Duet Partners
Tel: +44 (0) 20 7416 6630 / Email: partners@duetpartners.com


Weekly Briefing Note for Founders

5th January 2023

This week on the startup to scaleup journey:
  • Understanding the true business model of VC
  • VC relationships: If you're not the customer, you're the product
  • Corporate finance is the last kind of help a startup needs

Understanding the true business model of VC

Only by understanding the business model of VCs can we understand their true motivations. For founders researching this topic for the first time, this can be a revelation. But this insight will not easily be offered up by the fund managers themselves. They would prefer to keep that detail under wraps - for it reveals where their real priorities lie. Private market fund managers, whether they be VC funds, PE funds or any other form of 'asset manager', have 2 income streams, often referred to as '2 and 20'. They make money from fees and carried interest ('carry'). The fees are typically 2% of the entire fund size every year. On a $500M VC fund, that's $10M/year. This is typically used to run the investor's business operations and that primarily goes on salaries. The carried interest, often set at 20%, is the investor's share of the net returns, which is ultimately distributed amongst the fund manager's partnership. If the $500M fund is fully deployed and generates a 3x return (after fees), that equates to $1.5B. After returning the original $0.5B to investors, the VC pockets 20% of the remaining $1B 'profit', i.e., $200M. On a typical 10-year fund, the VC will also collect around $100M in fees, so their final 'take' is around $300M if all goes according to plan. Many established VCs will have several funds being deployed over that period, so the fees being collected start to compound.

If VCs raise larger and larger funds each time, two things happen, according to VC, Kyle Harrison: (1) the dollar value of the annual fees they're collecting gets much bigger, and (2) the possible return threshold gets lower. It's much harder to 3x a $0.5B fund than it is to 3x a small $50M fund. But if you're managing $10B in assets instead of $0.5B, which is now the case at the top end of VC, you're collecting $200M just in fees each year instead of $10M. Such a huge fee base distorts the traditional risk/reward balance of the VC model. Successful asset managers quickly start to see the opportunity that exists in raising more and more money and driving up the assets under management (AUM). It's not surprising that there's always a steady stream of new fund managers trying to enter the VC scene. But in times of economic uncertainty, LPs - the investors in these funds - gravitate to making safe decisions and this usually means doubling down on established fund managers to the exclusion of the newcomers. As a result, over the past year, we have seen a growing concentration of larger and larger funds in the hands of fewer and fewer fund managers. 60% of all the capital raised in 2022 went to $1B+ funds; that's up from 34% in 2021. The top 20 firms are now managing 10% of all venture capital.

This concentration of decision-makers is troubling enough, but something even more concerning is happening: an enmeshment of venture capital. We are increasingly seeing VC firms - particularly established franchises with tens of billions of dollars of AUM - investing in smaller, newer firms as LPs. In many cases, the VC firms acting as LPs are executing on the same or similar investment strategies as the VC firms they invest in. Established funds anchoring new ones isn’t a new phenomenon, but as this practice has accelerated, the conflicts have become clearer. Such emerging managers are compromising their own independence and their portfolio companies’ optionality, potentially to the detriment of returns. This raises big questions for founders: 1. Do you know who your investors’ investors are? Do you ask? Do you care? 2. Does it concern you that this trend may decrease competitiveness among VCs during your fundraising processes and potentially impact your valuation, dilution, and future optionality? And 3. Are you concerned with information flows, signalling risk, and your VC's ability to provide objective guidance if their financial incentives are intertwined with other VCs? As the pool of venture capital becomes ever more concentrated, understanding the venture business model and the behaviours it encourages has never been more important.

VC relationships: If you're not the customer, you're the product

It's rare to find a VC that is truly open about the implications of the institutional business model. Kyle Harrison, General Partner at Contrary (and formerly with investment heavyweights Index, Coatue, and TCV), is one of these exceptions. In his blog he says that in venture capital, the ethos that is so often articulated to founders is "we are helping you build your business right alongside you." And while there are a number of exceptional VCs who practice what they preach, Harrison says it's important to remember the business model of venture capital and where founders sit in the food chain. This helps explain why such good words are not always followed by good deeds. As we highlight above, the VC world operates under a typical fund structure: raise capital from LPs, take a management fee, invest over the course of 5-10 years, then collect 'carry' on the performance of those investments. Harrison doesn't seek to imply that no VC is founder focused, many are. "But I think it's important to reflect on the reality that, despite the marketing, founders are not a VC's customer. LPs are". In other words, the real customers are where the revenue comes from, and both (1) fees, and (2) carry come to VCs through LPs.

Harrison provides an example: Accel invested $12.7M in Facebook in 2005, and that generated a 700x return. But of that $8.8B return, Accel received 20%. They didn't get it from Zuckerberg. They got it as their contractual reward from LPs: "For investing my money, I'll give you 2% every year, and 20% of the money you make me after I get my money back." So every revenue stream for a VC is coming from LPs, not from the startups in which they invest. Founders need to be aware of this and understand the many implications, because just like Facebook, if you're not the customer, you're the product. This disconnect is one of the reasons why Harrison thinks there is such a spread right now between founder expectations and VC's reality. "A VC is doing the math around the returns they can offer their LPs and as expectations for those returns have plummeted alongside public markets, the 'founder friendliness' in terms of price, flexibility, and overall "wooing" has gone down." This is because VCs have to take into account their customer's expectations (e.g. their LPs), even if it’s at the expense of their founders.

And this reality can be true to varying degrees depending on the firm. If you're a large firm with massive assets under management, your business model is increasingly focused on collecting the big pile of fees on that AUM. And when that's the case you grow your AUM in an attempt to offer more "products" to more "customers." Harrison cites 16z as an example. "They raised a $4.5 billion crypto fund, a $5 billion growth fund, a $2.5 billion venture fund, and a $1.5 billion bio fund — all just last year." Those are all different "products" that LPs can get excited about having exposure to. AUM aggregation is increasingly becoming the name of the game in VC land. In other words, this is now the scaleup strategy du jour of the big investment firms. And, as we have seen through 2022, with fewer deals being done at all stages, there is now more extreme consolidation of capital at both the fund and startup level. As a result, the funding gap has widened. To secure the most friendly terms, founders must offer VCs a "product" that will produce the returns that their LPs expect. In fact, it was always thus.

Corporate finance is the last kind of help a startup needs

Just as the investee company is the 'product' for institutional investors like VCs, the company is also the 'product' for another potential stakeholder, the corporate finance house. The traditional business model of corporate finance is the brokerage model. That is why corporate finance houses are often referred to simply as 'brokers'. They are typically engaged by companies to act as an intermediary between themselves and investors for the purpose of facilitating an investment transaction. The broker's 'value-add' has historically been the 'network' of local investor relationships that they have developed over time (via other transactions). To the broker, the investor is clearly their real customer, even though the broker is engaged by the company. It is the investor's money that ultimately pays the broker's success fees and may do so on multiple occasions as a result of presenting different companies. Thus the broker's ultimate allegiance is to the investor, in the same way that the investor's allegiance lies ultimately with their LPs, not the startups they invest in.

This brokerage model works well at growth stage where the company's investment proposition is largely a function of the financial momentum already developed. This provides a natural alignment with big, generalist funds who are now happy to work through an intermediary who runs a 'book' on the deal. The company CEO, with many funding rounds behind them, should also be well practiced in the art of investment preparation and pitching. At early stage, however, things are very different: 1. The investment proposition will be far less financially evidenced and will rely more on the vision and specific capabilities of the founder(s). For this reason, investors want to deal directly with the founder from the very first approach to closure. 2. Founders, especially first-time founders raising their first institutional funding round, will likely not be expert in the art of investment preparation and pitching, so are also seeking specific guidance here, and 3. The best-matched investors will likely be thematic or thesis-driven funds, and could be located almost anywhere in the world. Startup boards that default to the appointment of a traditional corporate finance broker therefore often find that this is rarely a pathway to a successful outcome at early stage. Sometimes, it's the last kind of help a startup needs.

It is not surprising that the most common approach to early-stage capital raising is therefore the 'DIY' strategy, led by the founder/CEO themselves. Enlightened boards, cognisant of what a complex and time-consuming task this can be, especially if this is the first institutional raise, will look to provide the CEO with some form of specialist support. For example, this could be via one or more of the company's independent non-execs (NEDs) that has relevant capital-raising experience, or via a dedicated 'startup to scaleup' advisor. This could be a boutique advisory firm, like Duet, made up of former operators (founders and other startup execs) that are practiced in the art of early-stage capital-raising preparation and execution. These firms will also have access to the very latest global investment research, which has become essential as international investors now provide the lion's share of UK Tech investment. In these early-stage advisory relationships - unlike the traditional brokerage model - the company is truly the 'customer' and never the 'product' that simply facilitates a transaction. This is why the NED or external advisor, whose allegiance is to the CEO rather than the investor, often becomes a trusted confidante throughout the entire scaleup journey.

Happy reading!

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