I spent some time reading Facebook's IPO filings.

#1 thought? Something a top up-and-coming Venture Capitalist told me last year:

To the "A" round go the spoils. The "B" round investors take almost the same risk, put in more money, and end up with lower returns.

(Note that I'm referring not to the seed round, but to the first and second venture capital rounds.)

So this morning I tweeted it:

Facebook's first venture capital investor put in $12.7 million, now worth $10 billion.

Facebook's second venture capital investors one year later put in $27.5 million, now worth ~$1 billion.

Mind you, those second round investors made a lot of money; that's a venture capital home run.

But the first round investors hit one of the greatest home runs of all time. YouTube it.

So I tweeted again:

The main point is that the B round investors took almost the same risk with twice the money, and got a much lower return.

Why do I think it's almost the same risk? Facebook's business model was as unproven in the second venture financing as it was in the first venture financing:

"That was a way out-on-a-limb investment â a very controversial deal," one local venture capitalist told me this morning. "There were arguments within Greylock about why it could be a bad investment."

If we look at four other big hit venture investments of the last ten years -- Groupon, Zynga, LinkedIn, and Twitter -- the companies seemed to have the same level of risk in the "B" rounds as in the "A" rounds, but the valuations were much higher as the companies increased a key metric (groupons sold, daily active users, total users, tweets per day) instead of profits.

By comparison, two of the biggest hit venture investments of the 1990s -- eBay and Google -- never took a second venture round. They took that single "A" round and employed it to grow the company to the point where it could go public.

William Quigley noticed this trend last year:

Here is the important, and game-changing, point: in order to participate in the great wealth creation taking place in this and future technology cycles, you will have to be a founder, an early employee or a private investor. The so-called easy money will be earned before a company goes public. This is a radical shift from earlier technology cycles.

Not a lot for the public to get excited about when a tech company IPO's these days.

And even among the investors, it's the first money in that makes the lion's share of the gains. #OccupySandHill

Consider Groupon as an example:

• Groupon's "A" round investment, led by NEA, was $14.8 million -- and is now worth $2.28 billion.

• Groupon's "B" round investment the following year, led by Accel, was $20 million -- and is now worth $867 million.

The "B" investor risked more money (even though to this day the sustainability of Groupon's business model is unproven) and received a lower return.

Or consider Pinterest, which has not had a liquidity event so we don't know what the final returns on investment are:

• Pinterest's "A" round investment, led by Bessemer, was $10 million for 20% of the company.
• Pinterest's "B" round investment six months later, led by a16z, was $27 million for 15% of the company.

The "B" investor risked more money and received a smaller ownership, just six months after the "A" investor, for a company that "is working on creating a business model" and therefore has not de-risked the opportunity. (Yes, I believe they can figure it out.)

Having said all that, I believe that it requires a lot of courage to be the first to invest in an unproven business. Great "A" round investors have that courage.

"A" round investing is what venture capital SHOULD be all about... and therefore it's only fitting that to the "A" round go the spoils.

An important point is that most A round investors continue to invet pro-rata over multiple rounds to maintain their ownership so the returns by round might be misleading (didn't look at returns br VC & when they put it in. )

Good point. :)

See also: VC Behavior Sometimes Looks Insane But Generally It's Sound.

But doesn't pro-rata investing mean that you keep ante-ing up according to your previous ownership %? So if A round investor got 10% of the company for $10mm, yes he will end up putting in more than that over time... but he'll get to keep owning 10X more of the company than B round investor who put in $20mm for 1% and is ALSO putting in more money pro-rata at each round?

Joyce, that's right. Mark Suster's visualizing dilution essay illustrates this, too.

Yes, they put more money into each round to maintain their share.

But as Joyce says, it's not much compared to the gains those shares represent.

I completely disagree that these 'A' and 'B' investors were facing "almost the same risk", especially in the Facebook case.

First, your examples, chosen from companies that have been successful at least through the 'B' round, suffer survivorship bias: what about all the 'A' rounds that never get a 'B' round, or only a down round?

Second, the difference in Facebook's prospects in the ~year between the 'A' round (May 2005) and 'B' round (April 2006) were gigantic. Their userbase roughly tripled in size, and the gorilla in their category (MySpace) got bought by a non-tech company (in July 2005) – which both confirmed exit values, and removed a nimble private company from the race to be the biggest social utility.

There are lots of ways a trendy young company can flame out – and every year they don't is big. In May 2005, Facebook was one of many entrants in a hard-to-understand category. A year later they were still killing it as competitors were, one by one, slowing down.

I would also disagree that there was ever much 'business model risk' for the eventual category winner. Having the top site, with network effects, where everyone volunteers their relationships, interests, and interpersonal communications would always offer plentiful ways to make money. It was all execution risk: would someone else win? (What if Google hadn't fumbled Orkut, putting their 'wood' behind that 'arrow' way back in 2005? What if MySpace had adopted a more Valley-Zuck-Parker-Thiel mentality? What if Yahoo360 had been given the same strategic emphasis as Google+ is being given today, when it could have made a difference?)

Oh hey, did you know I worked at Friendster in 2004? Top site with network effects has no risk huh? Bwahahaha!

No, seriously, I think YOU are the one with the survivorship bias. I can tell you for a fact that there were SO MANY things that had to break exactly right, so many quirky things that went Facebook's way, for them to enjoy their current status as the top site. Just for one tiny trivial example: you might not believe how casually they made the decision to allow unlimited free photo hosting -- which none of their competitors offer even now, right? And when you see a category littered with former top dogs who were easily abandoned by their users... I think it's a little flip to say there was little business model risk when David Sze invested.

We can say that the example companies (Facebook, Groupon, Zynga, Twitter, LinkedIn) are representative because the lion's share of venture capital returns come primarily from the big winners.

The main point of this post was to say that for the best investments, there's a huge difference between being the first investor and being the second investor, as far as return on investment goes. I stand by that.

I do remember that when MySpace was bought, there were many people who thought that the extra capital from News Corp was going to help MySpace become much, much bigger than Facebook.

Facebook's dominance was in no way assured in April 2006, especially given how easy it was for consumers to move from one website to another. (And yeah, where the heck were Google, Microsoft, and Yahoo while this was happening?)

It was a very gutsy call to be the "B" round investor in Facebook. Many people thought that investment would not see much return, if any.

Furthermore, Greylock was mocked when they publicly announced that they had made the investment.

And I actually think the "business model risk" for Facebook is still playing out.

• What if advertisers decide they're not getting good bang for the buck with Facebook advertising? Facebook's revenue streams aren't diversified; if major advertisers start pulling out it could have a vicious cycle effect.
• What if Zynga gets paid by a Facebook competitor to get off the Facebook platform completely? Then 13% of Facebook's revenues vanish overnight.
• What if users get fed up with Facebook and someone else comes up with something better? Consumers can and will leave the service.
• What if governments decide Facebook has too much power and start to regulate it like a utility? So much for it being a growth stock.

And so on. Facebook still climbs a mountain of risk every day.

Joyce, you're reading my comment exactly backwards. I agree there was tons of risk in Facebook in both their 'A' and 'B' rounds – there could have been giant losses, after either round.

My point is there was much *less* risk in the 'B' round, unlike Adam's claim that both rounds took "almost the same risk". MySpace had proven possible exit values (and Facebook was likely already rebuffing acqisition offers) *higher* than the *total* 'A' round valuation. Competitors were slowing as Facebook was accelerating. The chance Facebook would be 'the winner', for those who thought there'd be one runaway winner due to the network-market dynamic, was still growing.

And even the risk Facebook faced wasn't "business model" risk – which I interpret as, "if we have the biggest marketshare, is there any way to make money from that?". ("Does this business model even work?") It was, "will we attain/retain enough marketshare/scale against Orkut/MySpace/Friendster/Yahoo360/Hi5/other-entrants?" That's execution risk.

I think both the 'A' and 'B' investors took a big risk, and richly deserve their rewards – plenty of other sophisticated investors passed at the same time. But the 'A' investors, even just a year earlier, made a way "gutsier"/riskier call, that fully justifies the extra ~20X size of their return.

(And, Oh, Hey, if we're trading relevant-perspective anecdotes, did you know in 2002 I reviewed Jonathan's Friendster pitch .DOC when the main revenue model was going to be paid dating-service subscriptions? And urged him against his own instincts to seek patents, just as a defensive/investor-protecting measure? And recommended Friendster to two of its first round of angels?)

I believe that 2006 was the year that Facebook was trying to move from being for college and high school students, to being for everyone.

That was high risk because why would everyone want to hang out with students, and why would students want to be there if everyone else is there?

The execution risk was still very much there in 2006: ComScore reported that Facebook's traffic was in decline in February, right when Facebook was raising its funding. (Facebook, of course, disagreed with ComScore. But still.)

It's funny that WebProNews featured Facebook's 2006 business model: local ads in college markets, brand ads to high school and college students, and sponsored market research groups for high school and college students.

Not the multi-billion dollar business we know and love in 2012.

The chances of something that appealed to 13-22 year olds in 2006, still being around in 2012, were not good. 13-22 year olds are fad driven, and the Web lets them easily move onto something else.

We can agree that it was a gutsy call by Greylock and Meritech.

But back to my original point: Who gets the best venture capital returns? The earliest investors.

Rereading that CNN piece, I see that Union Square Ventures, Foundry Group, and Spark Capital had the best IRRs of the last decade because they were the earliest venture investors in Zynga and Twitter (and in USV's case, both).

The later investors in Zynga and Twitter did great too, but their IRR was not as high.

Guts beget the best returns. "A" round isn't for everyone, but those who do it well do VERY well.

Very good points made here, and in the comments.

I do feel like the A round investors take a bit more risk, only because A round investors lack the cushion of earlier investors who are injecting more capital in the company to maintain their share. It's money that's helping the company innovate, grow, and hopefully become great; It's also extra money that the B round investor isn't spending. That said, any venture capital investment is a huge risk, but it's better to be late and make 40/50x than miss out and make 0... assuming you believe in the opportunity enough to invest in the first place.

I leave with a baseball analogy...

Facebook is like Bucky Dent hitting that game winning home run against the Red Sox in '78. Like Joyce said, everything had to go just right. I'm pretty sure if they went back in time and did everything exactly the same again, it wouldn't work out - at least not like it did. What Facebook has done is extraordinary and should be celebrated. However, I don't think we should pretend that it was result of anything other than a crap ton of hard work done and great decisions made by lots of smart people who happened to be at the right place at the right time. That's the valley - you bust your ass just to sit at the table. Just to have a chance to get lucky. Personally, I think that's what makes it great, and I love it for many of the same reasons that I love the great game of Baseball :-)

Well said, John, and now you have me jonesing for baseball season to start...

:-) You're not the only one!

The difference today is that the insiders have wised up and the public (and helpful fund managers) buy into the hype.

Now the goal is to hold off on the IPO until just before peak hype will be reached. Then offload a tiny piece of the stock in the IPO and then dump all the locked up shares onto the public markets as fast as possible before the hype dies. Employees are at the end of that line of course.

This is born out by the last dozen or so IPOs that are now below water, because there is just too much stock to maintain the lack of business model exposed in the IPO disclosures.

On the bright side, Facebook only needs needs about 10 billion active users to justify its valuation, 50 billion actives in a few years - so expect all the insiders to get out in a hurry.

You may have spoken in haste. Facebook's valuation is doing just fine, thankyouverymuch!