The story of venture capital (and its precursors) is a story of risk. You can take this back as far as you like, from ARDC to Christopher Columbus. From whaling expeditions to space exploration.
Risk is the product.
And, essentially, it boils down to this calculation:
The merit of any investment depends on whether the probability of success multiplied by the forecasted return is greater than the cost.
Investments that are perceived to have a high probability of success attract a lot of competition.
Investments that are perceived to have a low probability of success attract very little competition.
Venture capital is at the far end of this spectrum, where the ‘skill’ is in recognising when the market has mispriced risk because an idea is unconventional rather than bad.
This brings us to the first category of risk in this conversation: idiosyncratic risk.
Idiosyncratic Risk
(the specific risk of an investment)
Idiosyncratic risk reflects the specific potential of an investment: the probability of success, and the assumed return if it is succesful.
Assuming you cannot change the probability of success or the assumed return, there are two ways to handle idiosyncratic risk:
Making low probability investments profitable by diversifying away total failure.1
These are the two main levers of venture capital, which is focused on what Howard Marks refers to as uncomfortably idiosyncratic investments:
The question is, do you dare to be different? To diverge from the pack is required if youāre going to be a superior in anything. Number two, do you dare to be wrong? Number three, do you dare to look wrong? Because even things which are going to be right in the long run, maybe look wrong in the short run. So, you have to be willing to live with all those three things, different, wrong, and looking wrong, in order to be able to take the risk required and engage in the idiosyncratic behavior required for success.
Idiosyncratic risk contrasts with the other main category of risk that investors must consider: systematic risk.
Systematic Risk
(broader market-related risk)
If idiosyncratic risk is typified by venture capital, then systematic risk is typified by index funds. Consider the extent to which index fund performance is influenced by individual companies versus major political or economic events.
Nevertheless, systematic risk is a consideration in venture capital, and there are two ways to handle it:
Avoid consensus, where competition drives up prices without increasing success rate or scale.
Avoid market-based pricing, where macro factors can drive up prices without increasing success rate or scale.
Exposure to systematic risk essentially destroys an investor’s ability to properly manage (and extract value from) idiosyncratic risk.
Alpha vs Beta
If we consider idiosyncratic risk as the source of ‘alpha’ (ability to beat benchmarks) in venture capital, systematic risk reflects the ‘beta’ (convergence with benchmarks).
A striking shift in venture capital over the last 30 years, particularly the last 15, is the extent to which the balance has shifted from idiosyncratic risk to systematic risk. This is a consequence of prolonged ‘hot market’ conditions, where consensus offers a mirage of success.
Consider a typical VC in 2025. They’re likely to be focused on AI opportunities, guided by pattern-matching and market pricing (aka, “playing the game on the field”). Investing, in this scenario, is reduced to a relatively simple box-checking exercise.
All of this implies significant systematic risk; the firm is riding beta more than they are producing alpha. This creates extreme fragility.
Systematic risk has always been a concern, but it has been amplified in recent years by cheap capital and social media. The herd has grown larger and louder; more difficult for inexperienced or insecure investors to ignore:
Taking systematic risk means following the crowd. It’s an easier story to sell LPs, and there’s less career risk if it goes wrong as accountability is spread across the industry.
Taking idiosyncratic risk means wandering freely. It’s tough to spin into a coherent pitch, and there’s more obvious career risk associated with the judgement of those investments.
Despite mountains of theory and evidence supporting idiosyncratic risk as the source of outperformance, it’s just not where the incentives lie for venture capital.
The Jackpot Paradox
There are fundamental consequences of the drift towards systematic risk in venture capital:
The muscles of portfolio construction and valuation atrophy, as consensus-driven ‘access’ dominates behavior and idiosyncratic risk falls out of favour.
The typical ‘power law’ distribution of outputs collapses as few genuine outliers can be realised from a concentrated pattern of investment.
As returns converge on a mediocre market-rate, investors manufacture risk by feeding power law back into the system as an input, trying to create outlier returns.
Success is further concentrated in a system that becomes increasingly negative sum overall.
This broadly summarises where we’re at today. A disappointing scenario that represents failure to the actual bag-holders on the LP end, failure to founders, and failure to innovation.
A lot of the blame falls in the lap of LPs. The low fidelity interface with GPs means that LPs have a general bias towards compelling stories which invite systematic risk.
Thus, venture capital is reduced to a wealth-destroying competition for access to the hottest deals, fundamentally at odds with the concept of ‘uncomfortably idiosyncratic’ risk and generating alpha.
Show me the incentive and I’ll show you the outcome
Charlie Munger
One of the most thought-provoking articles in venture last year was Jamin Ball’s “Misaligned Incentives“, in which he talked about the difference between 2% firms and 20% firms.
The 2% firms are optimizing for deployment. The 20% are optimizing for large company outcomes. Thereās one path where the incentives are aligned.
The article was significantly because it was represented a large allocator acknowledging the issue with incentives in private markets. Not a novel take on the problem, but resounding confirmation.
Ball stopped short of suggesting an alternative incentive structure, which was probably wise given visceral opposition to change. Many influential firms have grown fat and happy in the laissez-faire status quo of venture capital.
Ball ā like many people, myself included ā framed carried interest as the ‘performance pay’ component of VC compensation. The problem is implicit: we have therefore accepted that fees are not connected to performance.
For decades, we’ve accepted the wisdom that carry = performance, and fees = operational pay. Nobody thought to question that reality.
Unfortuantely, for many firms (and certainly the majority of venture capital dollars under management), carry is a mirage. It exists so investors can pretend that performance is a meaningful component of their compensation while they continue optimising for scale.
European Waterfall vs. American Waterfall
European waterfall is a whole-fund approach to carry, whereby GPs don’t receive carried interest until LPs have had 1x of the fund (plus a hurdle) returned to them. American waterfall operates on a deal-by-deal approach, with a clawback provision if the fund isn’t returned (plus a hurdle).
We know the american waterfall model (while imperfect) has historically outperformed, and yet the european waterfall has become standard. Venture capital has biased towards the ‘LP friendly’ approach to carried interest, even though it reduces their carry income, because it enables more easily scaling funds.
We find strong evidence that GP-friendly contracts are associated with better performance on both a gross- and net-of-fee basis. The public market equivalent (PME) is around 0.82 for fund-as-a-whole (LP-friendly) contracts but is over 1.24 for deal-by-deal (GP-friendly) contracts.
In summary, the problem is not that VCs have picked fees over carry as the more attractive incentive, it’s that carry has been used as a smokescreen for the exploitation of fees.
Consider these few points, from the perspective of a seed GP:
If you charge a fee to manage the fund, you should not raise a successor fund without a serious step-down in those fees. Otherwise, what are you being paid for?
You should not charge management fees on investments you’re no longer truly managing. If you have no meaningful influence over a company in your portfolio, what are you being paid to do with it?
Indeed, if you’re no longer truly managing those investments, it’s incumbent on you to sell enough of your stake to lock-in a reasonable return when the opportunity is available.
If you raise a larger subsequent fund, you should be able to explain how that strategy allows you to extract a similar level of performance from a larger pool of capital. Otherwise, how can you rationally justify a larger total fee income?
Everybody knows that markups are bullshit. If you want to raise a second fund, get at least 2x back to your LPs through secondaries first. DPI is the only proof that there’s value in your investments.
None of this should be surprising or even unintuitive, and yet…
Successor fund step-downs are remarkably uncommon.
Most US funds still do fees on total comitted capital, not even fees on invested capital, never mind fees on actively managed investments.
Few GPs have a sophisticated view on early returns, with most still focusing on MOIC rather than IRR and assuming late-stage price inflation will continue.
VCs expect founders to present a coherent pitch covering growth strategy and the implicit capital requirements. The LP-GP relationship is far cruder.
The whole venture ecosystem knows markups are barely worth the paper they are written on ā and yet these incremental metrics continue to drive fundraising activity.
Over the past 15 years, LPs have become so preoccupied with getting into the hottest name-brand funds that there has been little scrutiny given to the fundamental logic of terms.
In an entirely fee-based environment, without carry as a smokescreen for bad actors, fees would likely be more clearly connected to performance ā addressing the concerns laid out above.
This has the benefit of being a more predictable approach to compensation, likely attracting more responsible fiduciaries and level-headed investors. Less swinging for the fences, and more methodical investing and steady DPI.
However, it would also mean losing an important minority of brilliant investors who are genuinely motivated by carry.1
Ending the AUM game; 100% carry
In a scenario where investors only ‘eat what they kill’, performance would matter so much ā across so many dimensions ā that VCs would have to very quickly develop better practices on portfolio management and liquidity.
Of course, the downside is that compensation would be heavily backloaded, with no compensation for the early years of deploying capital and developing exits. A deeply unhealthy barrier to entry for emerging managers.
What’s interesting about these two edge-cases, on opposite ends of the spectrum, is that both produce the same outcome: a greater level of professionalism, with a more sophisticated view on portfolio management and liquidity than we see today.
Clearly, neither extreme is a good option and the ideal is somewhere in the middle ā with both fees and carry in the mix. However, central to incentivising better outcomes is an end the fee exploitation game, with two key realisations for LPs:
Fees must be connected to performance, in that a GP should not be able to raise another fund if they have not yet demonstrated concrete performance.
The only meaningful demonstration of performance is DPI. Fortunately, as the market embraces secondaries, it’s possible to generate meaningful DPI much sooner.
Venture capital needs to evolve alongside more distant exit horizons by making better use of secondary liquidity, more cleanly dividing the market into early and late stage strategies ā which can each then better play to their strengths:
We were able to take a 1x or a 2x of the entire fund off [the table] and still be very long in that company. That locks in a legacy, locks in a return, and shortens the time to payback.
For funds like [mine], selling stock of private startups to other investors will be ā75% to 80% of the dollars that [limited partners] get back in the next five years.
Youāre told āilliquidity is a feature, not a bugā and ālet your winners ride.ā But when the physics of the model shift, you often need to with it.
You sell at the B, and you actually ā for us, with the way our math worked ā could have a north of 3x fund. But I also wouldn’t want to give up the future upside. We actually ran that through the C and the D. The big ‘Aha’ for me was that selling at the Series B, a little bit, was actually very prudent for a couple of reasons.
With all of this in mind, it no longer unreasonable for LPs expect something like a 2x return on their capital by year 6, and for VCs to raise new funds based on hitting that 2x target. Ensuring a decent return (on an IRR basis) for their LPs while companies are still within their orbit of influence.2
Unsurprisingly, proposals to fix fee income are unpopular, and not only with those who profit from the status quo. There is a lack of systems thinking which would allow participants to grasp the interconnected factors which shape outcomes, and see the opportunity for change.3
secondaries aren’t a good market ā because they’re only used to sell poor quality assets ā so they’re not a good market
returns in venture come from a few giant outcomes ā so we hold to IPO ā so more value accrues to a few survivors ā so most of the returns come from a few giant outcomes
you can’t get liquidity on markupsā because they’re optimised for fees not liquidity ā so markups aren’t liquid
In essence, power law and illiquidity are both absolutely realities of the venture strategy, but both have also been used to excuse and entrench suboptimal practices.
The Opportunity of Secondaries
A common misconception: the value of investments increases consistently (even exponentially) over time, so GPs should always hold to maturity. This idea has played a significant part in slowing down the use of secondary transactions. It’s not really true.
Investments often don’t increase in value. Quite often, they fail outright. Failure rate does reduce over time (39% at seed, 13% at series D), but it remains significant throughout.
Typically, you think of a series A startup as less risky than a seed startup, and a series D startup as less risky than a series A startup. This is often true, but because VC dollars both add and remove risk, the move down the risk curve is less linear.
This is especially true for ‘the biggest winners’ who are often absorbing huge amounts of capital from the ‘venture banks’:
But in recent years, this picture has been skewed even more, especially if the capital raised comes from a mega VC fund. At each funding round, there is a significant re-risking of the startup, to the point that you are not moving meaningfully down the risk curve for a long long time. And even at a late stage, a mega funding round can bring you right back up to the point of maximum risk.
These rounds are also often highly dilutive; particularly with the proclivity of large firms to ignore pro-rata and cram-down early investors.
So, in an absolute sense, there is a sustained risk of failure which slowly concentrates portfolio returns into fewer companies over time, which will decelerate TVPI growth (or even turn it negative).
On top of that, there are often terms included in later rounds which mean that shares held by early investors become relatively overvalued. Particularly, IPO ratchet clauses and automatic conversion vetos. Thus, even if the theoretical TVPI of a seed fund remains flat, in reality it may be falling:
“In November 2015, Square went public at $9 per share with a pre-IPO value of $2.66 billion, substantially less than its $6 billion postāmoney valuation in October 2014. The Series E preferred shareholders were given $93 million worth of extra shares because of their IPO ratchet clause. This reinforces the idea that these shares were much more valuable than common shares and that Square was highly overvalued.”
Looking at AngelList data, the best time for a fund to sell (on an IRR basis, and ignoring the clauses above) would be year 8 ā with value concentrating (but not really net expanding) in years 9 through 12.
That means the typical investment (assuming a 3 year deployment period) would be best positioned for a (partial) sale in years 5-7. Considering this, it’s difficult to make the case that GPs should be holding 100% for the ultimate outcome, every time. If they do, they are concentrating their risk without necessarily improving the portfolio outcome.
To take this a step further, we could assume in a more rational market, less dominated by hype (more secondary activity driving more pricing tension, fewer bullshit markups), the illustrated TVPI would flatten out more gradually ā so less of an obvious time to sell.
In short, the story here is not about opportunistic secondaries to drive better IRR. The real case to be made is for a comprehensive secondaries strategy, and opportunistic holding. For too long, there has been ideological friction around secondaries which has held back venture performance and enabled some very bad habits. It’s time to change that.
If there’s a chance to wipe the slate clean for venture capital, for LPs and GPs to return to first principles on compensation, incentives and ideal outcomes ā to begin aligning venture capital with a high-performing meritocracy ā it’s here, today.
Ironically, innovations in venture capital havenāt kept pace with the companies we serve. Our industry is still beholden to a rigid 10-year fund cycle pioneered in the 1970s. As chips shrank and software flew to the cloud, venture capital kept operating on the business equivalent of floppy disks. Once upon a time the 10-year fund cycle made sense. But the assumptions itās based on no longer hold true, curtailing meaningful relationships prematurely and misaligning companies and their investment partners.
While GenAI can improve worker efficiency, it can inhibit critical engagement with work and can potentially lead to long-term overreliance on the tool and diminished skill for independent problem-solving. Higher confidence in GenAIās ability to perform a task is related to less critical thinking effort.
In colder markets, founders just need capital on reasonable terms, and it doesn’t really matter where it comes from. Value-add propositions and brand strength are less important; access to hot companies doesn’t move the needle as much for LPs. Instead they care more about differentiation through strategy.
In hotter markets, the opposite is true. Investors will be chasing the fastest growing companies in the most attractive categories, out on the thin ice of excess risk. LPs, sold the same dream, care only about how GPs can parlay their way into those deals. How you invest is irrelevant, what matters is your network and your brand.
Strangely, at the peak things begin to come full circle. In 2021, when there the incredible amount of capital was spread across a record 1,594 firms, there was a horseshoe effect: with such abundant opportunity for investment, LPs and VCs once again saw the opportunity in strategy-driven alpha.
In normal circumstances, the next stage of this cycle is the crash. The firms that leaned the hardest into chasing heat would be the most exposed, with portfolios that are the most obviously out of alignment with value. What’s left are the firms who chose to focus on solid strategy, who can begin harvesting deals in the down market.
In 2022, this shift was derailed by the emergence of venture banks, designed to escape the typical cycles of venture. The largest firms raised the most capital in subsequent years. Access remained an important part of the story for LPs, especially with the convenient rise of AI.
In fact, you could argue that this was the second time that cycle was disrupted, as many experienced investors called the top in 2016-2018 only to be thwarted by COVID. Two years of intense, irrational enthusiasm for digital only exacerbated the problem.
The Importance of Cycles
Consider how much of the natural world has evolved alongside fire. Wildfires serve an important purpose in preventing ecosystems from choking themselves to death on redundant biomass, and there are even species that have evolved to use fire as a mechanism to spread their seeds.
Humanities view of fire as a threat, and the goal of suppressing it entirely in the natural environment, has had disastrous consequences. We have seen the emergence of ‘mega-fires‘, where biomass accumulates to the point where spread is fierce and inevitable.
There are clear parallels here in venture. The extent to which the market is suffering today is proportional to the amount of time it took to hit a correction. What’s worse, for reasons described above we haven’t yet really allowed the full cycle to complete.
Forcing a Reset
While venture banks steam off into the distance, and venture capital tries to figure out how to navigate this environment, there are three signs of change.
Increasingly, there’s talk of smaller LPs like family offices looking to pursue direct investing strategies. In theory, this affords them a similar level of risk with better economics, but questions remain about their bandwidth to do this properly.
There’s been a surprising number of high profile GP departures, both launching their own funds and not. In many cases, this means partners are giving up wharever carry incentive they had. This suggests some discomfort in the status quo.
An increasing number of founders talking about bootstrapping or ‘seedstrapping’ (one and done fundrasing), or other strategies to avoid the problems assocaited with getting on the venture capital treadmill and the expectations involved.
For the GPs that remain, it’s time to consider what the world would look like if the cycle had completed. How would they be forced to act in a truly ‘down market’ environment. Indeed, if you consider that many smaller firms have been priced out of AI, that may already feel like their reallity.
It is clear that the bar for performance is significantly higher in a cash constrained environment with higher interest rates. While that may not change the reality for venture banks, it is existential for traditional venture capital.
The ‘Knowledge Work’ Problem
In hot markets, where investors take a prescriptive approach to investment, there is a huge problem with atrophy. Completely separate to the poor investments that come out of these periods, it’s also worth examining the practices they establish.
Investors that spend all of their time chasing hot deals based on a number of set criteria have the same basic problem as knowledge workers that rely on Generative AI solutions: they are not using their critical thinking muscles. Executing orders, not problem solving.
Consider how little actual thinking you have to do about an investment if your process is focused on second-order factors. Is it on an a16z market map, is it on YC’s Request for Startups, are other “tier 1” investors are in the round? Will downstream investors will give you the markups you need, and will LPs will be excited about it?
This behavior, geared towards capital velocity, is focused on second order information and pattern matching. It is a prescriptive approach that informs what gets investment, displacing the first-order considerations about things like team, opportunity, valuation, market and strategy.
This dissertation focuses exclusively on moral hazard, which refers to a venture capitalistās propensity to exert less effort and shirk their fiduciary duties to the investors to maximize their self-interest; specifically, a VCās propensity to choose subjective selection criteria over more cognitively taxing objective criteria when faced with multiple options and fewer resource restrictions.
While this approach might broadly work for venture banks, with an army of low-impact investors looking to index across new technology trends, it will not deliver the returns required by the traditional venture model.
This might sound like cowboy investing. A Rick Rubin-esque vibes based approach to venture capital. It certainly can be, and if you happen to be Rick Rubin it might just work ā but why take the risk?
The way for these investors to operate from a position of strength is to build process alpha. That is, do everything you can to prevent being wrong for predictable reasons (controlling for bias), and to manage the risk of being completely wrong a lot of the time (portfolio construction). Not to overintellectualise investment decisions, but to give yourself the strongest foundation to embrace the risk of uncertainty.
To take the analogy a bit further, for all that Rick Rubin is a total eccentric, guided by his own taste without the need for external validation, he is not cavalier about it. He pays immense attention to environment and routine in order to help him get the best return on his time.
There’s never a need for investors to stray from this disciplined mode of operation, it just so happens that most are prey to the cycles of venture capital and the temptation to inflate fees when opportunity arises.
I had a meeting once with Howard Marks, who I had wanted to meet for a long time. Heās a famous bond investor that does a lot of writing. For 15 minutes he asked me questions about the venture industry, a lot of structural questions, and I answered him as best I could.
He said, āThatās a really shitty industryā. I said, āWhy do you say that, what do you mean?ā, and he said āCyclical collapse is built into the structure.ā
Bill Gurley on his conversation with Howard Marks, All In Summit, May 2022
ā2024ā could have been a short chapter in the history of venture capital. Another post-boom year of declining deal activity, recovering valuations, recaps and shutdowns. We left it with the public markets looking healthy and hope that IPOs might reappear on the horizon. All good reasons to flip the page to 2025.
Before you move on from 2024 entirely, consider the boiling frog. Venture capital has been quietly outgrowing traditional definitions over the last 15 years. Last year, as AI drove heat into a cool market, the cracks started to appear.
The venture capital industry has historically worked as a relay race where investors at one stage bring in the next stage of investors to fund and support companies as they scale. Right now, it feels like AI investing breaks this model in a few important ways.
This isnāt just about inflated valuations, overcapitalisation and ZIRP. Itās about the effort of a few firms to outgrow the boom-and-bust nature of venture capital through a new model for investing.
Consider the well documentedrivalry between Andreessen Horowitz and Benchmark, with their opposing views on capital abundance in venture.
Bill Gurley declined my requests for comment, but he has publicly bemoaned all the money that firms such as a16z are pumping into the system at a time when he and many other V.C.s worry that the tech sector is experiencing another bubble. So many investors from outside the Valley want in on the startup world that valuations have been soaring: last year, thirty-eight U.S. startups received billion-dollar valuations, twenty-three more than in 2013. Many V.C.s have told their companies to raise as much money as possible now, to have a buffer against a crash.
Benchmark has set the standard for “traditional” venture capital, managing small and efficient funds, close relationships with founders, and exemplary returns. In contrast, Andreessen Horowitz represents the era of ācapital of a competitive advantageā; a confluence of hyper-scalable SaaS, digital growth channels, and historically low interest rates. Not merely a competing venture strategy, but the emergence of a fundamentally new product that trades efficiency for scale.
The divergence of Andreessen Horowitz (and a few similar firms) from the traditional playbook has created some confusion, as greener GPs attempted to emulate aspects of both. Lacking either the AUM of Andreessen Horowitz or the discipline of Benchmark, they inevitably hit the slippery slope of badly managed risk. This can also be seen in the muddled logic on topics like entry multiples, valuation and concentration, where the ācommon wisdomā has often made little practical sense.
Fortunately, there is light at the end of the tunnel: As this new product is better understood by LPs, GPs and founders, the chaos is better controlled: LPs will have more realistic return expectations, benchmarks and timelines. GPs will be able to identify coherent strategies and compatible advice. Founders will have a clearer choice between traditional venture capital, and the new model of āventure bankā, and the expectations associated with each.
Too Big to Fail
In 2009, with the launch of their first fund, Ben Horowitz and Marc Andreessen slipped into the role of VC brilliantly. They had strong opinions about capital efficiency and portfolio structure, a level of sophistication that surpasses many of todayās GPs.
Despite the success of that first outing, capturing huge outcomes like Skype, the market soon presented a new opportunity. In 2010, rebounding from the GFC, incumbent firms were raising funds in excess of $1Bāa throwback to the dotcom exuberance that Benchmark had criticised. Institutional money was once again on the hunt for new opportunities and software had begun āeating the worldā.
As entrepreneurs (another contrast to Gurley) Horowitz and Andreessen felt no loyalty to the traditional playbook. They saw an opportunity to innovate; the chance to build a scalable model for venture capital and take a dominant position. So, they invested heavily in media to build a āhousehold nameā brand. They sought network effects by launching scouts programs and accelerators. Platform teams were assembled to handle their growing portfolio. Rather than an investment team, they built something more like a sales force. Essentially, they exploited a āboom loopā: raising money to maximise exposure, manufacture category winners, distribute healthy markups and raise more capital. In this environment, venture capital became a cutthroat zero-sum game with very little discipline.
Some of the VCs who funded predation succeeded spectacularly, and the basic incentives of venture investing that tempt VCs to employ this strategy persist. The goal of antitrust law is to push businesses away from socially costly anticompetitive behavior and towards developing socially valuable efficiencies and innovations. We think that Silicon Valley could use a nudge in that direction.
Jump to mid-2022, and the post-ZIRP hangover experienced by the venture market. Almost everyone had gotten caught-up during the decade of near-zero interest rates capped off by pandemic-driven irrationality (except Gurley, who had stepped back from Benchmark in 2020). The critics of the Andreessen Horowitz model began to emerge, pointing to their inflated check sizes and irrational pursuit of āWeb3.0ā. Now, like everyone else, Andreessen Horowitz would surely suffer from falling returns and backlash from LPs?
It happens that Andreessen Horowitz raised more than $14B in new funds during the first half of 2022, close to the combined total of their funds raised in the preceding three years. They were well prepared for the fundraising winter of 2023, a year which many large firms used to rebalance their portfolios through secondary transactionsāplaying on the extreme heat around companies like OpenAI, SpaceX and Anduril.
In 2024, as the slump continued (down roughly 50% from the funds raised by VCs in 2020 and 2021) Andreessen Horowitz came back and raised another $7B. In fact, the 10 largest venture banks raised more than half of all venture dollars last year. The firms that had contributed most to the collapse were suffering from it the least. How could this be? The outcome frustrated many smaller GPs who had been squeezed out of deals and were having a harder time closing funds.
Plans Measured in Decades
If you want to build a venture bank, you need billions of dollars on a regular basis, and it needs to be truly patient capital. Not high-net-worths, not family offices, perhaps only the largest pension funds and endowments. Most of all, you need sovereign wealth.
This transition away from venture capitalās traditional LP base was the central gambit of venture banks. With performance stabilised by the scale of their AUM, the ability to extend into other assets and an internationally recognised brand, they are able to court some of the worldās largest pools of capital. Rather than hunting alpha, they farm āinnovation betaāāindexing across as much of the fast-growing tech market as possible, with exposure to every hot theme, at every stage, both private, public and tokenised.
A lot of the detail is lost when youāre operating at that altitude. Valuation, consensus, discipline, marketsā¦ they all matter less if youāve escaped the typical venture capital fund cycles. Liquidity can be delivered through the secondary market, continuation funds, distributions of public stock or sales of crypto holdings. If itās a tough market for IPOs, you have the scope to wait it out. When thereās a āliquidity windowā, like 2021, you can jettison as much as possibleāas quickly as possible.
Our results suggest that the early success of VC firms depends almost entirely on having been āin the right place at the right timeāāthat is, investing in industries and in regions that did particularly well in a given year.
There is also opportunity in this bifurcation for GPs at traditional firms. While venture banks smother consensus themes, they do so on behalf of this new class of supersized LP. For everyone else, there should be less competition in the traditional LP baseāonce they recover their enthusiasm for the asset class.
The shift obliges smaller firms to focus on non-consensus themesāwhich they should have been doing all along. Access to āhot dealsā is no longer a core proposition for LPs, as it becomes clearer that the juice isnāt worth the squeeze. Instead, GPs should focus on evergreen investing theory. This includes portfolios structured to optimise for outliers and manage risk and a sourcing process that minimises bias, or what Joe Milam calls āProcess Alphaā.
The conventional venture model relied on the power law to rationalize overly concentrated portfolios and āhot deal chasingā when basic portfolio management theory emphasizes (non-systematic) risk management through diversification.
Some of that shift has been cultural, but much is simply that the pervasive practice of pricing with ARR multiples has favoured well-understood segments over the last decade. Deep tech and hardware suffered because VCs simply werenāt sure how to put a price tag on those companies.
Calculating or qualifying potential valuation using the simplistic and crude tool of a revenue multiple (also known as the price/revenue or price/sales ratio) was quite trendy back during the Internet bubble of the late 1990s. Perhaps it is not peculiar that our good friend the price/revenue ratio is back in vogue. But investors and analysts beware; this is a remarkably dangerous technique, because all revenues are not created equal.
As VCs develop a keener and more independent sense for value, the exit pipeline begins to look a lot healthier. Metrics that look at financial health in addition to sheer growth of revenue will more effectively align companies with the expectations of both public market investors and prospective acquirers. Like the old days of venture, much of growth and prosperity will be available for mass market retail participation ā which is great for the āsoft powerā of tech.
Some of the worldās most highly valued public tech companies entered the public markets with quite modest valuations, at least by todayās standards. Microsoft, Amazon, Oracle and Cisco all debuted with market caps south of $1 billion. Of those, only Microsoft topped $500 million. This translated to relatively modest gains for their private market investors, compared to the massive value appreciation they have all experienced post-IPO.
On the other hand, venture banks who have developed monster companies like OpenAI, SpaceX and Anduril, will be able to keep tapping into this expanded pool of private market capital via secondaries. Where companies are strategically sensitive, particularly in the realms of AI or defense, this may be seen as preferable to public company disclosure requirements or the threat from activist shareholders.
Secondary markets also represent an opportunity for traditional venture capital. As managers pick up better standards for valuation, providing greater transparency and explainability, activity is bound to increase. This means more options for liquidity, more consistent buy-sell tension to keep prices under control, and participation from a more diverse base of investors. Finally, it also offers greater cap table flexibility to founders and early investors.
Let’s be realistic here; you’re better off in the fullness of time if certain players are in your cap table, and not a seed fund.
2025 should mark the end of confusion about venture banks and their role in the ecosystem. After a decade of increasingly confused standards and benchmarks for traditional VC, the two products have been neatly split by the wedge of AI.
This is an opportunity for rehabilitation, as the confusion around the change has created more issues than the change itself. Both sides are now able to lean into their strengths, consensus vs non-consensus, alpha vs beta, and deliver the commensurate returns to LPs with matched expectations.
Make no mistake, 2025 will be a crucible for venture capital. The divergence of exits from public market performance is worse than ever, and confidence is low. Despite this, there seems to be a resurgence of smaller firms raising capitalāmatching historical patterns where incumbents lead the rest of the market by a year.
Critically, how will smaller GPs execute in the new environment? Will they learn the lessons from the last five years and play to their strengths? Or will they keep trying to span the chasm of small fund risk tolerance and large fund risk appetite?
In venture capital circles, the most widely discussed trend of 2024 (outside of AI) has been the concentration of capital into āventure banksā like Andreessen Horowitz, General Catalyst and Thrive Capital. The household names of venture capital have had a blockbuster year, while others carefully ration the tail-end of their last fund.
The first quarter opened with Andreessen Horowitz and General Catalyst scooping up 44% of the available capital. 2024 is closing on a similar note, with 9 firms having captured more than half of all funds raised so far. The 30 most capitalized firms this year collectively represent three quarters of the pool raised by at least 380 funds.
However, the real anomaly is not how much the large funds have raised, but rather how poorly everyone else has done. Why has the bottom fallen out of the market for smaller funds, if the giant firms are still able to vacuum up capital?
Ask a hundred GPs or LPs where they draw the line between small funds and large funds, or how they define multi-stage and multi-sector strategies, and you will get a hundred different answers. The lack of standard definitions and common understandings has dramatically hindered productive discourse about venture capital over the years.
Importantly, it has obscured the manner in which multi-stage venture capital has diverged from the rest of the market. Today, it operates a novel model for startup investment, targeting a new class of LPs with a very different premise.
A Rapacious Playbook
In 2011, Jay Levy of Zelkova Ventures wrote an article about the conflicting interests involved in insider pricing. His point was simple: when investors led rounds for existing portfolio companies, their desire for greater ownership would be outweighed by their need to show performance.
Two things are striking about this article:
Jayās concern probably seems alien or overly-dramatic to anyone who entered venture capital within the last decade. Today, itās just the game on the table.
It is also likely to be the single largest contributing factor to the pricing bubble that grew during ZIRP and exploded in 2022, if you follow the incentives created.
In a rational market, where VCs are all stage-specific, each round of investment has a different lead investor. That means, at regular intervals in the companyās development, it will be valued by a neutral third-party. Outside investors that want to maximize ownership will go up against founders that want to limit dilution. From that tension, we expect a generally fair outcome to emerge.
Venture capital relies on this tension, and the increasing financial savvy of investors as the investment moves downstream, stewarding companies toward exits. From qualitative analysis at the earliest stages to the quality of cash flow at maturity; you move the dial from founder strength to financial performance as you go from pre-seed to IPO, and so the expertise of investors evolves in parallel.
Multi-stage firms have a different (and fairly rapacious) view on this process. Instead of inviting scrutiny of the value of their portfolio companies, their strategy is to keep that in-house, or within a network of associated firms. Rather than rational pricing through the tension of buyer and seller, they have embraced the jagged edge of what Jay Levy described: why worry about valuation if pricing can be a competitive advantage?
Want 3-4x markups on investments to show LPs? Just do subsequent rounds at 3-4x and get them rubber-stamped by networked investors. With āperformanceā taken care of, itās easier to raise more capital to feed portfolio companies, fuelling aggressive growth to grow into those markups. Itās putting the cart before the horse, compared to conventional venture thinking, but it has a certain brutal charm.
So, weāre beginning to see that the ācapital as a competitive advantageā playbook didnāt expire with ZIRP. A decade of cheap capital was what it took to prove the model, and today it just needs a different class of LP to back it. Indeed, multi-stage GPs appear to have spent 2023 with their heads down, consolidating around the best-looking secondary opportunities (SpaceX, OpenAI, Anthropic, Anduril) ahead of a grand tour in the Middle East. Sovereign wealth, with giant pools of capital and no great pressure on liquidity, are complementary to the traditional large institutional LPs for this strategy.
Exploiting Venture Capitalās Flaws
As multi-stage firms have expanded their funds under management, theyāve had to similarly scale their ability to capture market share. This has been solved through a fairly innovative list of features, each of which exploits a different dynamic of venture markets:
Platform Teams: Leaning into size as an advantage, multi-stage VCs have built platform teams with the advertised intent to offer support and resources to portfolio companies. In reality, portfolio teams are the serfs of the venture world, managing the burden of a large portfolio for a relatively small team of partners while generally adding little value for founders.
Signalling Risk: VCs are wildly vulnerable to herd behavior. An example of this is āsignalling riskā: concern about the signal of how other investors respond to a startup. Despite being obviously silly, this essentially means “tier 1” firms get prima nocta on every founder they touch, so they scoop them up en masse with scout programs and EIR initiatives.
Backing GPs: While the rest of the market struggles, multi-stage funds can raise additional vehicles through which they become LPs in emerging managers. They look like the good guys, supporting the underdogs, broadening the market and encouraging competition. In fact, they are entrenching centralized positions in the relationship model of venture capital.
Operator Investors: In the last decade, there has been an ideological shift towards the idea of ‘operator investors’. Former founders are seen as the ideal archetype for venture capital, having first-hand experience building companies. As it turns out, they donāt really make for better investors, they’re just extremely well networked and have credibility with founders.
Procyclical Pricing: A huge amount of valuation wisdom has been discarded over the last decade, as the industry as a whole adapted to deal velocity with cruder pricing modelsāe.g. revenue multiples, raise/ownership, etc. These common practices lack critical specificity and amplify volatility in the market, a problem for venture firms that rely on rational pricing.
The Value of Venture Beta
The product of this multi-stage approach to startup investment is āventure betaā: returns will broadly track the market, while they expand in network, assets, and market share. For the largest institutional LPs, like sovereign wealth, this is fine: acceptable returns with minimal volatility, and they can brag about funding innovation with the support of the most prestigious firms.
Further out, this modelās success depends on whether it can produce companies that are attractive to public market investors or private market acquirers. Up to now, large infusions of capital with crude pricing have produced sloppy, undisciplined businesses. The IPO market is still reeling from being force-fed companies with poor financial health in 2021. Whether this misalignment can be fixed, or is inherent to the strategy, has yet to be seen.
Some early stage VCs have commented that multi-stage VCs still rely on small, contrarian firms to identify opportunities before they are ālegibleā. It seems more accurate to say that small firms are just another source of signal about new market opportunities for the mutli-stage strategy, rather than a crucial part of the chain. Scout programs, hackathons and accelerators all create redundancy for the competence of small firms in this capacity.
For Those Seeking Alpha
While historical patterns would indicate that the funding will bounce back for everyone else next year, it is worth some urgent reflection on how the growing share of multi-stage capital influences the market.
In the short term, multi-stage firms tapping into a new LP base shouldnāt have a huge impact on smaller funds, although many of their usual LPs will be spooked by the shift. GPs should have a good answer for how they adapt to this reality. How can they compete against the capital, network and brand strength of multi-stage firms in future? With increasing skepticism about the āvalue addā from venture capitalists, what do they offer founders that the multi-stage firms canāt?
For GPs with high domain expertise in hard sciences, there is enough evidence of outperformance to differentiate them from large generalists. For everyone else, the burden of proof is going to be higher than ever, and will require becoming disciples of venture theory: Read everything there is about portfolio construction, historical performance, decision making, biases and strategy, and build a rock-solid case for LPs that you deliver on the two critical fronts:
The potential to deliver excellent returns, in contrast to the mediocre performance of the largest firms. Not by swinging for the fences on every hit, but with properly optimized portfolio, price discipline, and solid understanding of the underlying theory.
Backing the best founders with the most important ideas. However good a multi-stage fund gets at identifying early stage opportunities, their model will always bias towards consensus themes and capital-intensive ideas. It is a limitation.
Essentially, GPs of smaller funds need to meet divergence with divergence, and embrace the strengths of their size and strategy: contrarianism and discipline, which amount to a form of value investing for early stage companies. Finding the easily overlooked. The alpha.
The Fork in the Road
Multi-stage GPs spent the last decade cosplaying as VCs, despite their practices being opposed to the conventional rationale of venture capital. You canāt make good judgements about price vs value or question consensus themes if your existence is predicated on assigning arbitrary markups and chasing the hottest companies.
Over the last decade, many VCs have sought to emulate “tier 1” multi-stage behavior, acting out what they believe LPs and peers expect to see despite the fundamentally incompatible models. This herding around identity and behavior reflects the extreme level of insecurity in venture capital, a product of the long feedback cycles and futility of trying to reproduce success in a world of exceptions. It has also produced some extremely poor practices, and bad attitudes.
The more VCs study the history, theory and current reality of private market activity, the more conviction they can develop about their own mindset as investors. The more confidence they have, the better they will fare as individuals in a discipline where peer-validation is poison and the herd is always wrong.
If thatās not for you, then there is a lucrative future to be had working at a venture bank.
VCs taking public money (pensions, sovereigns, etc) must publicly disclose all deals, terms, marks and position changes.
LPs managing public money must publicly disclose all fund positions and cash returns.
Tax treatment for anything up to ~series A should be extremely advantageous to small managers.
No passing public money through multiple layers (e.g. VCs acting as LPs to EMs).
LPs managing public money should not offer bonuses to their allocators based on short-term performance.
LPs managing public money should have something similar to polical rules around disclosing gifts, travel, hospitality, etc.
This is just a start. The highest level changes that should be made to correct some of the perverse incentives in venture capital today, providing adequate accountability for public capital.
In the last post, I talked about the hunt for liquidity in VC and the role that transparency has in building a healthy secondary market.
To take that further, we should look more carefully at the structure of venture capital, the direction the asset class is moving, and lay out a direction which can address the question of stronger secondaries and access to liquidity.
Venture capital spent the last decade pulling itself in two. The vast amount of capital resulted in the expansion of early investing while also keeping companies private for much longer. The role of a GP is now more specialised, with a greater focus either on the qualitative metrics at early stage, or the quantaitive metrics at later stage.
This divergence is new enough that it still causes significant confusion; it’s easy to find people talking at cross purposes because they exist at opposite ends of the market. The differences are so fundamental that they are practically separate asset classes.
It is in these differences that the future of venture capital lies: the value unlocked by embracing the divergent strengths of early and late stage managers ā with the former selling significant stakes from their portfolio to the latter.
This could represent a major positive development for venture capital, for a number of good reasons:
Reduce the dilution required in a startup’s lifetime.
Shortening the feedback horizons for LPs who cannot rely on incremental metrics like TVPI/IRR
Better optimised for a firm’s specialisation on go-to-market or growth problems
Reducing the risk exposure associated with downstream capital and later stage competitive pressure
Limiting capital waste by introducing sell/buy tension at an earlier point in the startup’s life cycle, encouraging more rational pricing
Preventing momentum investing from large funds distorting investment selection at early stages
In practice, this results in a division of the venture asset class into two main categories. While there will inevitably be some overlap in the middle, and some exceptions, it seems worth separating the two disciplines and their specific attributes:
Early VC: Pre-Seed – Series B/C
Smaller, thesis-driven firms that are focused on finding outliers. Founder friendly, research heavy, experimental, eccentric. Carrying a relatively smaller burden in terms of dilligence and transparency.
Larger, metrics-driven firms that source strong performers directly from the early stage firms. Looking at proven businesses with high growth potential through a more standardised lens. Transparent about both deployments and LPs.
Fund size: > $500M
LPs: MFOs/Larger Institutions/Sovereign Funds
Liquidity: IPO, PE secondaries, M&A
This bifurcation has two important additonal benefits:
It shortens the feedback window for VC performance, and disincentivises pouring capital into hot deals for inflated TVPI.
These two points reflect the goals of creating a more favourable environment for LPs, a more robust fundraising ecosystem that is less prone to bubbles and crashes, and an approach to enhancing transaprency without hampering the smaller early stage firms.
There are three hanging questions about the economics of this change:
Whether the basic 2/20 fee structure ought to change in this scenario, and whether it should be significantly different between the two?
The degree to which a rational market will change venture capital returns. How much have expectations been warped by the history of dumping overheated companies at IPO? Can we expect a more stable growth in value through the life of a company?
What is different for firms like Lightspeed which may be using a continuation fund to buy their own secondaries?
In both of these cases, I think the solution is to let the market experiment and work this out ā especially with added transparency and scrutiny on practices ā I have more faith in positive outcomes. Even for Lightspeed, the performance of both units will be under seperate scrutiny, so the incentives should still work.
Why now?
What has changed in the last two years which makes this proposition attractive? Well, the IPO window closed. The strategy (as discussed in my previous article) of dumping companies with inflated valuations on public market investors came to an end.
An underestimated effect of that strategy, which dominated VC for the previous decade or so, was that it meant a disproportionate amount of value was unlocked at IPO ā and VCs didn’t necessarily believe in the value of companies on the way there.2
Consequently, nobody wanted to offload their shares in a winning company until it went public. That’s when the big payout was. Clearly LPs liked the outsized returns for as long as they lasted, but now that era is over we are firmly back to looking at the timeline on returns.
In a market with a more rational perspective on value and pricing, you can make sense of a transaction at any point. Secondaries become much more appealing. Again, this is all covered in more detail in the previous article.
Certainly we appear to be at a point in history where every stakeholder in venture, from founders to LPs, should be interested in finding a better way forward.
This is just one proposal for what that might look like.
(top image: The Choice of Hercules, by Annibale Carracci)
The success of AI is existential for venture capital
Imagine entering VC in 2020, full of enthusiasm about a the unstoppable wave of technology. Your peers are impressed; it’s a prestigious industry that is perceived as commanding a lot of power through capital.
You have to put aside your personal thesis in favour of the firm’s strategy on crypto, micromobility, rapid delivery, creator economy, and web3. Each of those sectors are benefitting from venture capital enthusiasm and weaponised capital, driving prices through the roof. It’s an exciting time, though you’re not feeling as involved as you would like to be.
In fact, you’d quite like to make the case for investment in other industries; overlooked opportunities which offer larger ownership stakes and cleaner cap tables. It’s difficult to justify the change of strategy when the biggest markups are all coming from a few hot sectors, so you avoid the friction.
Capital is flowing into the asset class from LPs at an unprecedented rate. Rather than pressure to justify and properly diligence investments, you are pressed to ensure capital is deployed and opportunities aren’t missed. Access to hot deals and co-investment with the tier-1 firms is how you stay relevant to LPs. Success is now largely dependent on your relationships across the industry.
It creeps up on you that your colleagues have stopped talking about exits. TVPI looks phenomenal. There’s no rush for any portfolio to go public. Now the conversation is about pricing and the appetite of downstream investors. Beyond that, it’s someone else’s problem.
For the first time, your spidey-senses start to tingle.
Early in 2022, concern ripples across the industry. Worries of recession, interest rates on the rise, and a weak public market that has lost interest in recent VC-backed IPOs. In simpler times, you would have papered over the cracks by highlighting fund resilience. Now, the idea fills you with dread. None of your portcos are growing much and auditors are on your tail to correct markups.
With surprising speed, the tables turn. An era of unprecedented growth and optimism comes to an end. Y Combinator writes the eulogy with an open letter to their portfolio companies. Venture-backed hypergrowth is shelved in favour of finding a path to profitability. The red-hot sectors which had promised game-changing returns are quietly scrubbed from websites and bios.
By Mid-2023, venture capital feels like a fever-dream. Many of the most exciting investments from 2020 and 2021 have imploded or recapitalised. Layoffs are the norm, even for many VC firms. Nobody in the arena wants to talk about why.
Fortunately, nobody has to dwell on the cause of the downturn for too long: exciting new tech from companies like OpenAI and Midjourney provides the perfect source of distraction. A whole new gold rush to sell to LPs.
The incredible possibilities offered by powerful, accessible AI models will spawn companies with growth potential not seen since the early years of Google and Amazon. It promises to easily turn-around a few years of poor performance for the venture asset class.
Of course, there are nay-sayers. Not the doomers who speak of an AI-driven apocalypse, at least they buy into the incredible scope of the technology. They are believers. The real problem are the cynics.
The cynicās claim is that todayās āAIā is just an evolution of decades-long work on machine learning, neural networks and natural language processing. Yes, the hardware is a lot better, processing at scale is much easier, but fundamentally not a huge amount has changed. Models will be commoditised and commercial applications will favour incumbents who have data and distribution. Itās not the generational game-changer that venture capitalists claim.
Those who believe the hype (or those whose career depends on it) preach the gospel of salvation for an entire generation of managers. The narrative battleground is shifted to the conflict between these two groups, the doomers and the boomers, away from the cynics who offer nothing but grim reality.
Evangelism reaches new heights. Marc Andreessen who led the charge on the 2011 – 2022 bull run with his essay, “Why Software Is Eating the World“, proclaims even greater optimism with the publication of “Why AI Will Save the World“.
It gnaws at you. Do you really believe? Do the numbers make sense, or is venture capital back at its usual bullshit? Is it your responsibility to just blindly support this as an insider?
Worse, what if this fails too? The consequences for the venture asset class are difficult to contemplate.
At some point, you are sure the music is going to stop.
Until then, the only path you can see is to continue following your peers. As long as you are all doing the same thing, no failure can be pinned on you.
…Right?
Each day you scramble to find the hottest AI deals in your network and secure allocation. You keep making the same promises and assurances.
You lean into the identity, blend into the herd. Any sense of irony in wearing the uniform disappears. You begin to believe.
Thereās a weird phenomenon among VCs where the less successful they are, the more evil they become to founders to squeeze more money out of their best startups out of necessity which then becomes a vicious cycle of adverse selection.
Including the above, criticism of venture capital often applies a fairly broad-brush, which might feel unfair.
If you look a little closer, you’ll see it’s actually a problem of venture capital’s own making. An identity has emerged over the last decade which feels like an attempt to homogenise the asset class. This has been characterised by gatekeeping, consensus seeking, exclusionary behaviour, protectionism of networks and relationships, determining the āin-groupā and then restricting access to it.1
This identity appears at the core of venture capital, thanks to the gravitational effect of extreme insecurity: with so little in the way of transparent standards, particularly on measuring performance, most managers look for implicit validation from their peer group. They adopt the same attitude, use the same jargon, invest in the same categories, and follow the same practices.2
Toxicity seems to be compensation for insecurity in our industry. Itās not good.
Unfortunately, that group is clearly a negative force, having a chokehold on the public image of the asset class and an unfortunate influence on the overall returns.
Adverse Selection
If you follow finance and economics, you will be familiar with the problem of adverse selection. For those that arenāt, here a rough summary of the explanation from Nobel winning economist, George Akerlof, and his famous paper, āThe market for lemonsā:
Buyers in the used car market arenāt typically mechanics, so struggle to judge whether their potential purchase is in good shape or a bucket of rust with a new paint-job.
This imbalance of information between buyers and sellers creates a reluctance to ever pay full price – until eventually everyone selling good cars is driven out of the market.
To apply this to venture capital: you have a category of managers who deal with their performance anxiety by blending into the herd – aiming for consensus, not excellence. The ones who smirk when managers set ambitious targets, despite that being the name of the game.
These managers are the buyers in this analogy, hedging their bets out of uncertainty in their own ability, benchmarking against averages, and ultimately degrading the whole asset class.
For this, thereās no better analogy than The Monkey Problem, which I believe is credited to Astro Teller, Captain of Moonshots at X:3
Imagine you tell 100 people that their goal is to have a monkey on a pedestal reciting Shakespeare, 100 days from now. They know that you might check up on them along the way, and are concerned about demonstrating their progress.
The first thing everyone is going to spend time on is finding or making the most impressive pedestal, because that is the most attainable and demonstrable sign of progress – even if it is trivial compared to teaching the monkey.
In venture capital, the pedestal equivalent is the logo hunting, where managers will seek to invest in hot deals, or invest alongside ātier 1ā firms, in order to have those logos on their LP updates. Itās a superficial sign of āprogressā, and has no direct relation to the real goal of generating returns. They donāt really know how well they are performing on those terms, and they canāt really compare themselves to their peers.4
Turns out, when youāre building a venture firm truly from scratch (limited track record, no Ivy, didnāt work in venture prior, etc.), logos + investing alongside name brands matter far more than anything else.
To join the two together: the monkey problem creates the information asymmetry (inability to understand fund performance) which results in the lemon problem (the drift towards measuring manager performance via relationships and how well they fit the stereotype).
As a result, thereās increasing gravity around that āin-groupā network of VCs, and fitting into those patterns of behaviour and identity. Itās that group which becomes the subject of so much (often deserved) criticism, and the target of parody.
Managers who do not identify with this group are de facto not the target of that criticism. They are secure enough in their ability to not need to adopt the superficial signals of competence. Through their implicit understanding that venture capital is precisely not about fitting a pattern, they are likely to outperform those that follow the herd. Unfortunately they often face an up-hill struggle when raising successive funds.
This has a deeply concerning impact on the performance of venture capital, and the quality of ventures they back, as well as the diversity of founders and ideas that will be funded.
VCs may subconsciously be looking for founders who share similarities with themselves and may not be able to effectively assess founders who have exceptional but different qualities.
The solution to this, going back to the root of this problem, is to focus on the monkey.
Every stakeholder in the process, from founders to LPs, need to be clear that their responsibility is generating returns. There needs to be a real shift towards making and measuring returns, rather than assigning value to relationships and hype.
Specifically, for an informative approach with practical feedback windows (quarterly or annual, rather than decennial), that requires making TVPI a meaningful metric through standardised methodologies and transparent reporting.
This is never going to happen without some kind of broad industry consensus, which in turn is unlikely to happen while the āin-groupā VCs dominate the narrative and control what success looks like to protect their own necks.
For those who are holding on to the belief that venture capitalists are the last bastion of smart money, it is time to let go. While there are a few exceptions, venture capitalists for the most part are traders on steroids, riding the momentum train, and being ridden over by it, when it turns.
Not to mention the patagonia vest, vacations in Mykonos, or how many times they can squeeze āgrokā or ārubricā into a conversation. [↩]
Once-upon-a-time it was popularly characterised by āVC Twitterā, though that weird ecosystem has become more self-aware and at least partially a self-parody. [↩]
The moonshot factory, not the social media platform [↩]
We also discussed this during a recent episode of the Equidam podcast. [↩]
This is a question I saw on Reddit’s often-comical /r/venturecapital, which I thought was interesting enough to write out a decent response to. It hits at the root of a few major problems in the asset class which are always worth addressing.
A 409A valuation, named after Section 409A of the United States Internal Revenue Code (IRC), refers to the process of determining the fair market value of a privately held company’s common stock. It is often conducted to comply with the tax rules governing non-qualified deferred compensation plans, such as stock options, stock appreciation rights (SARs), and other equity-based compensation arrangements.
A lovely summary fromChatGPT
First thing’s first: Generally speaking, VCs don’t care about valuation, and especially not ‘fair value’.
Fair is irrelevant. Only market clearing numbers matterā¦š
…and that’s quite reasonable. VCs have their own investment strategy, their own approach to calculating risk vs potential, and if it works for them (and their LPs) then great. More power to them.
What’s important here is that while we often use the word valuation in reference to deal terms and portfolio performance, what we really should say 99% of the time is price.
In venture capital, price factors in a number of things, including the advantages of preferred stock over common stock, but most significantly it is geared at reflecting what the market would be likely to pay for that startup at the time. This is why VCs focus so much on comparable deals when pricing rounds, even if it ends up being a bit circular, with everyone copying everyone elses homework.1
So that is the status quo. But why are VCs interested in preferred stock in the first place?
Venture capital is all about power law, right? The idea is to invest in many startups, expect to lose money on 80%, and make a varying amount of money back from the remaining 20%.
Venture Capital āBackableā? š”
Iāve reviewed over 3000 African startup pitch decks in the last 4 years. The most important question I ask myself each time is.. ā¬
So why do they care so much about downside protection, rather than maximising that upside?
When you add a liquidation preference to a deal, the implied value of the equity increases, meaning you get a smaller % for your capital. Lower returns at exit. That kind of trade-off flies in the face of power law, so why is it of interest?
Liquidation preferences insulate VC firms from losses, so they can delay markdowns until after they raise another fund. VC returns follow a J-curve, therefore losses come much earlier than returns. Liquidation preferences can serve as valid reasons to not mark-down investments as companies begin to miss milestones or donāt receive an exciting Series A valuation bump.
William Rice, “Slugging Percentage vs. Batting Average: How Loss Aversion Hurts Seed Investors”
Liquidation preferences are mostly an irratational response from loss-averse VCs, some of whom may be trying to shield themselves against reporting poor performance to LPs. Maybe that’s overly cynical; I’m all ears if anyone has a better explanation.
The core assertion here is that in a more rational and healthy market, liquidation preferences probably wouldn’t exist and VCs would just buy common stock.
An industry with few standards
Now that we have some understanding of how equity is priced and why preferences exist, let’s return to the original proposition: that VC investments could be marked up or down based on 409a valuations.
In some cases, VCs do set marks with 409a valuations, but not all. Unfortunately – as with much of VC – there are no real standards.2
Some VCs will only set marks based on fundraising activity, some will also consider 409a updates, some will factor new SAFE caps. Some will ignore downrounds, some won’t.
The way VCs price rounds is subjective and non-standardised, and therefore way they track the value of those investments is also subjective and non-standardised.
It might be going too far to say that this was all designed to obscure performance and protect charlatans, but this is probably how I would design VC if that was my intention.
Performance > relationships
Putting aside deal pricing for now: a VC firm could use any framework that provides a systematic read on fair value, such as this one from Equidam, and apply that to tracking portfolio company performance.
This would represent a huge shift in how VCs operate, and how they manage relationships with LPs. It’s also something that I’ve written about at some length before.
The horizon for useful feedback could be annual (or even quarterly) rather than 5-10 years.
LPs could hold fund managers accountable for performance, and we may see that many household names (which attrract the lion’s share of capital and startup attention) are actually dramatically underperforming. They could more confidently back emerging managers, who could provide more meaningful metrics of success.
VCs would be able to follow portco growth more precisely and learn much more quickly about what works and what doesn’t. Good managers would be able to fundraise much more easily.
Crucially, it would make VC an industry based on performance rather than relationships and hype chasing as it is today. It would make VC better at backing innovation, which is what the whole asset class was built around.
The flawed idea that VC is all about relationships (who you know rather than what you know) is too often taken as biblical truth. A mountain of research, however, shows that in VC, personal relationships destroy economic value. Closer ties = worse performance. pic.twitter.com/BQUxF9UIEB
Startups are volatile, but capital should be stable
Finally, if VCs were also to price deals based at least partially on fair value, we’d avoid momentum-driven valuation rollercoasters like we’ve seen in the last two years. Much less risk of valuation bubbles and crashes, more stability for LPs and VC funds, more consistent access to capital for founders, and – again – an asset class that could better serve innovation.3
A more objective and independent perspective on startup potential, better suited to investment in the innovative outliers that venture capital was created to support.
I’ve spoken to a number of people – LPs, VCs and founders – about this topic. There’s a near universal acceptance that a standard for private company valuation would be of huge benefit to the whole venture ecosystem.
Unfortunately, none of them are particularly incentivised to make a stand on it.
Some may benefit from the status quo, and the rest are keen to maintain their relationships by not making waves.
If anyone has any data on this, I’d love to see it. [↩]
There are also huge second-order effects, like how it would make venture capital fairer by removing more of the bias found in less structured approaches to valuation – but that’s for another post. [↩]
