Limited Partners’ Early-Stage Investing Dilemma

VC funds can have a big influence on start-ups. VC funds get the capital to invest in companies from their limited partners (LPs). LPs can be individuals, families, or organizations (pensions, endowments, corporations, etc.). I connected with someone who knows the LP world well and helps LPs discover and evaluate VC fund managers. One of his points, which is accurate, is that when LPs find a VC fund manager to invest in, they want to back multiple funds managed by that person (i.e., invest for many years). He also said many LPs want to back VC managers who invest early in emerging technologies and markets. Said differently, they want to invest in a VC fund that can help them invest early and for many years in innovative companies.

Early VC investing is done at a nascent time in a company’s life cycle. Founders haven’t found product–market fit (if they’ve even built a product). It’s not surprising for founders to have a problem they’re passionate about and just an idea about how to solve it. This stage is commonly referred to as the pre-seed or seed stage.

Pre-seed and seed stage investing is different than later stages (when product–market fit has been achieved) in various ways. It’s more transient and in a constant state of flux. Let’s dive deeper into this:

  • Flux – The rate of change in the world is accelerating. People are constantly discovering new problems, creating new technologies, and thinking of new ways to repurpose existing technologies. And they’re doing this at a faster rate. Some things end up being viable to form a company around, and some don’t. Keeping a finger on the pulse of all this flux and identifying the promising people and problems isn’t easy. It requires constant refreshing of your perspective and relationships, among other things.
  • Transient – Companies either succeed or fail, so companies are constantly transitioning into and out of this very early stage. VC fund managers investing at this stage (likely emerging managers) are similar. The managers that fail stop investing. The successful ones raise a larger fund, which usually pushes them to start investing at a later stage ( more on that here and here). When this happens, it can cause misalignment between LPs and VC fund managers (more on that here) and cause VC fund managers to transition out of investing at this stage too.

Some LPs want to invest in cutting-edge companies early and they want to back a VC fund manager who can do this for them for many years. This approach works at later stages (Series A and later), but given the flux and transience at the pre-seed or seed stage, it doesn’t make sense then. These two goals are counter to one another when investing this early. I believe some LPs want to invest in innovative companies as early as possible because of the potential financial upside and societal impact. But backing the same VC fund manager for many years isn’t the right action to support that goal. It would likely have the opposite effect. I suspect LPs want relationship consistency (or something else) for various reasons and think backing the same manager is the answer. They may believe this because it’s all that’s been available to them historically (other than sourcing founders themselves).

There’s a disconnect here. The stated goal and the action being taken to accomplish that goal aren’t aligned, and I’m not sure people realize that. I suspect this is affecting the efficiency of capital and resource deployment to early-stage founders. There’s likely an opportunity to present an alternative solution that embraces the transient and flux nature of this early stage but also addresses LPs’ other concerns (e.g., relationship consistency).