The paradox of 2020 VC is that the largest funds are doing the smallest rounds

I talked yesterday about how VCs are just tired these days. Too many deals, too little time per deal, and constant hyper-competition with other VCs for the same equity.

One founder friend of mine noted to me last night that he has already received inbound requests from more than 90 investors over the past year about his next round — and he’s not even (presumably) fundraising. “I may have missed a few,” he deadpans, and really, how could one not?

All that frenetic activity though leads us to the paradox at the heart of 2020 venture capital: it’s the largest funds that are writing the earliest, smallest checks.

That’s a paradox because big funds need big rounds to invest in. A billion dollar fund can’t write eight hundred $1 million seed checks with dollars left over for management fees (well, they could, but that would be obnoxious and impossible to track). Instead, the usual pattern is that as a firm’s fund size grows, its managing partners increasingly move to later-stage rounds to be able to efficiently deploy that capital. So the $200 million fund that used to write $8 million series As transforms into a $1 billion fund writing $40 million series Bs and Cs.

That’s logical. Yet, the real logic is a bit more complicated. Namely, that everyone is raising huge funds.

As this week’s big VC report from the National Venture Capital Association made clear, 2019 was in many ways the year of the big fund (and SoftBank didn’t even raise!). 21 “mega-funds” launched last year (defined as raising more than $500 million), and that was actually below the numbers in 2018.

All that late-stage capital is scouring for late-stage deals, but there just aren’t that many deals to do. Sure, there are great companies and potentially great returns lying around, but there are also dozens of funds plotting to get access to that cap table, and valuation is one of the only levers these investors have to stand out from the fray.

This is the story of Plaid in many ways. The fintech data API layer, which Visa announced it is intending to acquire this past week for $5.3 billion, raised a $250 million series C in late 2018 from Index and Kleiner, all according to Crunchbase. Multiple VC sources have told me that “everyone” looked at the deal (everyone being the tired VCs if you will).

But as one VC who said “no” on the C round defended to me this week, the valuation last year was incredibly rich. The company had revenues in 2018 in the upper tens of millions or so I have been told, which coupled with its publicly-reported $2.65 billion series C valuation implies a revenue multiple somewhere in the 30-50x range — extremely pricey given the company’s on-going fight with banks to ensure it can maintain data access to its users’ accounts.

Jeff Kauflin at Forbes reported that the company’s revenues in 2019 are now in the lower three digits of millions, which means that Visa likely paid a similarly expensive multiple to acquire the company. Kleiner and Index doubled their money in a year or so, and no one should complain about that kind of IRR (particularly in growth investing), but if it weren’t for Visa and the beneficial alchemy of exit timing, all might have turned out very differently.

Worse that just expensive valuations, these later-stage rounds can become very proprietary and exclusive. From the sounds of it, Plaid ran a fairly open process for its series C round, which allowed a lot of firms to look at the deal, helping to drive the valuation up while limiting dilution for earlier investors and the founder. But that’s not the only way to handle it.

Increasingly, firms who invested early are also trying to invest later. That series A investor who put in $5 million also wants to put in the $50 million series B and the $250 million series C. After all, they have the capital, already know the company, have a relationship with the CEO, and can avoid a time-consuming fundraise in the process.

So for many deals today, those later-stage cap tables are essentially locking out new investors, because there is already so much capital sitting around the cap table just salivating to double down.

That gets us straight to the paradox. In order to have access to later-stage rounds, you have to already be on the cap table, which means that you have to do the smaller, earlier-stage rounds. Suddenly, growth investors are coming back to early-stage rounds (including seed) just to have optionality on access to these startups and their fundraises.

As one VC explained to me last week (paraphrasing), “What’s weird today is that you have firms like Sequoia who show up for seed rounds, but they don’t really care about … anything. Valuation, terms, etc. It’s all a play for those later-stage rounds.” I think that’s a bit of an exaggeration to be clear, but ultimately, those one million-dollar checks are essentially a rounding error for the largest funds. The real return is in the mega rounds down the road.

Does that mean seed funds will cease to exist? Certainly not, but it’s hard to make money and build a balanced, risk-adjusted portfolio when your competitors literally don’t care and consider the investment a marketing and access expense. As for founders — the times are still really, really good if you can check the right VC boxes.