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📰 Today's topic: Stop obsessing over ownership (it's killing your returns)

Every VC and fund-of-funds talks about needing to buy enough ownership in their portfolio companies.

Almost no one questions why.

Here's a thought experiment: If you invested $5k into Uber's seed round in 2009 and held until the IPO, you would have made $25 million.

That $5k doesn't buy you any ownership worth talking about. So is that a failed investment?

Obviously not.

It's about multiples, not ownership

This successful outcome isn't due to ownership in the company. It's due to multiples on the dollars you invested.

And this is how every early-stage investor should be thinking. Multiples. Not ownership.

So how did this ownership obsession start? It's actually a great mental model for later-stage investors.

If you have a Series B company that's clearly winning and growing fast, you want to buy as many shares as possible. It's clear you'll get the greatest multiples from putting money into that company over other companies that aren't growing as fast.

The ownership mental model makes sense when you have a clear, limited number of fast-growth choices.

But this isn't the case at pre-seed and seed.

Different paths to 100x returns

At early stages, there are tons of permutations to get to the same multiples.

Here are ways to get to 100x as a pre-seed or seed investor:

Option A: Get in at low valuations. Get 100x on a decent exit that no one has heard of.

Option B: Pay up at a higher valuation into a serial founder's company and get 100x on a $10B exit that everyone has heard of.

The pro-rata trap

Let's tie this thinking to pro-rata. Investors are obsessed with their pro-rata - the amount needed to re-invest in subsequent rounds to maintain their initial ownership stake.

But the right way to think about pro-rata isn't about maintaining ownership.

The right question is: What's the best way to get the best multiple on this tranche of money?

It may be that doing your pro-rata in a given company is the best use of those dollars. If you have an incredibly fast-growing portfolio company, that could be your best bet.

But in other cases, it could be putting that same money into 3 new companies at pre-seed at 1/3 the valuation each.

Let’s walk through an example

Say you invest $100k into Company X at a $5M post-money valuation. To get a 100x gross multiple, the company needs to sell for $500M. After 3 rounds of dilution, it would be about a 50x return.

Company X is raising a new round and asks if you'll do your pro-rata.

Most people would just say, "Yes! We need to plunk down $400k to maintain our ownership."

It's possible that's the best use of $400k.

But the right way to think about it is: How can I maximize my returns on this $400k?

If the company is doing well but not clearly the fastest thing ever, it might be better to put $100k into 4 more companies at lower valuations.

Which is the better-yielding investment of the $400k? The 1 company? Or the pool of new companies?

When not doing pro-rata is actually smart

Let's also be clear: if you don't do your pro-rata, that shouldn't be a negative signal.

Your portfolio company could be doing really well, and as a result, the valuation could be quite high.

You'd want to do your pro-rata if the company is growing outrageously fast (top 1% territory) and the multiple still makes sense even at the higher valuation.

You'd also want to follow on if your company is doing well but is somehow overlooked by other investors and you have insider information that it's more de-risked than the market realizes.

But if your company is doing well and everyone knows about it, the valuation might be sky-high and you might find that the traction may not justify it. At that point, you might get better multiples putting that capital into new companies at lower valuations.

Today's insane market dynamics

I'm seeing a ton of flurry throughout the private and public markets right now in the AI space. Companies getting marked up and valued at high valuations.  

But we at Hustle Fund are maintaining discipline when writing checks.

This year, there have been multiple times where investors have come in days or a week later and driven up the valuation cap 2-4x.

This AI market is insane.

So when the company goes out to raise again at the next stage, do we follow on? The follow-on price these days may be 6-15x higher than when we wrote the first check.

And even if a company is doing well, a 100x multiple from the new price isn't necessarily guaranteed - not at seed or Series A when product-market fit hasn't been established yet.

Unless a company has clear product-market fit and is growing outrageously fast - like 50%-100% month-over-month - we tend to lean towards writing first checks (instead of follow ons) in this market and just generally speaking.

Back to first principles

The point of this story is: MULTIPLES on your money is what matters.  

Going back to first principles is critical since the market always changes and evolves.

Stop chasing ownership percentages. Start optimizing for multiples.

– Brian from Angel Squad

🍫 A snack for the road: Come hang out with us during Uncapped Note Live

You might be wondering, “What the heck is Uncapped Notes Live?”

Well, it’s a 24-hour startup hotline where you can ask any burning questions you have. Why did that investor ghost me? Is my co-founder pulling their weight? How do I fix my messy cap table? The spicier, the better.

The Hustle Fund team + friends will be LIVE answering your questions in real-time. Drop in at 2pm or 2am. Stay for 10 minutes or 10 hours. Ask questions or just listen to everyone else's drama.

Think late-night radio show, but instead of relationship advice, you're getting unfiltered business advice from investors who've deployed hundreds of millions of dollars.

December 17th at 12pm PST - December 18th at 11:59am PST. 24 hours. Zero filters.

Let's get unhinged together.

Overheard in SF…probably

“We’re not just disrupting the market, we’re disrupting the very concept of markets. Markets are so Web2.”