Inception Funds vs. Early Stage VC

Allocating to “Early Stage"

TLDR: Pre-seed institutions and “inceptions funds” are misunderstood by LP’s, and are evaluated as if they were traditional early-stage venture funds.

Broadly speaking, pre-seed venture capital is viewed under the same lens as traditional early-stage venture capital.

This is a huge mistake.

As an allocator, you’re looking to create strong returns in your portfolio. To do that, it’s fairly common to allocate 10-30% of your capital toward private equities in order to generate alpha relative to the public markets. Within private equities, you might allocate half of that money to venture capital—a more risky and earlier bet on young, but very fast growing companies. Then, within venture capital, you might select a series of funds to allocate to in order to diversify the risk and improve direct deal flow.

But allocating to the earliest stages is a nascent game compared to the rest of the financial markets. In fact, venture capital only represents about 6% of all private equities. It’s tiny by comparison to the public markets, and as you move earlier and earlier in a company’s lifecycle, the investments both get smaller and more risky making it increasingly difficult to deploy large amounts of money. That’s because, for the amount of risk you’re taking, it’s almost impossible to deploy $1B into an early-stage company unless you’re Inflection, and instead, it’s rather ubiquitous to for companies to start out with $1m or less.

The fact that the dollars are so small, relatively speaking, and that the risk is so high, very few allocators have found it attractive enough to spend enough time becoming experts in this segment of the market. That’s why most allocators mistakenly apply the same logic to investing in Seed - Series C investors as they do in Pre-Seed.

Applying traditional early stage venture capital investing frameworks to pre-seed funds, or “inception round” investing, would be like eating at a French restaurant in Kentucky. Sure it might taste similar, but the chances of it truly being any good are low. No offense, Kentucky.

After talking with countless allocators the past three years, there are a series of misconceptions about what a pre-seed institution does relative to their “first check” VC peers. Let’s first just define the two.

Pre-Seed Institution or “Inception Fund”

A pre-seed institution is a venture capital fund that aims to invest fairly small dollars in a high volume of companies at materially lower valuations given the risk of investing before there is even a product or a customer. Traditionally, this would be checks of $100K-$250K into 50-200 companies, at valuations less than $3m. Importantly, a "pre-seed institution” is often an accelerator—they invest in companies that are 6-16 months old, typically have a product and users, and aim to accelerate that already existing company to their seed round.

Inception Funds on the other hand will work with founders even before incorporation, and almost always before there is a product or users.

Early Stage Venture Capital

Early stage venture capital is what you more traditionally think of as VC. High conviction, deep diligence, industry expertise, repeat founders, $500K - $5m investments at $10m-$25m valuations. Typically these funds are making 20-30 investments.

As you can imagine, those are very different investment vehicles. However, allocators are not trained to look at those two models differently, or understand the details as clearly. In part, that’s because there are very few pre-seed institutions relative to the thousands of early stage VC’s.

Some of the most common misconceptions I come across…

Misconception #1 - 2-3X Performance is Good

2-3X performance is good when you are investing billions of dollars, and when you can achieve this under 7 years. If neither of those things are true, then you could simply invest in the S&P 500 and double your money fairly systematically, and still be liquid in the meantime. If you are investing in early stage venture, 2X is great relative to other funds, but it’s not great relative to other investment options. I don’t understand why allocators get so excited about 2-3X. Venture investing should be about asymmetric upside, and potential returns beyond 3X requires a much more nuanced approach than what you typically see happening in traditional early-stage venture.

Statistically speaking, investing in traditional early-stage venture is often much worse than simply investing in the S&P 500. While average returns are often quoted to be 1.5-2.5X, those stats ignore the fact that averages are skewed upward by outlier funds, and the median performance is actually more like 1X. Additionally, many of these statistics often also suffer from survivorship bias, never reporting on the failed funds, like the 2,725 funds that disappeared over the past two years.

Allocators may get into Tier 1 funds where outliers are more consistent, in which case yes, the downside is more like 1.5-2x, and your upside is higher than 3x, but not by much. If the fund is investing earlier enough, sub-$50m valuations, you may also qualify for Qualified Small Business Stock (QSBS) which provides tax-free gains up to $10m per investment, but remember you’re also illiquid for 7-10 years on average.

So, if you are going to invest in traditional early-stage VC, you want to find funds who have 1) Unique Deal Flow, 2) Asymmetric Information, 3) Fund Size <$200m, and 4) Ability to Retain Ownership.

These are funds like Benchmark I (93x) and Intialized I (55x). They both had unique deal flow; Benchmark through their executive recruitment muscle, and Initialized through their relationship with YC. They both had asymmetric information by way of relationships, and at the time, inside baseball in Silicon Valley. Many of these outstanding funds were small enough that one outlier could create dramatic upside for LP’s and GP’s alike, and their follow-on capital enabled them to retain ownership and limit dilution in future rounds.

Stay away from traditional early-stage funds who don’t meet these criteria.

However, funds that do have a performance record and meet this criteria often charge premium carry and aggressive management fees. Supposedly 3/30 in Benchmark’s case, or 3.5/35 in a16z’s. That means 3-3.5% fees on the committed capital, and 30%+ of all of the profits in a market that is traditionally “2 and 20.” For any allocator, and particularly a fund of funds with another layer of fees, it’s important to run these calculations. A 3X fund can quickly move from top decile to top quartile or even average net of fees.

On the other hand pre-seed institutions typically have a more front-loaded fee structure, generate their own deal flow, still develop asymmetric information in funds <$200m, but rarely are able to retain their ownership in a meaningful way. That is starting to change with YC’s new fund and Antler’s Elevate fund, but I digress. These funds create their alpha through low valuations. By doing this, pre-seed institutions can target 3-10X returns instead of 2-3X, and I’ll cover how this works in more depth down below.

Misconception #2 - Traditional Early-Stage Funds are Unique

Traditional early-stage funds are NOT unique, but they will all tell you they are:

“We are different because we are operators, with outstanding advisor networks, and impeccable customer introductions. We specialize in <<industry>>, and we get our deal flow through our unique networks from working at X-Co, starting Y-Co, and investing in Z-Co. Everyone says they help founders and add value, but we *actually* do.”

If I’ve met 500 investors, 499 of them have said that exact same paragraph to me.

As an allocator, your bar for uniqueness needs to be exceptionally high, but the chances are, you won’t find a true outlier in venture capital unless you are talking to a true Tier 1 or a newcomer with novel or maniacal approach.

Instead, you should look for uniqueness in point of view, operating prowess, time commitment, and references. Investors are paid to be right when others are wrong. They, and their LP’s, only make money when they find something asymmetric and non-linear to the rest of the market and the world. To do this, you need to look at the world differently and operate accordingly. Outlier returns may come from luck, but it’s not enough to back charisma of a GP, you need to back the way they think. You need to back the one whose founders will pound the table for them. You need to back the one who is investing all of their time and energy the way a great founder would—not a vacation monster or tourist investor.

I am regularly surprised at how few allocators press VC’s on their level of obsession. The quality of the questions, and the understanding of the asset class is often naïve—unclear on how simple things like SAFEs work, or what dilution math is. It’s also unlikely that an investor will truly understand fee structures either. As an allocator, you should press an investor on the nuances of their approach as hard as you might press a founder on their financial model, track record, ambition, vision, and leadership philosophy.

Misconception #3 - Fund Models are Generic

Investors are more generic than their fund models, and fund models being generic is a huge misconception. Fund models actually provide latitude for enormous creativity, but very very few investors obsess over these details. Instead, they build generic pie-in-the-sky models and often misunderstand basic topics like dilution and co-sale rights. Even more rarely do they develop unique financing structures (ie General Catalyst’s credit fund), interesting technology (776’s Cerebro operating system), or novelty in founder underwriting. I would argue Antler has done all of the above, but this piece isn’t about me/us.

For example, very few funds have innovated on the 2 and 20 model I mentioned earlier. Some have moved to premium carry, or included hurdle rates—not taking profits unless performance meets a higher threshold, but those aren’t innovations. The former is greed and virtue signaling, while the latter is necessity in order to secure capital. And the list goes on…

• As an allocator, you should question if fees are charged on committed capital, called capital, or active capital. Almost every investor charges on committed capital. You should be asking why.

• You should ask about the first principles of their follow-on investing, or if they are purely picking & choosing based on the momentum and emotions of the board room.

• You should press deeply on their dilution math, expectation of preference stack complexity, ability to co-sell/exit early, and what their approach is to holding on in later rounds.

• You should push on their sourcing strategy, technology, evaluation process, investment committee approach, and what about their investment philosophy is counterintuitive or non-standard to their peers.

This list is, without exaggeration, endless. If an investor cannot have an endless conversation about the nuances and creativity of their fund model and approach, you are essentially gambling your money. By definition, to be better than average, you need to be different.

The exception to this rule is the flywheel of a brand, and the pricing power of a previous incredible result. Unlike the public markets, past performance does perpetuate more commonly in venture because there are few other indicators to go on, and many great founders want to work with successful VC’s in order to both “borrow their credibility” and work with a winning team in order to further de-risk the otherwise insanely difficult task of building a unicorn.

Misconception #4 - Pre-Seed is Early-Stage VC

Early-stage VC in actuality is educated guessing on markets and founders, securing ownership in nascent companies with great potential and execution. The game is essentially to develop a thesis on a space or technology, take 10-20% ownership across 20-30 companies, maintain your position in the winners as best you can, and pray for Power Law.

The reason VC is deemed so risky is because of this section of the asset class.

Thousands of investors play the early-stage game, and as mentioned, average returns are 1-2X over 10 years. In my opinion, this asset class is basically gambling. That’s also what makes it exciting and enticing.

In fact, the math is kind of like Roulette—2.7% chance of picking the right number, or in VC, a strikingly similar chance of picking a unicorn. The difference is, Roulette pays 35:1 where VC often pays 100 or 1000:1 if you hit it right. Sometimes much more.

Pre-seed institutions and inception funds on the other hand, are an entirely different, less risky, and higher upside game mathematically. The reason for this is entry valuations and deal volume. Average entry valuations from pre-seed institutions is $2m and they will typically invest in 50-200 deals.

Very importantly, this is not the same as pre-seed in the sense of “pre-priced round” financing or friends & family investments. Those valuations are closer to $8m in the US. By comparison, institutional pre-seed investors achieve deeply discounted valuations because of the services component to their businesses. YC is $1.78m, Techstars is $1.33m, and Antler US is $2.75m. They achieve these valuations because they provide 1) Capital before others will, 2) Investor introductions for later rounds, 3) Borrowed credibility, 4) Community, & 5) Coaching. Early-stage VC’s cannot provide this because their 2 and 20 fee structures do not support the operational expenses.

Take a look at these two examples:

Fund A

Fund A will raise $35m and invest in $28m net of fees. Roughly $15m will be deployed into 15-25 seed rounds for 5-10% ownership, and the rest will be reserved to protect their positions. This fund will have a 30-40% fund-through to Series A, resulting in 5-7 companies marked up 3-5X. With a generous 5% hit rate, they would expect to have 1.25 unicorns, and 5% ownership net of dilution yielding $50m or a 1.4X fund, plus some smaller exits from the other 24 companies, moving performance to 1.5-2X. Remember, this is at 5% hit rate—not the Roulette 2.7%—so we’re being optimistic here.

Because of QSBS, you pay no tax on your gains after holding it for 5 years, so you end up with a pretty good outcome, but you would have had a fairly similar outcome and full liquidity investing in the S&P 500 over the same time period.

Fund B

Fund B will raise the same $35m, investing the same $28m net of fees, but they will front-load those fees and invest in 140 companies at a $2.5m valuation. The average fund-through rate is 45-85% with YC being the top of that mark, but let’s use 50% to be conservative. This fund will conservatively have 70 companies raising seed rounds, and the average seed valuation is the US is ~$13m.

This means Fund B has built a Seed Portfolio of 70 positions already marked at 5X. From there, 30-40% will graduate to Series A resulting in 20+ companies valued at $30-$50m, or 12-20X.

The question you have to ask is, if you’re investing $35m, would you rather have a Series A portfolio of 20 companies already marked-up 15X or a Series A portfolio of 6 companies marked at 4X?

Of course, it’s also important to understand money at work dilution. Fund A will have larger checks and money a work in the 6 companies remaining, and Fund A will also typically continue deploying into their winners and retain ownership longer where Fund B will have smaller checks in each company and not retain as much ownership.

However, in both cases, you can expect ~50% dilution from original position, so it is almost always advantageous to take the mathematical approach to early-stage, allocating to inception funds rather than the high conviction emerging manger. The latter being a mega outlier is broadly predicated on the surface area of their luck. You have to remember, hindsight is 20/20 so even the luckiest people can be deemed geniuses looking back, but that is almost never the case at the time of investment (Read: Airbnb, Uber).

Finally, it’s important to note that in the case of a true pre-seed institution, attrition will be dramatically higher, typically around 75%, but the odds of overall fund success are higher too. The reason is basic math and systematic alpha. In the case depicted above, Fund B, the pre-seed institution is creating systematic alpha by predictably investing at low valuations with a high fund-through rate. Together, they yield a far more robust Seed & Series A portfolio which reduces the risk and increases the odds of an outlier.

More simply stated, the risk is not accurately priced in at day zero due to the lack of access to capital that founders have. This means you can make those 140 bets at a $2.5m valuation (or $1.78m in YC’s case), and because of the high market fund-through rate, you can build a far more successful portfolio.

Misconception #5 - Fund of Funds are too Expensive

Because of the above, the natural question then is, why not invest in fund of funds? Well, most think they’re too expensive, but in actuality, fund of funds are actually incredible for early-stage venture because they replicate what a pre-seed institution is doing. They increase the volume, diversify the risk, and only charge a small incremental fee for producing it rather than needing to stand up the services businesses that are accelerators or inception funds. Funds of funds also produce direct deal flow and asymmetric information that make it much easier to invest larger sums of money into less risky companies at a later stage, and it’s less expensive to pay an extra layer of fees than to develop your own sourcing & diligence processes.

Pre-seed institutions are actually quite similar in this way. They aggregate many more deals to diversify risk. The major value that pre-seed institutions have over funds of funds is the low valuation entry points. This is impossible for funds of funds to replicate unless they invest in the pre-seed institutions themselves, and at the same time, there are very few pre-seed institutions producing enough volume to deliver this level of risk reduction while maintaining this level of upside. You can list them on one hand: YC, Antler, Techstars, SOSV, 500 Startups, and some might include Entrepreneur First, Mass Challenge, and Plug & Play, but the latter part of that group has historically remained at the lower end of hit rates with 2% becoming unicorns, compared to YC who has achieved ~6.6%. Techstars meanwhile has had its highs and lows, currently going through a rebuild and a departing CEO, while Antler’s oldest fund is only 6 years into an asset class that takes 10 years to mature.

That’s why, if you subscribe to the line of thinking outlaid here, it’s also important to dig into culture, counterintuitive thinking, operating prowess, and performance metrics beyond DPI, such as leading indicators like MOIC and portfolio company revenues.

Broader Thoughts on Allocating to Early-Stage

Ultimately, pre-seed institutions are wildly misunderstood, and traditional early-stage VC’s are educated gamblers. If I were investing in traditional early-stage VC in this market—which by the way may very well be some of the best vintages in VC history (a topic that is fairly over-reported on)—I would think about some core philosophies in addition to the above:

1. Pick a solid pre-seed institution to be the foundation of a broader strategy. Low entry valuations and a sound operating model & brand. They need to be attracting the highest caliber people possible and have a unique investment philosophy. At Antler for example, we only invest after we work with founders in-person for 8 weeks.

2. Choose 5-8 traditional early-stage funds that meet the core criteria above. Unique deal flow, asymmetric information, relatively small fund size, and ability to retain ownership.

3. Gain access to 1-2 Tier 1 brand name funds for stability. This will both reduce risk and create value for your other investments as well as help you diligence your own direct deals.

4. Hold an unapologetically high bar on the fund manager’s time commitment and obsession over their work. You want Kobe Bryant doing three-a-days, not a Twitter-talking-head. This, like investing in founders, is the only guarantee of compound results over time.

Taken together, this is a strategy that reduces risk while retaining asymmetric upside, but it’s not enough to simply follow this approach. You also need to be prepared to consider a few more components in your own willingness to deploy:

1. “Be fearful when others are greedy, but be greedy when others are fearful.” 2023-2026 may be moments to go all-in. Market pull-backs and platform shifts rarely happen, let alone at the same time. The time is now. Ignore your target allocations by sector, and recognize the long-term potential.

2. Plan to invest over multiple vintages. Investors are building their own brands, core strengths, and pattern recognition. Investing in one fund and letting it ride is not smart. Plan to invest in multiple funds from the same manager because your first fund may be what builds the brand and the access, where the second and third fund may harvest the fruits of that labor.

3. It’s not enough to find an obsessed fund manager, you too, also need to obsess. Understand what edges are being created by the fund, what unique and creative ways they are developing long-term value, and if that value matches your own investment goals.

Ultimately, if you’re allocating to venture capital you’re very likely under-thinking it and missing very real differences between funds despite an otherwise homogenous playbook on who, what, and how VC’s run their funds. If you are as methodical and as obsessed as the world’s best founders are about building their businesses, you too can find managers who operate in the same way and who will produce the meaningful returns amongst the sea of average and uninspiring returns that is typical venture capital. Whether you’re finding managers or finding founders, it’s not enough to be good, you need to be different, because like Black Swan events, the way to make real money is to be right when others are wrong.

See you Monday.