I loved the Minsky Moments article. And, this one clearly lays out incentives of different types of VC market players. As a seed stage VC, analyzing whether the startup has a credible plan to make it to Series A is a part of any diligence process. But it's not the only factor.
If you analyze the outliers that "return the fund", it cannot be, because many of them *were* contrarian at the time that they were seed stage. This is easy to forget later on. A seed stage VC needs a systematic way of selecting for founders that have long-term defensibility strategies that will lead to outsize exits at the end, in order to make up for the larger number of failures at seed stage than at later stages. It is precisely the heavily funded consensus seed stage startups that can likely purchase their way to a Series A through sales/marketing/PR that don't have the evolutionary pressures to develop such a strategy.
Very true. I think the very best seed investors try to find companies that are contrarian at the time, but will become consensus later on -- surfing just ahead of the consensus wave, as it were. That way they can be part of the ecosystem (and take advantage of late-stage cash) while still generating alpha versus the market.
Love your point about "evolutionary pressure"! Nothing like constraints to force creativity and healthy habits.
I wonder if the "venture is the Keynesian beauty contest" phenomenon is also a function of how large and institutionalized venture funds have gotten. It's no longer an industry where general partners are making decisions but there are hundreds of analysts, associates and principals who don't have the same level of skin in the game as partners. Their performance is more measured on short-term metrics such as markups on investments they led, and therefore they are more likely to identify exactly what downstream investors are looking for and front-run them. The average tenure at many of these large funds is short (2-4 years) so many of the analysts, associates and principals may just be optimizing their metrics over a shorter time period.
Agree 100% and this is definitely part of what's going on. Funnily enough I made the exact same comment to another reader, in a private email:
[There's a] principal-agent problem between the individual investors at the fund, and the fund itself. The "fund" cares about realized DPI, hence final outcomes, hence the entire lifecycle and viability of the investment. But the individuals making the investment decision care much more about markups, because that's what matters to their careers. Average tenure at a fund keeps decreasing: unless you're a senior or founding partner at a firm (or a big part of the firm's brand), it's very likely that you'll move to another opportunity at some point -- and statistically, that point is likely to happen *before* your investments actually come to the end of their lifecycle. (This is made worse by startups staying private longer) (which in turn is caused by the rise of the venture majors and late stage capital -- it all hangs together). So if your investments haven't reached fruition (exit), then the only remaining signal is markups, and hence your incentives change.
Great read as always. It feels like the VC market is still in the same stage as the wheat market was prior to the introduction of futures contracts, that brough liquidity and hence arbitrage between stages. What would be a similar financialization product in the VC industry? Or does the lack of legibility in the underlying companies prevent this step from happening altogether?
I think it's a lack of homogeneity more than anything else. Wheat is fungible, early stage tech startups less so. The best you can do is impose (artificial) homogeneity via round benchmarks and valuations, but that's a far cry from true fungibility which is what you need for futures to work.
Market makers need consensus to function, explaining why Valley groupthink isn't a bug but a feature. Though unlike commodity traders, VCs become evangelists for their positions. Maybe because wheat doesn't need storytelling, but the future always does.
"wheat doesn't need storytelling" is such a great way to phrase it! Though in a way, what the CBOT and CME did is create a shared story / belief / trust system around wheat. VCs have to do that individually, hence the evangelism.
Great essay - curious to hear your thoughts on how these large venture managers will expand beyond their core product, which is equity financing. Like you said, this product is playing a dual-role of market making. But what's the next logical step from here? Debt funds? M&A advisory? FoF?
I think one obvious candidate is new financing structures, beyond vanilla preferred shares. VC financing is pretty basic compared to (say) their PE counterparts. SAFE notes and token-based financing are the only real innovations I can think of in the last decade or so. (There's a good theoretical argument that venture debt is better suited to the growth stage than equity capital, but it hasn't taken off).
M&A advisory is kind of already happening, at any rate it's part of the implicit value-add that the venture majors pitch, to win deals. The portfolio approach also means that FoF is kind of baked in as well.
But it's a really good question. I'm also very curious about the answer...
I loved the Minsky Moments article. And, this one clearly lays out incentives of different types of VC market players. As a seed stage VC, analyzing whether the startup has a credible plan to make it to Series A is a part of any diligence process. But it's not the only factor.
If you analyze the outliers that "return the fund", it cannot be, because many of them *were* contrarian at the time that they were seed stage. This is easy to forget later on. A seed stage VC needs a systematic way of selecting for founders that have long-term defensibility strategies that will lead to outsize exits at the end, in order to make up for the larger number of failures at seed stage than at later stages. It is precisely the heavily funded consensus seed stage startups that can likely purchase their way to a Series A through sales/marketing/PR that don't have the evolutionary pressures to develop such a strategy.
Very true. I think the very best seed investors try to find companies that are contrarian at the time, but will become consensus later on -- surfing just ahead of the consensus wave, as it were. That way they can be part of the ecosystem (and take advantage of late-stage cash) while still generating alpha versus the market.
Love your point about "evolutionary pressure"! Nothing like constraints to force creativity and healthy habits.
Excellent read!
I wonder if the "venture is the Keynesian beauty contest" phenomenon is also a function of how large and institutionalized venture funds have gotten. It's no longer an industry where general partners are making decisions but there are hundreds of analysts, associates and principals who don't have the same level of skin in the game as partners. Their performance is more measured on short-term metrics such as markups on investments they led, and therefore they are more likely to identify exactly what downstream investors are looking for and front-run them. The average tenure at many of these large funds is short (2-4 years) so many of the analysts, associates and principals may just be optimizing their metrics over a shorter time period.
Agree 100% and this is definitely part of what's going on. Funnily enough I made the exact same comment to another reader, in a private email:
[There's a] principal-agent problem between the individual investors at the fund, and the fund itself. The "fund" cares about realized DPI, hence final outcomes, hence the entire lifecycle and viability of the investment. But the individuals making the investment decision care much more about markups, because that's what matters to their careers. Average tenure at a fund keeps decreasing: unless you're a senior or founding partner at a firm (or a big part of the firm's brand), it's very likely that you'll move to another opportunity at some point -- and statistically, that point is likely to happen *before* your investments actually come to the end of their lifecycle. (This is made worse by startups staying private longer) (which in turn is caused by the rise of the venture majors and late stage capital -- it all hangs together). So if your investments haven't reached fruition (exit), then the only remaining signal is markups, and hence your incentives change.
Great read as always. It feels like the VC market is still in the same stage as the wheat market was prior to the introduction of futures contracts, that brough liquidity and hence arbitrage between stages. What would be a similar financialization product in the VC industry? Or does the lack of legibility in the underlying companies prevent this step from happening altogether?
I think it's a lack of homogeneity more than anything else. Wheat is fungible, early stage tech startups less so. The best you can do is impose (artificial) homogeneity via round benchmarks and valuations, but that's a far cry from true fungibility which is what you need for futures to work.
Wow!. I couldn't stop reading this once I started. It distills some profound observations in the form of an easy to read essay :)
Simply the clearest explanation for "why are things the way they are" in the world of venture investing.
“The more the increase in valuation [from the previous round], the more under-valued the company is likely to be.”
I am 70% confident - but cannot prove - that this was Peter Thiel. Not on Twitter, obviously.
That sounds extremely likely actually!
Thanks for this, Abraham
Market makers need consensus to function, explaining why Valley groupthink isn't a bug but a feature. Though unlike commodity traders, VCs become evangelists for their positions. Maybe because wheat doesn't need storytelling, but the future always does.
"wheat doesn't need storytelling" is such a great way to phrase it! Though in a way, what the CBOT and CME did is create a shared story / belief / trust system around wheat. VCs have to do that individually, hence the evangelism.
Great essay - curious to hear your thoughts on how these large venture managers will expand beyond their core product, which is equity financing. Like you said, this product is playing a dual-role of market making. But what's the next logical step from here? Debt funds? M&A advisory? FoF?
I think one obvious candidate is new financing structures, beyond vanilla preferred shares. VC financing is pretty basic compared to (say) their PE counterparts. SAFE notes and token-based financing are the only real innovations I can think of in the last decade or so. (There's a good theoretical argument that venture debt is better suited to the growth stage than equity capital, but it hasn't taken off).
M&A advisory is kind of already happening, at any rate it's part of the implicit value-add that the venture majors pitch, to win deals. The portfolio approach also means that FoF is kind of baked in as well.
But it's a really good question. I'm also very curious about the answer...
Wow 🤩