Does the Current Venture Model Still Work?

How the Middle Fell Out of Venture Capital

Every time I talk to a GP about the new fund they’re raising, it invariably turns into a conversation that lands on the same three conclusions:

(a) The best option is to have billions and billions of dollars of AUM, live off the management fees, and become really good at consistently raising very large sums of institutional capital;¹

(b) If you can’t do that, then the next best option is to have the smallest fund possible (big enough to win deals and cover basic costs but small enough to keep the hurdle low) where you invest very early, hit on a few and get into carry quickly; and

(c) That anything north of $100 million and south of $1 billion tends to fail expectations for most funds and isn’t the right approach.²

I didn’t start taking equity until 2011 and deploying capital until 2016, so I don’t have firsthand knowledge of what venture was like before then. But it seems to me that several things happened between roughly 2010 and 2020 that changed the industry fundamentally.

First, venture funds became far more mainstream. Institutional capital allocators (pension funds, endowments, sovereign wealth funds) started putting a lot more money into alternative assets like venture and private equity. By 2021, alternative investments comprised 40% of allocations for public pensions, compared to just 14% in 2001. So that’s over a trillion dollars (even if most went to private equity and not venture).

Second, several regulatory changes made private market deals far more accessible. The JOBS Act allowed issuers to advertise private offerings publicly provided they only sold to accredited investors. Title III of the JOBS Act also authorized equity crowdfunding, bringing certain non-accredited investors into the mix. The dollar amount here may not have meant a lot, but it further legitimized venture as an asset class.

Third, the norms around venture itself changed, leading both to much higher valuations and to venture funds able to credibly claim they needed billions of dollars in capital. The irrational exuberance of the early-mid 2010s changed baseline thinking around valuations and round size, making it logical for institutional investors to then materially increase their allocations to venture.³

And at the same time, media attention towards startups, VCs and tech exploded. Business leaders became celebrities. In the time from when society recovered emotionally from the Great Recession until the pandemic hit, there was a general feeling of pride and excitement about tech startups and their ecosystem.⁴

Once that happened, major Sand Hill Road funds started regularly raising billions of dollars for new funds. At that point, when you have to allocate that much money, you become much less sensitive to valuation and because you have to make so many bets, you almost become a mutual fund covering an asset class rather than being early stage tech investor who falls in love with a highly ambitious founder and a highly disruptive idea and then works for years bringing that vision to fruition.⁵

Between 2010 and 2020, average valuations for Series A-D increased by 3-4x. In 2010, average pre-money Series A valuations ranged from $7-15 million. By 2020, it was $30-40 million. Series D valuations in 2010 were typically in the tens of millions. A decade later, add a zero — valuations were in the hundreds of millions.

Now work your way to an exit. Companies started staying private longer, which meant Series F and G and H became commonplace. And to make the game work, everything had to keep going up: valuation, round sizes, predictions. The downstream funds — mainly private equity at this point — have the same need to deploy lots of capital at high valuations in order to raise their own new funds and increase AUM.

But by the time the startup finally goes public? The outcome often is suboptimal because the public markets look at the fundamentals of the company in question and don’t love what they see (the same thing happens often in M&A processes, resulting in exits below the last round’s valuation). By definition, venture capitalists are always going to be more optimistic about what a company and a founder can do. But when you add valuations based more on the need to deploy than the true value of the company and then subject the company to the scrutiny of public investors or sharp corporate deal teams, the result is venture funds often not seeing their investments meet expectations.

What does that mean? It means the model itself may be fundamentally altered. Now, to be clear, there are a bunch of funds who typically raise between $100 million and $1 billion and do exceptionally well. We can name most of them off the top of our heads. But in a world where there are over 4,000 active funds and where roughly 90-95% of them have AUM under $1 billion, the mid-sized funds that truly succeed amount to a tiny fraction of the total.

Our first fund was $35 million. We invested in companies like FanDuel, Lemonade, Ro, Bird, Circle, Coinbase, Care/Of and others. It did really, really well. Fund II is still mainly illiquid but at $70 million, it too will generate very strong returns for our LPs and good carry for us. But Fund III at $140 million? There are several clear winners in the fund where we have strong positions. But odds are, by the time we return the initial $140 million, pay back fees and distribute 80% of profits to investors, even with bigger stakes invested, the carry will probably not be as good as the first two funds. It turned out that — absent becoming world class fundraisers overnight and generating billions in AUM (zero chance) — we were probably better off smaller.

Because our expertise in regulatory issues is somewhat unique, I was able to decide to stop taking outside capital altogether and just get equity directly for our work. It’s a great model because we now own all the upside without the hassle of raising and running a fund. But that model requires:

(a) Having true expertise in an area that founders really need help with and are willing to part with meaningful equity for;

(b) Being able to show that your expertise broadly translates to helping startups specifically;

(c) Having enough cash to pay your team to do all of the work until liquidity occurs⁶, and;

(d) Having the flexibility and discipline to stick to the right model (for us, it includes warrants, preferred equity, pro rata rights and liquidation preferences).

Which means it doesn’t work for most people.

So where does that leave the industry when it comes to feasible, sustainable models in the world we now live in?

Those able to raise mega funds should clearly keep doing so. It may not be the traditional notion of venture but it pays off.

Those who are able to raise enough money to have a diversified portfolio and real ownership and do all of the work the fund requires without needing more than $1-$1.5 million in annual fees (per fund) should do so. That can be lucrative and the job, at its core, is still about building individual great technology companies.

Those who can get equity in sought after startups without having to write a check should do so.⁷ It’s a better model.

But if you can’t run a fund on a shoestring and you can’t raise billions of institutional capital and if you can’t get equity in return for your expertise? Then it’s unclear to me whether the current venture model still makes sense.

1. To be clear, this is a different job than traditional venture capital. This is a job about constant fundraising by courting institutional investors all over the world. If your goal is to find great founders and ideas, invest and help nurture them into fruition, this is a different job. It’s a lot more like being the head of a major hedge fund or private equity fund. It’s probably a lot more lucrative. But it’s a regular finance job, not a tech job or a job focused on creating and bringing about specific new, disruptive ideas that transform society.

2. Yes, there are dozens of funds in the $100 million to $1 billion range that you’re thinking of right now who have had non-linear success. That’s true. But they are outliers when you’re trying to figure out the overall industry model.

3. Ironically, AI fits perfectly into the new narrative and new reality. Mega venture funds now have lots of money to deploy and everyone can agree to act like an AI company should not be held to the normal (or sometimes any) standards of unit economics, EIDBTA, margin, actual TAM or a dozen other things. So the irrational exuberance is back. In fact, this may be most personified in the AI infrastructure race with trillions of (mostly borrowed) money being invested into a very specific approach to AI (one that requires endless compute and energy) that may not even turn out to be the right one.

4. For those of you for whom working with the media has not been a core part of your job, keep in mind, there’s a time honored trend where they build you up, knock you down and then build you back up. Some of the knocking down was already happening by the late 2010s. And today, those cycles are on hyperspeed (especially since there’s an entire world of people online who are not part of the actual media and mainly just focus on the tearing you down part).

5. Sure, the mega fund AUM and fees based model is far more lucrative and intelligent, but to me, it feels more just like working in finance rather than doing something really tangible, usually unsuccessful — but occasionally remarkable.

6. I still own my first business, a national political consulting firm, which gives me the revenue to cover our venture expenses without receiving management fees for it.

7. Provided that being full time fundraisers is the life they want.