Why Don’t VC Fund Managers Keep Funds Small?
A friend read my posts about larger VC funds creating hurdles (here and here) and asked a great question. Why don’t emerging fund managers keep their funds small? I didn’t address this in my posts, so I’ll touch on it today.
Fund managers are usually compensated in two ways:
- Management fees – The percentage of the capital raised that's used to run the fund. For example, if you raise a $10 million fund with a 2% management fee, you have $200,000 annually for salaries, rent, etc. Specifics around management fees (i.e., duration) can vary by fund. But this is how fund managers keep the lights on and give themselves runway (i.e., salary) to find and support companies.
- Carried interest (carry) – The share of profits paid to the fund manager as incentive compensation. For example, if a fund realizes a $10 million profit (i.e., money above the original capital investors’ commitment) and has 20% carry, the fund manager would receive $2 million in carry. Carry is unpredictable. It’s usually paid as the fund receives capital from company liquidations over the life of the fund (usually 10 years).
If managers successfully raise a fund, management fees are predictable, while carry isn’t guaranteed and payment of it is unpredictable. I’d imagine most managers opt to increase their fund sizes to increase the predictable cash flow from management fees, even though it could lower fund performance.
I wonder if emerging managers would keep their funds small if cash flow wasn’t directly tied to the size of the fund?
Community-Led Capital Deployment
I had a great chat today with someone with a new venture capital fund. In six months, its founders went from inception to raising a $30 million fund. I was curious how they accomplished this in such a short time. I’ve talked with a number of emerging funds managers, and it usually takes eighteen months or more to raise a fund. And first funds are often less than $30 million. I learned that their journey hadn’t started six months ago with the fund idea. Rather, it started a few years ago with a community.
The founders started by creating a nonprofit organization focused on highlighting the contributions of people in their community. They wanted to create a place where ambitious people could connect with others like them and highlight each other’s successes. Their grassroots efforts led to a network of highly successful people in various industries, corporate partners, early entrepreneurs, and a host of other supporters. After a few years, they realized there were high-potential early founders in their community whom they wanted to support.
They created initiatives to support these founders, but they knew funding was key. Instead of sending the early founders to traditional venture capital firms, they decided to raise their own fund. The idea was for capital to meet founders where they already were . . . in their community. Founders don’t have to learn to penetrate the traditional VC network because people in the community who understand the founders write the checks.
I like how these founders built a mission-focused community that also attracted talented founders. I think this is a great example of doing early-stage investing differently. Capital is finding its way to founders outside the purview of traditional venture capital networks. Interestingly, their work caught the attention of established VC firms, which ended up investing in their fund.
Why Can’t We Focus Anymore?
A friend mentioned Stolen Focus: Why You Can't Pay Attention—and How to Think Deeply Again and suggested I read it. Focus is something lots of founders struggle with, given the constant context shifting and never-ending to-do list. I decided to learn more about the author before committing to reading the book. I listened to a podcast that had the author, Johann Hari, as a guest. Here are some takeaways:
- Daydreaming – This isn’t a bad thing. It’s a valuable form of thinking. We process the past, think about the future, and make connections.
- Sleep – Lack of sleep has a bigger impact than most realize. You need eight hours’ sleep to be able to focus fully. When you’re tired, entire parts of your brain have gone to sleep.
- Flow state – When you’re doing something important to you and get into a deep state of focus, you’re in a flow state. It’s the deepest form of attention and can cause you to lose track of time. Shortening your list of goals to just one that’s meaningful to you and pushing yourself to the edge of your abilities increases your chances of getting into a flow state.
- Food – What we eat plays a bigger role in our ability to focus than we realize. For example, eating foods high in sugar for breakfast gives you a short-term boost but causes a crash (brain fog) later in the day.
These points resonated with me, and I agree with them—especially the value of daydreaming. I view daydreaming as a form of reflection. As a founder, I underestimated the power of reflection and how it leads to valuable insights that improve decision-making. I’m not a daydreamer, but I’ve been writing a daily post for more than two years. This established a habit of reflection that’s been invaluable. Compounding reflection has helped improve my decision-making—one reason I continue to post daily.
I don’t agree with everything Johann said, but I enjoyed the interview. I’m interested in hearing more of what he learned in years of researching focus, so I’ll add his book to my saved items list.
Students Pushing an Emerging Space
Today I had a great chat with three university students. The trio are passionate about an emerging space, and they recognized that other students are too. They rallied other students and founded a club for people interested in this space. This club is now a few hundred students strong. This momentum has forced faculty and administration to take notice. The club is officially recognized by the university, and the administration is looking at ways to develop curriculum to better prepare students to enter this emerging space.
These three students have their fingers squarely on the pulse of an emerging market. They see the potential in it even though the masses haven’t yet recognized the momentum behind this movement.
I loved talking with these students. They’re hustling to make things happen and forcing the powers that be to acknowledge their momentum. These students are likely on to something, and I can’t wait to see the next chapter of their journey. They might not recognize it, but I suspect this trio are entrepreneurs in the making.
Larger VC Funds Can Complicate Life for Limited Partners Too
A few weeks ago, I wrote about an example of an emerging VC fund manager’s success creating a problem because his fund size increased. I’ve heard this multiple times from both emerging fund managers who’ve raised larger funds and established fund managers who started with small-fund investing at the earliest stages. I recently had a chat with someone from a family office that’s a limited partner in venture capital funds (i.e., it invests in them).
He shared a few interesting things. The first is that they want to invest in great companies as early as possible (i.e., a few hundred thousand dollars at the pre-seed level). They don’t have the ability to source them internally, so they try to find fund managers who focus on this segment and invest in their funds. They believe that emerging managers with micro funds perform best at the pre-seed stage (more on this in another post). Finding and evaluating these emerging managers is difficult. It can be just as hard to find a promising emerging fund manager as it is to find a promising early-stage founder (they’re both early-stage founders in my mind), and this family office isn’t staffed to do that kind of outbound sourcing.
The second challenge was around stage creep. If they find an emerging manager to invest in whose pre-seed investments perform well, that manager usually raises a larger fund. The larger fund likely causes the manager to start investing at a later stage than the family office’s target (e.g., a few million dollars at seed+ instead of pre-seed). And this causes another problem: the family office has deployed capital with another manager at the later stage (that is, it already has a seed+ fund manager), so it now has overlap.
The family office now must start the cycle all over again. It needs to find another emerging manager who focuses on pre-seed or go with an established manager focused on pre-seed-stage investing whose larger fund will negatively affect returns.
There are lots of variables and things to consider that I didn’t get into to keep this simple, but that’s the gist of our conversation.
Of course, all family offices aren’t created equal, and family offices aren’t the only type of limited partner. Different classes of limited partners have different risk appetites for pre-seed investments, and even within those classes, each organization is motivated by different things. This is an anecdotal story, but one I've heard from more than one family office.
It’s interesting that there’s a desire for certain types of limited partners and emerging managers for investment at the earliest stages of a company’s life cycle, but the current VC construct isn’t working efficiently for emerging managers, limited partners, or start-up founders.
Weekly Reflection: Week One Hundred Twenty-Six
Today marks the end of my one-hundred-twenty-sixth week of working from home (mostly). Here are my takeaways from week one hundred twenty-six:
- Music industry – I spent time researching the music industry. I think there are some things they’ve done well that can be applied to venture capital. My network in Atlanta came in handy for this research.
- Insights – I’ve been working on a project that has had its ups and downs. This week I was able to piece together some insights that led to a breakthrough. Excited to build on this momentum next week.
- Routine – I changed my routine a little this week. I felt like I needed a spark. The changes worked. I was a bit more energized and productive.
- Problem on my mind – I’m thinking more about a particular problem. I’ve noticed I wake up at night with new ideas about it. This week I started jotting them down so I can go back to sleep. I’m struck by the fact that, like I said in another post, the last time I thought about a problem this much, I started a company to solve it.
Week one hundred twenty-six was busy. Looking forward to next week.
Create-X Demo Day
Today I attended Georgia Tech’s Create-X demo day at the Fox Theater. Around 80 start-ups in this cohort were working to solve interesting problems. More info on each company here. I always find the early founders at this event to be top-notch, and today was no exception.
One thing I noticed that added value to today’s event was its format. It was an open house: People could move around freely. No sitting at all. No pitches. Each start-up had a booth, and people could visit the booths at their own pace. I really like this format. It allowed visitors to spend more time with the start-ups they were most interested in, and it promoted serendipitous interactions among the visitors. I bumped into several people I hadn’t seen in some time and had some great conversations. And I was able to introduce people who didn’t know each other.
Rahul and team did a great job. I’m glad I attended, and I plan to keep supporting the program!
Is Fear Your Headwind, or Your Tailwind?
I’ve been learning more about Jimmy Iovine’s knack for identifying new markets. I watched an interview he gave in which he shared what’s allowed him to continually succeed: he harnesses fear. He “turned it into a tailwind instead of a headwind.”
Jimmy went on to say that fear is a powerful force that can work for you or against you. If you can harness fear, you have an asset that gives you a big advantage. Most people don’t know how to harness fear, so this powerful force works against them. Jimmy has trained himself to lean into fear when he feels it (Mike Tomlin has a similar approach). Everyone is always afraid of something. The “something” changes over time, so fear is never gone. You can’t eliminate it, so harnessing it is the best strategy.
I agree with Jimmy on this. Fear has been a powerful force that helped me accomplish things that I didn’t think I could. I’m still working to harness it as well as he does. But I’ve gotten better at recognizing when I’m fearful or uncomfortable as I’m making a decision. If there’s a fear-producing or uncomfortable option, I usually go with that option. Nine times out of ten, it turns out that I’m happy I made that choice and I grow because of that decision.
Is fear your headwind, or your tailwind?
Jimmy Iovine Mastered Outlier Markets
I think of outlier markets as new markets that are both outside the purview of the masses and growing quickly with the potential to be massive. I’ve spent time learning about people who took innovative approaches to finding outlier markets and helping them reach their full potential. This led me to learning about Jimmy Iovine.
He’s a producer turned record label executive turned tech start-up founder. He cofounded Interscope Records, which helped usher various music genres to the attention of the masses. His method was to partner with little-known musicians and independent label owners who understood these genres better than he did. His role was to help them navigate the politics of the music industry and handle marketing and distribution. Interscope has been a massive success. It’s been home to artists and record labels such as Death Row Records, Maroon 5, Lady Gaga, Dr. Dre, Tupac, Snoop Dogg, Nine Inch Nails, Eminem, 50 Cent, Kendrick Lamar, Limp Bizkit, and others. All have been huge successes and had a big impact on the music industry. Hip-hop alone has gone from being an outlier genre to dominating global charts.
Jimmy went on, with Dr. Dre, to form Beats Electronics, which he sold to Apple for $3 billion. Jimmy and Dr. Dre saw that streaming and headphones were markets with huge potential. They built Beats to take advantage of this insight. The headphones were a big success, but the Beats music app was what Apple wanted. The technology is the foundation for what’s now known as Apple Music. Apple doesn’t break out the revenue for Apple Music, but the category that includes this service generated $19.6 billion in revenue for the quarter ending June 2022. Apple Music alone likely generates multiple billions of dollars in revenue quarterly.
Jimmy has a knack for outlier markets—they’ve had an outsize impact culturally and generated outsize financial returns for him. His approach was tailored to music, but I think there are elements of his playbook that can be applied to other spaces, such as start-ups or venture capital.
Luck Is About Probabilities
Luck can play a big role in the life of a start-up. Especially in the early days. The right, seemingly random event can materially change a company’s course. I had a chat with a friend recently about luck. He thinks luck is random. I disagree.
One definition of “luck” is “favoring chance.” Said differently, it means favoring the possibility that a particular outcome will happen.
Luck is about probabilities. What is the probability that something you want to happen will happen? Depending on the outcome you want, there could be ways to skew the probabilities in your favor. A simple example is the power of staying top of mind with people. I have a close friend who many people consider lucky because he’s regularly presented with great opportunities. He’s been successful because of these opportunities. What people don’t see is the consistent effort he puts into staying top of mind with lots of people, which increases the likelihood that people will think of him when new opportunities arise. My friend creates his own luck by increasing the odds in his favor.
What actions can you take to increase the probabilities you’ll get the outcome you want?