Why are the mega rounds and growth funds increasing every year?

Mark Suster of Upfront Ventures posted a few analyses regarding the dynamics of VC fundraising and investments in different stages recently. As usual they generated a lot of discussion in our tiny little circle called venture capital.

One thing that everybody agrees is that the “impression” of huge amount of money flowing into VC and startups is skewed by the fact that most “growths” come in the form of mega rounds and growth capital.

Source: “ A Deep Dive into What Has Really Changed in Venture Capital ” by Mark Suster (Upfront Ventures)

Source: “A Deep Dive into What Has Really Changed in Venture Capital” by Mark Suster (Upfront Ventures)

The pic above is from one of Mark’s recent articles “A Deep Dive into What Has Really Changed in Venture Capital”. As can be seen the real “venture” rounds, defined to be below $100M, only grew from $41B to $70B during 2013~2018, compared to growth capital rounds that grew from $48B to $131B.

Keep in mind that Fitbit only needed $65M through out its history to hit a $6B IPO, never needing a mega round. Nonetheless, mega rounds are here to stay and early-stage investors like us won’t be able to change that trend. If anything sometimes they offer secondary exit opportunities for people like us who are in a deal 4~6 years earlier than the growth people. The net effect is probably positive.

The question is, though, the real rationale of fund managers raising growth funds of say $500M or $1B. The traditional VCs focus on people (entrepreneurs, key hires, co-investors, etc) but the growth funds seem to care more about the dollar sign. Fundamentally these are two different animals but we’re seeing many traditional VCs moving into mega rounds. So why?

Some VCs argue that they do so because they’ve an unfair advantage in startup insights so why not just pocket the extra returns. The problem of this argument is that sometimes the VCs joining the mega rounds without prior early-stage tickets.

Ultimately I think it’s just plain mathematics. If you’re a typical early-stage VC fund of say $100M. Even if you perform okay and return 3X, GPs’ economics look like this:

  • 2% management fees over 10 years: $20M

  • 20% carried over $200M net profit: $40M

  • Total = $20M + $40M = $60M

For a $1B growth fund aiming to return 150% though:

  • 1% management fees over 10 years: $100M

  • 20% carried over $500M net profit: $100M

  • Total = $100M + $100M = $200M

Note that here I’ve already lowered the management fee to 1% as it’s typically the case for growth funds. The return expectation is also lowered to 50%. Absolute dollar-amount-wise this still works out to be more than 3X GP economics than the traditional VC funds.

It’s just too tempting for some VCs that have been in the industry for a long time to imagine harvesting these economics with probably less effort than before: no more handholding 20-something founders, no more debates over a $5M annual budget in an early-morning board meeting, no more sweating to persuade a former Google executive to join a 20-people startup whose founders still have pimples on the cheeks, etc.

Still, there are real VCs that hold the fort. Fred Wilson famously claimed that at Union Square Ventures they kept the fund size to be $150M-ish since that’s how their mathematics work. KPCB recently returned to more founder-focus investments as Mary Meeker left to run her own growth funds.

Ultimately it really depends on the different penchant of the GPs. I personally get lots of energy working with founders directly, helping them scale, etc. Pure financial transactions are never of my interest (despite being a rare VC who holds CFA charter). It’s also telling that in really successful IPO exits one still find the early-stage VCs being the largest shareholders in addition to the founders.

To each his/her own, as always.

Does book value matter?

Never go against a mainstream technology whose unit price keeps dropping every year