The generational transition question is not unique to the venture capital industry; it’s an issue in private equity, venture capital, hedge funds, and any other partnership business with outside stakeholders who provide investment capital. The venture industry has examples where generational succession and transition have gone well and examples where it hasn’t. A successful transition seems to require three things, all of which are necessary:

• The current leadership team needs to find a leadership team or individual they believe can take over the firm and continue to generate similar or greater returns.
• The limited partners who back the firm have to believe the chosen successor is capable of taking over the firm and continuing to generate returns that meet their expectations.
• The chosen successor has to believe that staying at the firm and taking over is an attractive option relative to the other things available to that person.

The best analogy for this process is a 3-legged stool. If you remove any of the three conditions above, succession doesn’t work, and the stool isn’t stable. In talking to more experienced folks who have navigated this process, I was surprised at just how hard it is to get all three of those conditions to line up at the right time. In many cases, the firm’s leadership felt they had met two conditions but not all three. And, unfortunately, all three are necessary.

In particular, the explosion in new fund formation in the past decade has made that third bullet point particularly challenging to navigate. As things continue to tighten in the venture fundraising environment, I wonder if that will change the dynamic around succession conversations.

The post Succession in Venture Capital is a 3-Legged Stool appeared first on Charles Hudson's Blog.

Sometimes it’s not your fault, but it’s still your problem.

I didn’t quite get that quote the first time I heard it. The more time I spend in the world of entrepreneurship and venture capital, the more I understand what this statement means. If you are a founder leading a company, you will encounter many situations where you have to deal with circumstances that are not your fault – you didn’t cause them, but they will impact your company and hence are your problem. They will block you from making progress if you don’t solve them. Here are a few examples of things that fall into this bucket:

• Your sector is out of favor with investors, and it’s hard to raise money – I’ve talked to many founders who are building companies in sectors that have fallen out of favor with investors. Raising money in these sectors is hard; many investors have become skeptical or cynical about whether these sectors can produce large, meaningful companies.
• Your existing investors don’t have any money to support your next round – Many companies raised rounds from funds flush with capital several years ago. Some of these funds no longer have the capital to make additional follow-on investments; it might have more to do with the financial position of those funds than it does with your performance. No matter why they can’t invest, their inability to invest is your problem to manage.
• You hit the milestones that you thought would unlock the next round, but the goalposts moved – Some companies raised rounds that they thought would provide enough capital to get them to the next milestone and unlock the next round. The venture environment today is different from several years ago, and the bar has been raised. As a founder, you need to clear the new bar, not the one you thought you’d have to clear when you raised the round.

Right now, we are in a moment where many founders find themselves confronting problems they didn’t create but must tackle. This is not the time to complain or lament your fate – it’s your opportunity to rise to the occasion and push through despite the challenges.

I publish most of these posts on my Substack, Venture Reflections.

The post It’s Not Your Fault, But It’s Your Problem appeared first on Charles Hudson's Blog.

There is no magic number, in terms of revenue or KPIs, that will unlock a Series A round by itself. Metrics are just one of many inputs that go into the decision.

I have read many Twitter posts, LinkedIn articles, blog posts, and other articles talking about what it takes to raise a Series A. Most of those posts focus on the metrics (usually customers or revenue) that a company needs to clear to raise a Series A round. We have had over 80 companies raise Series A round at Precursor, and each company had its own journey to get there.

I have also come to appreciate a few other things about raising Series A rounds (or any fundraising round for that matter) that I hope help founders who are on the fundraising journey:

Revenue is a coarse, imperfect metric. Revenue, on its own, is a very coarse metric. To fully understand a business, most investors want to understand margins, cost of customer acquisition, sales efficiency, growth rate, churn, and other KPIs that round out the picture. Focusing solely on a top-line revenue metric as a goal doesn’t tell the full story of the quality of the underlying business.

Startups are more than a bundle of KPIs. A startup company is more than just a bundle of KPIs and numbers. If startups were just a bundle of KPIs, fundraising would be fairly deterministic – you could plug those numbers into a spreadsheet and make a decision. The team, product, and market opportunity all matter as much, if not more, than the metrics, particularly in the earliest stages. Think about the current enthusiasm for AI-related startups. Many of those companies are raising large rounds, not based on metrics but on investor belief that those companies will become large, valuable businesses in the future.

Asking a Series A investor what they want to see to yes obligates them to say something. If you ask an investor what metrics they want to see at Series A, they will likely be able to tell you what would make you competitive in the pool of opportunities they see. Still, they likely cannot tell you what metrics your specific company needs to hit. I don’t think most investors know what they want to see in a potential investment until they see it.

It’s hard to draw conclusions from other people’s fundraises. Reading headlines and news about the metrics (or lack thereof) other companies had when they raised their Series A rounds won’t tell you much about what your specific startup would need to achieve to unlock a round. It’s very hard to know exactly why a given investor or set of investors ultimately said yes to an investment unless you were part of the process. These articles also won’t tell you about the many companies with stronger metrics that weren’t able to raise; nobody writes articles about those companies.

Revenue should be an output, not a goal. For our most successful companies, revenue is usually the output of a working business model that delivers customer value. Chasing revenue for revenue’s sake, particularly revenue that isn’t correlated with your core product or service offering, isn’t highly valued by investors and you’re unlikely to get credit for it when you’re raising.

Sometimes metrics are just confirmation bias. In some cases, investors really want to invest in a company for a myriad of reasons. In those cases, whatever level of traction the company has (including none) becomes confirmation bias and supports an investment decision that has already been made. It’s tough to draw too many conclusions from these rounds; this often happens in really hot categories or with repeat or high-reputation founders.

There are a few things that I think do seem to correlate with raising a Series A. I say these things with the clear recognition that they are highly subjective:

• A clear path to building a large company with a $1B+ terminal value, as judged by the investors from their point of view
• Be in the top 5-10% of opportunities in that VC’s pipeline of companies
• Strong founding team that investors believe can take the company to the next level

The post There’s No Such Thing as Series A Metrics appeared first on Charles Hudson's Blog.

That is very much a story about past misdeeds. All of those should be examined, and we, as investors, should reflect on our decisions and the things we chose to overlook when things were up and to the right. Given that we are discussing the past, I think the most interesting and important question is what comes next. I think a lot of the mistakes that were made will be cast as a lack of due diligence or attention to detail. Regardless of the cause, I think the cure is very apparent – we will go back to a world in which due diligence and governance will become much bigger issues for companies earlier in their development.

I want to make a distinction between what I consider due diligence (the work that is done before investing) and governance (the ongoing work that is done to make sure that companies are doing what they say they are doing and that there are proper controls and checks and balances in place around spending and reporting). The natural reflex is to pivot toward more due diligence, particularly regarding revenue, bookings, and user metrics. This is necessary but not sufficient. I think we will pivot toward a world where “trust but verify” is the ongoing norm, with more emphasis on the verify piece relative to the trust piece. I am not saying that every startup played fast and loose with data and reporting when things were going well; this was not the case. But I think that standards around verification will tighten and go back to what they looked like in earlier eras of the venture business. Here is what I think this means for founders who are fundraising before a Series B round:

We will see a strong push for audited financials at Series A
Audited financials are expensive and somewhat cumbersome for early-stage companies. They are probably unnecessary at the pre-seed and seed stage. And, in a world of intense competition, waiving this requirement is an easy way to sweeten a deal and improve a term sheet. Given the reputational and financial risk to firms around companies that misrepresent information, I suspect that requirements for audited financials will creep into term sheets earlier in companies’ lives than we saw in the last 3-5 years.

Board seats and the associated control provisions will become a bigger conversation in all but the hottest deals.
There will still be companies that can raise meaningful amounts of capital without giving up a Board seat. But I think Board seats will be back on the table as part of fundraising conversations. Investors will have a heightened appreciation of the liability associated with being a Board member and will also insist on more from portfolio companies to serve as Directors. I am unsure how this dynamic will play out. Still, it will be a new conversation for many companies that have raised multiple rounds without serious conversations around Board governance.

The burden of proof for substantiating core KPIs will increase
I am not entirely sure how this will play out, but there will be a lot more scrutiny around non-financial KPIs and user metrics. I think investors who feel burned by trusting reported numbers will look for more comfort and assurance; I’m just not entirely sure what the trusted system of record will be to document and report these numbers.

During boom times, investors compete to win deals in many ways. Some give on terms, some on price, and some on governance. I think the record will show that many investors gave on multiple dimensions during a period when founders had lots of leverage and choice. We are returning to a period where I think the balance will reset, and we will land where I hope most companies have greater oversight and we can put more trust in the reported data and KPIs.

If you are a founder raising from a venture fund that has had to deal with a high-profile case of misrepresented data or malfeasance, you should expect extra scrutiny from the firm along these dimensions. Once bitten, twice shy. And if your only fundraising experience was the world of 2019-2021, the new diligence and governance world will likely feel quite jarring.

The post All Venture Booms End with a Return to Governance appeared first on Charles Hudson's Blog.

In a world where all funds were part of the same ecosystem, the venture capital business worked like a relay race. The pre-seed and seed investors worked with companies to get traction, the Series A and B investors provided capital and support to help them prove out scale, and growth-stage investors helped prepare them for life as public companies. Each participant had their own lane and specialty and mostly focused on the thing or things they did well until it was time to transition that company to the next person in the chain.

Lately, I’ve felt this relay race metaphor no longer describes how the venture capital industry works. The largest firms in our industry have gotten significantly larger in the last ten years, in terms of the share of industry assets they manage and in absolute size. They have built out platform and investment teams that allow them to fundraise for and execute against any investment strategy that they think is attractive and is a good use of their time and capital. They can invest across stages, geographies, and vertical specialty industries in ways smaller firms cannot. These large firms have the entire private market as their opportunity set and continue expanding into lanes that used to be the province of smaller, specialist firms. And, given their previous success, relationships with LPs, and access to capital, I expect the largest funds in our industry to remain large. If you’re a seed-focused VC firm, you likely feel the presence of the larger, multi-stage firms that have established and scaled their own seed investing initiatives. The largest firms in the venture ecosystem do not need to wait for those earlier in the process to source and serve up companies to fund; they will do some of that early-stage work themselves. I do not see this dynamic changing anytime soon.

At the same time, many of the upstart and specialist firms that started off as small, sub $100 million firms have grown in size and ambition. Firms that were once happy to participate in the relay race now want to hold on to that baton longer and capture more value before bringing in the next investor to do a follow-on round. As I wrote a while back, the equity available to investors is finite and zero-sum at the end of the day.

Many of these up-and-coming firms are no longer content to stay in their lane – they want to have a bigger role in the venture ecosystem and push into the territory that used to be the sole domain of larger firms. Firms that used to play nicely together can no longer make the math around ownership work if they both want to participate. In the end, I think that this type of competition between firms is good for our ecosystem, and it gives entrepreneurs more choices in terms of whose capital they ultimately decide to take. Some of these up-and-coming firms will become the iconic firms of the next generation as they push through and expand scope, and others will not make it. This kind of dynamism is good for the ecosystem overall.

The biggest disconnect, however, is still around the scale of exit that works given fund size. The relay race analogy I mentioned at the beginning worked best when everyone was happy with the same scale of outcome. One consequence of the largest funds getting larger is that the scale of outcome that matters for these funds is significantly larger than what moves the needle for a smaller fund. The largest venture capital funds need terminal exits of $5-10 billion at a minimum (with reasonable expectations of 15-20% terminal ownership) for those exits to impact their fund economics. Smaller and medium-sized funds have returns equations that work reasonably well at $1-3 billion exits. It’s very hard to have a coherent, handoff-based ecosystem when the participants have a 3-5x spread in what a meaningful exit looks like. This gap creates a problem for the venture ecosystem. Smaller firms, whose funds can achieve solid returns with $1-3 billion exits, cannot, generally speaking, fund companies from inception to IPO. At some point, they know they will need to bring in larger funds to do subsequent rounds. As a result, it is rational and common to try to forecast what that next investor will want to see to say yes to the next round. There are two big challenges with this approach. First, the smaller firms only see a subset of the full opportunity set that multi-stage firms see. There are entrepreneurs, particularly successful, repeat entrepreneurs, who exclusively pitch the larger, multi-stage firms, and those opportunities compete with the pipeline of companies that earlier-stage firms have backed. Without seeing the full opportunity set, it can be hard to know how truly competitive one’s portfolio company is relative to the full set of opportunities the follow-on investor sees. Second, perhaps more importantly, there is a wide gulf between a $1 billion outcome and a $5 billion outcome. It is totally rational for smaller firms to focus on companies that could achieve $1 billion outcomes (rare as those are). And it is also totally rational for multi-stage companies to focus on $5 billion-plus outcomes given their fund sizes and return objectives. This means great companies can fall into the gulf between big enough outcomes for small funds and too small for big funds. The venture industry doesn’t have a great solution for this chasm today, and I’m not sure how it will get filled, given the current incentives around fund size, fund strategy, and expected returns.

All of this is unfolding in an era where access to capital for startups has become more challenging, venture fund sizes will come down (or at a minimum moderate), and capital efficiency is again back in vogue. I am personally excited to see how this next phase of our business plays out. I’ve talked to many of my friends in the private equity and buyout industry about how things played out in those industries, and I think there are some lessons to learn about how things played out there.

The post What Happens When Small and Large VC Firms Decouple and Have Less in Common? appeared first on Charles Hudson's Blog.

I have been the consumer-focused partner at a large (but not huge) generalist VC firm. I haven’t done a Series A investment in a consumer software company in several years. Other than Bytedance, what did I miss that mattered from a returns standpoint?

I have spent a fair amount of time thinking about my friend’s comment, and I think he’s right – we have had some consumer companies hit rapid growth only to return to earth. We’ve seen it in social audio, video, photo, and live shopping. Listening to this great podcast conversation between Eric Newcomer and Sarah Tavel from Benchmark also gave me more things to consider regarding the challenges facing consumer startups today.

One quick thing to note – there is one category of consumer apps that has continued to do quite well, and that is games. The games business continues producing many large outcomes in private and public markets. Games have largely returned to being an investment area where specialist firms with lots of experience in the category and relationships dominate, so I am excluding them from this conversation.

In the past, we’ve had two catalysts that tend to produce the opportunity to create new consumer startups at scale. One was the emergence of a new platform, like smartphones or social media, that brought new capabilities to market and allowed entrepreneurs to either create net-new experiences or create experiences optimized for those platforms. The second catalyst has been the emergence of newer behaviors, including one-to-many social audio, creating and consuming short-form video on mobile devices, and augmented reality experiences on mobile phones. Sometimes these new platforms come with new distribution channels that can turbocharge growth, which makes the platforms even more attractive. Right now, it doesn’t feel like we have a large-scale new platform or enduring emergent behavior that can provide a tailwind for a new consumer company.

Two other things I think are also likely contributing factors are the relatively small number of VCs primarily focused on consumer investing and the challenge of connecting the dots on how consumer investments can move the needle for larger funds. I remain optimistic that the market for consumer investments will come back at some point, but for now things are challenging.

The post Will We Ever See Another Renaissance in Consumer Investing? appeared first on Charles Hudson's Blog.

The background for this quote was the question of what Netscape would do if Microsoft bundled a browser (which they did) in the early days of the Internet era of the late 1990s and early 2000s. If you’re unfamiliar with this quote, it reflects the observation that some companies compete by building a bundle of products that work better together or are distributed together to take advantage of existing customer relationships. A few examples of bundling include Microsoft using its existing relationships with customers to distribute Teams as part of its offering when competing with Slack, and Google using Google Calendar and Chrome as ways to effectively bundle Google Meet with its existing products that have big footprints with both customers and consumers. In the case of unbundling, the idea is to focus on building a product that’s best of breed and can overcome the distribution advantages that the bundled alternative product has. If you think about how Slack and Zoom competed with Microsoft and Google, respectively, you can see how products that focus on being the best product in their respective categories can compete with bundled offerings, and in some cases win.

I heard this quote for the first time early in my venture career, and it really stuck with me. It has been true across multiple investing cycles. I think it continues to be relevant as bundling and unbundling is a cyclical dynamic, and individual markets move between periods where bundling is the dominant strategy, and periods where standalone products have a real advantage.

A few months ago, I read a tweet from Yoni at Slow Ventures about how sales doesn’t need more point solutions, it needs something more like what Rippling did for HR. I’ve also been talking to many startups about what they’re seeing regarding customer buying behavior. It feels like we are on the cusp of moving back toward a cycle where bundled offerings might be more attractive than point solutions.

This feels particularly important to me when I think about where the venture capital business is today. Venture capitalists used to invest in a wide variety of businesses and business models. In the last 10-15 years, investing in B2B software-as-a-service companies became the main event in our business. There used to be a balance between consumer, B2B SaaS, and other sectors, but it feels like venture capital has become a business almost completely focused on funding the next generation of B2B SaaS companies. This makes sense – the public markets have been very receptive to SaaS businesses given their margins, predictable revenue, and a macro environment that has been very friendly toward increased software spending as companies have transitioned to cloud-based software.

The focus on B2B SaaS companies makes sense when you consider the tailwinds for the last 10-15 years (or perhaps longer). Software budgets were growing because software was eating the world. We also had several functions, namely HR/People Ops, Sales, and Marketing, that had an explosion of new tools and technology developed specifically to meet their needs. Combining that with the commercial cloud’s maturity, many forces pushed companies toward spending more money on software across multiple departments and functions. This surge in software spend, particularly in new categories that had not previously purchased much software, created a lot of room for brand-new companies to emerge and build strong brands.

The net result of this was a very un-bundled software ecosystem. There were tons of best-of-breed products for almost every vertical and use case. Look at the market maps for sales technology, marketing technology, or HR tech. You will see an explosion of novel, interesting products that were able to find a foothold by doing one or two things very well. Buyers, for the most part, were willing to work with a wide variety of point products and get them to talk to each other in pursuit of having the best discrete products.

In speaking with many startups and people on the buy side of technology, it feels like things are changing. More customers seem to want fewer things – fewer vendors, less complexity, and better ROI for their software spend. I think internal cost-cutting initiatives are driving some of this desire to revisit the benefits of best-of-breed products versus bundles. In addition to the cost-cutting pressure, the complexity of managing multiple best-of-breed products is starting to create challenges for customers, many of whom have smaller teams due to layoffs or hiring freezes. In some cases, I’m seeing the pendulum swing back toward having a single system or vendor where everything works over assembling one’s own collection of individual tools.

I am curious to see how this transition plays out. As someone who invests primarily in companies that do not yet have product-market fit, the un-bundled software world has been a great place to invest. You can build an MVP for a product of limited scope with a modest budget. Buyers were very willing to purchase point solutions from new vendors if those products could address the buyer’s pain points. Moving back toward a world where buyers have a strong preference for do-it-all bundled products could upend all of this. Historically, larger, bundled offering cost more to build and scale and have much larger MVPs to build. Those companies typically require larger initial capital investments to get going, and that’s a different funding model than how we’ve built many software companies in the past decade.

The post The Rebundling Cycle Has Begun in B2B SaaS appeared first on Charles Hudson's Blog.

Here’s the TL;DR if you are pressed for time:

You cannot save your way to success. Our portfolio companies that graduated from pre-seed to seed typically spent more per month than those that failed to graduate. This result was consistent with what I’ve observed; the companies finding product-market fit spend more to keep up with growth and customer demand. Companies with monthly burn rates that started and stayed low beg the question of whether money was the problem keeping the company from growing versus one of several other things getting in the way of the company growing and scaling.

Since 2016, the average monthly burn rate difference between successful and unsuccessful companies has been fairly small: $59,333 for successful graduates vs. $47,365 for companies that failed to graduate. This suggests that the more important thing is how the money is spent and what it produces than how much is spent overall. The job of a pre-seed founder is to turn investor dollars into insights that get the company closer to finding product-market fit.

Spending more is more likely an effect, not the cause of success. I would not want anyone to conclude that the answer to finding product-market fit is to spend more money. I think the data reflects the reality that companies struggling to find product-market fit often pull back on spend and try to keep burn low to extend runway while they search for product-market fit. Those who have found product-market fit feel more comfortable spending more money and have good investments they can make to handle growing customer demand better. We are also looking at this at the level of averages – we have companies that spent very little and were able to get to the next round and others who spent more than the average and failed to graduate.

Before diving into the data, here are a few caveats to consider:

We define pre-seed rounds as rounds of $1 million or less for companies that do not yet have product-market fit and oftentimes don’t have a live product. That is our definition; other people have more expansive definitions of what constitutes pre-seed, but that is an important caveat for this analysis.

For the purpose of this analysis, we focused on the gross burn rate for the 12 months before a company graduated from pre-seed to seed. Since we invest early, we have pretty good data on what companies spend before raising their seed rounds.

We excluded investments less than 12 months old; we don’t expect those companies to have yet graduated, and including them would have made the results noisier.

A quick note on the chart above. The X-axis is the year and the Y-axis is the average gross monthly burn per month. The green bars represent companies that graduated to seed in that calendar year, regardless of when the pre-seed round was raised. The orange bars represent the pre-seed companies that failed to graduate in that calendar year, regardless of when the initial investment was made. As we noted above, we excluded investments that were less than 12 months old; it didn’t seem fair to judge an investment made late in the calendar year that failed to graduate by the end of that year. The focus was also on looking at the average burn rate for the 12 months prior to closing the seed round to avoid any spikes in burn rate that can happen in the months prior to a fundraise.

Going back to 2017, the average monthly burn rate for companies that graduated (the green bars) was higher than for those that failed to graduate (the orange bars). A few other observations from looking at the data over time:

Today’s burn rates are much higher than when we started investing in pre-seed companies in 2015. I believe some of the increase is due to the dramatic increase in investor capital that came into the early-stage ecosystem during the low interest rate environment period that ended in 2022. In 2022, the burn rates for companies that graduates and non-graduates were roughly equal; I’m curious to see if where things land as we get more data on the 2023 cohorts.

Since 2020, the average monthly burn rate for companies that have not yet graduated has almost doubled. The average burn rate for these companies has continued to rise while the burn rate for companies that graduated has stayed roughly the same. I suspect this is due to 2022 being the year where many VCs didn’t make many new investments but instead bridged or extended existing companies that needed more time and money to continue developing.

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The post Finding the Right Burn Rate for Pre-Seed Companies – The Relationship Between Burn Rate and Graduation Rate for Our First 150 Pre-Seed Investments appeared first on Charles Hudson's Blog.

To be clear, even an emerging manager on his or her first fund with no full-time employees will spend time on management tasks beyond investing. Other than investing one’s own capital as an angel investor, I don’t believe there’s a way to be a VC without management taking up some portion of your time. This post is more about the tension between investing and management emerging as firms grow than about finding creative ways to remove all management responsibilities.

The one interesting thing that emerged from all of these conversations was that a relatively small set of factors seemed to have the most impact on the amount of time spent investing versus on management:

Assets Under Management (AUM) – Assets under management drive management fees, and management fees govern the budgeting decisions about how large a team a venture capital firm can have. I know of very few firms with less than $100 million AUM with large teams and relatively few firms with $1 billion or more in AUM that don’t have large teams. Increasing AUM tends to lead to larger teams and hence more management responsibility. There are some notable exceptions to this rule, and those firms have intentionally stayed small.

Team Composition – Management demands increase with the number of non-Partner people on the team. Whether you have analysts and associates, a platform team, or in-house operations and finance resources, management load increases with the number of non-GPs on the team. Generally speaking, Partners don’t spend much time managing each other, so most of the management load comes from the number of people who have non-investing roles in the firm.

Product Assortment – The more investment strategies (products) a firm has, the more time the leadership team will spend on management. This makes sense; having a seed, Series A, and growth strategy all under the same roof increases the amount of time the leaders of the firm need to spend keeping aware of what each of those groups is doing.

Firm Leadership Ambition and Goals – Some people want to build big firms with lots of people, lots of AUM, and lots of products. Other people want to keep things lean, GP-only, and simple. In many ways, the most important thing is what the founders and leaders want to build. The outputs often flow from that core decision.

In the end, being thoughtful about what you want to build will hopefully keep you from finding yourself in a place where you don’t like the way you’re spending your time. It’s no fun to build something that you don’t enjoy operating.

I also publish a lot of these posts on Substack, you can follow me there as well.

The post Do You Want to Manage or Do You Want to Invest? appeared first on Charles Hudson's Blog.

There is a certain part of that statement that was obvious to me then and is still obvious now. Your fund size, for the most part, dictates your check size, ownership targets, and portfolio construction. A fund of a given size only has a few levers to pull to get to top-tier returns. The larger your fund, the fewer levers you generally have to tinker with to generate great returns.

There is a second part of this that I didn’t really appreciate until about three or four years ago. The size of your fund also dictates the scale of outcomes that can actually move the needle for your fund, and that shapes the lens through which you evaluate the terminal scale of startups that come across your desk. The larger your fund, the larger absolute scale of outcomes you need and the more of those outcomes you need to acheive to make your math work.

We are currently in the midst of an era where many VCs raised very large funds, relative to strategy, in 2020, 2021, and 2022. At the time those funds were raised, the public and private markets were signaling that the terminal outcomes for very good companies were in the $5-10 billion range. We also had what we believed to be exceptional companies that might ultimately be worth $10-$100 billion at exit. In an era where terminal values for great companies sat at those levels, large fund sizes made sense and there was a clear path to returning them if you could get into great companies.

Fast forward to today, and it feels like great and exceptional companies are likely worth half of what we thought in terms of terminal value back then. We can adjust our expectations on a forward-looking basis, and we can even adjust previous valuations through down rounds. What we cannot change, though, is the math of fund size. Regardless of ARR multiples and future expectations, the demands for cash-on-cash returns remain the same for a fund of a given size. What changes, though, is the investor’s perception of what it takes to build companies of the terminal scale that will move the needle for a fund of a given size. Today, it might be 2-3 times (?) harder to build a company with a $1 billion terminal value than it was 2-3 years ago. The market expects way more in terms of total revenue and efficiency to warrant that valuation. And I’d argue that the payoff for truly exceptional companies is also harder to achieve and that $10+ billion public or private outcomes will be harder to achieve going forward than they were in recent memory.

The biggest understanding gap I see between founders and VCs today is this understanding of the relationship between the investor focus on terminal outcome and the founder focus on the microeconomics and unit economics. Most VCs I talk to are looking at new investments first through a lens of terminal value before looking at unit economics. Most founders I talk to are focused on the cost of customer acquisition, lifetime value, revenue retention and other metrics that are under their control. In my experience, there isn’t much of a market today for companies with good unit economics and (perceived) low terminal scale. I think investors understand this and founders do not. The net result is a lot of of frustrated founders who don’t understand why they can’t raise with $1-2 million in ARR and investors who don’t understand why founders don’t realize they are in small markets, regardless of early traction.

There are many good arguments I’ve heard from founders that the world should not work this way. But founders have to deal with the world as it is, not as they would like it to be. So long as fund sizes remain large, the expectations on terminal size will remain high.

I also publish a lot of these posts on Substack, you can follow me there as well.

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