How To Build Capital Allocation Strategy For A Seed Stage VC Fund

When a Venture Capital (VC) firm decides to invest, it is critical to understand the investment rationale. The investment thesis drives the investment approach. This, along with the fund’s capital allocation strategy, drives the investment. 

The last two quarters of 2022 have been a tough time for the founders raising capital. The froth in the valuation, which had been on the way north since 2019, ebbed in 2022. Instead of growth at all costs, ‘unit economics’, has become the new buzzword. It’s elementary. Back to basics.

VCs identify the companies in which they want to invest based on their investment thesis. They carry out due diligence (DD) and, based on the outcome of the DD, look to invest in the identified company. 

While the DD is taking place, SWOT analysis and, if necessary, PESTLE analysis are performed in accordance with the VC fund’s approach. The fund can be a lead investor or a co-investor. Again, the VC fund invests based on the fund’s size and mandate. 

The first investment cheque is issued based on the fund approach of having a holding of 10% or less. Most importantly, the fund’s size and risk-to-reward ratio determine the target sizes for their first and subsequent cheques.

How Do VCs Determine The Target Cheque Size?

VC firms look for market size, differentiating technology, and competent teams, among other things, when screening a seed-stage startup.  It takes into account the company’s positioning, accounting needs, target market, product-market fit, and go-to-market strategy. 

The size of the cheque varies according to the company’s valuation, investment stage, expected return on investment, and growth potential.

A target cheque size takes into account variables such as the amount of equity available for purchase, the expected hit rate, and the firm’s risk appetite. It differs for investors that lead the funding rounds versus those that follow. 

A lead investor who negotiates the deal looks to own up to 20% of a startup’s equity stake with their cheque. That is typically half the amount, leaving the rest open for follow-on capital from existing or new investors. Typically, VC firms include pro-rata rights (Pre-Emptive Rights) in the Term Sheet to ensure that their capital holdings are not diluted in future fundraises.  

Capital Allocation Strategy For The First Cheque Vs Follow-On Rounds

Entrepreneurs frequently overestimate the true value of their businesses. In that case, the VC’s risk-to-reward ratio is likely to be higher, increasing the likelihood of rejection. 

Their capital allocation depends on the minimum acceptable diversification, the expected size of the first investment into each company, capital reserved for follow-on rounds, and the target maximum fund allocation per company.

Investing the initial cheque entails the following risks:

• Change in the ecosystem: Edtech which boomed in the pandemic period, due to an online mode of learning, is now facing headwinds and hybrid looks like the approach
• Regulatory: Neo banks which proliferated, are now under the RBI regulations, which have a stiffer compliance
•  Talent: Good tech talent is in short supply and there is a risk of attrition in the team
• Founder dynamics: There can be a change in founder dynamics post the fundraise, which can impact the business

These are only some of the matters to be considered while investing.

Seed-stage investors seek to focus more on offering advisory services, connections, mentorship, and time. They prefer putting smaller initial amounts into a company and increasing their position in later rounds based on its performance. 

How Do Exit Multiples Change?

Exit value is the selling price of a company. There is no such thumb rule. When the funding season was on, valuations were doubling every three months. And today the froth has ebbed. The valuations again vary depending on the sector and moat of the company. 

However, metrics such as EBITA, market share, and serviced geographies all play a role in determining the valuation. 

Approach

Investing in early-stage startups involves both risks and multifold rewards or failure, which demands comprehensive diligence. 

To maximise ROI, venture capital strategy incorporates multiple stages of company evaluation, due diligence, and capital allocation. In line with the outlook and growth expectations, first-cheque capital is typically small.

The company’s performance, market share, growth, moat, and potential exit value are what drive VCs to double down.