Can You Buy Your Way Into Series A as an Individual Investor?
An analysis of Seed VC performance and an alternative strategy for individuals and family offices
Recent feedback on Parachute was, “This sounds like a way for individuals and family offices to buy their way in as Series A investors.” While this was not the intent of Parachute, it was an interesting proposition because shifting focus to Series A over Seed is a de-risking strategy normally inaccessible to individual investors and family offices. An in-depth analysis of step-up valuation multiples provided insightful conclusions on Seed venture capital performance and the cases where Parachute could be an alternative for individual investors to buy their way into Series A rounds.
Context and Assumptions
Parachute is an insurance under development that individual investors can use to protect the capital they invest in early-stage companies. The product intends to provide downside protection on direct deals where the client has no other infrastructure to protect their capital. Clients can take out coverage at the time of investment, and if an asset fails while the client is paying their premiums, Parachute will reimburse the shortfall of their capital. Parachute premiums are very high, and we allow clients to cancel anytime. This is often when an asset reaches a milestone, like being profitable, cash flow positive, or successfully raising another round of capital (i.e., Series A).
The key data we will use is Carta’s “For startups seeking early-stage funding, ‘requirements have definitely gone up,’” which reports step-up multiples on valuations between Series Seed and Series A. The median multiple between these two rounds is 2.8x. This implies that a company that raised Seed capital at $20M post-money valuation/cap will raise their Series A at a $56M post-money valuation. The top quartile of assets had a step-up multiple of 5.2x, and the bottom quartile had a multiple of 1.8x. Then, we also assume a dilution of 20% for the new capital raised. Combining these two parameters allows us to calculate when an investor is better than break even in their position at Series A when they invested at Series Seed.
Last, the key to this analysis is understanding our goal: we want to see if an investor could use skill (picking ability) or Parachute to act as if they were investing alongside a Series A investor, even though they only have access to the deal at Seed. Skill is less relevant for Parachute clients because they invest in the deals they are interested in. It’s their money, and they are not beholden to LPs. We use this as a helpful benchmark and alternative strategy (and Parachute customers may consider it when evaluating VC fund managers). What matters more to Parachute clients is the amount of coverage (time) they can afford on an asset’s performance to be no worse off than if they invested in Series A directly. Parachute clients will use this time to judge whether or not they think the asset they are considering could hit the Series A milestone in that time.
Fundamentally, Parachute was designed to help investors better understand their risks with a founder. Providing this time will lead to more insightful and actionable conversations between founders and direct investors on managing an asset. The question is, could an investor use Parachute to effectively invest directly in a Series A round instead of only at Seed? A feat generally thought of as impossible.
The top-performing exception
The top quartile of companies graduating from Series Seed to Series A was 5.2x. Even factoring in dilution, in almost all cases, an investor at Seed is much better off than the Series A investor. They were paid for the risk of investing in the Seed round. The investor made 4.3x their money in a marked valuation for this single deal. Finding one of these deals justifies taking losses and write-offs. The Seed investor only needs 22% of their assets in this top quartile to justify their investment activity.
While 22% sounds like a low bar, it’s twice as good a picker than everyone else. This is because 40-50% of assets graduate from Seed to Series A, and this is the top quartile of those companies. There’s a 22% chance of picking up on the deals of the top 10% of Seed companies. So to be at 22%, the manager has to be at least 100% better at picking than the market. This is helped dramatically by having a firm with a track record and resources to attract the best entrepreneurs. This game theory helps the top Seed VCs stay at the top.
Similarly, would it be worth it for an individual or family office to bet on a Seed asset with a clear plan to 5x by Series A? Yes. If this opportunity arises, an investor could purchase 54 months of Parachute coverage before they start to lose capital. The key would be to remove coverage before that 54 months, which could happen at Series A or an earlier milestone. For instance, if it takes 12 months to learn that the asset will be 5x at Series A, then the investor’s multiple reduces from 4.3x to 2.4x at Series A. However, the investor gets 12 months to learn this information instead of blindly relying on picking.
In a top-performing Seed asset, the return is so high that it does not matter how much it costs to get into the deal—it just matters more to get into the deal. However, this is the exception. The question, now, is whether Parachute makes sense on every deal to effectively be an individual investor with a Series A investment strategy.
Investing at Seed for most investors
As discussed, this high-performing exception is only 10% of Seed assets. The other 90% are split between assets that do not graduate from Seed (60% of assets) and those that graduate at a much lower step-up multiple (30% of assets). The median step-up multiple is 2.8x, which will be higher than the mean of this cohort. Meanwhile, the bottom-quartile has a step-up multiple of 1.8x. When factoring in the discount, these respective step-up multiples are 2.3x and 1.5x. Both indicate that there is value to investing at Seed for an investor, but the question is how right or how long an investor has to invest effectively in the Series A round of the asset.
For investors to break even on a median asset, 44% of their investments must graduate to Series A at the median step-up multiple. This is slightly better than the market graduation rate to Series A. However, if we factor in access, assuming the best founders are attracted to the best investors, not general investors, picking may need to be significantly better. Ironically, non-established investors need to be considerably better skilled than established ones.
The real question is how much coverage is the equivalent of picking 44% of investments that graduate to Series A. It’s 36 months of coverage. The losses on paying 36 months of premiums is negated with the step-up multiple on the invested capital, making the Series A position worth what the Parachute customer spent. If an investor invested $100k in [Asset Y] at Seed, the investor also spent $54k in premiums, but their position in [Asset Y] at the time of Series A will be marked at a value of $154k!
If a client finds themselves in a lower-performing asset with a step-up multiple of 1.8x, the client can afford 24 months of coverage without losing any value on the step-up multiple. However, if lower-performing assets also correlate with graduating to Series A at a lower rate, then the investor is better off because Parachute limited the customers’ losses! When the asset fails, Parachute would reimburse the client for the shortfall of the initial capital invested tax-free. The client only lost their premiums.
Concluding remarks
Parachute was started as a simplified way to manage the risk of direct investments. We saw the value that investors get from investing back into their own communities. Our experience with prior investors told us that managing the risk was the biggest problem of obtaining this value. So Parachute was designed to empower the 93% of Accredited Investors on the sidelines to invest back into their community. However, suppose a savvy individual investor or family office wants to use Parachute to execute a Series A VC investment strategy. In that case, Parachute is also a good tool.
From this analysis, we realize two key points. First, the best deals outperform the rest. Access and reputation are key to this, and even then, it is still probabilistic. Second, there is a tradeoff of time and skill. While skill can only be judged historically, Parachute can buy an investor the time to evaluate a deal in the future.