The Many Incentives of VCs
When I started in VC, there was one incentive — capitalize startups, help founders build their businesses, and bring in additional capital (when necessary). Hopefully, if the stars aligned, the funds delivered outsized financial returns for the risk, ideally 3X or more, to their LPs. This model was a relatively well-tested formula for venture-backed startups — provide enough capital to the company (but not too much) and maximize its chances for a healthy return, hopefully in less than ten years.
Today, the VC industry has matured from a small asset class to a full-fledged industry. Many players — accelerators, emerging managers, lifecycle funds, strategic vehicles, and large financial institutions — are investing in venture capital. There are ten times more VC firms today than when I started my ventures during the dot-com period.
As a result, I meet investors with a far wider range of motivations than the ones I pitched. It’s helpful for founders to recognize these motives early, ideally before they take capital. It will impact how these investors think about the investment decision, how they behave as investors and/or board members, and their decisions about follow-on investments. Most importantly, it will affect their thinking when exit opportunities arise.
All investors have strengths and weaknesses. But it’s important for founders to do their own diligence on what drives their investors and build a syndicate of investors that can balance differing incentives. At the end of the day, the investors most aligned with the founders’ goals are the best investors.
Here are some observations of the various incentives at play, considerations for founders, and questions to be asked of prospective investors…
🪜 Junior VCs building a track record: Early career investors are keen to make partner or figure out their next landing spot. Oftentimes, their time horizon doesn’t stretch much beyond that milestone.
Their incentive is to find startups and help them get marked up as quickly as possible. They may highly weigh the founders’ pedigree or co-investors’ brand as a signal of having invested in a “hot deal.”
While this approach can help founders optimize valuations, this short-term thinking can do longer-term damage. Moreover, we occasionally see founders abandoned by these VCs later on when they switch firms or leave the industry altogether. This mismatch of time horizons can be exacerbated by the increasing time it takes for startups to exit.
💰 The VC that’s really PE: Some firms have publicly stated their aim to be large, multi-stage asset managers. This noble goal on behalf of pensions and endowments leads to a different set of incentives than a small partnership focused solely on generating returns. Their pitch to LPs is not a gobsmacking IRR but rather a return that (hopefully) beats the S&P and can manage billions in assets (which smaller funds can’t do without dramatically changing strategy).
Increasingly, this strategy is about putting money into work. These investors favor capital-intensive businesses, roll-ups, or other strategies, allowing more deployment than the classic venture-backed startup. They may suggest more aggressive capital use than the startup founder is comfortable with, for example, suggesting a merger with a competitor or accelerating hiring at a speedy rate.
Taking capital from a growth investor at the early stage might also create negative signals downstream if that investor doesn’t choose to follow on. Additionally, some advice these investors give may be based on their later-stage experience, which is less relevant to early-stage learning.
Their investors need a safe place to stash vast amounts of money. These funds target <2X returns, and their benefactors are happy with this trade. These VCs may be distracted with capital raising or focus more on how much capital can be deployed into a given company rather than optimizing for multiples. Some firms have so many investments that founders may get less attention. On the other hand, they often have very deep pockets!
💸 Speedy capital deployers: The opposite of the AUM maximizers are the speedy capital deployers. They’re interested in funding as many startups as they can, as fast as they can. Generally, their goal is to get to their second or third funds ASAP. Some of these funds are less interested in large AUM funds and instead hope to raise sequential funds in a short period of time. Sometimes, this is before there is sufficient data to measure the first fund; other times, it’s simply a stated strategy.
Historically, the period between funds was 3–4 years, but we saw some funds raised nearly yearly during the “ZIRP” period. Fortunately, this behavior seems to have abated. Nonetheless, it’s helpful to ask during the “dating” process how often new funds have been raised and how much capital is allocated in a given fund for each investment. It’s also helpful to know if cross-fund investing is common and, of course, which fund the investment is coming out of.
🌴 Tourists testing the early-stage market: Early-stage investing falls in and out of fashion. A newly liquid founder might decide to invest heavily for a year or two before they realize all the overhead involved and dramatically pull back.
A late-stage fund might choose to invest more at seed in periods where the market is convulsive as a kind of flight to safety. Large fund investors shaken by turbulence in growth or the public markets may feel “safer” investing smaller checks into early rounds.
No matter the rationale, these investors can come in and out of early investing, and thus, some of their attention (and guidance) may also come and go.
🌟 Celebrity investors: Venture capital can make you money, but increasingly, it’s also a platform to help make people famous and build individual brands. While it’s tempting to be cynical here, venture capital is a very human business; therefore, the investors’ brands do matter. Often, these investors are quite helpful — their success in other fields boost their ability to help founders as VCs. The risk is that they may spend more time at events, doing PR, blogging, and tweeting than with their companies.
Sometimes, a large social following or big brand can be accretive to a startup — especially consumer companies or ones that benefit from early buzz. However, I do want to put in a plug for the vanilla VC whose sole vocation is funding startups, helping them scale, and ultimately succeeding the same way you will.
No matter who you choose, make sure you can identify their incentives. Ask the tough questions — understand their fund dynamics, their personal ambitions, and how they spend their time. An educated consumer is the best customer :)
