For most of my career in venture capital, I have felt that small firms (<$100M in fund size), medium-sized firms ($100M-$500M in fund size), and large firms ($500M+) are all part of the same venture capital ecosystem. Firms of all sizes had the same basic objective; find and support companies that could become IPO-scale companies worth several billion dollars. Each firm had its own strategy, portfolio construction, entry point, and returns expectation, but we were all playing for the same outcome. For most funds, reasonably large $1-3 billion outcomes were meaningful to everyone in the ecosystem.
In a world where all funds were part of the same ecosystem, the venture capital business worked like a relay race. The pre-seed and seed investors worked with companies to get traction, the Series A and B investors provided capital and support to help them prove out scale, and growth-stage investors helped prepare them for life as public companies. Each participant had their own lane and specialty and mostly focused on the thing or things they did well until it was time to transition that company to the next person in the chain.
Lately, I’ve felt this relay race metaphor no longer describes how the venture capital industry works. The largest firms in our industry have gotten significantly larger in the last ten years, in terms of the share of industry assets they manage and in absolute size. They have built out platform and investment teams that allow them to fundraise for and execute against any investment strategy that they think is attractive and is a good use of their time and capital. They can invest across stages, geographies, and vertical specialty industries in ways smaller firms cannot. These large firms have the entire private market as their opportunity set and continue expanding into lanes that used to be the province of smaller, specialist firms. And, given their previous success, relationships with LPs, and access to capital, I expect the largest funds in our industry to remain large. If you’re a seed-focused VC firm, you likely feel the presence of the larger, multi-stage firms that have established and scaled their own seed investing initiatives. The largest firms in the venture ecosystem do not need to wait for those earlier in the process to source and serve up companies to fund; they will do some of that early-stage work themselves. I do not see this dynamic changing anytime soon.
At the same time, many of the upstart and specialist firms that started off as small, sub $100 million firms have grown in size and ambition. Firms that were once happy to participate in the relay race now want to hold on to that baton longer and capture more value before bringing in the next investor to do a follow-on round. As I wrote a while back, the equity available to investors is finite and zero-sum at the end of the day.
Many of these up-and-coming firms are no longer content to stay in their lane – they want to have a bigger role in the venture ecosystem and push into the territory that used to be the sole domain of larger firms. Firms that used to play nicely together can no longer make the math around ownership work if they both want to participate. In the end, I think that this type of competition between firms is good for our ecosystem, and it gives entrepreneurs more choices in terms of whose capital they ultimately decide to take. Some of these up-and-coming firms will become the iconic firms of the next generation as they push through and expand scope, and others will not make it. This kind of dynamism is good for the ecosystem overall.
The biggest disconnect, however, is still around the scale of exit that works given fund size. The relay race analogy I mentioned at the beginning worked best when everyone was happy with the same scale of outcome. One consequence of the largest funds getting larger is that the scale of outcome that matters for these funds is significantly larger than what moves the needle for a smaller fund. The largest venture capital funds need terminal exits of $5-10 billion at a minimum (with reasonable expectations of 15-20% terminal ownership) for those exits to impact their fund economics. Smaller and medium-sized funds have returns equations that work reasonably well at $1-3 billion exits. It’s very hard to have a coherent, handoff-based ecosystem when the participants have a 3-5x spread in what a meaningful exit looks like. This gap creates a problem for the venture ecosystem. Smaller firms, whose funds can achieve solid returns with $1-3 billion exits, cannot, generally speaking, fund companies from inception to IPO. At some point, they know they will need to bring in larger funds to do subsequent rounds. As a result, it is rational and common to try to forecast what that next investor will want to see to say yes to the next round. There are two big challenges with this approach. First, the smaller firms only see a subset of the full opportunity set that multi-stage firms see. There are entrepreneurs, particularly successful, repeat entrepreneurs, who exclusively pitch the larger, multi-stage firms, and those opportunities compete with the pipeline of companies that earlier-stage firms have backed. Without seeing the full opportunity set, it can be hard to know how truly competitive one’s portfolio company is relative to the full set of opportunities the follow-on investor sees. Second, perhaps more importantly, there is a wide gulf between a $1 billion outcome and a $5 billion outcome. It is totally rational for smaller firms to focus on companies that could achieve $1 billion outcomes (rare as those are). And it is also totally rational for multi-stage companies to focus on $5 billion-plus outcomes given their fund sizes and return objectives. This means great companies can fall into the gulf between big enough outcomes for small funds and too small for big funds. The venture industry doesn’t have a great solution for this chasm today, and I’m not sure how it will get filled, given the current incentives around fund size, fund strategy, and expected returns.
All of this is unfolding in an era where access to capital for startups has become more challenging, venture fund sizes will come down (or at a minimum moderate), and capital efficiency is again back in vogue. I am personally excited to see how this next phase of our business plays out. I’ve talked to many of my friends in the private equity and buyout industry about how things played out in those industries, and I think there are some lessons to learn about how things played out there.