Coming Storms: Three Reasons That VC Firms May Start Overlooking “We’re Conflicted” and Make Competing Investments
There was a time when far less written about — or by — venture capitalists. But I seem to recall “we won’t invest in two competing companies” was an oft-stated principle even in these more opaque days. To me, it seemed sensible, even from just a strategic framework, let alone ethical. Part of being an insider meant you needed to be trusted by entrepreneurs with early looks at their businesses. And if your reputation’s present value was the sum total of all future startups brought to you, well, putting that dealflow at risk was an expensive proposition.
While these “sorry, we’re conflicted out” decisions often didn’t get headlines — who writes about the deals they didn’t do? — there was a great 2012 blog post by a16z’s Ben Horowitz providing inside baseball on why they didn’t double down on Instagram after making an early investment in the now hugely successful app. At its root was they didn’t want to violate a commitment they’d made to another CEO in the portfolio. I didn’t know Ben at the time — and we’ve really only met casually a few times since — but it was one of those moments of operational clarity that gave him evergreen cred in my mind. Maybe for some VCs the “competitive conflict” issue was more about virtue signaling than actual virtue, but I knew if I ever went into the profession, I wanted to honor my founder relationships the same way.
And seven years into Homebrew I believe we have. We invest at the seed stage so companies are still very embryonic. Especially over their first 12–24 months prior to a Series A, Satya and I will often opt-out of investing even in adjacencies, because we want to give Homebrew-backed founders a wide berth to find themselves. There’s definitely been some short-term pain associated with these decisions — I can think of at least two times that we explicitly passed on companies related to current investments (despite there not necessarily being objections from the CEOs) and in both cases, the startup we passed on has outperformed the portfolio company!
But this post isn’t about us, it’s about anticipating that we’re at the start of a pretty significant change and challenge to these assumptions — that is, MORE venture firms are going to be investing in competing companies, sometimes to the dismay of the initial portfolio CEO. For three structural reasons:
- The “But It’s In a Different Fund” Explanation: The majority of venture firms traditionally had a single fund they would invest out of. Now almost every one also has a “growth/opportunity” fund and some others are separating their seed investments into still another. I’m hearing — but haven’t directly observed — that for purposes of competitive conflict, many firms believe that there can be a “firewall” between these funds, even if they’re all under the same firm umbrella and overlap in deployment timeframes. Funds have also gotten larger in general which mean you need more ownership and more outsized winners.
- Downstream Impact of Firms Investing Earlier: For a variety of reasons, the billion dollar venture firms are increasingly making their initial investments seed and A rounds, vs traditionally waiting for the A or B. One downside to this strategy is they are committing to a company before its reached breakout velocity -and- at the same time, giving it enough capital to operate for several years. I’m very interested to see what happens 12–36 months down the road when firms realize that one of their GPs has essentially blocked them out of a category with a seed bet. Can they afford to miss out on the winners in a vertical just because they made a smaller, earlier investment in a related company? The pressure for the earlier founders to sell, or wind down their company, or not make a stink about the firm investing in one of their competitors will be real.
- Companies Staying Private Longer: It’s just math — more companies in the portfolio for longer periods of time results in more potential for conflicts (although to be fair, at some point CEOs need to be comfortable with a firm making investments in the next generation of innovation).
Now it’s not just about VCs. Founders don’t get to speculate about products their startup *might* build 10 years down the road and block their current investors from entering those areas. Founders also should understand that if they choose to pivot into ideas totally different than the path they were going down when the investment was made, they might not automatically get “exclusive” ownership of that industry within a backer’s portfolio. But I do strongly believe startups CEOs deserve clarity on what principles and practices a VC firm employs when it comes to evaluating potentially conflicting investments. While their answer might be frustratingly subjective (if you’re a prized portfolio company you will always have more influence than if your startup is struggling) it’s one of things you might want to ask when evaluating competing term sheets.
Originally published at http://hunterwalk.com on October 13, 2019.