Venture Capital Funds: 5 Questions For Optimal Capital Deployment

Managing Venture Capital funds requires an optimal capital deployment strategy, a multifaceted challenge involving intricate knowledge of economic and structural aspects. While the media often portrays Venture Capital as a playground for unicorn-hunting and rapid fortunes, the reality for General Partners (GPs) is far more complex. Venture Capital is a high-stakes game of calculated risks, nuanced strategies, and rapid decision-making. A misstep can result in significant missed opportunities or financial setbacks that could affect the fund's performance. Active VCs and those considering raising a Venture Capital fund must master the art of capital deployment.

In this post, I examine the essential questions every GP must ask to determine their optimal capital deployment strategy. These range from deciding the initial investment size in each startup, to timing considerations, reinvestment options, and exit strategies. You'll learn how fund structures, carried interest, management fees, and return objectives influence these decisions. I also explore strategies for mitigating vintage risk, offer guidance for investing during bear and bull markets, and discuss how to focus on metrics that "move the needle."' Whether you are a seasoned GP or a future emerging Venture Capital fund manager, this guide will equip you with the insights and frameworks to deploy capital wisely.

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#1. How To Define My Average Investment Size?

One of the first questions a GP grapples with is determining how much to invest in each startup.

Why It Matters

Defining an initial investment size (the "average ticket") early on serves as a strategic compass for the entire fund. It dictates the kind of startups VCs can approach and align with their broader investment thesis. In other words, it's not just about finding a promising startup but also about aligning its needs with the fund's capabilities and limitations.

Fund terms and notions concerned:

• The LP/GP model
• Agency Risk & Permissions
• Fund size: Investment Strategy & Market Dynamics
• Money at work

The LP/GP Model

The LP/GP model is a foundational structure in Venture Capital that distinguishes between Limited Partners (LPs) and General Partners (GPs or VCs). LPs are typically institutional investors, family offices, large corporations, endowment funds, or high-net-worth individuals who invest capital into the fund but do not engage in its day-to-day management.

On the other hand, GPs are the fund's active managers, responsible for sourcing deals, making investment decisions, and overseeing portfolio companies. The GPs are compensated through management fees and carried interest, a share of the fund's profits.

This model establishes a division of labor, governance, and a distribution of risks and rewards, serving as the operational backbone for most Venture Capital funds. However, it is not without risk and limitations.

Agency Risk & Permissions

Within the LP/GP model, agency risks arise when the interests of the LPs and GPs diverge. For example, a VC might be tempted to invest more than the average ticket size in a hot startup, thinking it could become the next unicorn. However, making an outsized investment in a single startup could expose the fund to undue risk, something LPs might not be comfortable with.

One way to avoid such potential conflicts is to define thresholds above which the GPs need to ask the permission of a pre-determined proportion of their LP base.

In most cases, GPs must ask for permission from LPs or a governance board before making an investment that significantly exceeds the agreed-upon average ticket size or a certain percentage of the fund (typically 10%). This check and balance mechanism is built into the LP/GP model to mitigate agency risk and ensure that the GP's decisions align with the collective interest of the investors in the fund.

Fund Size

A fund's size sets the boundaries for the total capital available for investment. It is not solely a function of internal strategy but also influenced by external factors such as market environment and team expertise.

The investment climate can either bolster or hinder a fund's ability to secure capital commitments from LPs. For example, 2021 was a record year in VC funds raised. While 2022 benefitted from 2021's momentum, 2023 is already more challenging.

Additionally, the GPs' track record and domain expertise significantly impact investors' confidence, affecting the fund's size. LPs favor a "flight-to-quality," i.e., betting on sure names vs. emerging fund managers when the going gets tough. First-time VC managers who succeed in raising money typically operate with smaller funds.

The features of private equity funds—whether management fees, profit-sharing rules, or contractual terms—have long-lasting effects on the behavior of venture capitalists.

Paul Gompers & Josh lerner - Harvard (Source: The Venture capital cycle)

In their seminal 1999 book "The Venture Capital Cycle," Harvard professors Paul Gompers and Josh Lerner demonstrated that the features of Venture Capital funds determine how GPs deploy capital and monitor portfolio companies. Throughout this post, I'll refer to the link between individual characteristics and GPs' behavior.

For example, an oversized fund can result in undue pressure to invest large sums quickly, potentially leading to suboptimal investment decisions. Conversely, an undersized fund may lack the resources to participate in follow-on funding rounds, missing out on opportunities to increase equity stakes in successful startups.

The Investment Strategy Impacts The Average Ticket

The investment strategy and fund size of a Venture Capital fund are intrinsically interlinked, each shaping the contours of the other. Let's illustrate this point with two elements of the investment strategy, the development stage and the vertical addressed by the fund.

Early-stage funds deploy smaller ticket sizes. The startups they finance are in the nascent stages and do not typically require substantial capital injections. These funds tend to be smaller in size. On the other hand, late-stage funds necessitate larger pools of capital as they invest in more mature companies requiring significant funding to scale.

The industry vertical also plays a crucial role. For instance, a SaaS-focused fund might be smaller given the generally lower capital intensity of software startups. Conversely, funds targeting sectors like IoT or biotech often need to be larger, given the higher costs associated with hardware development or clinical trials.

The investment strategy not only dictates the fund size but also influences the criteria GPs use to screen deal flow.

Money At Work

The concept of "money at work" refers to the actual amount of capital from the fund invested in startups, considering the various costs and reserves that may reduce the investable capital.

For instance, management fees, usually charged as a percentage of the total fund size, reduce the amount of money available for investment. Likewise, reserves set aside for follow-on investments in portfolio companies further decrease the capital available for new investments. Other fees or operational costs may come into play, further diminishing the money at work.

The more fees and reserves are subtracted from the total fund size, the higher the return requirements become for the remaining capital that is actively invested. This is because the overall fund has to not only return the money invested but also cover these fees and reserves while still providing an acceptable return to the Limited Partners.

Understanding the dynamics of money at work is essential for creating an optimal capital deployment strategy. Since reserves have such a significant impact on the fund's deployment, I address this concept next.

#2. Shall I Optimize For Traction or Dilution?

The question of optimizing for traction versus dilution is a critical decision point in the capital deployment strategy of a Venture Capital fund, which needs to be addressed when the investment strategy is determined.

Why It Matters

This choice has profound implications for portfolio construction, deal sourcing, and ultimately, fund performance. At its core, this decision can define the risk profile of the fund and determine the growth trajectories available for its portfolio companies.

Fund terms & notions concerned

• Reserve Ratios
• Maximum Exposure
• Round-on-round markup

Optimizing for Traction

Also called the "spray and pray" strategy, optimizing for traction means making many small bets across a diverse set of startups with the hope that one or a few of them will realize exponential growth, providing a handsome return for the entire fund. (See the concept of the power law below).

This strategy relies on the notion that GPs, especially those investing at the early stage, have little impact on the development of the startups they invest in. Their main value is to source and select investment opportunities.

Funds such as 500 Startups—now 500 Global—were initially founded with this belief in mind. Their idea was to spread the net large enough that, given superior deal flow thanks to the brand and network, they would hit a few big winners over time.

I recently trained GPs from a fund in Brazil that had successfully raised $5 million, then $25 million, and is now raising $50 million for its third fund. Investing in a large number of startups out of the first fund helped them build enough track record to attract LPs in the second fund.

Pros: More money at work, lower average tickets, fast learning, networking, portfolio diversification, potentially building a track record.

Cons: No doubling down on winners, dilution, complex portfolio management.

Optimizing for Dilution

Conversely, optimizing for dilution emphasizes a more concentrated approach, where fewer investments are made, but with higher individual ticket sizes. The objective is to make more selective initial investments and maintain equity ownership as the startup raises more funds over time.

VCs typically negotiate a pro-rata right allowing them to invest enough in the next round that their ownership is not diluted. For example, a VC owning 10% in a startup raising an additional $5 million at a $25 million post-money valuation would calculate its pro rata share by determining how much it needs to invest, as the new price per share, to maintain a 10% equity stake in the startup.

The key here is to define sufficient reserves for follow-on investments. It allows the VC firm to maintain or increase equity stake during subsequent funding rounds, thus reducing ownership dilution. The decision is made when the fund is marketed to LP and has long-lasting effects on the capital deployment strategy.

Pros: Keeping ownership in potential winners, build relationships over time (+ influence / control).

Cons: Requires high-quality deal flow and superior evaluation skills, more time-consuming, lower portfolio diversification.

Which Strategy Is Optimal?

Assuming that GPs are not limited by market constraints, which strategy is optimal? To my knowledge, there is no definite evidence that one strategy beats the other—otherwise, it would be the only one followed.

There is no one-size-fits-all approach. The optimal strategy often depends on various factors such as fund size, team expertise, and market conditions:

• Larger funds might be more inclined to optimize for dilution due to their capital-heavy nature, while smaller funds may aim for traction to diversify risk
• A larger team with diverse industry expertise can manage a more diversified portfolio, better suiting an approach optimized for traction
• In a bullish market, optimizing for traction can capture the upside quickly. In contrast, a bearish or uncertain market might make a dilution-focused approach more prudent to protect ownership stakes in the best performers.

Ultimately, the optimal strategy will vary for each VC fund based on its specific circumstances and investment thesis.

#3. How Diversified Should the Portfolio Be?

Fund size and diversification are intertwined, profoundly impacting a Venture Capital fund's risk and reward profile.

Why It Matters

In finance, portfolio diversification is a risk management strategy that spreads investments across various assets to reduce exposure to any asset or risk. By holding a mix of different investments, a fund manager can mitigate some companies' negative performance with others' positive performance, thereby achieving a more stable and potentially higher return on the overall portfolio.

Fund terms and notions concerned:

• Portfolio diversification vs. concentration
• The power law of VC returns
• Maximum allocation
• Vintage risk

Is Portfolio Diversification Desirable in Venture Capital Funds?

I have long argued that, contrary to other asset classes, VC funds require a level of portfolio concentration to overperform. My rationale stems from the evidence of the power law of VC returns: a small number of investments yield exponential returns, often compensating for less successful ventures in the portfolio.

In other words, most of a VC fund's returns are often generated by a handful of star performers, so missing out on these could lead to poor financial performance. While this argument seems to favor spreading the risk to as many companies as possible—often referred to as a "spray and pray" strategy (see above)—there is a nuance.

Investors in growth equity and Leveraged Buyouts (now called "late stage") tend to diversify their portfolios in terms of potential returns. They typically mix low-risk, low-reward companies with their high-risk, high-reward counterparts to balance the portfolio.

Some of the most successful Venture Capitalists have built their reputations on a few outstanding investments. Maintaining a concentration level allows them to deeply engage with the Founders and effectively monitor and support their portfolio companies.

Maximum Exposure

However, some degree of diversification is necessary, but on other dimensions than potential returns. The first is the total percentage of the fund invested in a single startup. As mentioned before, Limited Partners (LPs) often set this limitation as a safeguard against putting too many eggs in one basket.

Striking this balance can be particularly challenging in the Venture Capital space, characterized as being "narrow but deep." Successful Venture Capitalists often double down on their most promising portfolio companies, piling in more capital to fuel growth. This approach may conflict with the limitations on total exposure, creating a tension that Venture Capitalists must carefully navigate to optimize returns while mitigating risks.

Sequoia's investment in the cryptocurrency exchange FTX, which spectacularly failed in the fall of 2022, is a case in point. Although the elite VC firm had been a strong backer of FTX, even leading its Series B round, it remained cautious in limiting its exposure to the asset.

We are in the business of taking risk. Some investments will surprise to the upside, and some will surprise to the downside.

SEquoia capital (Source: twitter)

In a letter to their LPs that they published after the FTX fiasco, Sequoia mentions that the $150 million invested in FTX represents only 3% of the fund concerned. The team also notes that this loss is offset by $7.5 billion in realized and unrealized gains in the same fund, concluding soberly that "the fund remains in good shape." Although unrealized gains are subject to variability, the letter reassured Sequoia's LPs.

Vintage Risk

Vintage risk refers to the variability in investment returns due to the particular year a fund starts investing. A fund that begins investing at the peak of an economic boom may have a different risk-reward profile than a fund that starts in a downturn. Diversification across sectors, geographies, and time can mitigate this risk, offering cushion against market uncertainties.

Spreading vintage risk in a Venture Capital portfolio requires a disciplined approach, especially during economic booms when the temptation to deploy capital quickly is high. The goal during such times is often to realize quick gains by exiting investments in the short term and subsequently raising the next fund.

It is the playbook that Tiger Global used in the years leading to the 2022 market reset, perfectly illustrating Gompers and Lerner's point that the structural mechanisms of Venture Capital funds heavily influence VCs' behavior.

There is massive benefit to time diversity in a VC portfolio.

Bill Gurley - BEnchmark (Source: 20VC)

However, this strategy can backfire and make it difficult to raise a subsequent fund, as Benchmark's Bill Gurley highlighted in a December 2021 interview (impeccable timing!). A concentrated investment in startups during a market peak can lead to significant downfalls during market corrections.

I learned that lesson during the 2007-2008 Great Financial Crisis. Funds that raised money in late 2006 and early 2007 and deployed capital quickly became trapped in illiquid and underperforming assets when the market turned between. The same phenomenon occurred recently when the market suddenly corrected in early 2022. The consequences are still playing out, as startup bankruptcies multiply.

Such experiences emphasize the importance of spreading investments across different market cycles to mitigate vintage risk.

#4. How Fast Shall I Invest & Exit?

I highlighted the risks of investing too fast in the preceding section. Now, I turn to other fund terms and mechanics that influence the pace at which GPs deploy a fund's capital.