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Upside Protection

Unlike many other types of investors venture capitalists are not as worried about downside protection. There is inherent downside protection in equity investing, namely you can only lose as much as you invest. Yet the equity can grow infinitely in value. Also unlike most equity investors, VCs expect to make the vast majority of their returns with only a small handful of investments. With the rest of the investments either being losses or a "push". Because of the fixed limit on the downside and a focus on the few investments with great upside potential. Therefore, it is more important as a VC to focus on upside protection. That is to capture as much return as possible on investments in companies whose valuations are growing very quickly. This can be done through a variety of mechanisms. I want to talk a bit about two of such mechanisms here.

Follow-on investing. Many VCs retain large portions of their funds to make subsequent investments in companies that are doing really well.[1] This helps to alleviate dilution in further financing rounds and exposes the firm to more of the positive upside potential. This is why small funds with a limited ability to follow on, can be disadvantaged. This can also be a huge disadvantage for angel investors who do not have reserves of capital to invest in their winners. Tucker Max has a good post that cites the limited ability to follow-on in winners as a reason for small angel investors to never start investing at all.

Convertible note with a valuation cap VS a note with just a discount. This is more subtle, but an important mechanism for investors who use convertible notes. For example, let's say you are the first investor in a very early stage company. The company is just a founder with an idea. You and the founder decide to use a convertible note for simplicity as well as to not have to come up with an exact valuation for the very early stage company. You give the note a 20% discount as it converts in the next round. This sounds reasonable, as you are taking more risk so your reward is a 20% discount.

Consider if the company is doing really well and they do an equity round with a valuation of $20 million dollars. Your investment converts at a 20% discount, $16 million dollars. A valuation much higher surely then you would have agreed to when the company was just an idea. However, if you had negotiated a $3 million valuation cap. Your investment would convert at the $3 million cap and you would effectively own 5x more of the company than just based on the discount note. That is upside protection. In the first case, you would effectively be punished for taking a chance investing earlier in the company because of how well it was performing so quickly.

This is important because at a $3m cap and a $20 million valuation this investment might be the one that returns your whole fund. It would not have done so simply with a 20% discount and certainly wouldn't cover the other losses and "pushes" in the fund.

Notes:

[1] Some companies also encourage this behavior with a pay to play clause.