Go big or go home
#26 | On why there's no free lunch in VC
Sometimes I feel like going deep into an argument and pulling out a very long piece, like last week.
Other times, I just want to rant about things I see during my job.
This week is rant week. Enjoy!
My pal Chris edited this piece while taking a break from his favourite new newsletter author, Anna Heim (TechCrunch), who's written some fun stuff for Resilience Media.
Everyone in VC agrees there's a big shift underway.
Whether we like it or not, we are seeing things that just a few years ago seemed impossible.
On one side, some companies became so big that they completely redefined the idea of what is a possible upside in venture. There are a handful of VCs still riding that wave, and raising huge funds.
A $20B fund sounds horrendously big, but when private companies can raise $40Bn at $300Bn valuation - as the mighty chat.com did - then returning such a fund doesn’t seem impossible anymore.
On the other side, there are people pointing out the arrogance of these funds. To deliver 2.5x on a $7B fund you need to capture around 30% of the total value created by the VC-backed startups during your investment period - which sounds unrealistic to be generous.
These people believe that there should be incentive alignment between GPs and LPs, and when you take 2% of $20B each year as a management fee, you have no interest in the carry anymore.
Truth to be told, many people smarter than me have noticed this shift long ago, before it became so evident to everyone.
However, I believe it’s worth discussing this topic once more because there's another shift happening, which requires a strong change in the mindset of venture investors.
If it’s true that big funds are getting bigger and bigger, it’s also true that it has never been easier to build a small, profitable and life-changing business.
First thing to understand here is that these gigafunds are playing a different game. It’s very easy to get hurt if you don’t understand the rules of the game you're playing.
Kyle Harrison has been active on this topic for years, so there's no need for me to elaborate much.
If Capital Agglomerators are targeting 2x funds, and Cottage Keepers have higher expectations for their small funds, at 5-10x returns, then we have a problem.
If both are competing for a different outcome, then one is willing to pay a higher price than the other. Here's the scenario: one Cottage Keeper and one Capital Agglomerator are competing to invest in a company with $5M ARR:
Cottage Keeper: Bids $250M; believes the company can grow into a $2.5B outcome, and that could generate their 10x return.
Capital Agglomerator: Bids $1B; believes the company can grow into a $2.5B outcome, and that could more than generate their 2x return.
Even if these two firms have the same fundamental belief in the company's outcome, their return threshold enables them to play different games.
The Puritans of Venture Capital
What this means is that the market is breaking in two, and as a manager of a small early-stage fund (the Cottage Keepers in Harrison’s piece) you have to recognize when a deal you’re considering belongs to the other half of the industry.
In some cases it is evident, but in others it’s not and sticking to your rules requires diligence and strength.
The main difference between the two worlds is that at early-stages gigafunds buy optionality, while small funds buy allocation.
For small funds it’s easy to fall into the trap of high valuation, competitive deals, thinking that even if you don’t get to your target allocation now you can still invest more later on. This is a big fallacy: if a deal is worth investing in in the next round, it will be too big for your small check to make a difference, while if your small check can make a difference in the next round then it means it’s not worth investing more.
At this point, a clarification is needed.
I know a few fund managers who reading these words would nod with satisfaction, thinking that they understand this and that’s why they are building a portfolio of safe bets: “I won’t invest in the next OpenAI, but that’s because I’m playing a different game.”
I’m sorry, but that’s bullshit.
There’s never been anything such as a “safe bet” in venture capital. The power law is the single reason VC exists as an asset class. Most of us won’t even return the money LPs invested but, the few that will, will make their LP very, very happy.
AI is making the concept of “safe bet” even more stupid.
Since it has never been easier to build a small, profitable and life-changing business, even if a low-hanging fruit existed, it would be picked by someone building a lean, AI-powered, probably profitable company.
Sometimes we get trapped in this world of billions and trillions, and tend to forget that selling a business for €5M is way easier than selling one for €5B, and €5M is enough for most of us who strive to have a peaceful and satisfying life.
So now, in an unstable, multipolar world where will bright, ambitious people turn next? Now that Facebook and Google are uncool, interest rates are high, software competition is going infinite, and institutions feel unreliable, what is the next high status path that will dictate our economy?
They’re going all in on cashflow and independence because they’ve learned that institutions won’t take care of them and can’t monopolize opportunity.
Free cash flow and independence (two sides of the same coin) are hedges against uncertainty, institutional decrepitude, and burnout.
Yoni Rechtman
All of a sudden those fund managers that believed in safe bets are seeing their spot in the world shrinking, eaten from above by gigafunds buying optionality and from below by ambitious people who JDGAF about these fund’s “value add” and are building on their own.
What’s left?
Simple. The crazy bets. Those deals that are so ambitious that seem impossible, so far-fetched that only venture capital, in the literal meaning of the word, can finance them.
If you are not brave enough to invest in these kinds of businesses, there is no space for you in this new era of VC.
Now more than ever, you can either go big, or go home.