Are VC Funds Getting Too Big For Their Own Good?

I’ve recently had very similar conversations on separate occasions with a number of different entrepreneurs.  The basic gist of these conversations, which Peter Rip touches on in his own post, was that the interests of VC funds and entrepreneurs seem to be diverging more than ever thanks to several trends, the most important of which is the increasing size of VC funds.

Problems On the Way In...
Large funds are creating both entry and exit problems.  On entry, large funds create problems because they are under pressure to invest as much as possible in each deal in order to preserve the operating leverage of the fund.  This means that it’s increasingly difficult for entrepreneurs to assemble a syndicate of VC firms as each firm wants 100% of the deal from themselves.  Syndicates are important for entrepreneurs because they disperse control and leverage multiple networks.  More importantly, the VC’s desire to put as much money to work as soon as possible often results in very significant up-front dilution for entrepreneurs.  Many VCs now say that they have minimum initial investments, usually around $3 to $5M, which can give the entrepreneur a frustrating choice between no funding and too much money with too much dilution.

... and Problems On The Way Out
On exit, large funds once again can cause problems because the funds are heavily biased towards “pressing their bets” and trying to get a home run vs. selling out more quickly for single or double because singles and doubles on $5M don’t “move the needle”.  Thus, entrepreneurs often find VCs dragging their feet on potential M&A deals because they don’t think a smaller early return is worth the time and capital they have invested.  On the other hand, many entrepreneurs want to sell out early because the money on the table is significant from their perspective and they are worried that in going for the home run they may ultimately strike out and end up with nothing.  Put another way, entrepreneurs don’t have the luxury of portfolio diversification so a bird in hand is as good as five in the bush.

These tensions are being exacerbated by two other trends.  The first is that thanks to dramatically lower technology costs in some sectors, it often takes less money to get a company off the ground than it has in the past.  Thus, VCs are paradoxically looking to write larger checks into industries that actually need less money.  Second, exit valuations have become more predictable and less rich which means that dilution stings more than ever.  Giving up 50% of a business that could be worth $500M in a few years is a lot easier than giving up 50% of a business that will likely on be worth $25-$50M.

The Bad News and The Good News
The bad news for large VC funds is that if my recent conversations are any guide it seems like more and more entrepreneurs are picking up on the implications of these dynamics and adjusting their behavior accordingly.  These changes could lead to a serious case of adverse selection, wherein the best entrepreneurs with the most capital efficient ideas either self-fund or raise money from angles while only relatively risky ideas with large capital requirements seek capital from large funds.

The problem for entrepreneurs is that there’s not a lot they can do to change the behavior of the large funds.  For the most part these funds are behaving rationally and really couldn’t change how they behave if they wanted too given the economic incentives/restrictions they face.  The good news is that for those less sensitive to dilution there’s a lot of money out there and it’s easier than ever in some respects (save perhaps Q1 2000) to raise a large amount of money if you need to.

If It Fits, Sign It
The best advice that I would have relative to this trend for an entrepreneur is that if you have the luxury of choosing your VC firm, you should try to pick a firm whose financial interests are best aligned with your own and not necessarily the best “name” or the best price.  If you have an idea that will take a lot of money to get off the ground and if success if more important to you than money, you are probably best off taking money from a large firm as they are not going to sweat writing big checks and will likely be more patient than the average VC.  If you have a very capital efficient idea and are interested in making money as soon as possible I suggest you go with a small VC firm whose investment in your company will be material enough from their perspective to align everyone's incentives.