Really fun article that brings a lot together. Two comments... the math in the Puritans section mixes asset class and individual firm data. -> If a unicorn is 75% owned by "VCs as a class" at exit (more likely than Freds 50-60% for the firms that have later, bigger exits) then $150B as-a-class and 3X goal as-a-class means VCs need $600B exits as-a-class (not $2.2T). But I agree it is still Mission Impossible, startup exits are well below 600B most years (except 2021).
Second, more on portfolio construction... its muddy to say that "cottage wants 10X while aggregator wants 3X". OK yes.... but the target return must be adjusted by stage. Really both want 10X *per seed deal*, both want 2X *just before IPO*, and both want to give LPs 3X *as a fund*. The difference is that Cottage typically does not have late stage dollars to invest, so they must price Seed/A low enough get 10-20X on winners and hit 3X as a fund once a bunch fail. Whereas, Aggregator puts the vast preponderance of its money into late stage after winners are known. They can afford to overpay at Seed as a loss leader and earn profit later.
Its not really a free lunch for founders... they can get a better price in Seed/A from a big fund, albeit with less partner-level support, but they may pay the piper in middle rounds as they have to contend with the signaling effect, which gives the big firm who is already on the cap table considerable negotiating power.
Overall the late-stage scale gives a clear early-stage edge for big firms... on any normal business where the needs are predictable (and can be served by platform machine rather than a partner). Whereas Cottage wins when the startup does NOT fit a standard mold and *does* need close partner attention early.
As a student, this was a very educational read. The simplicity of covering the history of why these two types of firms were born and how they coexist was great.
I understand the point that LPs don't want to be invested in 1k+ firms and rather cut the number down by 10x size checks, however do these shark LPs have employees to scout firms and deploy their capital / via their FOs? If so, why would they cut larger check sizes with an expectation of 20-30% of the returns they would expect on lower check sizes, when they could hire a few more people to scout these firms? (or is it because of a lack of that high volume of good firms)
Great article! I would wish to understand better the founder perspective of having received funding from each strategy and what outcomes have resulted from their perspective
Does the extract below assume that the risk of an S&P 500 investment is the same as the risk of a VC investment? I’d think that the minimum threshold return required by an LP from a VC investment would be higher than 2x given the higher risk compared to an S&P 500 investment.
“If you'd invested $250M in the S&P 500 5-10 years ago you would have generated ~12.7% per year, or a 1.6x return. The longer, the better. So your threshold is ~2x for a venture fund with 5-7 year lifecycles, because that would be ~1.6x net of fees. That's it! Big capital agglomerators working with big LPs can promise 2x funds, and the business model in that particular equation can work.“
What happens if the next generation of founders and companies don't need as much capital? What happens if the next generation of founders once released after the coming toilet flush, who had underwater stock options remember the lessons and mistakes of their bosses. What happens if the new generation of founders realizes that economic alignment between the agents and actors makes a difference?
Great article. It would not be a good thing for the innovation economy if there were just few dominant capital providers and gatekeepers.
Splendid post, Kyle. This is one of the best things I have read in a bit!
Two things that I have been pondering - and would like to see what you think about:
(a) With respect to the return expectations, while I do agree with what you are stating. It got me thinking, really. No sophisticated LP invests in a multi-billion dollar fund expecting a mere 2x. They understand the power law dynamic and are seeking outlier returns, albeit with a diversified portfolio approach. Large funds need to generate outsized returns somewhere within their portfolio to justify their existence. This necessitates a nuanced strategy, not a spray-and-pray approach. How long in the "Fund #" game before this act gets called by LPs? It cannot be an infinite game.
LPs, especially endowments and sovereign wealth funds (who form a large chunk of the %age of capital deployed) aren't seeking consistent 2x returns; they're hunting for the rare 100x outliers that compensate for the inevitable failures. With that said, should we expect more granular LP involvement, with specialized teams focusing on specific stages, sectors, or even investment theses. Will this also lead to LPs demanding greater transparency and data-driven insights into portfolio construction and performance attribution? Also made me wonder about how we see the emergence of new LP-GP partnership models, perhaps including co-investment vehicles and bespoke fund structures that align incentives more closely?
(b) I think, for a while, I am noticing that Founders are increasingly sophisticated and discerning. They don't just need capital; they need strategic partners who can add tangible value. This could be in the form of talent acquisition, go-to-market strategy, operational expertise, or access to unique networks. While you do touch on it for a bit, do you think that the best VC firms will become true "platforms" that offer a suite of value-added services, including talent recruitment, marketing and PR support, operational best practices, regulatory guidance, and access to exclusive networks of customers, partners, and investors. This, I think, would require a product-oriented mindset, focusing on delivering tangible value to portfolio companies and measuring the ROI of these services. Should we expect to see the emergence of specialized VC operating partners with deep domain expertise, embedded within portfolio companies to provide hands-on support and accelerate growth. Do you think such a “platform-as-a-service” model will become the defining characteristic of the next generation of leading VC firms?
Thanks! Look forward to the next one! Again, loved reading this!
Amazing post Kyle
Really fun article that brings a lot together. Two comments... the math in the Puritans section mixes asset class and individual firm data. -> If a unicorn is 75% owned by "VCs as a class" at exit (more likely than Freds 50-60% for the firms that have later, bigger exits) then $150B as-a-class and 3X goal as-a-class means VCs need $600B exits as-a-class (not $2.2T). But I agree it is still Mission Impossible, startup exits are well below 600B most years (except 2021).
Second, more on portfolio construction... its muddy to say that "cottage wants 10X while aggregator wants 3X". OK yes.... but the target return must be adjusted by stage. Really both want 10X *per seed deal*, both want 2X *just before IPO*, and both want to give LPs 3X *as a fund*. The difference is that Cottage typically does not have late stage dollars to invest, so they must price Seed/A low enough get 10-20X on winners and hit 3X as a fund once a bunch fail. Whereas, Aggregator puts the vast preponderance of its money into late stage after winners are known. They can afford to overpay at Seed as a loss leader and earn profit later.
Its not really a free lunch for founders... they can get a better price in Seed/A from a big fund, albeit with less partner-level support, but they may pay the piper in middle rounds as they have to contend with the signaling effect, which gives the big firm who is already on the cap table considerable negotiating power.
Overall the late-stage scale gives a clear early-stage edge for big firms... on any normal business where the needs are predictable (and can be served by platform machine rather than a partner). Whereas Cottage wins when the startup does NOT fit a standard mold and *does* need close partner attention early.
As a student, this was a very educational read. The simplicity of covering the history of why these two types of firms were born and how they coexist was great.
I understand the point that LPs don't want to be invested in 1k+ firms and rather cut the number down by 10x size checks, however do these shark LPs have employees to scout firms and deploy their capital / via their FOs? If so, why would they cut larger check sizes with an expectation of 20-30% of the returns they would expect on lower check sizes, when they could hire a few more people to scout these firms? (or is it because of a lack of that high volume of good firms)
Thank you Kyle!
Great article! I would wish to understand better the founder perspective of having received funding from each strategy and what outcomes have resulted from their perspective
Does the extract below assume that the risk of an S&P 500 investment is the same as the risk of a VC investment? I’d think that the minimum threshold return required by an LP from a VC investment would be higher than 2x given the higher risk compared to an S&P 500 investment.
“If you'd invested $250M in the S&P 500 5-10 years ago you would have generated ~12.7% per year, or a 1.6x return. The longer, the better. So your threshold is ~2x for a venture fund with 5-7 year lifecycles, because that would be ~1.6x net of fees. That's it! Big capital agglomerators working with big LPs can promise 2x funds, and the business model in that particular equation can work.“
Really enjoyed this one. It pulled together a lot of threads I have been thinking about.
Thanks for sharing. I think the middle ground will (quickly by VC standards) become empty as we have seen in so many other sectors.
Agreed
What happens if the next generation of founders and companies don't need as much capital? What happens if the next generation of founders once released after the coming toilet flush, who had underwater stock options remember the lessons and mistakes of their bosses. What happens if the new generation of founders realizes that economic alignment between the agents and actors makes a difference?
Great article. It would not be a good thing for the innovation economy if there were just few dominant capital providers and gatekeepers.
Splendid post, Kyle. This is one of the best things I have read in a bit!
Two things that I have been pondering - and would like to see what you think about:
(a) With respect to the return expectations, while I do agree with what you are stating. It got me thinking, really. No sophisticated LP invests in a multi-billion dollar fund expecting a mere 2x. They understand the power law dynamic and are seeking outlier returns, albeit with a diversified portfolio approach. Large funds need to generate outsized returns somewhere within their portfolio to justify their existence. This necessitates a nuanced strategy, not a spray-and-pray approach. How long in the "Fund #" game before this act gets called by LPs? It cannot be an infinite game.
LPs, especially endowments and sovereign wealth funds (who form a large chunk of the %age of capital deployed) aren't seeking consistent 2x returns; they're hunting for the rare 100x outliers that compensate for the inevitable failures. With that said, should we expect more granular LP involvement, with specialized teams focusing on specific stages, sectors, or even investment theses. Will this also lead to LPs demanding greater transparency and data-driven insights into portfolio construction and performance attribution? Also made me wonder about how we see the emergence of new LP-GP partnership models, perhaps including co-investment vehicles and bespoke fund structures that align incentives more closely?
(b) I think, for a while, I am noticing that Founders are increasingly sophisticated and discerning. They don't just need capital; they need strategic partners who can add tangible value. This could be in the form of talent acquisition, go-to-market strategy, operational expertise, or access to unique networks. While you do touch on it for a bit, do you think that the best VC firms will become true "platforms" that offer a suite of value-added services, including talent recruitment, marketing and PR support, operational best practices, regulatory guidance, and access to exclusive networks of customers, partners, and investors. This, I think, would require a product-oriented mindset, focusing on delivering tangible value to portfolio companies and measuring the ROI of these services. Should we expect to see the emergence of specialized VC operating partners with deep domain expertise, embedded within portfolio companies to provide hands-on support and accelerate growth. Do you think such a “platform-as-a-service” model will become the defining characteristic of the next generation of leading VC firms?
Thanks! Look forward to the next one! Again, loved reading this!
This is an exceptional post. Really thoughtful and comprehensive.
I wonder where the middle will go. Maybe to emerging markets.
This is phenomenal. One of the best posts I’ve read about venture at large.
Just amazing. I learned a lot. Thanks a million!
what a great read!
Wow! Well done! Amazing article