The 'Safer' Strategy: Toward Sustainable Venture Capital Returns

In the dynamic world of venture capital, conventional strategies often hinge on outsized returns, a practice increasingly under scrutiny. Bill Hambrecht, a vanguard in investment banking, posited that substantial returns from venture investments derive from a steadfast commitment to retaining shares in standout companies. This approach, demonstrated by industry behemoths such as Microsoft, Oracle, and Adobe, showcases the enduring value of strategic patience, offering lessons in the power of long-term investment foresight.

In stark contrast, the contemporary venture capital landscape is marked by the Power Law Cartel's quest for extraordinary gains, promoting a diversification strategy that inadvertently dilutes the impact of singularly exceptional investments. This strategy, designed to mitigate risks associated with individual investments, paradoxically constrains the potential for achieving above-average returns, leading to an observable underperformance across the venture capital asset class.

A Paradigm Shift in the Making

The introduction of the Simple Agreement for Future Equity with Repurchase (Safer) by Next Wave Partners in 2023 heralded a new chapter in venture capital, advocating for a model that duly acknowledges and compensates the risks borne by early investors. This paradigm shift offers a promising avenue for General Partners (GPs), suggesting a more reliable return stream aligned with the post-investment revenue growth of startups.

Unveiling the Achilles' Heel of Venture Capital: Illiquidity

Venture capital is inherently long-term and illiquid, with returns typically materializing only after extensive periods. This fundamental characteristic demands a reimagining of liquidity strategies beyond conventional exits like acquisitions or IPOs.

For venture capitalists, it’s all about Distributed Paid-In (DPI) capital, the metric used in the venture capital industry to measure the realized return on investment for Limited Partners (LPs) in a fund. It represents the cash distributions received by LPs divided by the total amount of capital they have contributed to the fund.

DPI is an important metric because it reflects the actual returns that LPs have received from their investments in the fund. It indicates how successful the fund has been in generating profits and returning capital to its investors.

For emerging managers, DPI is a critical measure of performance and success. LPs often seek a combination of cash returns and outsized returns when evaluating the performance of a fund.

The problem in modern venture capital is that DPI is inextricably linked to the Power Law principle. The power law suggests that a small number of investments in a fund's portfolio will generate the majority of its returns, which underscores the premise of the Unicorn investment thesis perpetrated by the Power Law Cartel.

So-called Unicorns, says the Cartel to the LP, need time to compound and reach their full potential.

Just how much time?

Data from 1,000 funds shows material positions can take a decade or more to compound.

For many years this was the accepted standard. Except now the chickens have come home to roost. Years of capping the potential for above-average returns by diversifying away alpha, combined with a series of reckless scandals (see Theranos, WeWork, FTX, SVB, et al) and a high interest rate environment, has led to a systemic underperformance within the venture capital asset class.

A Case for Rethinking DPI: A ‘Safer’ Play for Startup Investors

The Safer model offers an alternative, focusing on predictable returns from early-stage investments without sacrificing the potential for significant exit-related upside. This approach not only protects early investors from dilution but also aligns investment returns with actual company performance, a stark contrast to the speculative nature of traditional venture capital.

The job for the emerging manager to execute under the performance metric of DPI amidst a failing investment thesis is an impossible task.

I propose that we rethink DPI all together.

My goal as a Safer investor is a predictable return stream based on startup revenues post a honeymoon period, ensuring a steady ROI as the company grows. And by retaining a small portion of the Safer amount for conversion at acquisition, I still get to benefit from the upside potential provided by an exit event. Further, the alignment of returns with revenues minimizes the risk of substantial dilution in later funding rounds, safeguarding my early investor position.

A Dilution Resistant Strategy

Angel Investors are typically the first individuals or entities to invest in early-stage startups, providing crucial funding to kickstart the company's growth. As early investors, they take on significant risk as the success of the startup is uncertain and unproven. However, once the company achieves serious growth and raises substantial capital from later-stage investors, Angel Investors often lack mechanisms to protect their initial investment and maintain their position in the company.

While some Angels may have pro rata investment rights, and the balance sheet capable of supporting follow on investment, this alone may not be enough to fully protect their position.

Pro rata investment rights refer to the right of an existing investor to participate in future fundraising rounds in order to maintain their ownership percentage in a company. This means that if a company raises additional funding, investors with pro rata rights have the option to invest an amount proportional to their existing ownership stake.

If unable to exercise pro rata rights fully, Angel Investors may find their initial investment significantly diluted, reducing their potential returns and influence in the company. This is because later-stage investors, such as larger or institutional venture capital firms, often negotiate more favorable terms and receive additional protections to safeguard their investments.

To address this issue, an Angel may seek to negotiate for additional rights or provisions in their investment agreements. Some examples include anti-dilution provisions, which protect against future equity issuances at a lower price than the Angel Investor initially paid, or liquidation preferences, which give them priority in receiving proceeds in the event of a sale or liquidation of the company.

However, it's important to note that negotiating these additional protections can be challenging and complicated, especially for individual Angel Investors lacking significant leverage. Startups may be hesitant to grant such rights as they may limit future funding opportunities or complicate the capital structure of the company. Further, incoming institutional investors will often negotiate the elimination of these terms as a condition of investment.

To me, the risks of being a classic Angel Investor don't match the rewards. And this is precisely where the Safer can help.

By structuring the instrument with zero conversion triggers outside of a liquidity transaction, no maturity dates, no interest rates and no preferences, the Safer can sit on a company's balance sheet entirely unencumbered by the typical cap table shenanigans characteristic of VC lore.

Case Study: A Safer Investment in Action

The practical application of the Safer model is illustrated through an investment pricing exercise I completed for an online commerce platform, demonstrating how a focus on sustainable revenue growth can lead to substantial returns. By prioritizing revenue-based returns over speculative market valuations, the investment strategy outlined offers a blueprint for consistent, above-market performance.

Over the next seven years the company estimated that it would produce a little more than $50M in revenue following the 1 year Safer honeymoon period. The annual forecasts were as follows:

Year	Revenue
1	0.00
2	2,779,870.00
3	3,039,870.00
4	5,204,451.00
5	9,864,106.00
6	12,974,268.00
7	16,860,600.00
Total	50,723,165.00

Given a certain set of circumstances, it would be possible for the company to out perform the forecast. But as an investor pricing risk, it is important to not get swept up in potentiality.

In order to accelerate the first phase of growth on this trajectory I determined the company would need approximately $2M.

The following chart breaks down how I programmed the Safer calculations to yield a prospective return:

The Compounding Advantage of Safer Returns

Creating consistent return on investment is only part of the advantage the Safer offers. A detailed analysis of the forecasted returns under the Safer model reveals the magic of compounding, a principle that amplifies profitability through strategic reinvestment. This segment will elaborate on the mathematical foundations underpinning the compounding advantage, offering insights into how the Safer model can significantly enhance investment outcomes.

Let’s consider the impact of compounding in my portfolio company example.

By the end of year 6, the total impact of Safer Return compounding, including the invested capital and the generated profit, would be approximately $2,175,879.

The total profit generated over these six years, assuming an 8% annual profit rate with profits being re-invested every year at the same rate, is approximately $482,751.

Yes, I am talking about a potential 25% boost on my $2M original investment.

The specific amounts invested annually over five years are:

• Year 1: $138,993
• Year 2: $151,993
• Year 3: $260,222
• Year 4: $493,205
• Year 5: $648,713
• Year 6: $0 (No new investment, but profit is calculated for the amount accumulated until Year 5.

At the end of each year, the total amount is increased by 8% to account for the profit. This profit is then re-invested along with the new investment for the next year, compounding the growth of the investment.

For each year, the process involves adding that year's investment to the total amount and then applying the 8% profit rate.

After five years of investments and at the end of the sixth year (with no new investment but applying the 8% profit rate), the total amount reflects the compounded growth.

The total profit is the difference between this final total amount and the sum of the investments made over the five years.

The analysis shows that with these adjusted investment amounts and the same 8% annual profit rate, compounded annually, I would stand to achieve significant additional profit, highlighting the impact of both the investment amounts and the compounding effect over time.

Safer compounding is a game changer for fund managers trapped in a world controlled by the Power Law Cartel.

Where Do We Go From Here

As a fund manager, there are several points of differentiation that I am after:

• Protecting the downside risk of early-stage investing;
• Providing more predictable and consistent returns to the investment fund, higher than the return averages of old fund models;
• Debunking the established rule of thumb that a investment fund must invest across hundreds of portfolio companies and raise mega-funds in order to achieve optimal returns;
• Eliminating the need to rely on power law principles, and in turn re-setting focus on simply recruiting and investing into viable businesses within the scope of my market thesis.

The traditional venture capital model faces increasing scrutiny as new opportunities emerge for fund managers to adopt innovative strategies. At this pivotal juncture, the venture capital industry must embrace models that better strive for consistent returns amid prevailing uncertainties.

The ambition to reshape the venture capital landscape is not merely aspirational but foundational to the ethos of innovation. By venturing into unexplored territories with the Safer model, there is an opportunity to redefine the metrics of success in venture capital investment, marking a significant departure from outmoded practices.

Maybe I’m crazy to believe I can help reshape the future of startup investing and achieve Venture Reciprocity. But then again, a founder is what a founder does.

And so here I am.