So much has changed in venture capital since the start of the year, and many founders don’t fully understand it. It’s just a radically different business than it was in January. And the founders don’t really need to understand everything the evolution of venture capital. But they should understand some.
One is the concept of “reserves,” which is very important for VCs, but not usually something founders need to understand in The Best of Times.. Because in the Best of Times, there is always more money to invest in the best performers — and even mid-range artists. The money almost always comes from somewhere to make second and third checks to the winners.
But in the tougher times, really in the more stressful times of the adventure (like right now)… that money for the second and third checks almost disappears.
What is happening? Let’s go through it.
Imagine a “typical” $150 million venture capital fund. (There really isn’t a typical fund, but at the end of the day, most funds around this size are managed almost the same way):
- 20% or more of the fund is eaten up by fees. That really only leaves $120 million to invest. (Yes, there are ways to “recycle” to increase the amount available to invest, but that’s not very important for this analysis).
- Typically, the fund would make 20-30 base investments using half of that $120 million, so maybe $2.5 million checks on average ($2.5 million x 25 = 62 .5 million dollars)
- The other half of the fund, net of fees, is “set aside” for follow-on investments. Pro rata, and second and third checks in later rounds and some bridge rounds.
Now, not all of those 25 investments will make another round, but often 70%+ will. So that means more than 20 investments, all of that will require another check. Out of a $65 million pool.
Now, when times are good and twists and turns happen seemingly every week, there isn’t much stress. If, as a VC, you originally invested $10 million before, and you say it’s 2021 and the same startup is doing a 100x round with a $300 million valuation, that first equity fund- risk can choose to invest more or not. No one will care much if they invest in this last round, as it is oversubscribed. And the price is 30 times higher, so anything but a huge check won’t really move the needle on property. Many funds have also raised separate Opportunity funds to invest more money in these subsequent deals.
Fast forward to 2022. Now it’s 5x to 10x harder to do these uprounds. Maybe even harder than that. Now imagine that 10 of those 20 portfolio companies are doing well but don’t have Tiger Global or Softbank to magically make the next round at a high price. This $150 million fund now has to invest in these 10 towers to support them. And sometimes you almost have to.
Now it’s 10 holding companies vying for a slice of that $62.5 million in reserves. Imagine that the first half has already been invested, so there is only $31 million left.
All of a sudden, you’re in triage mode:
- Venture capital partners are beginning to worry that their investments won’t get any of the now-scarce reserves
- Check sizes for expansions, starting rounds 2 and above are reduced as many other existing businesses require checks
- In good times, reserves seem less rare, so at the margin, successful but not very successful portfolio companies get another check. The exact opposite happens in more difficult times.
- If you can avoid writing that next check as a VC, you can try to do so. There isn’t much left.
- So fewer and fewer hands are being raised to help write extra checks to portfolio companies that need them.
It becomes more acute both with new funds and with older funds. Older funds are running out of reserves. For example, 2017’s SaaStr Fund I has now deployed $61 million of its $68 million. There is only $7 million left to invest for the next 4 to 5 years. It’s tight (I admit). Tighter than I had modeled, even.
And new funds are under pressure to be more diligent. The bar for second checks is also higher here, with reserves suddenly looking a lot more defensive than they did a year ago. And really, with founders competing with everyone else in their VCs’ wallets for those now scarce reserve dollars.
Venture capital activity in the third quarter appears weak
If we project, looks like this:
*Q3 ~$84B, ~6.3K deals
* Q1 $142 billion, 9,000 transactions
* Q2 $109 billion, 7.7k transactions
Of course, there are 2 months left in the qtr, so that could change significantly.
But right now, quite a dramatic drop for Q3https://t.co/UqQPYQbz0q
— Anand Sanwal (@asanwal) July 29, 2022
Net net, your VCs have far less to invest in you than just a few months ago, and internal scrutiny of these controls is on the rise. And that alone generates a lot of stress and makes extension towers much more difficult. The funds are pulling spreadsheets, forcing the ranking of companies in their portfolio, and starting to smoothly allocate what’s left mostly to the real winners.
In fact, many savvy CEOs and VCs have been very quick to extend this year to tap into these limited reserves of reserve capital.
In many cases, it is simply too late now.
A reason to be even more careful about how you spend this very expensive venture capital.
And also – ask. Ask your VCs how much they have left to invest and what it would take. If they are suspicious, push them harder. You deserve to know. In fact, as founders, it’s your job to know. You just have to ask. Nobody asks.
A related article here:
Need a second verification of your VCs? This is how “reserves” work
Posted on August 1, 2022