Tag: venture capital

One of the concepts we emphasize at Equidam is the inversion of qualitative and quantitative factors in startup valuation, as you go from Seed¹ to pre-IPO funding.

The archetypal Seed startup (perhaps just an idea) has nothing to measure. Investors must use their imagination, peer into the future, project a scenario. On the other hand, a startup raising the last round of private capital before an IPO will be weighed and measured almost entirely on financial metrics.

Even as early as Series A you have access to some useful data. Can they actually build the thing? Do customers really want it? Does anyone want to work there? All sources of rich signal to help you make an objective decision about the company.

Seed is different. Success comes down to the quality and consistency of your subjective, independent judgement. In many ways it is a unique discipline within the strategy of venture.

What happens if you try to find a path in the data?

You find…

• Great founders can look like anyone
• Great startups can be based anywhere
• Almost all of the dogma is wrong
• Consensus is a value-destroying trap²
• Confidence is a value-destroying trap
• There are no easy answers

Essentially, it’s a hunt for outliers with no shortcuts and two specific qualifiers for any investment strategy:

1. Any attempt to pattern-match to past success is going to dramatically limit your pool of opportunity, with no clear upside.
2. Any constraints built into your investment strategy (sector, region, industry) are essentially a sacrifice of volatility (potential alpha).

Thus, the ideal Seed investor is likely to be a generalist, with no preconceptions about what great founders look like, where they come from, or what they might be building.

Rather than the hubris of a (supposed) rockstar stock-picker, Seed investors will find confidence through constructing solid processes, systematically rewarding good decisions and mitigating bad ones.

They wont necessarily benefit from operational experience, but they will benefit from being able to recognise a good business. Indeed, some basic financial principles, often overlooked by today’s managers, can help uncover the potential in novel opportunities.

Finally, and perhaps most importantly, they’ll have a firm grip on the biases which manifest in all forms of investing. Particularly the curse of overconfidence which erodes the positive influence of success.

In summary, considering all of the above, we should expect Seed investors to present with an idiosyncratic worldview, some robust fundamental skills and an appetite for risk.

Sadly, reality is the opposite: Seed investors are often risk-averse herd animals with little real competence. They have Rick Rubin-esque affectations, pontificating on ‘taste’ and ‘craft’, while copying each other’s homework and hiding deep insecurity.

Why? Predictably, it’s the incentives.

In the last 15 years we’ve seen the emergence of a Startup Industrial Complex, where a treadmill of capital, services and brand-strength was offered to participating firms and startups. If you wanted quick, reliable markups and easy downstream financing for your portfolio then you hopped on board.

This movement destroyed the institutional contrarianism of Seed investing. Billions of dollars were piled into safe SaaS money-printers when capital was cheap. When the market for safe investments was saturated, investors responded by dumping huge sums of capital into silly ideas (remember NFTs?).

That’s “risk”, right?

This worked during ZIRP, because everything was going up and to the right. Public markets were so cracked-out on COVID and cheap capital that they grabbed anything at IPO. But it was never going to last.

Seed VCs (and their LPs) need to recognise that role is, and always has been, to find breakout companies before they are obvious. Not to compete for deals. Not to seek validation from colleagues. To find those outliers. To be uncomfortably idiosyncratic. That’s it. That’s everything.

Critically, while it may lag by a decade or so, everything else is downstream from Seed.

The entire venture capital strategy depends on Seed investors doing their job properly. The entire premise of venture-backed innovation, and the promise of venture-scale returns, are entirely dependent on the health of Seed.

(image source: “Venice; the Grand Canal from the Palazzo Foscari to the Carità”, by Canaletto)

1. Pre-seed isn’t real [↩]
2. There is a variety of perspectives you can use to confirm this. [↩]

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. There’s one path where the incentives are aligned.

Jamin Ball, Partner at Altimeter Capital

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 — like many people, myself included — 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.

Paying for Performance in Private Equity: Evidence from VC Partnerships

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.
• GPs are being paid to hold companies when they’d be better off securing an exit, or propping up zombie portfolio companies just to continue harvesting fees.
• 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 — 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.

Today, with the market bifurcated into ‘venture banks’ and traditional venture capital, there is the opportunity to return to first principles.

We can start by examining the extremes:

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Ending the charade; 100% fees

In an entirely fee-based environment, without carry as a smokescreen for bad actors, fees would likely be more clearly connected to performance — 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

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Ending the AUM game; 100% carry

In a scenario where investors only ‘eat what they kill’, performance would matter so much — across so many dimensions — 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.

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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 — 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:

1. 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.
2. 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 — which can each then better play to their strengths:

Indeed, some of the best early stage investors around today are already adapting to this reality:

The times that it’s easiest to sell into these uprounds, are probably the times you should think seriously about it if you’re a seed fund.

Mike Maples, Jr, Parter at Floodgate

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.

Josh Kopelman, Co-Founder of First Round Capital

For funds like [mine], selling stock of private startups to other investors will be “75% to 80% of the dollars that [limited partners] get back in the next five years.

Charles Hudson, GP at Precursor

You’re told ‘illiquidity is a feature, not a bug’ and ‘let your winners ride.’ But when the physics of the model shift, you often need to with it. 

Hunter Walk, Partner at Homebrew

I’ve been doing the ‘anti-VC’ strategy of selling my winners […] When a company gets overvalued, and I can no longer underwrite a 10x.

Fabrice Grinda, Founding Partner at FJ Labs

You sell at the B, and you actually — for us, with the way our math worked — 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.

Charles Hudson, GP at Precursor Ventures

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

Indeed, many of the objections are based on silly recursive logic, e.g.

• secondaries aren’t a good market ➝ because they’re only used to sell poor quality assets ➝ so they’re not a good market
• returns in venture come from a few giant outcomes ➝ so we hold to IPO ➝ so more value accrues to a few survivors ➝ so most of the returns come from a few giant outcomes
• you can’t get liquidity on markups➝ because they’re optimised for fees not liquidity ➝ 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.

To quote the brilliant thread from Rob Go:

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 post–money 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.”

Squaring Venture Capital Valuations With Reality

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 — 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 — 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 — to begin aligning venture capital with a high-performing meritocracy — it’s here, today.

Ironically, innovations in venture capital haven’t 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 it’s based on no longer hold true, curtailing meaningful relationships prematurely and misaligning companies and their investment partners.

Roelof Botha, Managing Partner of Sequoia Capital

[EDIT 24/06/2025: Added a quote from Charles Hudson]

1. Listening to Jack Altman’s podcast with Josh Kopelman of First Round helped change my mind on this. [↩]
2. I believe a 2x return is not an unreasonable target, but the market would adapt if it were. [↩]
3. This observation is based on the feedback I had to an initial proposal. [↩]

In venture capital circles, the most widely discussed trend of 2024 (outside of AI) has been the concentration of capital into “venture banks” 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? 

There are a range of opinions on this question: Consider the insights shared by Sam Lessin, in The Venture Capital Regatta; Yoni Rechtman in Return, Bifurcation or Megafund Dominance; or Charles Hudson, in Three Future States of the Early-Stage VC Ecosystem. Both are respected investors with valuable perspectives but a slightly different set of base assumptions, so triangulating on objectivity is difficult. 

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:

1. Jay’s concern probably seems alien or overly-dramatic to anyone who entered venture capital within the last decade. Today, it’s just the game on the table. 

2. 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 company’s 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 “performance” taken care of, it’s easier to raise more capital to feed portfolio companies, fuelling aggressive growth to grow into those markups. It’s putting the cart before the horse, compared to conventional venture thinking, but it has a certain brutal charm.

So, we’re beginning to see that the ‘capital as a competitive advantage’ playbook didn’t 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 Capital’s Flaws

As multi-stage firms have expanded their funds under management, they’ve 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 “signalling risk”: 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 don’t 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 models—e.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 “venture beta”: 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 model’s 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 ‘legible’. 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 shouldn’t 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 “value add” from venture capitalists, what do they offer founders that the multi-stage firms can’t?

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:

1. 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. 

2. 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 can’t 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 that’s not for you, then there is a lucrative future to be had working at a venture bank. 

But you need to decide which path to take.