So much has changed in venture capital since the start of the year, and many founders don’t fully understand it. It’s just a radically different business than it was in January. And founders don’t really need to understand all the changes in venture capital. But they should understand some.
One is the concept of “reserves”, which is super important to VCs, but not something founders usually need to understand in The Best of Times. Because in the Best of Times, there’s always more money to invest in top performers — and even mid-pack performers. Money almost always comes from somewhere to write second and third checks into the winners.
But in tougher times, really in more stressful times in venture (like right now) … that money for second and third checks almost disappears.
What’s happening? Let’s walk through it.
Imagine a “typical” $150m VC fund. (There’s no typical fund really, but in the end, most funds of approximately this size are run almost the same):
- 20% or more of the fund is eaten up by fees. That really leaves just $120m to invest. (Yes, there are ways to “recycle” to get the amount available to invest up, but that’s not super important for this analysis).
- Typically the fund would do 20-30 core investments using half that $120m, so maybe $2.5m checks on average ($2.5m x 25 = $62.5m)
- The other half of the fund, after fees, is “reserved” for follow-on investments. Pro ratas, and second and third checks into later rounds and some bridge rounds.
Now, not every one of those 25 investments will do another round, but often 70%+ will. So that means 20+ investments, all that will need another check. Out of a $65m pool.
Now when times are good, and uprounds happen seemingly every week, there’s not that much stress. If, as a VC, you invested at $10m pre initially, and say it’s 2021 and that same startup is doing a 100x round at a $300m valuation, this early VC fund can pick and choose whether to invest more or not. No one will care much if they invest in this later stage round, since it’s oversubscribed. And the price is 30x higher, so anything but a huge check won’t really move the needle on ownership. Many funds also raised separate Opportunity funds to invest more money in these later deals.
Let’s fast forward to 2022. Now, it’s 5x-10x harder to get those uprounds done. Maybe even harder than that. Now, imagine 10 of those 20 portfolio companies are doing OK but don’t have Tiger Global or Softbank to magically do the next round at a high price. This $150m fund now has to invest in those 10 rounds to support them. And sometimes, is almost forced to.
Now, it’s 10 portfolio companies competing for a slice of that $62.5m for reserves. Imagine first half has already been invested, so only $31m is left.
All of a sudden, you’re in triage mode:
- VC partners start to worry their investments won’t get any of the now scarce reserves
- The check size for extensions, seed-2 rounds, and more gets cut, because so many more existing companies need checks
- In good times, reserves seem less scarce, so at the margin, good-but-not-great performing portfolio companies get another check. The exact opposite happens in tougher times.
- If you can get out of writing that next check as a VC, you may try to. There just isn’t much left.
- So, fewer and fewer hands are raised to help write additional checks into portfolio companies that need them.
This gets more acute both with brand new funds, and with older funds. Older funds run out of reserves. For example, SaaStr Fund I from 2017 has now deployed $61m of its $68m. There’s only $7m left to invest for the next 4-5 years. That’s tight (I’ll admit). Tighter than I’d modeled, even.
And newer funds are under stress to be more diligent. The bar for second checks is higher there too, with reserves all of a sudden seeming much more defensive than a year ago. And really, with founders competing with everyone else in their VCs’ portfolios for those now scarce reserve dollars.
Q3 VC activity is looking soft
If we project out, looks like this:
* Q3 ~$84B, ~6.3K deals
* Q1 $142B, 9K deals
* Q2 $109B, 7.7K deals
Of course, 2 mos left in the qtr so could change bigly.
But right now, pretty dramatic decline for Q3https://t.co/UqQPYQbz0q
— Anand Sanwal (@asanwal) July 29, 2022
Net net, your VCs have a lot less to invest in you than they did just a few months ago, and the internal scrutiny on those checks is way up. And that alone drives up a lot of stress, and makes extension rounds much harder. Funds pull up spreadsheets, force rank their portfolio companies, and start soft-allocating what’s left mainly to the true break-out winners.
In fact, many savvy CEOs and VCs very quickly did round extensions this year to tap into these limited pools of reserve capital.
In many cases, it’s just too late now.
A reason to be even more conservative with how you spend that very expensive venture capital.
And also — ask. Ask your VCs how much more than have left to invest, and what it would take. If they are cagey, push them harder. You deserve to know. In fact, as founders, it’s your job to know. Just ask. No one asks.
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