As a founder learning the ropes of venture capital, you might see VCs as asset managers, with LPs as their customers and your equity as the asset being managed.
This is heavily implied by the chain of responsibility: you are required to report your progress to your VC investors who want to see milestones crossed and targets met. Similarly, VCs then have to report on the fund’s investments to their LPs.
It would be an odd relationship if customers were accountable to service providers, right?
Understanding the relationships
When an LP commits to investing in a VC fund, they are typically locking themselves in for a ten year relationship. That’s three to four years over which they expect their capital to be invested, and six to seven years in which they hope they’ll start to realize those returns. This mirrors the kind of relationship you will have with a VC, which lasts a similar period of time from investment to exit.
In this context you might understand that LPs don’t really resemble a customer, and neither do VCs. Instead, they are the shareholders and operators of a specialized financing instrument for early stage companies. The relationship matters, updates are intended to prompt feedback, and success is shared. Crucially, both parties rely on the firm building a reputation for offering a good service, fair terms, and accelerating success stories.
Fred Wilson of Union Square Ventures shared more of the VC perspective on this in his 2005 blog post:
The entrepreneur creates the value, they are the ‘raw material’ in the venture capital business. If there were no entrepreneurs, there would be no venture capital business.Fred Wilson of Union Square Ventures, in “The VC’s Customer“
How this shapes fundraising
It can be difficult to view this from the perspective of a founder, as it assumes you are in a position of control – an odd fit with the usual perception of the venture capital process. Isn’t fundraising all about struggling with an endless string of rejections? Again, the bigger picture allows us to see how the relationships really function.
Healthy markets rely on consumers having freedom of choice, and this is where venture capital suffers from an image problem: When you’re hammered with messaging about how slim the odds are for success, it can seem like raising money from a top-tier firm is the most important signal for success. The moth-like attraction to the top of the market means those firms are swamped with pitches and thus issue even more rejections.1
However, if you look at venture capital as a marketplace of firms looking to service startups, you might be more inclined to think in terms of practical comparison. Ignoring the logos, who can best serve your particular needs? Where are the hidden gems and less obvious bargains?
Consider consumer brands, where bigger companies tend to be worse at serving more specific (more technical, higher performance) consumer needs. A larger target market implies more mainstream use cases, and your brand often becomes more important than the performance of your products. At that point, there are likely to be smaller brands that outperform in a particular niche where their expertise makes a difference.
This is a reasonable metaphor for venture capital, illustrating the benefit of approaching fundraising as a customer looking for a solution rather than an entrepreneur with their hat in their hand. As with any transaction, you are looking for the best bang for your buck, and smaller specialist funds are likely to deliver exactly that – for all sides of the transaction.
Highly specialist portfolios from young firms have a top-quartile hit rate of 61%, representing a 2x increase from the most generalist portfolios.Liam Shalon of Level Ventures in “Outperformance in Early-Stage Specialist Firms: A Data-driven Analysis“
- And often lose focus on the fundamental role of VCs: financing innovation, not shaping the future.