When early-stage founders building high-growth companies think of raising their first bit of capital, they think find a venture capitalist. What they don’t think about is where the venture capitalist gets the money. The people who invest in a venture capital fund are limited partners (LPs). VCs have a responsibility to be good stewards of LPs’ capital—and if they aren’t, they won’t get any more of that capital.

I had breakfast with an out-of-town venture capitalist raising a $100+ million fund that invests in seed-stage (product built, but no product–market fit) companies. They’re not investing at the idea stage, but still early. He worked at a notable fund for years, but this is the first time he’s raised his own fund. We discussed his fundraise and the LP environment. He’s been focused on institutional investors (endowments, pensions, foundations, etc.), given his relationships and experience. He’s gotten good traction with his fundraise, but he’s hearing that many institutions prefer to back a manager at fund three and beyond. They want to get to know you during fund one and two. They want to see the company’s track record and performance and build a relationship with the manager over the first two funds. Once they get comfortable with a manager, they’ll back them over a few funds.

My conversation with this manager reinforced my view that early-stage investing can present a dilemma for LPs because what they’re comfortable with doesn’t align with the flux and transient nature of the early stage.

I walked away from this conversation, and others, feeling like there’s ample capital available from folks who want to invest in early-stage companies. But the current venture capital construct isn’t ideal when it comes to matching capital to founders. I’m wondering, is this an opportunity for an alternative that institutional LPs would like, or will LPs backing early-stage companies forever not be institutions (individuals, family offices, etc.)?

I’ve shared my views on how short-term valuation changes affect psychology. I was reminded of them recently when I had a great dinner with two established, successful founders, one of whom recently sold his company. The topic of public markets came up, and both shared that their portfolios have lost material amounts of money. The most interesting thing they said was that looking at their portfolios regularly is frustrating. One of them even mentioned that he was nervous about checking it given the recent market trajectory. They’re both considering selling losing positions to stop the bleeding.

Liquidity is a big difference between the public and private markets (i.e., venture capital). Some view the liquid nature of public markets as a benefit. There are benefits to it, but I also see a downside. Because of the liquidity of public markets, investors can constantly check the value of their investments. When valuations fall for macro reasons (i.e., the company is doing fine), some investors may sell their investments with the click of a button. Even though the company is doing fine and could appreciate significantly in value in the future, today’s pain is too much to bear, and people sell prematurely.

Private markets are different. Investors can’t check the current value of an investment. Companies are usually valued at the last round of capital raised. As companies face hurdles or the macro market changes, the valuation is still at the latest round. Resetting the valuation usually means raising a new round or a private party transition between two parties. Neither of these options is easy. If a seller is able to coordinate a transaction with a willing buyer, some companies can have the right to block the transaction. All of this means that investors in private companies are more likely to stick it out with private investments when times get tough.

The illiquid nature of private investments makes it hard for some people to embrace them. I think this illiquidity isn’t necessarily a bad thing. For winners, it forces investors to stick with investments during hard times. As companies get past the hard times, these investors reap returns they likely would have missed out on if they’d been able to sell their investment early.

Last year I had a friendly debate with someone about getting more capital to more early-stage founders. At the time, I believed scale was the way to go. Build larger VC firms (not funds) to increase the number of seats in a historically cottage industry. Make it possible to institutionalize the knowledge of how best to fund and support early-stage founders, which would become more distributed as team members left these larger firms. Build firms, not funds, was mostly my thought process.

I’ve had the opportunity to speak with many emerging and established VC fund managers, their limited partners (LPs), academics, and of course founders since then. These conversations have made me realize my original thesis was incorrect (that’s the power of discovery). Scaling larger VC firms with larger funds isn’t the way to get more capital in the hands of high-potential early-stage founders.

Larger funds create challenges for LPs and VC fund managers (emerging and established) doing early-stage investing:

• Smaller funds are a better fit because they enable fund managers to write a check that’s an appropriate size for an early-stage company.
• Early-stage investors need to suspend disbelief and make nonconsensual investment decisions. Otherwise, investors fund what everybody else is funding. That’s hard to do in a large organization, because decisions tend to lean toward consensus when more people are involved. Smaller teams are more likely to make nonconsensual decisions.
• I also believe in a world where great founders are more geographically dispersed—centralized capital deployment isn’t as effective in reaching high-potential founders. A dispersed model would be more effective because it would help capital meet founders where they are.

It’s been interesting to see my thinking on this topic evolve and realize that the person I was chatting with was more right in his thinking than I was.

I’ve had the privilege of chatting with many emerging VC fund managers this year. One thing I consistently hear about is a goal to raise continually larger funds. For example, a first fund might be $10 million. If it does well, they’re planning for fund two to be $50 million and fund three to exceed $100 million. They’re driven to do this to increase cash flow from management fees, which provide them with more resources.

Most of the emerging managers I’ve chatted with are investing very early. Most aim to invest as close to when the company is created as possible, even if there isn’t a product yet. These emerging managers have unique perspectives and networks they believe position them to find non-consensus and high-potential founders very early. I agree that they’re more likely to find and fund non-consensus founders or markets, and I view them as playing an important role in the early-stage start-up ecosystem. If things go well, these founders, fund managers, and fund limited partners will realize massive outcomes.

Raising larger funds will give emerging managers more resources, but it will also compel them to begin investing at a later stage. The challenge here is that the edge they have investing early might not carry over into a later stage.

The current VC fund fee structure—specifically, the traditional management fee, usually 2%—isn’t ideal for emerging VC fund managers. Successful emerging VC managers want more resources, and rightly so. But they don’t necessarily want bigger funds, because it’s harder to deploy a larger pool of capital. I see an opportunity to provide an alternate structure to emerging managers investing early-stage who exhibit early signs of success. I think this will not only solve the resource problem but also better align emerging managers, their limited partners, and founders. The early-stage startup ecosystem will be the better for it.

I met with a successful founder who shared an interesting insight with me: he sold his company for ~$200 million and is happy he wasn’t able to easily raise capital early in his journey. Most founders view insufficient resources as a negative, so my curiosity was sparked.

The founder and his early investors viewed the market they were going after as a $10+ billion opportunity. It was a new market, and his company was at the forefront. Wanting to be the undisputed market leader, he tried to raise a war chest to go after this opportunity. He didn’t raise the $100 million he wanted, but he was able to raise $20 million.

Fast forward a few years. An interesting thing happened. The new market he was going after ended up not being as big as they’d anticipated: $1 or $2 billion instead of $10+ billion. The much smaller market was split among this founder and all his competitors.

As the smaller market size became clearer and investors started getting closer to the end of their fund life cycles (~10 years), they started thinking about the company exit. They decided to run a process to sell the company and got an offer for ~$200 million. It wasn’t the $1+ billion they’d hoped for years earlier, but it was satisfactory given the smaller-than-expected market.

I won’t get into all the math, but since the founder raised ~$20 million total at a fair valuation, the ~$200 million exit gave his investors a satisfactory return. Therefore, the founder and the company’s employees weren’t subject to liquidation preferences. Investors, employees, and the founder were all happy.

Though the ~$20 million this founder raised wasn’t what he hoped for, it ended up being the right amount of capital to build a company appropriate for the size of the market. If he’d raised $100+ million, his outcome would have been materially different. He wouldn’t have been able to sell for ~$200 million because that wouldn’t result in a sufficient return for investors (exiting would have been delayed by years). Or, if he’d sold for ~$200 million, that would have limited or eliminated payouts to himself and his employees because of liquidation preferences.

This founder’s story highlights the importance of founders understanding the potential size of their market (to the extent possible) and seeking resources to build a company appropriate for it.

I’ve noticed that a number of venture capital firms prefer to hire people with a finance background. Those with investment banking and private equity work experience are thought to be great candidates. In my chats with emerging and established managers, several mentioned they’re seeking junior hires and emphasized a desire for candidates from finance.

I’ve never worked in finance, but I have friends who have. It’s notorious for long hours and hard work. Anyone who’s done time in this world is thought to have a great work ethic, which is likely true. One learns a host of skills in that environment that many think highly of (financial modeling, research, etc.).

A banking background provides a strong skill set and will set people up to succeed in some stages of venture capital, but I don’t think that applies to the early stage. Evaluating companies at the idea stage or before product–market fit requires skills that a finance background likely doesn’t equip you with.

Early-stage investing tilts strongly toward evaluating people and markets to find the nonobvious. Identifying founders’ strengths and weaknesses and what’s possible if they’re surrounded by the right resources and support is key. It’s difficult—more art than science. Many people have a hard time ignoring the unpolished exterior of a founder they can’t relate to and seeing their potential. Evaluating nascent markets can be equally difficult. Recognizing the severity of a pain before others understand it and the market size if the founders can create an ideal solution can require one to suspend disbelief and ignore current reality.

Skills acquired working in finance are great, but I don’t think they make you an ideal early-stage investor.

I’ve spent time with lots of emerging venture capital fund managers recently. These managers are like the founders they invest in. Many of the same qualities required for a start-up’s success are needed for a fund to succeed. Today I met a fund’s founding team that had an interesting dynamic. They reminded of me of the hipster–hacker–hustler concept for creating an ideal team:

• Hipster – The hipster focuses on the product being desirable to customers. They think about things like user experience and product design. They tend to be in tune with what’s trendy and cool. They have a unique customer-driven perspective.
• Hacker – The hacker is a builder. Building new stuff excites them, and they can focus intensely on it. They’re driven by data and logic. They see the world as black and white and may not have much charisma.
• Hustler – The hustler makes sure things get done. They relate well with people and are persuasive. They can hold people accountable to results, sell to customers, and rally people behind their vision.

The team I met today had all three: a hipster, a hacker, and a hustler. The complementary nature of this team shows. They’ve built a fund with a unique perspective and way of doing things in a relatively short time. I think this team will do well in the long term, and I’m excited to follow their journey and the journeys of the founders they support.

During the last few years, we’ve seen a significant increase in the number of venture capital funds started. I’m happy that more people are deploying capital to founders. I think this is great for founders. But I’m concerned about how efficiently the capital is being matched to high-potential founders—especially those outside venture capital networks.

I’ve investigated and found that many (not all) funds have similar strategies. Sourcing, evaluating, and supporting founders look similar, with small tweaks. A lot of these funds were raised in 2020 and 2021. Those were great years because the start-up market was booming. These new funds benefited from the rising tide. They didn’t find and evaluate nonobvious founders with high potential. Many used VC network consensus to find and evaluate the companies they invested in. More capital was available, and lots of their investments enjoyed markups because of the abundance of capital—not because of traction earned by solving a problem well.

If the current market downturn continues, companies that aren’t focused on solving a problem well enough to reach product–market fit will struggle to raise additional capital. Their runway will shorten. Early-stage funds with unoriginal strategies that invested in these types of consensus start-ups will face hurdles too. If their portfolios aren’t performing well, they’ll have a harder time convincing others to give them more money to deploy in more consensus deals.

I’m curious to see how this pans out. I believe the non-consensus early-stage investors with original strategies will excel.

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I spent time today talking with a friend and fellow investor. We talked about similarities in various venture capital firms. Many firms are fishing in the same pond, we agreed—they recruit people from the same network and use similar strategies to source and evaluate founders. He said something that resonated with me:

“If everybody follows the same playbook, the returns will reflect this.”

My buddy makes a great point. If a venture firm is making investments similar to those of other firms and generally doing what other firms do, that’s consensus investing. They’re likely investing in consensus founders solving obvious problems. That’s a recipe not for outsize returns but for average or below-average returns.

This truth was masked by the rising market over the last few years since a rising tide lifts all boats. The tide seems to be going out now, and I’m curious to see what changes early-stage firms make to their playbooks.

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I listened to Michael Moritz share his thoughts on venture capital investing. Michael is a former journalist turned venture capitalist at Sequoia Capital (he joined in 1986). He isn’t just an investment partner—he’s been part of the firm’s leadership team for decades. He played an integral role in the firm’s international expansion and expansion into investing beyond venture capital stages. Given his unusual path to venture capital and the firm’s success, I was curious to hear what he had to say.

One of Michael’s insights that jumped out to me was his perspective on classifying founders and ideas:

To me, the best investments are the ones that don’t fit into a convenient bucket.

He cited Airbnb, Yahoo, Uber, and others as examples. The concepts behind those businesses were different than the norm at the time. It’s obvious now that they’ve worked out, but back then, the founders and their niche ideas weren’t obvious winners. Michael and others had to intentionally look past that.

I like Michael’s perspective. Sequoia’s investments in non-consensus ideas and people led to outsize results. Even though those founders and ideas didn’t fit into logical buckets at the time, investors still made the leap of faith to partner with them. This wasn’t just one or two lucky investments. Sequoia has a history of doing this, which implies that it’s core to their strategy and contributes to their success.

It makes sense that nonobvious people, ideas, and problems won’t fit into buckets. If they did, they’d be obvious.

I think other VC investors can learn a lot from Sequoia. The best people and problems can seem odd. But if you look past the surface, ignore the consensus feedback, and take the leap of faith, you could find yourself with a series of outsize returns and lifelong partnerships with founders who change the world.