Fundraising: non-obvious facts
Part 8 of a primer on early stage tech fundraising based on YCombinator's guidance and my own learning in-the-trenches as a successful founder
Previous posts in this primer:
There’s a lot of things about how the VC industry works that aren’t obvious until you spend time in the industry or trying to fundraise (I’ve done both). Early in my career I spent six months at SignalFire, which at the time was a new VC, and I was helping the CEO and founder Chris Farmer raise his first fund.
Understanding the structure of where VC money comes from and how VC returns work helps you better understand the incentives and decision-making process of your investors, which will make you a savvier fundraiser, and give you context on the “advice” you may receive from investors and prospective investors along the way.
VCs raise money from Limited Partners (LP) that tend to be large organizations with very large wealth portfolios they are looking to diversify across asset classes. Examples of LPs include university endowment funds (Harvard’s is $50B), pension funds (the largest of these is Japan’s Government Pension fund at $1.7T), high net-worth individuals (wealthy people), and family offices (the entities that manage the funds of wealthy people). Venture Capital has historically been considered one of the most volatile asset classes with some of the highest returns and the greatest variance on those returns.
Signaling quality
The top VCs are oversubscribed every time they raise a new fund. Why? Well, simply put, they have the best returns, so anyone who can get into their funds wants to. Are they better investors? Well, yes and no. It all comes down to signaling.
Many of the top startups are oversubscribed every time they raise a new round. Why not just raise more capital? If you raise more, you either have to dilute yourself as a founder and give away more of the company, or raise your valuation, at which point it becomes harder to exceed your valuation at later rounds. If the VC market takes a downturn, your business may have improved according to all key metrics, but you may be forced to take a down-round because valuations are lower. Down-rounds have negative signaling to everyone: your employees are disheartened (their equity isn’t worth what they thought), prospective employees are less compelled to join you, investors are scared off, etc.
So, even if a funding round is oversubscribed, you won’t always want to take more capital. Which VCs get selected into those oversubscribed rounds? The top funds. Why? Signaling! It’s useful to be able to tell prospective employees that your lead was Sequoia. Even if every other VC in the industry wanted to invest in an oversubscribed round, founders are incentivized to pick the VCs who offer the best signaling value to the market. This is why it isn’t necessarily true that the top VCs are actually better at picking winners; most of the “top VCs” were early to the industry, established a network, brand recognition, and credibility early, and have continued to lean on that to get into deals that are obvious to many but that they are able to access due to the signaling value of their brand.
In order to try to compete at this game, there’s been a bit of an arms race within VCs to create value-added elements to what they do. Andreessen Horowitz built a massive recruiting arm to help with placing top talent at their portfolio companies. SignalFire built an incredible database with hard-to-find information to help companies learn about their competitors. If you find yourself in an oversubscribed place, you’re lucky you’ll have options to choose from, and you can ask what value-added services the firms provide (it may also be helpful to back channel with other founders they’ve invested in to find out which of those services are actually useful, and which investors they’ve individually enjoyed working with).
Big or bust
The VC model relies on a “big or bust” philosophy that requires few of their companies to succeed, and the ones that do need to massively succeed in order to return the fund plus upside. Over the last few decades, there’s been an upward pressure on fund sizes at the largest funds, since there is so much LP money clamoring to get in. As fund size goes up, this puts more pressure for there to be a few massive returns in order to return the dollars invested plus upside, which further etches the pattern that the large funds only want $10B+ companies.
The largest funds have tens of billions under management. To put some overly simplified math behind this, a $1B fund that invests an average of $10M in 100 companies taking 10% ownership in each needs to have at least one of those companies have a $10B exit in order to return $1B to its investors (10% of $10B = $1B) - and that doesn’t even account for positive returns. This is why, for these larger funds, even $1B exits aren’t enough, and $100M exits don’t even register on the radar. They would need ten $1B exits to return this fund without any gains to investors - or 1 in 10 investments would need to have that outcome. Due to network effects* playing such a key role on outlier outcomes throughout most of the tech industry, the expected likelihood of one company getting to $10B is actually higher than ten companies getting to $1B in a portfolio of 100 companies. This is why VCs may push you to hire faster and scale earlier than you feel like you’re ready; they want you to be either that one giant winner, or one of the 99 that don’t get there at all. $100M and $1B outcomes aren’t enough. The bigger the fund size, the more this pressure is present.
That said, there are some investors who are happy with $100M+ outcomes. Angel investors don’t tend to have the breadth of investments that large VCs have and they don’t have constraints on returning a fund at a particular size. (They can also be more mission motivated since they are investing their own capital.) Smaller seed fund VCs (with $50M-$200M funds) are in a similar boat. A reasonably rational investing strategy for these folks is to look for compelling founding teams with great companies that have strong business fundamentals (e.g., already have recurring revenue) and could conceivably be a $100M exit on a 3-5 year timeline. If they are in markets that won’t likely be $10B exits, these investors won’t need to compete with the big guys to get into deals, so they are more likely to get into good deals at good valuations. If you are likely running this type of company, it’s good to be aware of that and think about which investors to target given that.
Conviction vs consensus funds
Conviction funds are ones where a single person can make a decision to invest. Either because there is only one partner running the show so they have full authority, or the way the partnership is structured gives full permission to single individuals to make their bets. It’s fairly rare that large VCs operate this way.
Most VCs operate as a consensus. Deals need to be reviewed at the Monday morning partner meeting and everyone either needs to be onboard, or at least not a “no”. Some funds that claim to be conviction funds will in practice still operate closer to consensus funds, since it will cost the partners social capital to invest in your business if others don’t agree, which means the amount of conviction they’ll need to have is extremely high. If you are a particularly edgy business, unless you already have extremely strong numbers, you’ll have a hard time raising from consensus funds.
Some VCs will be familiar with these terms; others won’t. It can be helpful to ask about their decision making process in an intro call, particularly if you know you’re running a business that’s extra unusual or in a more controversial area.
Vice clauses
Vice clauses essentially prevent VCs from investing in “sex, drugs, and rock and roll” (well, minus the rock and roll part). The history of vice clauses as the lore has it comes down to where VCs get their money from. Many university endowments are limited partners (LPs) in VC funds, and many universities have religious affiliations. Years ago, universities with religious affiliations required the VCs that accepted their money to add clauses into their contracts that would prevent them from investing in “vice” businesses - which vary depending on the clause, but may include businesses that touch sexuality, controlled substances, gambling, tobacco, firearms, and alcohol. This tends to become most relevant for sex toy companies, sex-positive businesses, and cannabis and psychedelic startups. The larger VCs are most likely to have these conflicts; angels and many seed funds do not have them. There are also a number of funds that specifically target working with these types of businesses but they tend to be on the smaller side and focus on the earlier stages. If you are building in one of these spaces, know that there is more capital available at the early stages than at the later stages and you likely will struggle to have access to the breadth of capital that comparably successful non-”vice” businesses have at Series B and later, with the scarcity compounding over time.
*The VC fund NfX has done a lot of fantastic writing on networks effects and how to think about this in the context of startups. Here’s one article from them on this topic.
Luna Ray works with post-PMF founders as an executive coach. She is the founder and Chair of YCombinator-backed Plura and ex-Meta, Instagram, Faire, and Bain & Company.