VCs & Founders are Underdogs Again

I’m a sucker for an underdog. If I flip on a random football game where I don’t know or care about the teams, it’ll start off as just entertaining. Team A makes a nice catch – hell yeah. Big tackle by Team B’s defensive end – nice work. But during that time, almost subconsciously, I’m weighing their chances. I’m taking inventory of who is “supposed to” win. And I slowly, but inevitably, start pulling for the other team. I start complaining about the refs. I’m getting annoyed about the play-calling.

Sometimes – the best times – my underdog team will rise to the occasion. They’ll rally, responding to the pressure, and start to come back. You can feel the momentum shift, and it’s elating to see them making plays and evening the odds.

But then, when my underdog team gets lucky enough to pull ahead, something shifts in my mind. I can’t help it. I start noticing the defeated looks of the opposing players. I see the body language of the underdog quarterback – he’s too cocky now – he’s starting to annoy me.

Before long, I’ve completely reversed myself, and I’m cheering for the other team.

Right now, we’re seeing an entire industry go through one of those underdog reversals. Which one, you ask? Venture Capital.

Bad News Bears

In January, Sequoia (considered one of the greatest VC’s of all time) announced they were reducing fees. Based on conversations with VC friends who know a hell of a lot more than I do, this would be like seeing a bright red “SALE” sign outside of a Restoration Hardware – it’s nice, because things were overpriced before… BUT it also serves as a red flag. It makes you wonder if the business is struggling.

Then, in March, Founders Fund (another legendary firm) announced that their fundraising target for the latest fund would be cut in half – from $1.8B to $900M. Founders is run by Peter Thiel – Co-Founder of PayPal, early Facebook investor, mother of dragons – if he can’t raise the funds he’s targeting, then how is everyone else doing on fundraising?

Basically, not great.

And just last week, Sequoia announced even more bad news – cutting the size of two of their funds, a total of $835M in failed fundraising.

Hang on Joey… are you about to say VCs are underdogs? Aren’t these the people who Shark Tank their way into equity shares, are revered and feared by founders, and make piles of cash doing it?

Yes, but hear me out. When it’s done well, these VCs are the firms that make bets on founders. At a time when bank loans aren’t an option, or when there’s an opportunity that requires incredible speed and timing, they step in to provide a service and make it happen. They help pull the future forward. And yeah, recently, it’s been bad news bears for them. But it’s worth understanding what changed and why it matters.

Theories and Queries

Per usual, I had some ideas about why I thought this was happening – and of course I did some research… but this time, I also phoned a VC friend to help me dig even deeper. In this section, I’ll talk through those theories and what I learned.

Theory #1 – Smaller startup valuations mean smaller VC funds

To understand this one, let me start with a simplified explanation of how VCs work:

• The General Partner (GP) is the fundraiser and investment decision maker, and they raise funds from Limited Partners (LPs). When the GP picks a startup to invest in, they are allocating a portion of their total fund to that investment. GPs typically aim for 20% of the startup’s equity, and they traditionally aim to raise a fund that lets them write 20-25 checks to startups. Too many more, and they are over-diversified, hurting returns. Too many fewer, and they’re too concentrated, raising the risk of each investment. 

• The LPs don’t make decisions about what startups get invested in – their only VC decision is which VC to pick. But LPs (typically large institutional investors) make investments in other asset classes too. They’ll hold equities, real estate, and all kinds of other assets to diversify their portfolio.

• The startups make decisions about how to operate their companies, and in exchange for the funding they get from VCs, they give up some equity and some control (often handing VCs board seats).

So back to my theory…. Just like equities and other risky assets have been hurt by the Fed’s interest rate increases, startup valuations have also been hurt. To write the same number of checks AND avoid spiking their equity % ownership, the VCs have to raise smaller funds.

Adding to that… because AI is blowing up and is relatively cheap for startups to get access to (open source models, including from the likes of Meta, are all over the place…), there’s also an argument to be made that the $$ required to launch a startup is smaller.

My VC friend agreed that this is real, but also encouraged me to think about two LP dynamics. Here’s the first one…

Theory #2 – LPs are over-allocated to VC

Remember how I said that LPs invest in all kinds of assets? Well they also have rules-of-thumb about how much of their capital they want to allocate to VC. They might say “no more than 20% into VC”. And when their VC portfolio goes nuts (in a good way, with IPO’s and other “exits”), they can pare down their position to rebalance to that 20% number.

Right now, the problem is that they are over-allocated to VC not because VC is doing well, but because everything else is doing poorly and is more liquid. Their commercial real estate allocation – shitty. Their equities allocation – less shitty but not great. VC is doing badly, but it’s an illiquid asset class (only “marked to market” when fundraises/transactions/exits happen vs. equities which are marked/valued every second of a trading day).

For example – let’s say you’re an LP, and you put 20% in VCs, 30% in equities, and 50% in everything else. If equity values go down 10% and everything else is down 5% (again, VC value doesn’t change), then you now have 24.5% in VCs, 27% in equities, and 47.5% in everything else. You have too much in VC… Ok no problem – wait until the next fundraising round (at least you’ll get a markdown when it’s re-priced lower) or get lucky with an exit.

But exits are much rarer these days.

So your VC firms call you trying to sell you on their new funds… but you’re looking at your allocation and shaking your head.

Theory #3 – Shift of power from Founders and GPs to LPs

This second LP dynamic is what really brings it home (and does a better job explaining Sequoia’s fee cut). Because LPs are (mostly) over-allocated, but GPs are continuing to try to launch funds and fundraise at the same rate as during the boon times… we now have many sellers chasing fewer buyers.

It’s a buyer’s market.

Before the market peaked, it was a full-on sellers’ market, and firms like Sequoia benefitted tremendously. In fact, they had so much demand (so many LPs interested in parking their $$; so many founders hungry for their support/reputation) that they had raised fees above the industry standard. For both the management fee and the performance fee, Sequoia’s rates were 50% higher than almost everyone else. How wild is that?

So now, the shift in power away from GP’s and towards LP’s is in full swing. No shit Sequoia cut their fees.

As a consequence of that, Founders are also shifting much of their power back to VC’s. During the bull market for VC over the last several years, valuations were sky-high and VC’s had to push them ever higher just to have a seat at the table. Now, GP’s are “sharpening their pencils” – paying a lot more attention to cash flow, being much stricter about the things they throw money at. Founders aren’t all-powerful anymore. The tides have turned on them.

So what?

If you’re asking yourself why this matters – I get it. VC can sometimes sound like an alien world, with ridiculous amounts of money and risk flying around. But here are three rebuttals to that.

1. Power shifts aren’t just a VC thing. Landlords are cutting rent while real estate slows down. Tech employers are pulling employees back to offices while the labor market shows signs of softening. I think we can learn a lot from the power shifts that impact other people, so we’re prepared and recognize the ones that affect us.

2. All the over-eager, optimistic “pulling the future forward” stuff I talked about earlier, that’s not just for tech geeks. Every company you admire… every company you know… it was a startup at some point. It was an idea that someone (or a small group of someone’s) had, and they made it happen. Folks taking risks – with their effort or their capital – has driven humanity forward.

3. Everyone loves an underdog, right? If you haven’t followed before, VC is a pretty fun game to watch. And now, founders, the individuals that could in a different life be you or me – are facing some really long odds. If you’re an underdog person, jump on the bandwagon with me.  

Thank you for reading Forests Over Trees. This post is public so feel free to share it.

Bonus Bullets

Quote of the Week:

— Steve Jobs

Quick News Reactions:

• GPT & Google’s Robots: Large language models have helped Google breathe life into their robot prototypes, including the “RT-2”. I love it, even if it’s a Star Wars copyright suit waiting to happen.

• Twitter IOU’s: Twitter sorry, X, has rolled-out ad-rev-sharing globally, after a pilot with some of its largest creator accounts. This is a good move to lure some creators back, probably. But you need pizza (ad revenue) before you start dishing out slices (sharing).

• NFT Projects: The British Museum has partnered with a crypto company (The Sandbox) to issue NFTs and build immersive experiences. I’m relatively crypto positive, but that’s a bold move, cotton, we’ll see how that works out for you during this crypto bear market.