VCs With Multiple Stage-Specific Funds Are Likely To Rewrite The Existing Etiquette. And What This Means For Founders.
Let’s start out by admitting that the question of ‘competitive conflict’ has always been more of a situational dynamic than industry standard. In some ways it’s ALWAYS to an investor’s benefit to suggest a potential new investment wouldn’t be competitive to an existing portfolio company, and it’s ALWAYS to the current portfolio company’s benefit to suggest it might be.
While a norm of ‘we don’t invest in directly competitive companies’ is likely the median response if you asked a bunch of investors, in truth there’s always an asterisk. Sometimes this applies only to lead investors, and if they consider the investment ‘active’ (eg on the board, still doing their pro rata, etc). Or they’ll give a portfolio startup a window of exclusivity of a few years before considering more companies in the vertical. Maybe restrict the conflict to what a company is currently doing now, not what the founder says is on their roadmap five years down the road. And of course there’s the “unless we’re going to make a lot of money [on the conflicting investment]” asterisk. But in the years since we started Homebrew, I’ve observed the breadth of investor positions to be both more fluid and less restrictive than ever, often to the confusion (and annoyance) of founders. A major driver of this has been the growth of venture firms into cross-stage investing using different funds.
Historically most large venture firms were basic single fund operating vehicles — they raised from their LPs every three years or so, and a firm then invested the capital. Then rinse-wash-repeat. You made initial investments out of the next fund, while making pro rata decisions in the previous fund(s), and each fund had a 10–12 year lifecycle. Then some of these firms began raising their own Growth funds, a mix of extending their pro rata into existing portfolio company’s later rounds but also entering into new investments at later stages of their evolution. Almost every major VC now has at least an “early stage” and “growth/opportunity” vehicle. And most recently, several firms have also created separate substantial seed vehicles to lead those rounds.
How does the expansion of firm mandate change incentives for its individual partners? In some firms the partnership spans one or more of these funds (ie GPs float across the seed and early stage vehicles based upon the investment, not their org chart), while in others, a GP is tied to a specific fund. Some firms are equal partnerships in terms of economics but most have carry tied to a combination of seniority, performance of the fund you’re a partner in, and your own investment outcomes. Every firm has their own logic behind its compensation structure and it’s almost always opaque to founders.
Why do I care about how investors at other firms get paid? Well, because I think it has implications for how our industry rethinks what competitive overlap looks like within a portfolio. Specifically, I’ll posit that the ‘new normal’ is going to be “we don’t make competitive investments within a FUND, but we will make competitive investments within a FIRM.”
Simply, a firm with a seed fund, an early stage fund and a growth fund might choose to have broadly competitive companies spread across each of these vehicles and not consider it a conflict. They will make the case (often credibly) that these companies will be indirect, not direct, competitors, and that there will likely be different GPs working on each deal. This approach will allow GPs in different vehicles to not have their performance handicapped by their partnership. Imagine you’re a Growth GP for a multibillion dollar fund and you couldn’t back a bunch of different fintech companies because your Seed GP colleague made a handful of $4m investments in similar companies just getting started. It’s just unsustainable to run a cross-fund competitive conflict policy at scale.
Now, to get back to my opening line of this post, this will *still* be art more than science. Portfolio founders with lots of power can play their hand to “block” new investments by their lead investors they believe could be competitive down the road. And certain GPs will be more, or less, consistent (some might even say ethical), on working with their colleagues and current portfolio to avoid sticky situations.
So what’s a founder to do? Here’s my advice:
Don’t Overthink This Dynamic Early On: If you’re raising a seed or A round and engaging with a multistage investor, it’s fair to ask them about their conflict policies, etc but I wouldn’t disqualify someone just because they *might* make a competitive investment out of a different fund. I’d just bundle this into the general bucket of “do I trust this investor to be a good partner/co-owner of my company” diligence. If for some reason you really don’t like the idea of a conflict arising then restrict your seed fundraise to firms that don’t have multiple vehicles.
Stay Close To Your GP, And Other GPs At The Firm In Your Vertical: In general, continue to pitch/sell/communicate with your investors. If you’ve taken money from a firm with cross-stage funds, I’d spend time with the GPs who might make competitive investments. The more they are convinced that you will be the winning investment in your space, the less likely they are to compete with you. Of course there’s the risk that you are educating them about a vertical that they’ll then go to market on, but play it as you want. Also never underestimate the personal relationship aspect — let them get to know you so they don’t screw you 🙂
Understand When Your Investor’s Pro Rata Shifts From The Fund They Invested In You From To Their Next Stage Fund: This is subtle but I’ve seen it firsthand. A firm might have a strategy to do an initial check (and potentially first pro rata round) out of its stage specific fund (eg a Series A from its Early Stage fund) but then at a certain point the pro rata decision might pass to the next stage fund (eg the company’s Series A and B done from Early Stage fund but the Series C would be the Growth Fund’s decision). If the sequential manager has a conflicting investment they will use that grounds to not do the pro rata, trying to be consistent with the commitments they made to the founder *they* sponsored. The danger to the founder sponsored by the previous fund is to the outside market it can look like their VC is no longer supporting the company, because we all know, dollars are the strongest vote of confidence an investor has. This can be really tricky for everyone to manage. All I can suggest is conversations in advance and to not let one of your existing VCs lead an inside round right if the next round would be decided by a different partner at their firm. Or if it’s a new investor with multiple funds, to ask this question in advance of when does the pro rata changeover happen. Within a fund and within a firm pro rata discussions are always competitive to one another and always about scarcity of follow-on dollars.
If You Have Leverage, Use It: This is a more complicated strategy which can backfire if you overplay your hand but let’s not ignore the option. I have seen termsheets which include pro rata rights so long as a firm doesn’t make a competitive investment, after which case they lose the pro rata. I have seen Board seats contingent upon a firm not making competitive investments. And other agreements to this effect which are handshakes.
What do we do at Homebrew? Our business is a single stage, single fund strategy so it’s pretty easy: when we lead or co-lead a round that founder is our priority and we defer to their definition of competition for at least the first 3–5 years of the company. That feels right for us and the trust we want to build with the teams we back.
As a co-investor, what I really want from a multi-stage venture fund is just consistent and honest communication regarding their competitive practices, even if their firm biases towards more ruthless behavior. And of course the easiest ‘advice’ to a founder is Don’t Worry About Any of This, Just Win And It’ll Solve Itself, but for me at least, understanding the rules of the game mitigate surprises and misunderstandings. Or at least turn them into subtweets instead of lawsuits.