Investing in Idea and Growth Stage Startups, But Not Seed and Early

Yesterday an investor asked why I rarely participate pro rata in subsequent rounds of financing. On a basic level, my strategy is to either invest in opportunities that have a high risk/reward equation, defined as the ability to make a 15x return, or a “safe” investment where the startup is in the growth stage and there’s a clear path to make 3x (with a goal of 5x).

Now, less than 2% of venture-backed startups sell for $100 million or more, so if the startup is pre product/market fit, to make 15x, knowing that the chance of a $100+ million exit is nearly non-existent, the post-money valuation needs to be well under $4 million when accounting for future dilution. By the time the full seed round comes together, and hence the startup is past the idea stage, the valuation has often gotten too high such that I don’t invest or participate pro rata.

The second investment strategy is to participate once the startup is in the growth stage and has north of $3 million in annual recurring revenue (ARR). At this point, the startup has product/market fit, a repeatable customer acquisition model, and is working on scaling all aspects of the business. While it isn’t a “sure thing”, assuming there’s a great team, market, and unit economics, the chance of the business reaching a material size (e.g. $20 million in ARR) is high and an exit at a substantial valuation well above $100 million becomes much more achievable.

So, this approach skips seed stage and early stage investments since they don’t meet the risk/reward profiles. This approach also skips participating pro rata in the seed stage and early stage as the pro rata participation is the same class of money with the same goals. While this is a strange approach for many angel investors, it’s worked well for me.

What else? What are some more thoughts on this investment strategy focused on idea stage and growth stage startups?

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