VC Economics And Why Fund Size Matters To Companies
One of the biggest challenges of fundraising is finding the right fit in an investor. This can come down to alignment on a number of points: business objectives, personal values, personality fit, or simply gut feel. It’s important to get this right, as capitalization issues can stop a growing company in its tracks.
Important as it is, the investor vetting process can take a lot of founder time away from customers, product, and team-building. A couple things that can help focus the process are an understanding of VC economics, and the simple heuristic of fund size to determine alignment. Fund size is a decent proxy for fit for three main reasons: (1) matching the definition of success, (2) attention from the investor, and (3) avoidance of signaling risk.
VC Economics
We’ll start with a short primer on one aspect of VC economics. There’s a rule of thumb in traditional early stage VC that each investment must have the potential to return the entire fund. That’s typically what it takes to account for the high failure rates of investing in private, illiquid, unprofitable, early-stage startups. Failure rates, depending on the definition used, range from 25% to 50% for early stage VCs. The surviving portfolio companies therefore have to generate outsized returns to hit the 3x distributed cash target net of fees and expenses that VC funds aim for over their lifespan.
So for a $100M fund, every investment (of 15–30 total investments) should have the possibility of generating $100M of gross returns to the fund. For example, if the investor’s average ownership is 10% by the time of exit (which is generous — most would be happy with 5% after dilution), then working backwards, the underwritten exit needs to be $1B. If the investor doesn’t believe the market, product, or team can support that possibility, they can’t reasonably invest without changing their underwriting model.
This dynamic drives the (in our opinion) unhealthy and unstainable hunt for unicorns. Furthermore, as competition among VCs drives entry valuations and consequent exit expectations up, it creates a “lottery ticket” strategy of portfolio management. In other words, encourage everyone to shoot for the moon…or blow up on the launch pad. That risk appetite is easy for a VC with dozens of bets, but is very different for a founder who has a portfolio of one. This is the key point to understand about where investors and founders can become misaligned.
There’s a lot more to be written about how VCs operate and what that means for companies, but I’ll save those points for future posts.
Matching Definition of Success
In light of the primer on VC economics above, it logically follows that the smaller the VC fund, the more likely it is that a win for the company is a win for the investors, and delivering a win for everyone is a prerequisite for a company’s successful outcome.
A $50M exit can be the lucrative culmination of years of hard work and sacrifice for the founding team, as well as a big win for the early investors, but can be disastrous for investors with larger funds who were counting on a bigger outcome, especially if they invested at a $10M valuation or higher (yes, a 5x often isn’t enough). To use the framework above, if the investor owns 10% at a $50M outcome, that’s $5M of proceeds. If they’re investing out of a $100M fund, that’s only 5% of their capital returned. That’s a tough one for investors because it means $95M still needs to get made back from the rest of the portfolio (without even generating a profit on the fund), now with one fewer shot on goal.
Furthermore, each subsequent round of equity funding typically involves larger checks from larger funds, which both raises the bar for when a win is a win for all the investors (although not linearly as later stage investors don’t need to underwrite to fund returners), and gives more of the cap table to the preferred equity investors to block a sale below that bar. Eventually the bar gets so high that it’s quite literally “IPO or bust” as the mechanism for VCs to realize a profit on their investment. This is what people mean when they liken raising VC to a “hamster wheel.” It’s great when it works out, but can get messy in the 99% of cases when it doesn’t.
Our recommendation is to work with investors who would be thrilled with an outcome that matches your current expectations. As your company grows and you eye a larger prize, then bring on an investor with a larger fund size with the means and motivation to drive toward the larger goal. At least this is how things used to work before the rise of large multi-stage firms taking “FOMO flyers” or “lottery tickets” in early companies.
Attention from the Investor
The other reason fund size is important is what it means for companies in terms of resources and support from the investor. Larger, more established funds tend to have more resources for their portfolio companies, but those resources get used up quickly as their portfolios grow, and get concentrated in companies that are larger positions for the fund (“needle movers”).
Even if the shared goal is to drive toward a large outcome befitting the larger fund, a smaller company is naturally going to get less attention from a larger fund. Anyone who’s worked with large service providers knows this dynamic. Some excellent large funds get around this by investing in dedicated staff or technology for their portfolio companies, essentially operating more like companies than VC firms.
This natural dynamic of larger funds is usually not a problem for companies that run fairly independently, but it can come with a big potential negative in the form of signaling risk at the next fundraise.
Avoidance of Signaling Risk
Signaling risk is the risk that an investor known to lead inside rounds in their portfolio companies decides not to lead the next round for their company, thereby causing outsiders to wonder if something is wrong with the company. Put simply, if insiders aren’t buying, why should outsiders buy?
In the VC world where information is relatively scarce, signal of any kind is very important. VCs especially look for signal in what other VCs are doing. This can feel silly and frustrating for companies who go out to raise and get the question “who else is investing?” until someone decides to lead, after which “signal investors” clamor for allocation (if they like the signal) or pass (if they don’t).
The reason fund size relates to signaling risk is that plenty of large firms take “FOMO flyers” (“lottery tickets”) on small deals that they treat as options toward leading a larger raise that’s closer to their core strategy. They’ll even pitch it as a benefit to the company by saying “we can quickly and easily write a small check, and if things work out we can lead your next round, and that way you don’t have to pitch new investors (their competition).” If things don’t work out it’s a small loss to the large investor — a small price to pay for the option to back a big winner.
The flip side is this can be disastrous for the company when the firm doesn’t step up to lead the next round, especially when a fundraise is necessary to avoid insolvency. There’s less signaling risk when working with investors focused at the current stage of the company. And by the way, those large multistage firms will always be there later.
Ultimately, while going fast and breaking things is a great mantra for scaling, it pays to slow down and get things right when it comes to who you let onto the cap table (since you can’t fire your investor).
In conclusion, an understanding of basic tenets of VC economics suggests that companies pay special attention to fund size when choosing an investor. And while fund size is a simple heuristic to narrow the investor funnel, it is not a substitute for spending real face-to-face time with an investor to really feel out the fit.
