Can you Scale a Venture Capital Fund?
Can you Scale a Venture Capital Fund?
A breakdown of the VC ecosystem over the last few years and why the current fund structures are flawed
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When the VC industry started back in the 60s, it was originally called adventure capital.
As Sebastian Mallaby writes in his book The Power Law, "The idea [for adventure capital] was to back technologists who were too dicey and penurious to get a conventional bank loan but who promised the chance of a resounding payoff to investors with a taste for audacious invention."
Somewhere along the way, the 'Ad' got dropped and became Venture Capital, the business of investing in new ventures.
In its current state, I think we're on the precipice of dropping the 'Venture' and just being straight-up 'Capital'.
What started off as a cottage industry rooted in backing steep contrarianism, is now an industry of short-termed thinkers speedrunning their way to stardom.
For an industry that should intimately understand business models and incentive structures, it's done a pretty poor job of aligning long-term success with short-term performance metrics.
As a result, we've ended up in a gross reality with ludicrous sums of money being raised by both funds and companies and the media running riot on the extreme capitalism taking place.
When writing my article about how a founder should craft their startup's narrative, I couldn't help but think how broken this system was. Who was I, to tell a startup founder how to tell the story of their business? Unfortunately, that's the world we live in. VCs have created hoops for these founders to jump through and boxes for them to contort themselves into.
So let's talk about how we got here and where we are headed.
The Seed Mega Fund
What started with Softbank's Vision Fund 1, a $100 billion venture fund, quickly permeated through the rest of the venture ecosystem and spilled out into hedge fund land. Firms all over the world were raising large multi-stage funds in an attempt to compete with Softbank and eke out strong returns in what was quickly becoming the longest bull run in history.
With an oversupply of capital, demand quickly followed. Operators left their stable corporate jobs and later-stage startup roles, to have a go building a generational company themselves. This would normally be a good thing, but with a sustained oversupply of capital, this left a significant number of firms fighting for allocation in a small number of deals that are worthwhile investing in.
Now, early-stage venture valuations are never really tied to hard metrics, but rather an imputation of the amount of equity the founder wants to give up (i.e., dilution) and the amount they want to raise at any given time.
As an example, if a founder wanted to raise $1M, and exchange this for 20% equity in their business, this would mean the post-money valuation of the startup would be $5M.
Previously, there were clearer guidelines with how much dilution founders would take on with each round and a range for how much they should raise. However, with abundant capital in the market, these guidelines basically became nonexistent.
This meant that founders were given more money in exchange for less equity. What used to be a $1M seed round, was now a $4M seed round, and instead of 20% dilution, it was now 10% dilution. This was a fantastic deal for founders because they got a lot of money upfront and didn't need to think about raising for a long time.
As such, you now have companies that have 4 years of runway, led by founders who are still early in the journey of learning how to lead teams and scale an organisation.
Whilst VC firms were paying high prices on each investment, this strategy made sense due to a few factors:
They were burning through their funds and rather than raising a new fund every 2-3 years, raised funds every 1-2 years meaning they got a meaningful increase in assets under management and top-line revenue to grow their firm. Firms also frequently 'pre-allocated' capital to future funding rounds in an attempt to visibly prove they had deployed all their capital and needed new funds.
They had to do less work to deploy their capital. Rather than writing 30 $1M cheques and having to manage each of these companies, they could write 15 $2M cheques and look after fewer companies and spend less time running a due diligence process on startups.
Once a mega round was closed, the clock started ticking for the business to raise another round, ideally from another large fund. And so you got companies raising new rounds within 6 months of each other leading to a hyper-aggressive markup of investments across many venture portfolios.
This led to a few benefits for some firms and individuals. By optimising for investing in competitive rounds, these startups appeared to be 'the real deal' when in fact a large majority were just zombies. However, at the time the clout and signal that accrued to these firms allowed them to get access to other competitive rounds and also raise more funds from LPs.
If you can see through what I'm saying, the venture ecosystem displayed a certain level of Ponzi-like dynamics. Rather than thinking about how to actually make a startup successful, funds were thinking about how to get more money out the door in as short a time period as possible. This had significant flow-on effects on other parts of the ecosystem.
The Value Trap
Whilst the big funds were playing an AUM growth game at the top, smaller funds that weren't able to/didn't want to keep up, quickly found themselves boxed out of the ‘hottest’ deals or actively selected themselves out of funding companies that raised at high valuations.
For these funds, the problem that they faced was different. These funds had to search for good companies overlooked by the big funds that they could invest in, at low valuations or as Warren Buffett puts it, looking for 'fair businesses at a good price".
Whilst there is nothing fundamentally wrong with this thinking, in a lot of cases, these investments have turned out to be a value trap. Apparently undervalued at first, yet, actually a size-constrained business that shouldn’t have raised money.
By investing in 'unsexy' areas, fund managers also took a contrarian bet on what would look 'sexy' in the future and what big funds would back in a few years’ time. This would have been a great strategy if follow-on investors hadn't also moved down the capital stack and invested large amounts into seed businesses and exhausted much of their primary investment allocation.
The Lay of the Land Today
So now you have the following company profiles:
Startups that raised too much money too early and are struggling to prove PMF or grow quickly, yet have 3 years of runway
Startups that shouldn't have raised money at all, due to not being suitable for the venture model
Startups that are showing promising signs but aren't able to raise money at reasonable terms (i.e., not a down or flat round) because later-round investors are too busy with their existing portfolios to invest in new companies
On the other hand, you have a single sector (AI) where companies are able to raise tens of millions of dollars easily.
This is such a weird incongruence that largely defies logic, but is purely spurred by the short-term incentivisation of an industry that is meant to be long-term minded.
The venture capital model used to make sense. Each stage of fundraising clearly represented a derisking step.
During the Seed stage, investors gambled on the product displaying indications of Product-Market Fit. At Series A, they had to trust in the company's ability to scale its Go to market strategies. At Series B and later stages, investors needed confidence in the product's capacity to grow the market and that the company's culture remained steady after 4-5 years of rapid growth and scaling.
We are returning to this model at the earlier stages where funding is still open. Most raises now are tied back to milestones that need to be hit by the next raise and are sensible in size. However, I still feel we need to rethink whether the current venture capital funding model makes sense in the current climate.
Early-stage venture capital performance is reliant on three key levers.
Your fund size
The number of investments you make
Your ownership stake in each of these investments
People have different theories about the optimal ownership stake and how many companies you need in each portfolio, but realistically it’s all constrained by your fund size.
These are a few fund profiles:
In the table above, I’ve laid out 5 broad bucket fund profiles. At the lower end, we have a ‘spray and pray’ type fund that looks to make a lot of initial investments and then follow on into the best of these investments. At the other end, we have a typical seed mega fund that reserves most of its capital for follow-on investments (denoted by the red border) with a view to lead multiple rounds.
As you can see in the table, the average primary cheque size fluctuates based on how concentrated the strategy is, and how large the fund is. As such, if we were to set an ownership target, i.e., the fund aims to own 10% of every company it invests in, then we should be able to calculate the specific valuation ranges each fund can theoretically play in.
From this table, you can see the large disparity between how high a mega fund can potentially bid for an investment, versus a concentrated small/medium fund. I have taken 10% ownership as an indicative target as it is a fairly common benchmark in the industry. Moreover, for the diversified small fund, this ownership target likely isn’t appropriate (as can be seen by the valuation ranges) and they might instead aim to own 2-5% of a company.
So in the last column, you can see that the expected valuation range for a mega fund is somewhere between $40 - 53M. This is pretty close to being accurate for deals that were getting done in 2021 by mega funds.
The flow-on effect of these deals getting done is that these rounds are inaccessible to anyone else if they actually care about their portfolio construction. However, ill-disciplined mid and small funds did follow into these rounds and gave up their ownership in exchange for associating themselves with ‘hot’ deals. I truly do wonder if those deals are still ‘hot’.
Anyway, back to the topic at hand, all these figures are great, but what does this actually mean?
The starting Pre-Seed or Seed valuation for a company essentially dictates how big the company needs to be to actually be a strong returner for the fund. VCs expect that each of the investments they make return the fund at least once. This is represented by the TVPI metric, which is the total proceeds from investments made out of the fund divided by the fund’s committed capital. Typically funds target a TVPI of 3x+.
In this scenario, I’ve made a few basic assumptions around future dilution, and the expected uplift of the pre-money valuation at each round. In reality, a startup’s fundraising journey is never as linear or straightforward. Additionally, as mentioned before funds will typically try and maintain their ownership stake in a company as long as possible, but it’s quite spurious to forecast how much they will be able to maintain as pro-rata and super pro-rata rights are all negotiable and deal dependent.
As such, I have left this as a single investment amount that results in a 15% ownership stake for the fund. In this scenario, you can clearly see that this investment only reaches a 0.3x TVPI, in the event that the company is able to hit a ~$2B+ valuation. Just imagine how large the company would need to be to return the fund in its entirety!
Alternatively, let’s look at a similar scenario, from the view of a $50M Seed fund.
Keeping a similar capital journey as in the first scenario, in this case, the fund only needs to own 5% of a startup to return a 1.01x TVPI at the same $2B+ exit valuation. In real life, you can expect that this fund would own closer to ~10%, which lowers the valuation threshold needed for the company to return the fund.
As you can see the pressures placed on companies as a result of accepting investment from a larger fund is enormous and frankly unnecessary at the earliest stages when that shouldn’t be the core focus for the founders. Moreover, these are ‘perfect’ scenarios.
Startups frequently hit roadblocks and might stumble along the way. In these cases, the requirements to get back on the ideal pathway are so much harder meaning early investors can get screwed even if the company ends up being successful.
Where Do We Go in the Future?
Technology is a deflationary sector and through the recent AI breakthroughs, there will likely be a steeper deflationary effect on the industry. This can lead to two outcomes:
People continue to raise big seed rounds to support heavy distribution efforts
People raise smaller seed rounds as the hiring requirements are heavily stripped down.
My personal opinion is that the best founders will raise smaller seed rounds and focus more on hitting milestones. In the current market, efficiency and profitability are rewarded the most, and milestone-based funding breeds discipline and decisiveness.
There is sufficient incentive for founders to take this approach, rather than accept a large cheque and face the difficulty of growing into that valuation before the next round. Smart founders can see this play out in the ecosystem and should steer well clear of this.
As such, I believe the larger seed-focused firms will struggle to balance the workload of writing smaller cheques and managing more portfolio companies. It’s likely that these investors might move later down the capital stack and invest across Series B and C.
Smaller and medium firms will need to deploy their money carefully with a view to not writing too many small cheques and having insufficient ownership. Balancing ownership and the number of portfolio companies is key.
At Rampersand (my fund), we are a mid-sized fund with a thoughtful approach towards curating and crafting our portfolios in a way that balances optionality and concentration. As my colleague Hunter wrote, you need to choose an appropriate VC for the stage of business you are running. At the seed stage, that is undeniably a small or mid-sized firm who are not incentivised to push you and your startup to grow more than it needs to.
As we continue to traverse through the uncertainty that is the current economic climate, my hope is that LPs think critically about who they are giving their money to and look beyond track records and actually question the incentives behind different deployment cycles and fund models.
There is a significant opportunity for a new type of capital source that can come into the mix, especially in smaller markets like Australia where it just isn't sensible to be deploying over $50 - 100M a year from a single fund into early-stage venture capital. This could take the form of a VC/PE hybrid type model where companies that have been bootstrapped or have raised minimal capital (~10-20% dilution in total), are able to roll up into a holding vehicle similar to Tiny.
Or perhaps it's similar to Indie.VC where they have opened up an alternative for founders through equity repurchase agreements. Indie provides seed funding to startups and then they have 3 ways to manage their company's trajectory:
Raise from traditional VCs
Get acquired or merge with an existing VC-backed company
Or, bootstrap their way to profitability, and repurchase Indie VC's equity stake.
Increasing the level of optionality for founders, and decreasing the external pressure placed on founders to make fund mechanics work might spread the wealth around, but more importantly, incentivise more founders to give it a go without being intimidated about the repercussions of failing or stumbling along the way.
Regardless of what happens, it is clear that seed-stage investing is hard to scale. It’s a personal journey that requires time, patience and faith from investors and founders to get right. Over the next few years, we will feel the lessons learnt due to a rash, momentum style of investing. My only wish is that there is a significant shift towards more contrarian bets that give deserving founders a chance to prove that their version of the future is accurate.
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Abhi