To the extent you need risk capital, solving for aligned investors is just as important as solving for alignment with channel partners, employees, customers, etc. It’s all gotta work.

Fred Wilson wrote an interesting post today on VC fund math. It’s written from the VC perspective about what VCs should do, suggesting that entrepreneurs should consider an investor’s follow-on strategy. I think that’s right, though just an example of understanding (potential) investors’ business models and what it means for you.

Venture investors generally have a return target of 3x (or more) on the fund. In my experience, knowing their fund size and number of deals they plan to do can tell you a lot about their goals and incentives in your deal. If you choose a VC and you can’t make them successful, that will often end up your problem (e.g. pushing you to take imprudent risks).

How big is the VC’s fund? Regardless of size & strategy (% reserve + follow-on), a VC will typically they will be looking for your company to return their fund. This is what you’re agreeing to when you take their money.

The second question is, what percent of the fund does the VC plan to put into my company now and in total?

In general, if they put 1–10% of their fund into a winner, it needs to return 10–100x of their blended cost basis for them to succeed.

For a $20M seed fund doing seed to Series B, that might mean investing $2M total and owning 10% of a $200M exit. 1% of a unicorn can also be quite nice for small funds, so they may not need to follow on aggressively to make their math work.

For a $1B fund, a $5M on $25M post-money Series A with a 100% chance of a $200M exit is probably still a pass. It doesn’t make their math work. This exit “only” returns $40M, or 4% of the fund.

That doesn’t make VCs who pass on the company dumb, they’re just not aligned. If you don’t have a $1B+ story, don’t pitch a $1B fund. They believe only the 15 biggest outcomes a year matter, because that’s true for them.

In fact, the biggest funds not only have to pick a large number of these 15, but also buy significant ownership (20% is the rule) to make their math work. Their fund size requires it, so expect them to ask for 20%.

Note: The ownership dynamic leads to funky behavior on initial investments, biasing bigger funds to be ownership vs price sensitive. This generally means big funds will outbid small funds on price, which is great for the ego, but has implications for the next round as may take good exit scenarios off the table.

So, while it’s interesting to understand Fred’s points on reserves (know who’ll be there for you), I think from an entrepreneur’s perspective thinking moire broadly about venture funds’ models is important, & fund size is a key driver.

As an entrepreneur, you should be looking at each financing as a chance to soberly assess the opportunity. You’ve learned more about the market since the last financing, and are realistically better positioned to think through outcome scenarios than investors you’ll pitch for the round.

That may be a $1B Sand Hill fund. It might be a non-traditional option such as Bullpen,, family offices, strategics (rarely), etc. Or, you may look at your situation and realize taking more money right now would only increase the risk of getting a good outcome for yourselves, your team, and existing investors.

The right answer in that situation may be to sell if you know it can’t grow (or are just plain tired), or to figure out break even and keep working. You can always raise later if you discover a big opportunity later (it happens).

In my experience, entrepreneurs are much better at figuring out how to craft $1B narratives VCs want to hear than understanding why they want to hear them. Keep in mind that when you fail to pick aligned partners, you’ve screwed up 100% of your portfolio. When VCs make the same mistake, it’s more like one in twenty and as Fred alludes to, it’s built into the model.

I see a lot of grumbling about VCs screwing companies shooting for the moon. While I think there are certainly some bad apples here and there, I suspect entrepreneurs that default to raising the next round at the highest valuation without thinking this stuff through is a much more common source of founder and employee disappointment.