Fund Size Is Still Strategy - The Growing Disconnect Between Founders and VCs

Fund size generally dictates strategy and a tough market makes math tougher for VCs and I'm not sure that founders have digested what it means for them.

I have been working on Precursor for over nine years at this point. I got a lot of very good advice when I was getting started. One thing that has stuck with me since the beginning was some feedback I got from Mike Maples at Floodgate when I was still formulating the plan for Precursor. I’m unsure if he’s the first person ever to say this, but I remember our conversation very clearly - he told me that your fund size is your strategy. I didn’t fully appreciate what that meant as a new fund manager, but the longer I am in this business, the more I think it explains fund behavior and individual incentives.

There is a certain part of that statement that was obvious to me then and is still obvious now. Your fund size, for the most part, dictates your check size, ownership targets, and portfolio construction. A fund of a given size only has a few levers to pull to get to top-tier returns. The larger your fund, the fewer levers you generally have to tinker with to generate great returns.

There is a second part of this that I didn’t really appreciate until about three or four years ago. The size of your fund also dictates the scale of outcomes that can actually move the needle for your fund, and that shapes the lens through which you evaluate the terminal scale of startups that come across your desk. The larger your fund, the larger absolute scale of outcomes you need and the more of those outcomes you need to achieve to make your math work.

We are currently in the midst of an era where many VCs raised very large funds, relative to strategy, in 2020, 2021, and 2022. At the time those funds were raised, the public and private markets were signaling that the terminal outcomes for very good companies were in the $5-10 billion range. We also had what we believed to be exceptional companies that might ultimately be worth $10-$100 billion at exit. In an era where terminal values for great companies sat at those levels, large fund sizes made sense and there was a clear path to returning them if you could get into great companies.

Fast forward to today, and it feels like great and exceptional companies are likely worth half of what we thought in terms of terminal value back then. We can adjust our expectations on a forward-looking basis, and we can even adjust previous valuations through down rounds. What we cannot change, though, is the math of fund size. Regardless of ARR multiples and future expectations, the demands for cash-on-cash returns remain the same for a fund of a given size. What changes, though, is the investor’s perception of what it takes to build companies of the terminal scale that will move the needle for a fund of a given size. Today, it might be 2-3 times (?) harder to build a company with a $1 billion terminal value than it was 2-3 years ago. The market expects way more in terms of total revenue and efficiency to warrant that valuation. And I'd argue that the payoff for truly exceptional companies is also harder to achieve and that $10+ billion public or private outcomes will be harder to achieve going forward than they were in recent memory.

The biggest understanding gap I see between founders and VCs today is this understanding of the relationship between the investor focus on terminal outcome and the founder focus on the microeconomics and unit economics. Most VCs I talk to are looking at new investments first through a lens of terminal value before looking at unit economics. Most founders I talk to are focused on the cost of customer acquisition, lifetime value, revenue retention and other metrics that are under their control. In my experience, there isn't much of a market today for companies with good unit economics and (perceived) low terminal scale. I think investors understand this and founders do not. The net result is a lot of of frustrated founders who don't understand why they can't raise with $1-2 million in ARR and investors who don't understand why founders don't realize they are in small markets, regardless of early traction.

There are many good arguments I've heard from founders that the world should not work this way. But founders have to deal with the world as it is, not as they would like it to be. So long as fund sizes remain large, the expectations on termina size will remain high.