It's Never Been More Important to Understand Your Capital Provider's Business Model

Being a VC means that I talk to other VCs looking to raise money from LPs and founders looking to raise money from VCs. A little understanding goes a long way these days.

I’ve shared this post by Hunter Walk with a lot of my founder friends lately. I think it’s one of the more honest takes on how many VCs are thinking about portfolio companies that have, as he says, more “capital than momentum” and what it means for what the VC business model prioritizes.

I’ve been part of a lot of challenging conversations with founders who are at odds with their VC investors. The investors want to see a path toward an outcome that works for their funds and returns models. The founders are often focused on making sure that their companies are viable and can survive to continue to fight to see another day. For many founders, survival is both necessary and sufficient; they want to keep going and fighting with the optimistic belief that they will find a big opportunity. For many VCs, portfolio company survival is necessary but not sufficient; the VC model doesn’t work well if portfolio companies survive and stay alive but don’t grow or turn into successful exits. There is natural and inevitable tension here as the two sides don’t have the same incentives or benefits from every outcome. If you are a founder and you are experiencing new or renewed tension in your conversations with your VC investors, it’s worth re-examining whether you all have a shared view of the likely outcome of your company and whether you’re both as excited about what that outcome means. In many cases, I’ve seen situations where there are founder-acceptable outcomes that are below-the-line outcomes for VCs, and that conversation goes unsaid or unexamined. This creates a lot of unspoken and unexamined tension in the founder and VC relationship.

I think the same is true of VC fund managers who are looking to raise money from limited partners (LPs), many of whom are facing their own set of constraints and challenges. Many VCs raised a few years ago with the expectation that the next fund would be straightforward to raise. The world in mid-2023 is not the same as it was in mid-2022. We’ve seen a pullback in public company valuations, a big shakeup in the banking world, higher interest rates, and (probably most importantly) a notable lack in VC distributions back to LPs. Many LPs rely on regular distributions, either via IPOs, M&A outcomes, or secondary transactions, to generate the liquidity that they need to continue to make new VC commitments. Many LPs are facing real challenges in making new VC commitments; they are getting less money back from their existing managers than they expected, and they still have existing capital call obligations that they have to meet. And, in a world where VC firms are no longer the hottest investment opportunity available to LPs (that crown goes to private credit and secondaries at the moment), it takes a lot of courage to take a new or re-up venture commitment to your investment committee in a world where venture capital is down relative to other investment classes. It’s very hard to be in market as a venture fund manager without at least internalizing what’s happening on the other side of the table.

I’m a big believer that all pressure flows downhill. The pressure that LPs feel to generate liquidity in venture flows down to VCs. Many VCs feel pressure to generate liquidity for their LPs, either through M&A transactions or secondary sales. And, at a minimum, I think it makes many VCs think hard about what portion of their current portfolio will generate returns for their LPs and makes many of us more circumspect about which companies to support financially and which to ask to figure things out with the resources they have available. If your VC investors feel more tight or agitated or pressed of late, it’s likely that they are feeling the effects of pressure flowing downhill.

No matter where you sit in the ecosystem, it’s never been more important to realize what the people who provide you with capital are up against and what problems they are trying to solve. These things are not your fault, but they are your problem if you’re looking to raise money in this environment.