In 2017, the equivalent of the arrival of an alien spaceship happened. A fund of a size none thought possible appeared from the edge of the world and descended on Silicon Valley. At the helm of the ship stood Masayoshi Son. An eccentric business daredevil with a risk appetite that would have made Genghis Khan wet his pants. The ship was loaded with 100 billion USD ready to be deployed through cash canons of doomsday-sized calibers. Once Son gave the command to fire, the cash cannons colored the skies green for the following years. When the cash rain ceased in 2019, the Soft Bank Vision Fund had deployed close to 100M USD per day, every day, since its arrival.
The enormity of the Vision Fund can best be illustrated by comparing it to the most legendary VC of all time. Sequoia Capital was founded in 1974 and has delivered above-market returns ever since. Consequently, investors from around the globe vie for receiving an allocation. Naturally, such pressure makes their funds grow. Still, their 2017 fund Sequoia Capital Global Growth Fund II, their biggest to date, was “just” 2 billion USD.
Despite Sequoia being dwarfed by the Vision Fund, Sequoia perhaps best depicts the development in VC fund sizes. The first Sequoia Capital fund I from 1974 was a mere 3 million USD. The second fund grew to 20M USD. The third amassed 44M USD. In 2011 and 12 funds in, Sequoia Capital crossed the 1 billion USD mark for the first time.
When VC funds grow, so does the number of people needed to manage them. The first Sequoia fund had one partner. Don Valentine. Later, more partners joined. Later still, the partners started employing investment professionals. Like Sequoia, most VCs start out as a group of partners investing together. These partners share the workload, and only have a couple of people employed. Perhaps a CFO and a secretary. But as VC funds grow, they employ more people. These investment professionals differ from the partners in one important aspect. They do not have their own money in the fund. Consequently, these people tend to regard the firm as an employer, and themselves as employees. To many, this fact may seem trivial. But in the world of investing, this is anything but. As we shall see.
The House Money Effect
When VCs assess deals, they must weigh risks and opportunities. But risk and opportunities are interpreted values. Interpreted by the people meeting the founders. Until a few years ago, startup founders would meet partners in the funds. And the partners would make the assessment of the risk and opportunities. But recently, founders mostly meet with investment professionals.
Because investment professionals are essentially employees, their frame of risk and opportunity is quite different from the partners. Partners can make or lose money. Investment professionals can be promoted or lose their job.
One might conclude, that losing money is worse than losing a job. And this should make Investment professionals more risk-tolerant. However, this conclusion would be mistaken because of something called the house-money effect.
The truth is that even though the partners risk losing their money. The money they invest typically stems from profits from previous investments. It is the equivalent of going to the slot machine, winning money, and only playing with the money you have just won while keeping the original amount safe. Money recently won feels like “free” money. And the behavior that stems from someone gambling recently gained money, is called the house-money-effect. The effect gives one much more risk appetite than if one was risking money diligently collected. Did Masayoshi Son have house-money? Son made close to 100 billion USD when betting on a young Jack Ma, founder of Alibaba.
Arguably, the importance of the house-money effect in venture capital is under-appreciated. One definition of startups is that they are: a temporary organization designed to search for a repeatable and scalable business model.” (Steve Blank). The definition oozes risk and uncertainty. A temporary organization that is searching does not seem like a sound investment. And it isn’t. Thus, some version of the house-money effect must excerpt influence to make otherwise smart people engage in such risky bets.
In fact, one could argue that the house-money effect underpins venture capital. But then what happens when investment professionals take over the risk and opportunity assessment? Will venture capital change? It already has. And a large group of founders suffers.
The tale of two founders
Many investment professionals come from finance and consulting. That means investment banking, PE funds, hedge funds, pension funds, McKinsey, Bain, etc. These people are used to hard data. However, startup investing seems opaque because there is little hard data available. This conundrum has two consequences. First, investment professionals gravitate towards companies that can present hard data. In practice, SaaS companies with three years’ operating history and 100K MRR. Second, and perhaps even more consequential, they gravitate towards founders with scaleup resumes. That means Founders, executives, and VPs from Zendesk, Klarna, Bolt, etc. Why would they do this? Well, imagine that the investment decision proves bad, and the firm loses money. To an investment professional, it seems much easier to defend having invested in proven people with impressive resumes, than a team of nobodies. The latter requires some explaining to do.
Does this mean that only founders with scaleup resumes get funding? Not entirely, because there are not enough scaleup founders for investment professionals to solely bet on them. But it does produce a tale of two founders. Founders with scaleup resumes who can raise exorbitant sums of money at fantasy valuations. And everyone else who struggles to merely solicit a term sheet. Besides being a frustrating experience for the latter group (which is the vast majority), it might also prove the beginning of the end.
The only way to make money investing
Much research finds that first-time funds perform best. One example comes from another legendary VC. In 2019, we got a rare view into the returns of Andreessen Horowitz (A16Z) when internal data slipped into public hands. The first A16Z fund from 2009 returned 44% net IRR. The second A16Z fund from 2010 returned 16% net IRR. The third fund from 2012 returned 15% net IRR. Although the final outcome could differ from these figures, there is a trend. And the trend is declining performance. But wait, there is another trend! The first fund was 300M UDS. The second was 656M USD. The third is 997M USD. I suspect you know where I am going.
When fund sizes increase, the firms get “institutionalized”. The risk tolerant house-money-effect is diluted and replaced by hard data seeking I-cannot-be-fired-from-investing-in-a-Klarna-product-manager conviction making. But if the house-money-effect is underpinning venture capital, what happens to venture capital when it is “institutionalized”? The answer might be comforting, or the opposite, depending on who you are.
Investing is a self-correcting game where non-viable strategies will disappear over the long run. And paying exorbitant premiums for founders with scaleup resumes is not viable. Why would I think so? Because there is a law in investing that not even all the money in the world and legions of Bain consultants can buck. The law is this: One can only make money investing if one is both right and non-consensus. Essentially the law says: if everyone agrees that something is a good investment, that something will become so expensive that no money can be made. When scaleup-resume founders obtain stratospheric valuations, it can only have one reason: Everyone agrees that it is a good investment. Consequently, the law ensures the firms engaging in this strategy will suffer in the long run.
However, time is relative and venture capital has painfully slow feedback loops. The self-correcting nature can take years, and perhaps even decades to exert itself. Until then, startup founders without scaleup resumes will suffer. And guess who are among these: yes, most women and minorities! But more importantly, a lot of entrepreneurs with the ideas and talent to create all the house-money needed to keep fueling the wonderful world of startups.
At Accelerace we insist on being indifferent to the resumes of founders. We do not care who you are. We care only about what you do. If you are a founder and our views resonate, then visit our website here.