Fund Size is Strategy - Extreme Power Law Will Make Portfolio Company Conflicts a Relic of the Past

As multi-stage funds get larger and larger and the need to get into all of the power law winners is required to make their own fund math work, what happens to portfolio company conflict policies?

When I was raising our second fund in 2017, one of my LPs asked me a bunch of questions about how conflicts of interest work in venture capital. He came from the world of hedge funds and credit investing, and the notion that making an initial investment in one company would be a blocker to investing in a second company that appeared better positioned to win struck him as strange; that’s not how his business worked an he found it strange that I, and other VCs, would agree to tie our hands in this way. I told him the whole backstory on how venture works and why this norm existed. The TL;DR version of that conversation was that venture capital firms invest in private companies and often take board seats. Part of that arrangement grants the investor access to private information about the company's performance, product roadmap, and other sensitive details regarding the company’s plans. It’s not practical to have access to the same level of information about two competing companies while being a good fiduciary to each. I also believed the “no conflicts” norm forced firms to ask hard questions about whether they were willing to invest in a given company, knowing that it would foreclose the opportunity to invest in the known and unknown set of present and future competitors. I’m not sure that he found the answer satisfying, but it made sense to me at the time.

That being said, I think the norm of not investing in competitive companies has been a feature, not a bug, for our industry for a few important reasons:

1. It sends a signal to the entrepreneur that if you take a given firm’s money, they will not turn around and back your competitor. It’s a trust signal and a vote of confidence in the company, its vision, and its prospects relative to others in the same category.

2. It gives the investor an incentive to devote all their energy and effort to making the company successful, rather than exploring other investments in the category.

3. Starting at the seed stage, most investments come with the expectation of a board seat for the lead investor. Board seats come with duties and responsibilities that are much harder for an individual, but not a firm, to execute and fulfill if they are also involved with another company that sells a similar product to the same customer base.

4. This was not a really expensive policy to maintain when it wasn’t essential to be in every winning company. Being in the second or third best company in a category instead of the winner wasn’t material when funds were smaller, as you didn’t need to be invested in the far outliers to generate returns from smaller funds.

As venture fund sizes keep getting larger, I do think that tradition of venture firms having a norm (if not a stated policy) to not invest in competitive companies is likely to go away. This is simply a function of the fact that as venture funds have grown larger, it has become increasingly essential for those firms to be associated with the biggest and most important companies. The larger the fund, the more important it is to be an investor in the companies that are true outliers; there is no way to make the fund math work if you are not in those companies unless you are in other, similarly-situated companies. My sense is that there is more money chasing outliers at the moment than there are outlier companies to fund.

In many ways, this was a norm or policy that, although not entirely free to implement and support, was not prohibitively expensive for most firms to put in place, maintain, and operate as a general business principle. Given the current state of fund sizes, I wonder if that will continue to be true. The only way to return some of these really large pools of capital that are being raised in our business is to be in the biggest, most consequential companies that are created. If you missed them at Series A or Series B, can you afford to stand by your norms and principles and not secure a position in those companies? Here’s how I think most firms are dealing with this today:

1. Use a seed fund or scout strategy to meet as many promising, early-stage companies as you can. This gives good market coverage and access to what’s happening on the ground. There’s the risk of investing in too many companies that could block you from investing in the winner in the future, but this is an acceptable risk for most funds.

2. Focus on investing in Series A and Series B (instead of seed) rounds and pay up to get into the winners when it’s clear which companies are working. This helps reduce the odds of conflicting investments but pushes up the average entry price. This is a workable model so long as the terminal values are large relative to entry price.

At some point, this will break. There will be important companies where big funds can’t get primary ownership at the Series A or Series B, while also respecting conflict norms. I can see a few ways to finesse this issue and break the norm without creating unmanageable challenges:

1. Buy secondary positions in the companies that matter but that you missed - Buying passive secondary stakes in companies that you missed but want to own could work. Those passive, mostly common stock positions don’t come with board seats, information rights, or control provisions that could create conflicts. This solves for the financial impact of missing out on those companies.

2. Invest in competitors but have different investors take board seats and create firewalls to limit information spillover - While conflicts of interest are hard to manage at the individual investor level, there are more options at the firm level. There is a world in which firms tell founders that these conflicts can be managed by having different people work on each investment and having internal firewalls that prevent information leakage. We will see if founders believe these internal processes are effective.

One thing we haven’t discussed that’s particularly important is the founder's perspective! I don’t think founders want the investors who back them investing in competitors. This is an issue where the business model for funds is at odds with what most founders want. To be clear, most founders don’t want their existing investors to invest in directly competitive companies. Most founders lack significant “hard power” (i.e., the right to block an investment) in these negotiations; funds can and do invest in competitors if they choose to do so. However, there will always be a set of founders who possess soft power and will utilize it to encourage their investors not to engage in such behavior. The universe of founders with meaningful soft power to influence this is very small, but that universe of founders is very powerful.

I am very curious to see how this plays out in the coming years. I am happy to hear thoughts that others have on this topic.