Debunking the supply constraint of “great founders”
“Increases in venture fund-raising which are driven by factors such as shifts in capital gains tax rates appear more likely to lead to more intense competition for transactions within an existing set of technologies than to greater diversity in the types of companies funded.”
Short-Term America Revisited? Boom and Bust in the Venture Capital Industry and the Impact on Innovation, by Josh Learner and Paul Gompers
There is a stuctural paradox in venture capital, in the ratio of available capital to funded companies.
Research shows that in hot markets, when capital availability is high, venture capitalists tend to cluster around “obvious” opportunities — limiting who can access that money.
On the other hand, in cooler markets, there’s a broader spectrum of interest as investors return to hunting “outliers” — but less capital available to fund those opportunities.
In periods where the most important companies are likely to get funding, there’s implicitly less capital available to them.
“In hot markets, characterized by high investment activities and abundant capital, the landscape shifts dramatically compared to cold markets. […] This optimism propels VCs to find new ventures as legitimate that resonate with the heated market sentiment and capitalize on the prevailing momentum. At the same time, “too much money will chase too few deals”, leading to intense competition among VCs for promising investments and sparking a fear of missing out.”
Venture Capitalists’ Decision-Making in Hot and Cold Markets: The Effect of Signals and Cheap Talk, by Simon Kleinert and Marie Hildebrand
There’s a number of explanations. Clearly, it’s much easier to raise money from LPs if you’re doing the “obvious” thing. It’s also a faster route to generating markups, with a prayer that you’ll score a historic exit before the music stops.
In the past, these cycles were characterised by the inverse relationship between deployment and returns, and the inverse relationship between consensus and discipline. Periods of scorching the earth, and periods of carefully planting seeds.
That cycle was broken in 2022 by the emergence of “AGI”.
There was no correction for the large platform firms who rode the narrative to entice capital from larger and less experienced LPs. At the same time, they retreated from LP activity in the small and emerging firms that were being decimated.
The market has become exceptionally top-heavy, exacerbating the founder:capital paradox as more capital is concentrated in consensus-focused investors. Relative to scale, the volume and diveristy of investment is at an all-time low.
This is measurable in the behavior of the large firms, who have narrowed the focus of their investment, despite representing a greater share of the volume in early rounds in recent years.
The result is a narrowing of the entire market.
Not only does this result in “beta to the center“, it is also structurally limits how many new companies can be discovered each year.
Where small firms once might have focused on finding outlier investments (especially in cooler markets), many now focus on serving “hot” companies to the giants downstream.
“Most seed VC firms are not really investors, but rather brokers of ‘hot’ companies to larger VCs. Most care little about whether a company is a good business, but care a lot about who could lead a follow-on round in 12 months”
Ed Suh, Founder & Partner at Alpine VC
Essentially, the negative aspect of hot markets (clustering around obvious opportunities) now persists across all markets, as large firms have “escaped the cycle” and many small firms do what they feel they must to survive.
The market is already reshaping itself around this new reality.
The surge in scout programs is one reflection, as surviving investors seek to fill an origination gap left by the decline in small and emerging funds. Example’s like Sequoia’s early scout programs show this can produce results.
However, scout programs must be carefully managed to avoid incentivising ambitious future VCs to chase heat because they believe it will accelerate their career (or just don’t know better).
“VC can 2x, 5x or 10x over the next 10 years and we will meet the demand, with the smartest people of our generation.”
Garry Tan, President & CEO of Y Combinator
Similarly, many accelerator programs are in the process of scaling to meet this demand. Indeed, when done well, accelerators provide a valuable service of giving signal to companies which investors may otherwise overlook.
However, many accelerators see VC engagement as the north star for their success, rather than just a consqeuence of finding great companies, producing similar heat-seeking incentives.
In truth, both of these solutions can help shore-up an unstable venture market, but neither is a complete replacement for the coverage and competence that could be provided by a large and diverse network of GPs.
Here’s the bottom line: we do not know the ceiling on the supply of great founders, nor the ceiling on capital, because we much more quickly hit a ceiling on the number good investors.
Any time you hear an investor saying that venture is constrained by the number of great founders, what they’re really saying is that they are constrained by their ability to find great founders.
Similarly, beware investors who say there are too many venture capital firms. There is an obvious lack of good venture capital firms, which is partly down to restricted market access. It is not a competitive and meritocratic environment.
(top image: Johann Georg Platzer (1704-1761), “The Death of Samson”)
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