Downside protection doesn’t matter
Posted: June 26, 2014 Filed under: Uncategorized 5 CommentsWhen you are investing large amounts at high valuations there is a case to be made for ‘downside protection’ – i.e. that there is a reasonable scenario an investor will at least not lose any money or even make a small return in the case that the company they are backing is not very successful.
This is not the case for early stage investing. Downside protection really doesn’t matter and when I hear that argument it is a real turn-off. Let me explain:
- Our current fund is $200m.
- If we want to stay in business we need to return that 3-4x to our investors. So we need to generate say a total of $800m in proceeds from our investments.
- If we own 20% on average, it means we need $4bn of total exits across all companies ($800m / 20%).
- We will probably have 25-30 companies in our portfolio and 20-30% will generate those $4bn; so that means say 6 companies need to generate $4bn of exits – i.e. be worth $667m on average when they exit.
- That means we will earn on average $133m (20% x $667m) for our investors in a successful exit. An industry rule of thumb is 0.5x-1x the fund back for a successful ‘venture case’ investment – so that fits right in there .
Now our average early stage investment is $2.5m. In this case downside protection means I may not lose $2.5m or maybe I can even get $4m back.
Will our investors care if we return that amount of money when we need to return $800m in total? Absolutely not. And this is why I don’t care either.
Agree 1000%. Yes, ten times.
If you are a founder, please comment and tell us how much of your negotiation with investors was about downside protection, and how much faster you could probably have closed the deal. This is the single biggest difference between fast and engaging investors founders love and people who won’t be recommended to other founders. It is also probably the biggest divide between West Coast and European investors.
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