The Puritans of Venture Capital
Cottage Keepers vs. Capital Agglomerators
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Last week, I wrote about ~20 different ideas that I've been thinking about touching on this year. Rather than starting to randomly prioritize, I thought I'd ask my readers (you) what you were most interested in. I very quickly realized I'd made a critical mistake. I should have sent out a survey or something, because inviting responses to the email invited hundreds of replies into my inbox / Twitter DMs that I had to manually review one by one. Live and learn! But after tallying the results, the topic you were most interested was this one:
The Puritans of Venture Capital: Venture used to be a cottage industry. Some firms are still practicing as if nothing really changed. Can they survive? Will capital agglomerators eat their lunch? Or can they co-exist?
It was closely tied with Books 2.0, which I'll try and touch on next week. In fact, it came down to one vote! Mr. Hunter Walk was the final vote pushing Puritans to 133 vs. Books 132. Tight race!
So let's dig in!
People like humble beginnings. I think its because they're easier to understand. It's easier to envision Steve Jobs and Steve Wozniak in a garage with a soldering iron and some microchips. It’s much harder to comprehend a $2.9 TRILLION company with $30 billion of cash, 2 billion active devices and 161K employees.
The larger something gets, the harder it is to comprehend. There's no one single person who comprehends every aspect of a business the size and scale of Amazon, or Microsoft. They are living, breathing organisms.
What's interesting about large, complex organizations is that their marketing rarely even attempts to reflect the size and complexity of the thing. There's no incentive for complex organizations to make themselves easier to understand. The only incentive is to make the story attractive. So the marketing sticks to the narrative of humble beginnings, and only goes as far as "we're just getting started."
When it comes to venture capital, the complexity is far more nuanced.
Humble Beginnings
Venture capital is approaching its dotage. Arguably, the first modern venture firms were American Research and Development Corporation. (ARDC) and J.H. Whitney & Company in 1946. So we're coming up on venture capital's 78th birthday. But as we approach the end of venture's first century, its important to put that in "asset class years", akin to dog years. I've written before about how, relative to asset classes like debt that have been around for thousands of years, 78 just isn't very old.
There are some great books out there that have done a much better job outlining the history of venture capital than I could do. The two I've read recently are VC: An American History by Tom Nicholas and The Power Law by Sebastian Mallaby. I won't re-prosecute the entire evolution of venture. But the one key point is that, in terms of economic scale, venture didn't really start to be relevant until the 80s, and it didn't explode until the dot-com.
In the grand scheme of private markets AUM globally in 2022, venture capital represented just 22% across other asset classes like buyouts, private debt, and real estate.
Venture funding didn't even cross $10B a quarter until ~1999. Total venture capital deployed in the US hit $100B for the first time in 2000 during the first internet bubble.
Next, global venture funding peaked in 2021 at over $600B.
Since then, funding amounts have come back to earth with ~$200B invested in 2023 compared to the $600B+ in 2021.
As a business, venture capital is deploying ~$200-300B a year globally. While the ramp has been volatile with spikes in 2000 and 2021, that trend will likely continue to grow. So the broader question is HOW are those hundreds of billions being deployed?
A Cottage of Gold
People often talk about how venture capital is a "cottage industry." This goes back to when small manufacturing operations were being run out of someones home, or cottage. So when people say venture was a cottage industry, its almost like calling it a "Mom & Pop shop."
As an industry, I don't think that's quite right. One of the most famous early venture investments was when Arthur Rock backed the Traitorous Eight in building Fairchild Semiconductor. The money came from Sherman Fairchild, a millionaire businessman, with defense contracts from Raytheon, etc. It was more a function of big companies funding new ideas vs. a side-hustle they did from home.
Mario Gabriele explains how much value was produced from that group:
"As of 2014, an estimated 92 companies trace their roots back to Fairchild Semiconductor founders and employees (some suggest the number is closer to 400), with $2 trillion in value created. That includes Apple, Advanced Micro Devices, and Applied Materials, as well as venture firms like KPCB and Sequoia."
So right off the bat, we're dealing with big dollars, big egos, and big outcomes. Not much of a cottage-based yarn spinning operation, right? So what do people mean when they describe venture capital as a "cottage industry?" They're typically talking more about venture capital partnerships. The mechanisms through which capital deployment decisions were made, and the organizations behind those decisions.
The Venture Partnership
Historically, firms like Benchmark or Accel had teams of ~6-9 partners. For example, Accel in July 2006 had 9 in the US.
That was how just about every firm worked. There was a handful of people chasing founders and making decisions. Some were more egalitarian than others. Maybe there were senior vs. junior partners. The textbook example of a small partnership fund is Benchmark.
In a 2015 profile of Benchmark, Forbes described them this way:
"Giving everyone not just a voice but an equal voice is Benchmark’s stock-in-trade. Unlike most of its rivals Benchmark is deliberately egalitarian. There are no junior or senior partners, only partners, and no one plays a CEO-like role. The firm’s winnings—2.5% in management fees and 30% of the profits— are divided equally."
That means that whether you're Victor whose been at Benchmark for 7 months, or Peter whose been at Benchmark for 17 years, if they were to get Uber's $7 BILLION return right now, they would each split the same outcome.
Firms like Benchmark, Union Square Ventures, and First Round are textbook examples of the "cottage" vibes for a venture partnership. Small groups of people pursuing high ownership, both of their work and their companies, and often relying on strong individual conviction to drive group efforts in winning deals.
But then things changed.
The Bifurcation of Venture Capital
It's hard to pinpoint exactly when things started to change and what the driving forces were. But my sense is a16z was a big part of what shattered the mirage. In a 2015 New Yorker piece on Marc Andreessen, that is made pretty clear. First? a16z was literally designed to be the anti-Benchmark:
"A16z was designed not merely to succeed but also to deliver payback: it would right the wrongs that Andreessen and Horowitz had suffered as entrepreneurs. Most of those, in their telling, came from Benchmark Capital, the firm that funded Loudcloud (Horowitz's previous company)—a five-partner boutique with no back-office specialists to provide the services they’d craved. “We were always the anti-Benchmark,” Horowitz told me. “Our design was to not do what they did.” Horowitz is still mad that one Benchmark partner asked him, in front of his co-founders, “When are you going to get a real C.E.O.?” And that Benchmark’s best-known V.C., the six-feet-eight Bill Gurley, another outspoken giant with a large Twitter following, advised Horowitz to cut Andreessen and his six-million-dollar investment out of the company. Andreessen said, “I can’t stand him. If you’ve seen ‘Seinfeld,’ Bill Gurley is my Newman”—Jerry’s bête noire."
On top of the a16z vs. Benchmark rivalry, other firms like Sequoia and founders like the CEO of Okta were open about the impact that a16z's model had on venture as a business:
"A16z’s services model made a strong impression on Sand Hill Road. “Andreessen caused us to up our game on the marketing side,” Sequoia’s Doug Leone told me. “Younger founders pay attention to media, and we don’t want to be de-positioned.” Sequoia hired an in-house publicist and two new marketing specialists to complement the four it had, and most top firms made similar moves, even if they privately believed that a16z’s services were simply a marketing tool. Todd McKinnon, the C.E.O. of Okta, said, “Every firm we talk to now is ‘Hey, we’re doing all this recruiting, and we’ll introduce you to big customers.’ It’s become the table stakes.”
Eventually, the changing operational forces in venture started to push firms to adopt new strategies and begin to segment themselves in new and unique ways. One framework to think about it comes from Nikhil Trivedi, who coined the term "agglomerators," that I like to use as well. That framework saw firms draw lines across sector and stage.
Multi-sector and multi-stage firms, by definition, had to increase in fund size because they were chasing a dramatically larger subset of opportunities. That strategy shift was a real-time display of the idea that "your fund size is your strategy."
Increasingly, these larger, more diversified firms with bigger teams that could write bigger checks started to suck up more of the air in the room. In mid-2021, pieces were coming out with titles like "Benchmark’s VC Model Strained by Newcomers, Supersize Rivals."
"Traditional Silicon Valley firms are facing more competition from a wider variety of investors, including solo venture capitalists like [Lachy] Groom and hedge funds such as Tiger Global Management. These relative newcomers are inking deals at a torrid pace, often winning with speed, pricing and flexible investment terms. That’s made the market for investing in tech startups much bigger. And the accelerated adoption of technology during the Covid-19 pandemic could make this change permanent, say investors in the thick of this hyperactivity."
Oh the hubris of hype! Even referencing behind-closed-doors conversations where Benchmark partners are questioning their strategy, expressing frustrating at missing deals like *checks notes* Clubhouse... Yeah. It turns out in hindsight, the cottage approach may have protected some smaller firms from getting into the excesses that have since plagued eager participants like Tiger.
But I wouldn't argue that capital agglomerators were a function of a ZIRP-fueled fever dream, and we'll all return to a Puritan Partnership like Benchmark soon enough. Instead, I think its an example of "you gotta break a few eggs to make an omlette." Exercises in hubris, such as SoftBank's vision fund or Tiger's great global tech index, were just incidents that pushed the boundaries.
Other people, over the course of 2021, pointed out a hollowing of the middle. I've written before about Everett Randle's piece, "Playing Different Games" on why Tiger was "eating everyone's lunch.” While the specific example he chose (Tiger) proved to be wrong, the phenomenon he was calling attention to is right.
"Ultimately & over time though, similar to what’s happened in retail over the last decade+, we’ll begin to see a middle squeeze in venture/growth. The most funds most insulated from the effects of this squeeze will be akin to:
(1) Luxury retailers (Apple, Sephora, Tiffany & Co.) — either via longstanding brand power (FF/Sequoia/a16z/etc.) or vertical focus/mindshare (Ribbit in Fintech), OR
(2) Low-cost vendors (Walmart, Dollar General) — via high levels of scale and velocity driven by aggressive GPs, similar to Tiger (Addition, Coatue, etc.)
The most exposed and vulnerable will be funds stuck in the “middle”. When choosing between capital providers, sometimes Founders will want the $12 Amazon Prime 1-day-shipping Carhartt T-Shirt, sometimes they’ll want the $1,500 Gucci Cardigan, but very rarely will they want the $22 J.C. Penney Hoodie. You really, really don’t want to be the VC version of J.C. Penney."
Again; his example of Tiger as the ideal "low-cost vendor" is wrong. Tiger isn't Walmart. Tiger is like Spirit, the Halloween store, but instead of buying seasonal costumes, they were selling out-of-season produce that quickly rotted. He used an image I think about all the time that I've changed to reflect who I think is the real "low-cost vendor."
Truly the anti-Benchmark.
This hollowing out in the middle means that venture firms with medium funds and medium teams will have medium returns and be medium competitive. And, in the words of the good Lord himself:
"I would thou wert cold or hot. So then because thou art lukewarm, and neither cold nor hot, I will spue thee out of my mouth."
So once we spew out the hollow middle, that leaves us to turn our attention to a key battle in the future of venture capital: Cottage Keepers vs. Capital Agglomerators.
The Agglomerators
I'll start with capital agglomerators because they're the ones I've already written about the most. The key to understanding the capital agglomerator is understanding their business model. I wrote about this in "The Blackstone of Innovation."
Firms that are building their business around having more resources, more exposure, and more coverage are ultimately optimizing for one thing: fees. The more fees you have, the bigger the business you can build. And fees are a derivative of AUM. So in reality, you're focused on the AUM aggregation game.
Two of my pieces, The Rise of The Cash Man, and Institutionalized Belief in The Greater Fool give two case studies into Agglomerator Theory: (1) Adam Neumann's new company, Flow, and (2) the basically defunct virtual events company, Hopin. The key takeaway in both of these stories is that capital agglomerators are often driven more by (1) what story can I tell that SOUNDS really big, and (2) what company can I deploy a LOT of capital into?
Bigger teams and funds doesn't always mean slower-moving hierarchical decision making. A 2014 HBS case study on a16z described the firm's decision making framework this way:
"GP Jeff Jordan described the firm’s investment criteria: “We look for strength rather than lack of weakness. It’s easy to point out what’s wrong with a deal, particularly when you say ‘no’ 98% of the time. We want a passionate advocate—at least one general partner who is just pounding the table to do the deal.” Andreessen concurred: “Google, Facebook, eBay, and Oracle all had massive flaws as early-stage ventures, but they also had overpowering strengths. Some VCs have all their partners score a deal’s potential. We’ve learned that those aggregate scores don’t correlate strongly with ultimate returns. With that approach, you get the mush in the middle, with no great strengths but no big flaws.” Ultimately, any a16z GP could make a “go” decision if he or she felt strongly; the cofounders did not serve as tie-breakers, nor did they reserve veto power. a16z’s review process was different from that employed by many other VC firms, where partners invested only after majority votes and after their “silverback” failed to exercise his or her veto."
Instead, the most important characteristic of a capital agglomerator is their north star metric: returns. There is a dichotomy that exists with capital allocation give-and-take between GPs and LPs. On the one hand, its hard to generate high returns on big pools of capital. GPs can't usually deploy billions of dollars and still generate 5-10x returns. But on the other hand, the same is true for LPs. If you're managing a $100B endowment, its really hard to only deploy $5-10M checks. You'd have to back 1-2K managers if you want to have a $10B venture capital book. But if you can write $250M checks a pop? That's more in the realm of possible. You don't need to generate 5-10x returns on $250M.
If you'd invested $250M in the S&P 500 5-10 years ago you would have generated ~12.7% per year, or a 1.6x return. The longer, the better. So your threshold is ~2x for a venture fund with 5-7 year lifecycles, because that would be ~1.6x net of fees. That's it! Big capital agglomerators working with big LPs can promise 2x funds, and the business model in that particular equation can work.
The Puritans
On the opposite side of the spectrum are the Puritans. The firms that have remained relatively unchanged for 20+ years. Partnerships and funds both of a relatively humble size compared to capital agglomerators. Just look, for comparison, at the AUM ramp of a firm like a16z (founded in 2009) vs. Union Square Ventures (founded in 2004).
One of the main characteristics of a Puritan fund is that they've refused to increase the size of the funds. These funds are typically anywhere from ~$200-500M but rarely get much bigger than that. Even for firms like Benchmark, who have returned $22.6 BILLION (net of fees) to their investors over their eight funds. In the words of Christy Richardson, the director of private investments at the Hewlett Foundation, “They could raise as much money as they want, but they maximize for the opportunity, not their own pocketbooks."
One might ask why? If you CAN raise bigger funds, why wouldn't you? Or in a more recent example, why would Founders Fund choose to reduce the size of its fund from $1.8B to $900M? Because every venture fund exists under the weight of reality's gravity.
In a really interesting piece from USV's Fred Wilson back in 2009, he's going through a very similar mental exercise that most people are going through today. Venture had underperformed from 2000 to 2010 after the dot-com and then struggling through the financial crisis. So there was a similar call for systemic changes in venture. He asked the question, "if venture is going to deploy $25B in one year, what is the math to make that work from a returns perspective?"
"First, the money needs to generate 2.5x net of fees and carry to the investors to deliver a decent return. Fees and carry bump that number to 3x gross returns. So $25bn needs to turn into $75bn per year in proceeds to the venture funds.
Then you need to figure out how much of the companies the VCs normally own. The number bandied about by most VCs is 20%. That means that each VC investor owns, on average 20% of each portfolio company. We'll use that number but to be honest I think it's lower, like 15% which makes the math even tougher.
Using the 20% number, that $75bn per year must come from exits producing $375bn in total value.
But it is also true that many of these exits have multiple VC investors in them, sometimes three or four. So you really need to look at the percent ownership by VC funds in the average deal at the time of exit. That number is likely to be over 50% and maybe as high as 60%. If we use 50%, then to get $75bn per year in distributions, we need to get $150bn per year in exits."
The TLDR? If you want to get a good return on $25B deployed, you need $375B in total outcomes (e.g. M&A, IPOs, etc.)
What's crazier is that around this time in 2009, it wasn't just Fred Wilson talking about this conundrum. Mark Suster and Paul Kedrosky at the Kauffman Foundation were making similar points. In fact, in 2009, Kedrosky believed that $25B number for venture capital deployed needed to be cut in half to ~$12B. In 2023, even after a massive macro correction, that number was $144B. Adjusted for inflation to 2009, that's still $100B.
If we go back to Fred Wilson's math, $150B of capital deployed likely earned an average of ~20% ownership in companies. For that to generate a 3x return, you need total outcome value to be $2.2 TRILLION. Two trillion dollars of IPOs or M&A.
The philosophy of Puritan funds would state that they don't believe there are enough truly exceptional companies that can generate such massive outcomes to justify multi-billion dollar funds. And that is both (1) a reasonable assumption, supported by a lot of data, and (2) a sound strategy if you exist in a vacuum.
But here's the rub. Cottage Keepers and Capital Agglomerators have to co-exist. And their strategies impact each other, whether they like it or not.
Key Battlegrounds
Returns
The first area of conflict is the one I've described above. If Capital Agglomerators are targeting 2x funds, and Cottage Keepers have higher expectations for their small funds, at 5-10x returns, then we have a problem.
If both are competing for a different outcome, then one is willing to pay a higher price than the other. Here's the scenario: one Cottage Keeper and one Capital Agglomerator are competing to invest in a company with $5M ARR:
Cottage Keeper: Bids $250M; believes the company can grow into a $2.5B outcome, and that could generate their 10x return.
Capital Agglomerator: Bids $1B; believes the company can grow into a $2.5B outcome, and that could more than generate their 2x return.
Even if these two firms have the same fundamental belief in the company's outcome, their return threshold enables them to play different games. Again, this is something I've written about before in Playing Different (Stupider) Games:
"People will ask, "how, in 2023, can you do an investment with a few million of ARR for a $1B valuation?" Because capital agglomerators, by attracting massive LPs who are giving them $250M a pop, are playing a dramatically different game. No LP expects 10x returns on $250M of capital. They're more than happy with 2-3x returns. So those firms are underwriting very different outcomes. They just need those $1B entry prices to become $2-3B companies.
Is this the stupider game? Not necessarily! It's just a different game. So what's the stupider game? For other VCs, its not realizing that you're competing with someone who is playing a very different game. For founders, its realizing that to these firms you are a rounding error. Going from a $1B to a $3B valuation isn't always a herculean effort. But when you're at $8M of ARR? Getting to be a $3B business is such a statistical anomaly."
Which brings us to the founders.
Support
The other reality that is important is for founders to understand the mentality of the firms they work with. Cottage Keepers, like Benchmark, will likely do one deal per partner per year. Meanwhile, Capital Agglomerators have a lot of capital to deploy. So while Benchmark maybe did 5-6 deals last year, a16z did ~80.
And the argument is, "well, a16z has more partners." And that's true. While they have ~65 investors, they also have a myriad of specialists to support them. So as a founder its not that one is good and one is bad. It's that they're different.
But buyers beware. Capital agglomeration, when taken to excess, looks like Tiger. I have friends that raised tens of millions of dollars from Tiger in 2021, and today they can't get anyone on the phone to sign critical shareholder legal documents.
Downstream Capital
Some of the other key battlegrounds get really fuzzy. I've written before about the value chain of capital. One of the complexities startups will face over the next few years is that a decade of excess turned the typical startup into a hungry-hungry-hippo when it comes to cash.
When I wrote about this topic previously, I used Instacart as an example. At the time of their IPO, every round since their Series C was under water when compared to the S&P 500.
"The company had raised a total of $2.9B in total funding, they had existing debt of $774M, and an ending cash balance of ~$1.8B. Roughly, that means the company had to burn ~$1.8B to get to the size of business they are today. The reality is that you can't just "not raise" the capital post-Series B. Instacart, at least in its current state, needed at least ~$1.8B to generate that return for those early investors."
So as much as Cottage Keepers want to stick to their knitting and invest early out of reasonably-sized funds into great companies, the reality is that if those companies go on to be cash infernos, they NEED capital agglomerators. They need those lower-cost-of-capital wielding machines to help fund that extraordinary cash burn. Even more so in fields like AI, which is a force I've written about before as well:
"So you have an unstoppable force of reality-altering AI, and an immovable object of capital agglomeration screaming towards each other. Candidly, I think they're a match made in heaven and they're going to shape the world."
My friend, Jared Sleeper, just put out a great piece called "Beware the Banana Stands: Silicon Valley’s Incinerators of Capital." He describes a generation of cash-burning businesses that used customer subsidies from VCs to grow spectacularly fast, but seem to be like a grease fire in a pig farm, just incapable of giving up the burn:
"Many investors have been trained that rapid growth, happy customers and a big market are the holy trinity of venture/growth investing. Banana stand businesses don’t just seem to have these traits- they actually do have these traits. In fact, it is dramatically easier to build a company going “$4m to $15m of ARR with an NPS of 80” if a customer subsidy is core to the value prop. Building net-new, efficient frontier-expanding products is hard- giving money away is much less hard.
Going forward, Cottage Keepers and Capital Agglomerators can't ignore each other. There are things worth funding, and business models in venture that may support different phases of growth. But these players need to attempt some semblance of symbiosis, rather than race-to-the-bottom direct competition.
The Power Law
Finally, I'll end on this point. As of Q1 2022, there were over 1K unicorns companies. One thousand companies worth more than $1B. That's a trillion dollars of paper value.
Are there really THAT many generational companies? In the public markets, there are ~528 tech companies TOTAL worth more than $1B. That includes Amazon, Meta, Alphabet, Microsoft, etc. I would argue that the vast majority of "unicorns" are going to be de-horned.
The most common battle cry in the clash between Cottage Keepers and Capital Agglomerators is "there's too much money chasing too few deals." And that's true. But it's only true because of how we define "deals." Everyone wants to invest in the top 1% of companies but, by definition, that's a very small percentage of all the companies that are out there.
What people are increasingly realizing is that there are a lot of ways to make impactful technology. There are a lot of ways to make money. There are a lot of ways to fund a business. And both funders and founders alike would do well to acknowledge that diversity.
Capital agglomerators, in particular, are going to face a rough reality. There are probably NOT enough generational companies to justify all 50+ of you to have $3B+ funds every few years. A lot of you are going to end up bagholders in the next Instacart IPO. If you want to manage multiple billions of dollars, then you're going to have to start getting more comfortable with a diversity of businesses.
Even our textbook Capital Agglomerator example, a16z, has a history of being willing to flex into unfamiliar territory. In a16z's first fund, in 2009, they invested in Skype. You might think "sure. Skype is a tech name I know. Classic venture bet." Not the case.
Skype was founded in 2003 and by 2005, they had grown to 54 million users! While they were early in revenue, eBay saw the potential in Skype and acquired them for $2.6B in 2005. Four years later, Silver Lake led an investor group (including a16z, and Canada's Pension Board) in a spinout of Skype from eBay in a deal that valued the company at $2.8B. This was not a typical VC deal, and it was a big swing for a first time fund! But it paid off. Two years later in 2011, Microsoft acquired Skype for $8.5B.
Now, some people would nod their head approvingly while dismissing the deal in the back of their mind. Big swing for a new fund, but it established them to go focus on traditional generational companies. But I think that's the wrong takeaway. If you want to be a capital agglomerator, I think your takeaway should be you need to get weirder, not more normal and elitist.
I've written about this expansion before:
"As larger venture firms look to build their AUM, its completely reasonable to expect to see them launch distressed debt funds for struggling startups, venture debt facilities, maybe even real estate funds to give their startups office space. In the pursuit of AUM, you may see exposure that not everyone is ready for."
And people's reaction to that will be, "well that's a mistake." We've seen venture funds launch hedge funds, hedge funds launch venture funds, recruiting agencies launch venture funds, and mutual funds launch... Benjamin Franklin-themed, meme-fueled... Bitcoin ETFs? *shudders*.
And I understand. A lot of those experiments have NOT worked. But just because some people have done it wrong, or at the wrong time, or for the wrong reasons, doesn't mean it can't work.
Blackstone is a testament to the ability to build a business in VERY different asset classes. I've returned again and again to this quote from Stephen Schwarzman, the founder of Blackstone:
"The [way] we thought about building our business was to keep challenging ourselves with an open-ended question: Why not? If we came across the right person to scale a business in a great investment class, why not? If we could apply our strengths, our network, and our resources to make that business a success, why not? Other firms, we felt, defined themselves too narrowly, limiting their ability to innovate. They were advisory firms, or investment firms, or credit firms, or real estate firms. Yet they were all pursuing financial opportunity."
Key Takeaway
If you're a Capital Agglomerator, then don't limit yourself to a 1% type of company. Broaden your horizons to areas that represent financial opportunity.
And if you're a Cottage Keeper, then you need to build a product-led venture firm. Answer the question WHY should a founder choose you. What is the job a founder hires you to do?
Otherwise, the battle is going to consume the thing we're fighting for and everybody loses.
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Amazing post Kyle
This is an excellent article.