest webinar:  Masterclass Live!  The Art of Evaluating a Venture Deal

See video policy below.

Lead Partner’s Sector/Stage Experience

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    Investment Team's Score

    [X] out of 8

✔ 6-8: Lead partner has made many investments in this stage or sector

✔ 3-5: Lead partner has made few investments in this stage or sector

✔ 1-2: Lead partner has no investing experience but has relevant operating experience in this stage or sector

✔ 0: Lead partner is making his/her first investment in this stage or sector

We then take the analysis one level deeper, evaluating the lead partner who is sponsoring the investment. What is their investing and potentially operating experience or specialty knowledge? How long has the partner been at the firm? What deals did they lead, what were the outcomes, and how comparable are these investments to the company in question?

Conviction of Lead Investor

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    Investment Team's Score

    [X] out of 8

✔ 6-8: High; check size indicates strong conviction from the lead

✔ 3-5: Medium; check size indicates moderate conviction from the lead

✔ 0-2: Low; check size suggests a “throw-away” check from the lead

Finally, we review the size of the lead investor’s capital commitment relative to their portfolio average to gauge the level of conviction being shown to a specific opportunity. If they previously backed the company, how does this investment compare to the previous and that of other investors in the round?

As a result of these steps in our deal underwriting, our portfolios are intentionally curated around investments where we believe we are aligned with the industry’s top performers.

Case Study

So how do these factors play out in a real deal? This example illustrates how the lead investor figured heavily into our investing decision.

One of many investment areas where AV is and will continue to be active is “vertical market software.”  We believe that many purpose-built solutions can effectively compete against general enterprise players to build valuable and lasting businesses with attractive recurring revenue, deeply embedded workflows, and powerful network effects. Think of Toast in restaurants or Zenoti in beauty salons.

We recently invested alongside a leading VC in an early-stage company following a similar playbook to these market leaders. The specific partner leading the round has an impressive record of relevant historical successes. But what made the opportunity so compelling was that several senior executives from previous portfolio companies were also making significant personal investments. We were excited to be among such a strong collection of investing and operating talent in this transaction.

Challenges

Distilling individual partner performance vs. a firm’s performance. Sometimes an individual is really the one identifying and sourcing the best deals. So, following this individual when they break away to form their own firm makes sense. Other times it’s really the firm that attracts a certain type of founder and / or the firm’s team / process.

If you’re interested in learning more about venture investing, check out the many resources on our website. You can also read our earlier blog in this series, Deal Dynamics, and view our Masterclass webinar here.

Learn More About the Foundation Fund

~20-30 investments diversified by stage, sector, geography, and lead investor. Deployed over 12-18 months.

Max Accredited Investor Limit: 249

This communication is from Alumni Ventures, a for-profit venture capital company that is not affiliated with or endorsed by any school. It is not personalized advice, and AV only provides advice to its client funds. This communication is neither an offer to sell, nor a solicitation of an offer to purchase, any security. Such offers are made only pursuant to the formal offering documents for the fund(s) concerned, and describe significant risks and other material information that should be carefully considered before investing. For additional information, please see here. This communication includes forward-looking statements, generally consisting of any statement pertaining to any issue other than historical fact, including without limitation predictions, financial projections, the anticipated results of the execution of any plan or strategy, the expectation or belief of the speaker, or other events or circumstances to exist in the future. Forward-looking statements are not representations of actual fact, depend on certain assumptions that may not be realized, and are not guaranteed to occur. Any forward-looking statements included in this communication speak only as of the date of the communication. AV and its affiliates disclaim any obligation to update, amend, or alter such forward-looking statements, whether due to subsequent events, new information, or otherwise.

This communication provides some information regarding Alumni Ventures’ investment process, but is not intended to comprehensive and functions as a summary only. This communication is not personalized advice of any nature.