The Traditional Early Stage Investment Model Is Obsolete

Early stage investments used to mean small sums, high risk, and the promise of high returns. Now, longer exit timeframes and the private money saturating the market mean specialized funds must adapt, or risk extinction

Sophie Shulman 16:5425.12.19

This year will go on the books as one of the best years for tech initial public offerings, but it could prove to be the exception. WeWork’s IPO fiasco stopped the flow, and it is unclear whether an Airbnb IPO could set public listings in motion again. Regardless, IPOs are no longer a must in the tech lexicon. If, in the not so distant past, the timeframe for an exit was extended from a period of five to seven years to a decade, data now suggests that 14 years is a more realistic expectation.

In the past, the IPO rush could be partially attributed to fears that the party could be over at any minute. Today, after a decade of almost constant climbs in the venture capital markets, no one is in a hurry, especially considering the amount of private funding available to companies raising capital.

Left to right: Yossi Vinitski, Yifat Oron, Edouard Cukierman, Aya Peterburg. Photo: Sharon Levin, Amit Sha’al, Abigail Oz

This new reality has created a complex situation for venture capital funds, especially those specializing in early stage investments. Entrepreneurs are waiting for the unicorn label before even considering an IPO, requiring fund partners and limited partners to come up with more creative ways to get their investment back.

VC funds that specialize in early stage investments have a real problem surviving today, according to Edouard Cukierman, the chairman of Israel-based Cukierman & Co. Investments House and managing partner at Catalyst funds, which was an early investor in Mobileye and invested in several other prominent unicorns, including Taboola.com Ltd.

“Some of the funds that operated here in past decades could not manage to raise sophomore funds, and those that did changed their mode of operation, such as splitting their business into a growth fund for later stages and an early stage fund,” Cukierman said in a recent interview with Calcalist. “That way, you can show good returns on the growth fund that are not impacted by investment activities in early stages. Those who stayed with just an early stage investment strategy did not make it.”

Cukierman’s point of view may be on the more extreme side, but it is evident that the venture capital early stage investment model has been destabilized. How are these funds, which usually raise relatively low sums of money, supposed to handle both the doubling exit duration and the entrance of private investment funds and hedge funds? Those arrive armed with vast amounts of money, far beyond the reach of most early stage funds, and lead “mega-rounds”—not millions of dollars or even tens of millions of dollars, but hundreds of millions of dollars per round.

Early stage is a very broad definition, according to Aya Peterburg, managing partner at S Capital, which recently closed a $150 million early stage fund. The division is mainly according to investment size, and some funds specialize in investments of $500,000 to $1 million, she recently told Calcalist. “Unlike those funds, we aim for a first investment of between $4 million and $8 million. We understand that reality has changed and therefore we raised more money than such funds traditionally raise from the get-go. We also made a decision to invest it in a low number of companies—no more than 10—and keep the rest on hand to participate in early rounds without diluting our share,” she explained, describing a relatively newer model early stage funds have been implementing. “If the company we backed justifies it, we could remain invested for a decade, even,” Peterburg said. “Because most funds raise capital towards growth investments now, the early stage scene is less crowded.”

Around 400 venture capital funds operate in Israel, compared to approximately 100 in 2000. But where two decades ago most focused on early stage investments, today more and more funds set their sights on later stages, where you need to bring the big bucks but the risk is much lower.

Early stage venture capital investment funds need to undergo a change in perception and start managing the timing of an exit instead of letting the market dictate it, said Yifat Oron, the CEO of Israeli Bank Leumi subsidiary Leumitech and a former partner at Vertex Venture Capital. “It requires a new perspective but it will enable the industry as a whole to mature and reach new heights,” Oron said.

According to Oron, instead of waiting for an IPO or the acquisition of their entire stake, early stage funds should sell to late-stage and buyout funds. Oron cautioned, however, that in many cases, ego drives funds to act against their interests. “Early stage investors need to leave at the stage where late-stage investors come in,” Oron said. “It is also better for the companies themselves, which then arrive at an IPO with investors that are less impatient to exercise their shares. Today, in most cases, early investor funds dump their stake immediately after the vesting period is over, hurting the stock. Funds that came in later are not looking to sell immediately after an IPO.”

Gil Dibner, previously of Gemini Israel Ventures and Genesis Partners and now the general partner at early stage fund Angular Ventures, told Calcalist he will be happy to make an exit by selling to a later stage fund. The vast amount of money currently available in the market after a decade of minimal interest means early stage funds now have more liquidation options, he said. “What does a large investment round actually mean? For me it is an opportunity to sell part of my stake, making up for my initial investment—and still maintain the potential for profit.” Late-stage investors that come in at the mega-round stage are looking to buy as many shares as possible so they have no problems with the fact that early investors are leveraging the opportunity to sell, he said.

“To make the right exit, early stage investment funds need partners that understand the new reality,” Dibner said. His solution is to raise commitments exclusively from institutional, rather than private investors. “In most cases, I recommend against selling early, telling partners to wait a while longer. In such cases, it is better that the limited partners be institutional investors that not only have a better understanding but have more restraint.”

S Capital, however, intends to stick to the old approach of waiting for a complete exit in the form of an IPO or acquisition, so as to not miss out on full returns. “It doesn’t bother us that valuations rise when large players come in, because the dilution is not significant, in the end,” Peterburg said. “In our experience, when new investors come in, they like to see that the first investors remain and reinvest.”

Dibner, who recently raised $42 million in commitments, believes that the primary change is mainly the identity of the entity that produces the exit. But those who insist on an old-school exit strategy will still need to adapt to survive the entrance of mega players. The most immediate adaptation is the need for more money.

“The gameplay is changing for early stage funds not just in relation to exit aspects, but even during the earliest funding rounds,” Yossi Vinitski, head of tech at Israeli Bank Hapoalim, explained. “If in the past funding rounds started at between $500,000 and $1 million, today seed rounds are between $2 million and $5 million, and series A rounds can reach between $8 million and $15 million. If in the past, an early stage fund could have settled for $50 million to $70 million, today you can’t play the big leagues with less than $100 million.”

There’s a catch, of course. The early stage model is based on very small investments that carry a very high risk—but also hold potential for immense returns. Early stage players are somewhat of a commando unit of professionals who enter the scene before anyone else, but their relative advantage can disappear when they become too large.

“It is easier for a small fund to make a return on investment than it is for a large fund,” Vinitski, who like Oron also has a venture capital background, said. “The exit needs to be bigger, which means you need more personnel. And not all who thrive in a small fund are suited for a large one.” The side effect of the situation, he said, is oversized investments, when investors give a company $4 million instead of the $2 million it really needs and overinflate not just the company but the entire ecosystem.

Boaz Peer, a director at Qualcomm’s venture arm Qualcomm Ventures, which invests in both early stage and growth companies with the backing of a giant tech company, has a somewhat different viewpoint. “Today, funds do not expect to see returns within two to five years, they know they will see returns in six to eight years at the earliest,” he said. “There are always companies that need a little more time, but in the end the math is simple: early stage poses a higher risk and offers higher returns. While it is true that we have more money invested during later stages, it is the early stage investments we made that brought us amazing results.”