LP Expectations vs. VC Realities
‘We’re looking to underwrite a 5x net return from our seed managers in this vintage.’ — Overheard from a large institutional LP last November
Amongst this jargon is a simple message that is terrifying for most VCs — ‘I expect you give me back 6.5 dollars for every dollar I give you. 🤪’
In the boom of the past 2 years the expectations on seed fund returns have risen sharply. You can understand why — over a third of the funds deployed just last year in Europe are already 2x on paper. Many of the 2009–2013 vintages that have matured in the past 18 months have led quite a few GPs to retire or move to Miami.
And with these changing expectations come changing behaviours.
One of the biggest changes these expectations from LPs bring on VCs is an even sharper focus to optimise for the home run outcome at all costs.
A 100m exit for a company that’s only raised a seed round is life-changing for founders. But in a world where a fund is trying to return 6.5x gross it simply doesn’t move the needle enough to matter.
The power-law always determines VC returns. So while getting a 5x here and there was nice, it wasn’t going to put you on the Midas List. Now with even higher expectations, investors are much more inclined to want to take a higher likelihood of a zero with a low likelihood of a 50x, than a guarantee of a 5x on their money.
The game has moved on, fund size has increased, valuations have gone up and if exits aren’t in the 10x+ range it’s unlikely to make any difference to a fund other than recycling the capital back into something that you think can get you to that 10x+ number.
In this misaligned time, seed investors need to have honest conversations with founders pre-investment. They need to let them know that losing your principal isn’t a problem. That’s part of doing business.
But if founders aren’t willing to turn down tens of millions personally at some point along the way? Most VCs are probably the wrong partner for them.
Because when founders do their jobs right those decisions aren’t a matter of if, but when. The biggest fear investors have isn’t losing money. It’s their best investment selling long before they should.
Now, it’s not all on the founders here. It’s part of the investors' job to allow founders to take on this risk. Secondaries are the easiest tool here to keep the risk balance reasonable to turn down exit options along the way. It’s a small part of the job to help founders dream bigger and give them the tools to take the big risks.
This change in expectations doesn’t just change things on an individual investment level. It also changes the way venture investors have to think about wider portfolio management.
Fred Wilson’s logic on taking money off the table was that it pretty much always made sense for early-stage funds. But now with expectations rising even more on seed funds, they become more and more likely to want to hold and continue to build positions in their winners.
This creates a whole new world where funds try to do their pro-rata through many rounds of funding — even once their core funds tap out they keep going via SPVs or Opportunity Funds to keep putting more money behind those potentially power-law fulfilling companies.
The changing expectations even changes investors’ behaviour post-exit. In the past VCs handed over their public positions to LPs and returned to investing in the next generation of disrupters. Now with GPs and LPs correctly seeing that there is even more money to be made by holding onto these shares, there’s theoretically a case where your seed investor is your largest shareholder many years after you go public. The Sequoia fund being the first of many funds to likely use this kind of structure.
This is the divergence we’re seeing between what VCs are selling to raise outside capital and what founders actually want. The VCs have even more pressure now to swing for the fences and to hold onto their winners till the bitter end. Yet for the founders, as Bryce said, it’s frequently just about a better chance at some kind of life-changing success.
The razor I apply to investing and start ups is that every decision that increases your probability of wild outlier success should also increase your probability of total failure.
If you want to be a shot at being a 10x returning fund? You’ll have to take on the higher likelihood of being a 1x. If you think you’re going to build the next Stripe? You’re going to have to run the risk of going nowhere.
The stakes as a founder are much higher on this razor. They have one chance to bet big. VCs have many. We’re climbing the same wall but they’re free solo while we get to make 20 mistakes along the way. No safety, more glory. Not for the faint-hearted and important for everyone to know where the others stand.
