So what's the takeaway from this data? It again reinforces just how much of a power law business venture capital is. It's the top 1% of companies that ultimately drive the majority of VC returns.
Startup funding in 2023 is tough. Acquisitions are low with Series A startups being acquired most.
Every Internet / software company I've spoken with, is aiming for profitability much faster / earlier than they would have 1-2 years ago. In many cases, this means getting to cash flow (CF) neutral with $25-50M raised, versus $250-500M earlier.
Any investor lucky enough to pick a top-performing VC was awarded with an IRR 'off the scale' relative to all other strategies. Mostly, though, the few big winners were funds that either backed tech giants pre float or caught 2021’s Spac boom
The average startup today has 5x more VC capital available than its counterpart did in 2013 and there is no conclusive proof that 5x more money is required to build a successful business.
- Raise a seed round with the primary aim of becoming profitable (as opposed to the primary aim of raising a Series A) - Raise a venture round from a top fund, gaining one top board member, but from there, opt out of raising a series of rounds - Raise smaller, disciplined amounts of capital, or delay raises if the company is profitable and growing well
Lots of startups caught in no-mans land at the moment. It's really *not* a bad idea to sell to another larger, stronger startup. All stock and at a big discount is still MUCH better for everyone than dying a slow, delusional death over the next 24-36 months.
A summary of some parallels between dot com and now:
— The promise of exciting new technology innovation (and of riches) attracted lots of talent to found, join and invest in startups
— Unprecedented dollars flocked to VC. This drove up valuations, causing “” — over capitalization and speculative investing.
— To survive the long winter, companies figured out how to do more with less. They got back to basics (the new “B2B”?) — carefully managing burn rates, cash, revenue quality, customer retention and margins, becoming more capital efficient
— Layoffs, bankruptcies, scandals and lawsuits unfolded over years, not all at once
— VC is no longer a game of prediction and pattern matching. "VC by CRM" is dead. For funds to really stand the test of time, investors need to generate insights.
— One huge differentiation in this era is the number of founders who are coming from academia rather than industry.
— The pace of innovation also means that VCs are having to radically change their methods of assessment for new deals.
— Fundamentally we need to think differently about what purpose data collection is serving, which will enable us to move from producing predictions to producing insights. Prediction is entirely a function of data, there is no subjectivity involved.
— A VC fund portfolio needs 10-20% of the portfolio to be top decile (with 10 funds, 1-2x) to fully justify risk/return. From a DPI standpoint, this is likely through smaller funds, but not necessarily on Net IRR
— Top Quartile VC vs. PE is essentially very similar when taking into account timing of cash flows (only 2% delta in Net IRR, TVPI multiple difference of .3x). Slight outperformance in VC.
— Curating, not selection, is a helpful tactic when sourcing investments. Of the 35 unicorns in our first seed portfolio, 14 unicorns came from first time funds.
— Managers with the skill to understand probabilities and how to play the venture odds in their favor have shown to capture more outliers in our first seed portfolio. Funds that captured 5 or more outliers in our portfolio invested in north of 70 deals.
— Staying grounded in first-check investing is challenging and I think this is due to behavioral biases, agency issues and duration.
— Consistently investing in every vintage year, taking your time to do proper due diligence, holding your opinions loosely and spending time to make sure your long-term mandate aligns with the GPs long-term vision can help lead to a successful venture program.
Fund size matters. It is much easier to have fund-returning exits in smaller funds.
Access matters. If you aren't accessing the best performing funds, the asset class isn't worth the risk.
The best-performing funds stick to the same strategy and don't try to become giant AUM machines.
Fund managers are feeling the pressure to provide cash on cash returns to LPs to A) show realised performance and B) support the raise of future funds.
But DPI takes time. The power law takes time.
— If the problem is that diverse fund managers are riskier, for whatever reason, then the FoF model should give an added layer of protection should everything go astray. Typically, FOFs do good diligence, meaning the level of diligence will be lower for the LPs looking to invest in the funds backed by the FoFs. This might be a plus for some investors.
— “We’ve seen firsthand that it can take diverse-led venture firms over twice as long to raise their funds.”
LPs portfolio strategy in VC syndicates plays a much larger factor in determining LP returns than realized.
In layman – the odds are you’re not picking a fund (or multi-fund) returner with only 10 early stage investments. You should be highly diversified to better ensure exposure to the fund returning outlier/s.
Despite a common understanding of power law in VC, we still very frequently see LPs make a small number of concentrated investments in early stage companies – they invest too much too early and into too few companies.
For the LP, they're remarkably similar. They are slightly better off with lower management fees and a higher carry; however, it's negligible in comparison to the impact on the fund manager, who is materially worse with the higher management fee, lower carry scenario.
Potential impact of lower management fees: — Lower management fees leads to a lower budget and could make it more difficult to hire the right people (whether due to quality of experience).
Impact of higher management fees:
— The higher the management fee, the more you incentivise larger funds, or quicker deployment and raising of new funds. If you're an LP in the fund, you want to ensure that the fund managers are not just deploying into opportunities but into the *right* opportunities.
If you think about it, most established categories look more like a handful of winners than just one. In the travel sector, there is Booking.com, Trivago and Kayak. Even established categories like credit cards see both Visa and Mastercard dominating the market.
But I do get why venture clings to its winner-take-all mentality. VC funds can’t exactly invest in their favorite four companies in a category that are all competing directly against each other. That is not only bad practice, but it also risks leaking proprietary information.
“You have to bet on a single company or a single theme or subsector or thesis that you believe is going to break out. That is where the art and science in investing comes out,”
she wouldn’t be surprised if this notion of investing in markets where a number of players can exist and thrive may become an even bigger part of the venture conversation, given how antitrust and competition regulation in the U.S. is developing.