Venture Convection
A theory of the forces governing “irrational” VC behavior
Last night I saw a tweet that really resonated with me:
In VC, there is a commonly-observed pattern that the definitions of fundraising milestones float upward over time.
What does this mean? Here’s a great explanation from Pando, last year:
Simply put: “Seed” is no longer seed. Pre-seed is seed. And even that’s not the earliest round: There’s friends and family before that.
What does that mean for a Series A, once named because it, too, was the first institutional money into a company? Well those are what we used to call Bs, or maybe Cs. And all those late stage D or E mega rounds? Those are what we used to call IPOs.
“In the venture industry, we don’t change the names to match what’s actually happening,” Kumar says.
Why does this happen?
Imagine you’re a new venture capitalist.
You don’t have a track record yet, so the LP’s (“limited partners” — the people who invest in venture capital funds) aren’t exactly bending over backwards to give you their money. But through some luck, charm, and persistence, you do manage to raise a nice little $10m fund.
You’re in business!
Since you only have $10m, and you need to spread out your risk, your plan is to limit your “check size” to $200k. This gives you room to invest in 50 startups.
When you’re writing $200k checks, it inevitably means that you’re investing in early-stage companies. If all you can bring to the table is 200k, it’s going to be really hard to get a seat at the table for Medium’s $100m Series D next year. Even if you invested your entire fund — which would be a very bad idea — it just wouldn’t move the needle for Ev. No Medium for you.
But wait, there’s good news! Bigger isn’t always better.
Medium stock is pretty expensive compared to the tiny startups you’re investing in. It’s going to be difficult for their Series D investors to see a 1,000x return on that investment (Medium would need to grow to approximately the size of Apple to accomplish that). But you, on the other hand? If even one of your startups turns into the next Medium, you could burn the rest of your fund and still make a 1000x return!
So the winning strategy is clear: invest in killer early-stage startups.
But how? There’s a very finite number of Series D eligible companies. And a bigger, but still manageable amount of Series C deals. As you go earlier and earlier, the pool keeps getting bigger and bigger, and the game shifts from “multiple choice” to “needle in a haystack”.
You need to stand out, somehow. You need to create a brand and plant a flag in the ground, so that the world starts sending qualified founders your way. You need to own a word.
One way to do this is to focus on a specific kind of company: Marketplaces. Frontier tech. Internet of Things. Vertical Commerce.
But there is another way. Instead of owning a category, you can own a stage. You sense that there is a class of founders that are promising, but often rejected as “too early” by traditional venture capitalists. So you make up a new term for a new type of fundraising round, and you position yourself as coming before the traditional first round. Some people call it an “accelerator”. Some people call it “pre-seed”. But you, you decide to call it “original capital”.
Original capital. That sounds awesome.
Now that you’ve picked your word, it’s time to get out there and own it! You write blog posts, get interviewed on podcasts, throw a launch party, get some press, etc. In every bit of publicity, you make sure to mention the phrase “original capital”. Now, when your friends and acquaintances see a promising-yet-early company, they think of you.
And that’s how you get deal flow.
Fast-forward a couple years. The $10m you raised has been deployed. Most of your companies are just plodding along, and some have died / gotten acqui-hired, but a couple are actually doing really well. The plan worked! It looks like you’re going to make your investors a lot of money.
So what’s next? You like your job, and you seem to be good at it. You’ve got a good thing going. Why stop now? So you decide it’s time to get back out there and raise a new fund.
This time, you find it a lot easier to talk to LP’s. It makes sense: you’ve got a track record now! You realize that you can raise way more than $10m if you want to. You consider going for $100m! It’s still not huge by VC standards — Andreessen Horowitz manages $4b — but it’s definitely a big step up for you.
There’s only one problem: if you raise $100m, it’s going to be a lot harder to spend it $200k at a time. Your options are either to invest in 500 startups (how are you going to possibly find that many startups without lowering your standards?!), or increase your check size and make somewhat safer bets.
You’d like to raise the bigger fund, but this raises an existential question: your reputation is based on the whole “original capital” concept, and now you’re not investing quite as early as you used to. You’re not sure what to d0.
Briefly, you consider sticking to the smaller fund size. But it’s really hard to leave that much money on the table. You literally get paid as a percentage of the fund (2% management fees + 20% of the profits). So now, instead of $200k in yearly management fees, you could be making $2 million! With all that cash, you could hire a bigger staff, and still have lots of room left over to give yourself a solid raise.
Screw it. Let’s do the $100m.
You wonder… should you re-brand yourself? It’s easier to keep using the same terms to describe yourself that you’ve always used. Plus, there are a lot of your peers that are doing the same thing, and the investors above you are moving up the chain too. Besides, it doesn’t really matter what the rounds are labeled, right?
Right?
Meanwhile, one of your younger friends just raised a $10m fund, and they seem very focused on companies that you really would like to see more traction from before you feel comfortable investing…
Convection
The process I just described is one that affects all successful VC’s, to some degree or another. As you establish a track record, the demand for your fund from LP’s increases, which give you the option of raising a bigger fund, which constrains your ability to invest in early-stage startups.
I think if you really want to understand what’s happening, the best way is to compare it to a simple process that happens in nature: convection.
Here’s how convection works:
When you light a candle, it heats up the air around it. Hot air is less dense than cold air, so it wants to float upward, like a helium balloon. Since nature abhors a vacuum, cold air rushes in to fill its place at the bottom, next to the flame. But, inevitably, this cool air gets heated up, and it begins to rise to0.
That’s convection.
It’s pretty amazing to me how well this physical process maps to the forces that shape venture capital.
When you’re new, you start by raising a small fund and writing small checks. As you heat up, it creates pressure for your fund size to rise, making room for the next generation.
But there are some important differences. In a candle, convection cycles can be measured in seconds. In venture, cycles can take years or even decades.
Sometimes the process moves so slowly that it’s hard to see it happening. Take, for example, Sequoia. They are one of the greatest VC firms of all time. How did they get their start? Writing $150k checks to startups like Atari and Apple. (Once you adjust for inflation, the $150k is worth more like $500k in 2016 dollars, but still, my point remains).
Now, you can take a look at Sequoia’s investing activity and see that even accounting for inflation the check sizes are much bigger — usually at least a couple million.
The funny thing? They’ve called it the same thing this whole time: Series A.
The End.
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PPS — Of course, there is an upper limit to Venture Convection. No VC fund is going to entirely get out of the business of funding private companies and start picking public stocks. They don’t have aspirations to become the next Goldman Sachs. But I do think Venture Convection is real, especially at the early stage.
