I had a spirited debate with a founder friend this week. He raised $20+ million in venture capital for his company and sold it for nine figures. Based on his experience, he believes social proof is a critical driver in the fundraising process for founders. If you have a bigger, better network inside VC (investors and founders who have raised from investors), it gives you social proof. The more social proof you have, the more likely you are to get a meeting and get funded.

My friend is right. That is currently how VC works. I don’t think this is good. Venture capital is about finding new problems to solve and taking risks. Risks with ideas. Risks with people. Social proof is often justified as a proxy for what you can expect from a founder. The thinking goes, if you can’t figure out how to get a meeting with a VC investor, how will you get a meeting with a potential customer? Said differently, will this founder hustle to make things happen?

Founders need to have grit and hustle. Those qualities are critical to surviving the inevitable ups and downs. But social proof has evolved into something beyond evaluating hustle. It’s been used to derisk the entrepreneur; that is, it’s a way to evaluate whether this entrepreneur is a quality person worth betting on. If other people in the VC investor’s network know the founder, the investor can derisk the entrepreneur by asking others about them. Unfortunately, the feedback, instead of being about the founder’s abilities, is often based on shared personal characteristics and relatability.

In venture capital, you want to back founders who see the world differently and identify overlooked problems. Said differently, you want nonobvious problems and markets, which are usually identified by people with unique perspectives. These people and the problems they see may not be part of the “in” crowd. They may have different personal characteristics. People may not be able to relate to them or find commonalities, but that doesn’t mean they can’t be amazing founders.

Using social proof to evaluate founders isn’t a great practice. Instead, founders should be judged on their abilities, the severity of the problem they’ve identified, and the potential of the solution they envision. The number of connections they share with a VC investor shouldn’t factor into funding decisions. In fact, social proof as a founder evaluation tool can lead to false negatives on under networked high-potential founders solving nonobvious problems.

VC funds can have a big influence on start-ups. VC funds get the capital to invest in companies from their limited partners (LPs). LPs can be individuals, families, or organizations (pensions, endowments, corporations, etc.). I connected with someone who knows the LP world well and helps LPs discover and evaluate VC fund managers. One of his points, which is accurate, is that when LPs find a VC fund manager to invest in, they want to back multiple funds managed by that person (i.e., invest for many years). He also said many LPs want to back VC managers who invest early in emerging technologies and markets. Said differently, they want to invest in a VC fund that can help them invest early and for many years in innovative companies.

Early VC investing is done at a nascent time in a company’s life cycle. Founders haven’t found product–market fit (if they’ve even built a product). It’s not surprising for founders to have a problem they’re passionate about and just an idea about how to solve it. This stage is commonly referred to as the pre-seed or seed stage.

Pre-seed and seed stage investing is different than later stages (when product–market fit has been achieved) in various ways. It’s more transient and in a constant state of flux. Let’s dive deeper into this:

• Flux – The rate of change in the world is accelerating. People are constantly discovering new problems, creating new technologies, and thinking of new ways to repurpose existing technologies. And they’re doing this at a faster rate. Some things end up being viable to form a company around, and some don’t. Keeping a finger on the pulse of all this flux and identifying the promising people and problems isn’t easy. It requires constant refreshing of your perspective and relationships, among other things.
• Transient – Companies either succeed or fail, so companies are constantly transitioning into and out of this very early stage. VC fund managers investing at this stage (likely emerging managers) are similar. The managers that fail stop investing. The successful ones raise a larger fund, which usually pushes them to start investing at a later stage ( more on that here and here). When this happens, it can cause misalignment between LPs and VC fund managers (more on that here) and cause VC fund managers to transition out of investing at this stage too.

Some LPs want to invest in cutting-edge companies early and they want to back a VC fund manager who can do this for them for many years. This approach works at later stages (Series A and later), but given the flux and transience at the pre-seed or seed stage, it doesn’t make sense then. These two goals are counter to one another when investing this early. I believe some LPs want to invest in innovative companies as early as possible because of the potential financial upside and societal impact. But backing the same VC fund manager for many years isn’t the right action to support that goal. It would likely have the opposite effect. I suspect LPs want relationship consistency (or something else) for various reasons and think backing the same manager is the answer. They may believe this because it’s all that’s been available to them historically (other than sourcing founders themselves).

There’s a disconnect here. The stated goal and the action being taken to accomplish that goal aren’t aligned, and I’m not sure people realize that. I suspect this is affecting the efficiency of capital and resource deployment to early-stage founders. There’s likely an opportunity to present an alternative solution that embraces the transient and flux nature of this early stage but also addresses LPs’ other concerns (e.g., relationship consistency).

A friend read my posts about larger VC funds creating hurdles (here and here) and asked a great question. Why don’t emerging fund managers keep their funds small? I didn’t address this in my posts, so I’ll touch on it today.

Fund managers are usually compensated in two ways:

• Management fees – The percentage of the capital raised that's used to run the fund. For example, if you raise a $10 million fund with a 2% management fee, you have $200,000 annually for salaries, rent, etc. Specifics around management fees (i.e., duration) can vary by fund. But this is how fund managers keep the lights on and give themselves runway (i.e., salary) to find and support companies.
• Carried interest (carry) – The share of profits paid to the fund manager as incentive compensation. For example, if a fund realizes a $10 million profit (i.e., money above the original capital investors’ commitment) and has 20% carry, the fund manager would receive $2 million in carry. Carry is unpredictable. It’s usually paid as the fund receives capital from company liquidations over the life of the fund (usually 10 years).

If managers successfully raise a fund, management fees are predictable, while carry isn’t guaranteed and payment of it is unpredictable. I’d imagine most managers opt to increase their fund sizes to increase the predictable cash flow from management fees, even though it could lower fund performance.

I wonder if emerging managers would keep their funds small if cash flow wasn’t directly tied to the size of the fund?

I want to follow up on yesterday’s post about larger VC funds creating a dilemma for established firms. I chatted with an emerging manager recently. Raising his first fund wasn’t easy. After eighteen months, he hadn’t hit his $25 million fundraising goal and stopped at $10 million. That first fund is performing well, and he went out to raise his next fund a few years later. He wanted to raise $50 million but ended up with $60 million because of outsize demand from limited partners who wanted to invest at the ground level of amazing companies.

When we spoke, he was happy the second fund is larger but, at the same time, on the horns of a dilemma: he can’t deploy fund 2 using the same strategy he did with fund 1. He gave me some simple math. (Note that he ignored reserves for follow-on investments and other variables for the sake of getting his point across.)

He wants to invest at the ground level and aims to be the first check or in the first round of capital raised by early companies. From fund 1, he could write a $500k check—5% of his $10 million fund. He could make 20 of these investments, which is achievable, and deploy the full $10 million. The valuations were reasonable, and if one investment performs well, it could return the entire $10 million fund.

With fund 2, though, to write 20 checks each representing 5% of the fund, each check must be for $3 million. But the early companies he targets don’t need $3 million! Their first rounds are usually much smaller.

He now must choose among what he views as not great options: overcapitalize 20 early founders with $3 million at inflated valuations and negatively impact fund returns, stick with $500k checks and find 120 companies, do a hybrid of the two, or invest in 20 slightly later-stage founders (i.e., not at the ground level) at reasonable valuations.

This manager has done a great job of finding, capitalizing, and supporting founders during the earliest part of their business cycle. He’s successfully investing at the ground level of some amazing outlier companies. His strategy worked well for fund 1, which led to fund 2 being larger. He now must adjust his strategy because of the larger fund size, which could hinder him from supporting founders at the ground level. The math (simplified here) demonstrates how raising a larger fund can complicate backing founders at the earliest parts of their journey.

It’s been interesting to watch the last few years of venture capital. The number of firms raising larger funds appears to be increasing. This sounds good until you consider the math of venture capital funds. Most early-stage funds consider an investment a winner if it returns the entire fund or more. If you raise a $500 million fund, you’re looking for an investment in a single company to return $500 million or more. The number of companies capable of such a return is small, so when you find one, you must capitalize on it. If you don’t, a fund is less likely to generate a meaningful return for its investors when the companies that will fail are factored in.

Instagram is a well-known acquisition. It was founded in 2010 and acquired in 2012 by Facebook (now known as Meta) for $1 billion. Andreessen Horowitz invested $250,000 in Instagram’s early seed round and realized $78 million at the time Instagram was sold. That’s a 312x return. The challenge is that Andreessen made the investment from a $1.5 billion fund. Instagram was the investment of a lifetime, but it didn’t return the fund. It returned less than 6% of the fund. That means Andreessen would need to make 19 investments like this one to return its fund. That’s not likely. Do note that Andreessen made decisions specific to this situation that reduced the firm’s return, but this nevertheless illustrates the challenge of large funds investing at the ground level of a company.

The larger the fund, the larger the check the fund needs to write (unless it increases the number of checks) for a single investment to return the fund. When VC firms raise larger funds, many choose to invest at a slightly later stage (think seed instead of pre-seed or series A instead of seed) because the larger check size makes sense given the number of checks they want to write out of that fund. I think this leaves a void to be filled. The question is, what’s the optimal way to fill that void AND still generate a meaningful return?

I recently met with folks running an emerging fund who shared some interesting insights about their fundraise strategy. Their existing portfolio is performing well, and they’re out raising a new fund. They targeted $50 million, but because of recent market conditions they think they’ll land at $25 million. They’re adjusting the portfolio construction. They plan to do fewer investments and are raising the bar on what it takes for them to make an investment.

I wasn’t surprised to hear that funds are reducing the amount of capital they’re raising, given the macro environment, but the higher bar for investment was surprising given the success of their investments.

Risk aversion has ballooned, and founders should be aware of this and plan accordingly. We’ll eventually move back to embracing more risk, but I believe that will be a gradual process.

I was chatting with a founder this week, and he was asking me how to approach fundraising. Specifically, he was asking how to connect with investors via a warm intro when his circles don’t overlap with theirs. He doesn’t have relationships with people who know venture capital investors.

In the past few months, I’ve reviewed a number of fundraising decks for venture capital firms looking to raise money from limited partners (LPs). One of the things they consistently highlight to LPs is how great their network is. The better the network, the better your deal flow. The better your deal flow, the more likely you are to see a great investment opportunity—or so the logic goes. When you dig a bit, you realize that most examples used to demonstrate a great network are exclusive organizations (think elite schools and companies). So, investors are communicating to potential LPs that they run in exclusive circles that give them access to great founders whose companies would be worthwhile investments.

Lots of investors believe (admittedly or not) that founders should get a warm intro to them. Founders can always send emails directly or use other cold outreach methods, but the warm intro is what most investors value most. This dings founders who aren’t part of exclusive groups that attract venture investors. Investors are communicating to founders: Find a way into my circle. Come meet me where I am.

There’s a network problem in venture capital. Investors expect founders to find their way into exclusive (i.e., narrow) circles to seek investment. LPs view such access as a positive attribute and an indication of potential investment success. To me, it seems it should be the other way around. Investors should have broad networks that allow them to meet founders of all backgrounds where they already are and to see the world from different perspectives. LPs should view broad networks as a positive attribute that could lead to overlooked investments that offer outsize returns.

The network problem in VC is waiting to be solved. When it is, the impact on entrepreneurship is likely to be major!

Today I had a chat with an emerging venture capital investor who’s raising his first fund. He shared the journey with me, and it didn’t sound that different from a start-up founder’s fundraising journey. He worked to refine his story and pitch potential limited partners (LPs) to invest in his fund. He’s heard more noes than he can count but pushed through until he heard yes.

The fundraise has been a grueling multiyear journey for him and his partner. It’s finally coming to an end (for fund one at least). I asked him what his big takeaways are. He has quite a few, but two stood out to me:

• Knowledge gap – Just as founders don’t understand the VC landscape when raising for the first time, neither did he. It took him months to learn that each LP is different and looking for something different in the fund investments they make. After he filled his gap, he adjusted his outreach strategy.
• Timeline – Their raise process initially was open-ended, with no timelines. Potential LPs were slow to commit or decline. He and his partner were in limbo, and so was the overall fundraise process. Once they established a timeline and asked people if they could respect it, they got clarity on who was serious.

This emerging manager and his partner hustled their way to raising a $50+ million first fund. He’s now focused on building out the team and infrastructure to support the operation of his fund. I walked away from today’s call thinking of him as more founder than investor.

I had a chat with an investor today. Not only is he a successful venture capitalist, he’s personally invested in forty other emerging venture capital funds. I was amazed when I heard that number. Inspired by such a large number of data points, I asked him a question: What have you learned from these investments that surprised you? I didn’t know what his answer would be, but I was sure it’d be insightful.

He said there’s a high correlation between success and emerging fund managers who are disciplined about communicating with their LPs (people who invested in their fund). The fund managers who communicate best also run funds that have the highest returns (in his personal portfolio). It’s a small sample set but still a powerful insight.  

I’m a fan of founders keeping people in the loop via regular update emails. The upside to writing them far outweighs the downside. Based on today’s conversation, this appears to be a universal rule that applies not just to founders but to anyone trying to achieve outsize success.

I met with a founder about his successful fundraise. I was curious about what he learned from the process. Some of his learnings are to be expected; for example, realizing that to hit his goal, he needed to pitch more investors than he planned for. But he also shared something else: he didn’t crystalize his pitch (or finalize his pitch deck) until the end of his fundraise process.

This founder talked to many people who poked holes in his business from many angles. He was asked questions he’d never thought about. Most of those pitches ended in a no, but he reflected, talked with his cofounders, and made changes when necessary. While painful, the fundraising process gave him more clarity about, and confidence in, what they’re attempting to do.

A founder spends lots of time preparing a fundraising pitch deck. They often feel they’ve created a masterpiece. Many are surprised when they learn it’s just the beginning. Their masterpiece may look very different by the end of a successful fundraising.