Phoenix Rounds

Investing Before Inflection Points

Follow the discussion on Twitter

Recently, our friends at Boldstart Ventures wrote a piece about “Inception Investing,” investing at the formation stage of the company, highlighting the evolution we’re seeing in the seed stage venture market. We wrote about some of these dynamics in our post, “Seed is the new Series A,” discussing the implications of these evolutions and the need for investors to align their strategies and core competencies to where they’re best positioned for today’s market.

While there are many different ways to play the Seed market, we’ve largely aligned around two stages. Nearly half the rounds we’ve invested in at Equal have been “Inception” investments (including our 3 most recent deals). This entry point enables us to get great exposure to teams heavily aligned with our theses and we’ll even go as early as starting companies alongside founders (having incubated 4 companies in the last 4 years).

Our other frequent entry point is more complicated, but is a round we see emerging more frequently amidst the fallout from 2021. It’s a company that’s been around for a few years and never really took off. The team has earned the battle scars from the market, but was inhibited by one or a variety of reasons. Perhaps it was the inability to raise capital, a misaligned investor base, a flawed business model or simply market timing. We often find that these founders understand the market incredibly well, but lack the resources and support mechanisms to take the “big swing.”

Through whatever means, we end up connecting with these founders on an opportunity that is adjacent to what they are currently pursuing. We share our homework on a market opportunity with them, introduce them to our network of “bridgers” (i.e. industry experts / leaders that partner with our firm) to further vet that opportunity and craft a plan for that team to validate the opportunity and achieve product market fit within the next 12 months.

These aren’t bridge rounds, which are primarily used to extend runway to achieve the milestones necessary for the next financing. These are complete pivots in the business. These are ones where the existing business likely isn’t working, but the founders have developed amazing insight on customers and the market. These companies are willing to leverage those earned customer insights and relationships to take one last BIG swing — burning their existing business to the ground to build something different, but perhaps exponentially better. In many cases, existing investors aren’t willing to sign up for these types of rounds. The only data points they have on the company have been negative (i.e., the company isn’t working) and VCs generally want to concentrate their dollars behind their companies that are working the best, not a perceived losing hand. But make no mistake, this has been one of our most successful entry points.

In discussing this with Ed, he brilliantly coined these rounds as “Phoenix Rounds.”

Phoenixes are powerful mythical beasts, reborn after their death and rising from their own ashes. Much like a Phoenix, these companies are rising from the “death” of their existing business to build something better and stronger.

ThreeFlow, a SaaS-enabled marketplace connecting benefits brokers and carriers on a single platform, is a perfect example. The company had been around for 3–4 years when we initially met the team. Their revenue was still fairly limited, growth was not accelerating fast enough for venture scale, and local VCs didn’t understand their market. They had been pigeonholed into a SaaS business model that was notoriously difficult for their segment, since that is the business model that generalist VCs could best understand. We had met the team through one of our insurance “bridgers” who knew about our thesis in this space for a marketplace model given my prior investment in Riskmatch and shared with them our idea for a new approach. Over the course of several months, we got to know ThreeFlow’s team as they pivoted their business to a marketplace model from their original SaaS approach, even though it cost them their largest customer. Simply put, they bet the farm on the pivot. During that process we could see the strengths of the team — their subject market expertise, their salesmanship, their coachability and their determination — and developed the conviction to invest into their pivot despite revenue actually declining YoY. The team had come from industry (rather than traditional startup backgrounds that would have given them greater access and latitude with VCs) and had incredible relationships with both carriers and brokers, uniquely positioning them to establish critical mass for the marketplace in a way that no other team could. While not obvious on paper, we came to the conclusion that this could be a very special team to execute on the incredibly large swing of a marketplace approach to this industry. Since then, ThreeFlow has become one of our most promising companies and the category leader in Benefits Placement Systems. That’s a Phoenix if I’ve ever seen one.

ThreeFlow isn’t our only Phoenix. We LOVE these types of rounds because they provide the time for us to get to know a founder — for us to develop our own unique insight on them and on the potential for their business, rather than leaning on first-order thinking in a fast-paced auction process. Just as importantly, the founders get to know us through the process, seeing how we can be additive partners to their business. There have been countless companies outside our portfolio (Slack is a great example) that have emerged from failed first attempts to become “mythical” businesses.

Generally speaking, since these are not hotly contested auction-based financings, they provide the time for founders and investors to get to know each other. This enables investors who may have unique insight on the market to mutually align on a new plan with the founders. In many cases, we’ve seen investors (including ourselves) stress-test the potential pivot with customers in their network. The time spent on the process can provide a prospective investor the opportunity to see insights on the company and (more importantly) founder’s potential beyond the existing business, while providing the founder the opportunity to get to know the investors as additive partners to the business before adding them to their cap table.

These rounds can be messy and complicated, and they require work (usually prior to being on the cap table) to help a company pivot. They require market intelligence/networks to see data points before they are there, and may even require reworking the cap tables. In no way are these companies “obvious.” But investing to generate rare returns is rarely obvious. These rounds provide an opportunity for investors to find exceptional opportunities that others don’t appreciate and to help turn the non-consensus companies into consensus category leaders. Phoenix rounds will never be consensus, but mythical companies will be made there and we suspect mythical returns will be, too.