Startups Almost Never Talk About This — But They Should

Sarah Milstein
The Startup
Published in
7 min readAug 28, 2015


Last weekend, Danielle Morrill, CEO of Mattermark, tweeted up a storm of solid advice for startups looking to raise investment. There’s a lot of mystique around fund raising, and she talked about details people don’t usually mention: how hard it is to find Sequoia; where to eat lunch near Sand Hill Road; what the investors are signaling when they suggest breakfast at an out-of-the-way spot. She didn’t, however, talk about one thing that almost nobody on the startup side discusses and that almost everybody on the investor side is obsessed with: VCs’ limited partners, or LPs.

Though nearly invisible to startups, LPs are higher up the money chain than VCs, and their concerns dictate how venture investing is done. If you’re seeking early-stage or first-time investment — or if you like to complain about VC attitude, which is common among frustrated entrepreneurs — you should understand LPs, because they play a bigger role in the venture stack than most startups realize.

Here’s how it works. Contrary to popular imagination, venture capitalist aren’t just rich people who invest their own money. Instead, VCs, who may or may not themselves be rich, invest primarily other people’s money. To get money to invest, VCs “raise a fund,” which involves touring a dog-and-pony show to convince bigger investors to give them money to gamble on startups; it’s not unlike the dog-and-pony that startups do for investors. A venture fund can be anywhere from about ten million to more than a billion dollars, with the money coming from a collection of institutional investors like pension funds, large foundations, university endowments, and sometimes high net worth individuals (at many firms, the VCs also contribute to funds). The VCs who raise and run a fund are the general partners, and the investors in that fund are the limited partners. (Angel investors, by contrast, invest their own money directly in early-stage startups, and they often behave differently than VCs. An influx of angels in the past few years has contributed to shifts in the VC industry overall — another thing worth understanding, particularly if you’re seeking early-stage investment.)

The LPs who represent institutional funds typically put a very small percentage of the money they manage into venture capital funds, and they expect that percentage to be among the highest risk and highest return of their overall investments. Notably, institutional investors have a reputation for being risk averse. Note, too: A typical venture fund lasts 10 years, which means that VCs and LPs often have relationships that last at least a decade. But that’s just the start. VCs make initial investments from a fund in the first three to five years and reserve the rest of the money for follow-on investments in the successful startups. That means VCs are commonly looking for fresh investment every few years, and they like to go back to their existing LPs. Because their investments won’t actually pay off until later in the fund, they can demonstrate success when their startups’ valuations grow from subsequent rounds of funding. In other words, given their relationship with LPs, VCs have a direct interest in their startups’ taking on additional investment, regardless of whether that’s good for the businesses in the long run. This investment structure is not a secret of any kind, but it’s very rarely discussed among startups.

Entrepreneurs like to do the math to figure out what it takes for a VC fund to pay out its LPs at the rates they’re seeking (the big conclusion is invariably: Wow, a couple of the VC investments have get HUGE for the whole thing to work). So it’s pretty well understood among startups that the kinds of returns LPs are looking for require that VCs invest in startups that can grow very big, fast. But LPs don’t just promise money and then wait for an annual report on how it’s all going. For smaller VCs, they may be in touch monthly. For bigger firms, quarterly. And they ask hard questions about individual investments. One VC puts it this way: “If you’re an entrepreneur, you should know that I’ll have to explain your business to somebody else when you’re not in the room.”

Think of it like this: VCs report to another group of people. Those people care deeply about big returns, they are conservative spenders who like familiar patterns, they hold regular meetings with VCs to learn how their investments are faring, and their relationships can run for many years. If a VC wants to keep raising funds in the future, they have to keep their LPs happy — often for years before their investments start to pay off, which means making investments that the LPs can get behind.

Entrepreneurs understandably get upset when VCs don’t grasp your business’s potential or tell you your idea is too complex. While those things happen, and they’re shitty, it’s not just that VCs are under-informed. It’s also that their LPs won’t support investments they don’t understand. Additionally, to keep attracting LP money, VCs need to put their money in startups that other investors will like down the road. VCs thus have little incentive to try to wrap their heads around your obscure idea, even if it’s possibly ground-breaking. VCs are money managers; they do not exist to throw dollars into almost any idea.

It’s well documented that women of all races and black, Latino and Native American men draw disproportionately little venture investment as founders. Do LPs play a role in that dynamic, too? Because a lot of LPs represent public money and institutions that have social missions, they should, arguably, push VCs to invest in entrepreneurs who better represent the population overall. But if such LPs exist, they are spectacularly rare. In fact, VCs, LPs, and the investors who will jump into later rounds that prop up valuations all hold the same biases that favor a narrow group of entrepreneurs. So while LPs don’t say, “I’m not interested in these Latina founders from companies I’ve never heard of. Get us two white guys from Google!”, VC’s don’t have a particular incentive to invest in startups run by people that others in the venture stack don’t readily recognize as good bets. (Notably, a fairly high percentage of institutional funds are run by white women and people of color. That has yet to have an appreciable trickle-down effect in venture capital, which tells you a lot about both hidden bias and Reagonomics.)

If you are seeking venture investment, you should understand all of this. Not only whether your company can become a rocket ship, which we all want to believe, but also whether you can submit to a grow-at-all costs approach and to taking on additional investment, which involves giving away more of your company. And, if you’re part of an under-represented demographic, know that your company’s story will have to be particularly clear and strong. (It’s also a good idea to understand all of this when you want to complain about VCs; makes your arguments smarter.)

OK, so what if you aren’t sure whether you can grow super-fast, or whether you want to? Good news: VCs aren’t the only game in town. In fact, there are a growing range of options, many of which can be more attractive than venture capital, depending on your company and your disposition (boot strapping, crowd funding, good old revenue, etc.). This gets covered a lot, so I’m going to take a pass on re-writing the wheel. But I will note that if you’re seeking early-stage investment, you should understand the difference between angel investors and VCs, and you should know that seed-stage investors — i.e., VCs who make angel-like investments — are still institutional investors, motivated by institutional concerns.

Once you know the game VCs are playing, you can make a good decision about whether to engage. If you do go for it, read Danielle’s advice. It’s better for you as an entrepreneur when raising investment is demystified.

Disclosure: I currently work on, a project within OATV to fund startups that want to grow on their own revenue rather than on valuations.

Special thanks to Ross Fubini and Tony Stubblebine for reading earlier drafts.

Published in Startups, Wanderlust, and Life Hacking




Sarah Milstein
The Startup

Leadership coach for execs and emerging leaders. Formerly: Daily, ConvertKit, Mailchimp, 18F, Indie, Lean Startup, O’Reilly Media, more.