The Death of a Venture Fund

There are few movie tropes more common than the turnaround that can come from a near-death experience. Whether it’s A Christmas Carol or Coco, there is something compelling to everyone about the intense clarity that can come out of being so close to death.

That clarity can be a powerful part of how we live our lives. Neil deGrasse Tyson has a great video about his perspective on death.

As clarifying as a brush with death can be I wouldn't recommend productizing the experience like a vitamin pill. But to bring in another great thinker; Socrates said "the unexamined life is not worth living."

When I was at Index we would include two sections in our memos that were popularized by Larry Summers. We would write about a company's "pre-parade" and "pre-mortem." Not only a "dream the dream" scenario, but a "dream the nightmare."

Roelof Botha brought up this same topic in a recent Invest Like The Best episode in an even more poignant way:

I loved this concept of evaluating your own potential cause of death as a venture firm. And I wanted to explore it more, though I certainly hesitated. I almost didn't write this post for fear of it coming across as subposting some firm I think is "dying." But that isn't my intent.

And after reflecting on it for a while I thought, "if Sequoia, who is arguably the best venture firm in the world, is considering their own demise within a decade, then everyone should be doing that." Roelof explains it well:

Before I dig into the details, I wanted to set the stakes. In case you weren't sure? Venture funds are not federally-protected wildlife. They can most certainly die. Every venture fund has to justify their own existence, whether they believe it or not.

Over the last few years the number of venture firms has grown from ~900 to nearly 2,000 different firms managing $500B+ of capital. In a market correction some people predict as many as 50% of those firms could fail.

One prediction I have is that as venture funds have become more productized they've developed more IP and proprietary processes. As a result, even though you'll still see some firms shut down I also believe you'll see some venture firms get acquired. Not only for their portfolios or people, but for the things they've built.

So when you step back and realize that reflecting on potential causes of death isn't just a fun exercise, but a very possible reality for any venture fund you start to wonder--what could be my cause of death?

Fun fact. Asking a lot of your friends out of the blue, "why do you think your company will go out of business?" does not always elicit the safe brainstormy environment you might expect. (Apologies to all my VC friends that got confronted with this very heavy line of questioning over the last few weeks.)

I had ~30 conversations with folks across venture funds of all shapes and sizes and it becomes clear pretty quickly who hasn't thought about this question before, who has, and who really has. Some people definitely checked the "paranoid" box. And interestingly enough the people who had the most thoughtful responses to this question were often the people who were either already leading their respective firms, or were in line to do so.

So what did people say? Performance. Succession planning. Politics. There was plenty of overlap in their answers. What stuck out to me the most was how a lot of these fears closely aligned with the revolutions already going on in venture that I've been writing about. The productization and improvement in a venture funds offering can improve performance. The unbundling of venture and the emphasis on individual brands leads to more difficult succession planning. And the changes to "eat what you kill" decision making in venture firms leads to much more complex politics when you introduce talented non-investor contributors.

So let’s dig in to the death of a venture fund.

First and foremost venture capital is a returns-driven business. While it is crafted around helping to drive innovation it only exists because LPs look for yield on their capital and startup investing can, in the right circumstances, drive significant yield. I've written about this emphasis on performance before.

In 2006 Howard Marks wrote the now-famous memo, "You Can't Eat IRR." He unpacks all the problems with IRR in terms of relation to dollar size, time frame, and relation to actual dollars returned. Especially in an up-market like we've had for the last 13 years IRR can be misleading. As many VCs have learned (or been reminded of) this year? The ultimate return is cash in your LP's pockets.

When you think about venture as a business of outlier returns there are a few aspects in the world of venture that are changing. If ignored they could easily be the cause of death for a number of venture firms going forward.

Venture is not as risky as it used to be in large part because starting a company is not as expensive as it used to be. VCs get paid a lot (literally 20% of the upside) to take big risks. But in the world of tech startups you're starting to see some near-professionalized startup categories like enterprise SaaS. That does NOT mean there isn't any risk or failure in these categories, but the risk is lower because there are more established playbooks and expertise.

In categories like direct-carbon capture or space exploration you have dramatically higher costs and likelihood of failure, but significantly higher potential upside. If SpaceX is successful at leading Earth's efforts to colonize Mars? You're not talking about capturing 1% of a large market. You're talking about an extra-global GDP.

If VCs are too afraid to venture into contrarian categories with big risks they could miss out on the next generation of venture returns. And I'm talking the old wild west of venture returns where there is significant costs but potentially reality-shattering outcomes.

VCs are facing the "Big Budget Effect" that is plaguing Hollywood studios right now. In the year 2000 you had just three movies that had made $1B+. Titanic, Jurassic Park, and Star Wars Episode I. Today you have 45+ movies that have made over $1B, and some of them have made $2B+ like Avengers and Avatar.

As a result of these much larger outcomes we've built a movie-making system that is focused on big hits because the business model can't really absorb too many massive flops. So you get sequels, prequels, and spin-offs. Established IP and bankable stars. No big risks. And you don't get nearly as much experimentation, innovation, or creativity.

The same is true in venture. With such big funds and such fast deployment cycles its so much more difficult to take big bets on much riskier technology. But as the world becomes more capable of building technology VCs will have to earn their big fees by chasing ever bigger "unknowns." If they don't? They may miss out on the next internet.

For the last few years VCs have been living off the maxim of "playing the game on the field" to justify making investments at ever higher prices. A while back I looked at co-investing with a GP at another firm and we were talking about how they thought about their returns. When I mentioned we looked at this business as being able to go public in a few years and trade at 10x forward revenue, this GP surprised me with his perspective.

"10x forward revenue is ancient history. This deal sings at 20x."

Keep in mind even in late 2021 when valuations had skyrocketed in many cases; the median forward revenue multiple for SaaS companies was still 15x. Nowadays that same median multiple? 6x forward revenue. Turns out 10x and lower is far from ancient history. It's current events.

Bill Gurley laid this out quite well in a recent twitter thread.

For every investor the danger is playing the game on the field and not thinking through the fundamental aspects of the game itself. Companies, in the long-run, are weighed on their abilities to generate cash flows while continuing to grow. Funds that fail to think from those first principles will, in the long-run, suffer for it.

Outside of performance venture capital is a very human business as well. And when you look at the makeup of venture firms you have a pretty messy political structure. I've written before about the ways in which the old-school VC partnership has become somewhat outdated:

One of the biggest reasons firms struggle is because there is a big difference between building a team and building an institution. You can assemble a team of people to do a job. But an institution requires each member of that team to see their place in the long-term vision of the organization.

In firms that have been around for a long time the proof is in the ownership of the management company. The management company is the entity that collects the 2% fees across a firm's AUM. When you're managing billions of dollars? That annuity stream looks pretty attractive.

As a result you sometimes get a bloated partnership that is eager to take advantage of the cash flows from the fees in the management company they've built. But you get a lot of imbalance in who is providing the most value to the firm vs. who is seeing the largest share of the economics and upside.

h/t @litquidity -- I couldn't find the original

And successful succession planning isn't just about the transition, it's in the pipeline. Look at Sequoia who, as far as I can tell, is one of the only firms to really successfully experience multiple regime changes.

Doug Leone was at Sequoia for 24 years before he took over. Roelof was at Sequoia for 9 years before Leone even took over, and has been at Sequoia for 20 years before he recently took over. If you don't have a long runway for your pipeline of leaders then you're not building a long-term institution.

Succession planning is a tricky business and, alongside performance, was the only consistently cited "cause of [potential] death" answer in 75%+ of the responses I got from the VCs I talked to.

No! I still type much slower on an iPhone than I did on a Blackberry. It was amazing watching every single one of Blackberry's differentiation points become unimportant vitually overnight.

I've written before about how venture firms are building out their "product offerings" more and more thoughtfully. But one thing that will rear its ugly head as more venture funds attempt to become "product-led" is the ever-illusive product-market fit. Or in this case? Founder-investor fit.

There will be venture funds who design their entire product offering but, like the Blackberry, quickly see each bullet point of differentiation quickly become unimportant because it hasn't been crafted around a new generation of founders.

While Tiger has felt the reality of this most recent market correction more palpably than most their rise to power really did expose one of these weaknesses in venture. A lot of founders just want investors to leave them alone.Just because Tiger's economic value has taken a big hit doesn't mean that that insight was inaccurate. Those are the kinds of realities that every investor needs to design their product offering to take into account, or they'll quickly find themselves on the irrelevance heap.

In the world of "flash-in-the-pan” venture fund disappearance, you can most commonly point to what I would describe as committing a grievous sin. Fraud, sexual misconduct, founder sabotage. Things like that.

Beyond those clear examples of reputation implosion there is a bigger thread than underpins all of venture capital. At the end of the day startups are competing in a bloody knife fight for every customer, every hire, ever press release, and every product launch. VCs represent "borrowed credibility" to aid in that fight.

Your reputation is your currency in venture. The most common proxy for reputation is your brand. If your brand doesn't represent the kind of credibility founders want to borrow? Then your money's no good. This is why the top venture funds remain disproportionally relevant when compared to public market investors. That isn’t true of hedge funds. Top-performing public funds are just as likely to be the top-performing fund next year as they are to be the worst-performing.

In a white paper by Michael Mauboussin he makes this point around correlation of fund performance in venture over time. "Funds that have done well continue to do well." I first heard about the white paper in an episode of Acquired where they made it even more clear.

Some of the responses I got from the venture investors I talked to came from a place of practiced confidence. One investor told me, "We've been around for 20 years and we'll be around for another 20 years." And it struck me to think about how venture is effectively less than 100 years old. In the grand scheme of things? 20 years isn't very long. Neither is 30 or 40 years.

The opportunity to sit back and reflect on the causes of death aren't met to expose your own self-doubt or insecurities. They're met to act as a mental exercise to imagine your own weaknesses and to react accordingly. I don't want any venture fund to die. But I fully expect the relentless market for better ideas and higher quality execution to continue to demand a high level of performance from all of us. So we better eat our Wheaties.