Leaderless Rounds and the Problem of Weasel.vc

One of the quote-unquote negative characteristics of the New York City tech ecosystem that I talked about a few weeks ago is the lack of VCs who will take the lead role in a fundraise. From my count, there is somewhere between 200-300 active VC firms in New York (yes, there is something of that size in the city today — crazy really), only maybe 6-12 are fully comfortable taking the lead in a fundraise.

Why is this? The answer is actually a mix of resources and weird incentives that are not unique to NYC, but that seem to have hit so many firms simultaneously here that it has become the de facto norm.

To illustrate this, let's take a hypothetical $20 million seed fund which we can call Weasel.vc. They reserve 45% of the fund for follow-on investments, a number that is higher than in a series A fund like CRV, since they have to handle an extra round of dilution. Let's say the fees on the fund are a classic two and twenty, which would mean that about $3.25m of the fund will be spent on management fees (assuming the fees taper outside of the five-year investment window). So we have 20-3.25 = 16.75 * 0.55 = $9.21m or so for primary first investments.

Note: all math is back-of-napkin, of course.

Since this is Weasel.vc's first fund, its number one goal is to raise more capital for a fund two. The easiest way to do that early on in a fund's lifecycle is to show follow-on investments. If series A investors like companies in Weasel.vc's portfolio, then they will put more capital behind them, raising the valuation on those companies and giving Weasel.vc some early signs of strong returns.

Weasel.vc has to fundraise fund two, otherwise, they are done. So they want to guarantee a clear set of return winners to show limited partners that their model works. The best way to guarantee that outcome is to have more checks into more companies. So Weasel. vc offers $250k as a standard check in a seed fundraise. With let's call it $9.25 million of investible capital, that gives them 37 checks to write in the fund. That's a lot of bets!

The problem with this strategy should be clear. As any gambler knows, you want to put the most money behind bets where you have the greatest expected value of success. If you believe as a venture capitalist that you have the ability to choose the right companies, then you would want to put more capital behind those companies. It's the concentrated bets behind clear winners that will determine a fund's performance.

With Weasel.vc, while the firm has managed to make a lot of bets with very little resources, they have also spread the capital quite widely. They own very little of any individual seed round, so that even if they have a winner in the portfolio, the total amount of return is capped by low ownership.

That's bad, but it doesn't really matter for years down the line, and Weasel.vc needs to fundraise now for fund two. So you end up with a fund that will never lead and always follow.

The other path is harrowing. Going back to Weasel.vc with the same fund structure and size, but now they change their strategy to concentrate their bets and lead seed rounds instead of following them. That means with $9.21 million or so of investible capital, they can do about six projects, compared to 37 before. Wow, that's not a lot of bets!

It's entirely possible for a new venture capitalist to completely flub six bets. And that would mean the end of Weasel.vc. So sad.

So what I see in the market is an enormous number of firms that are willing to write those small seed checks, but almost a deafening silence of firms that are actually willing to stand up and seal an entire round up.

Compared to the Valley, this seems to be a dynamic much more prevalent in New York City. Part of this is the fact that venture capital here has expanded mightily in just the past few years, so the vast majority of firms are new and still in that "maximize chance of fundraising the next fund" mode. Another reason is that many of these new VC GPs come from other forms of finance, where the power law and concentration are not the keys to building sustained performance.

The other piece though is that there is a norm here that has just become more and more unacceptable in the Valley as competition has heated up. In the Valley, founders don't have the time to spend with people who don't want to lead. So if you don't lead, you ultimately lose access, which causes firms to re-evaluate their strategies.

I point this out for two reasons. The first is purely self-serving: CRV leads rounds. In fact, we only really want to lead rounds, and will fight hard for the companies we want to invest in to build the opportunity to do so. We typically decline to invest in rounds where we cannot lead.

The second is that the lack of leaders means that many founders in NYC just spend a prodigious amount of time fundraising in a way that is ultimately completely useless. I was just talking about a startup here that has already had approaching 100 investor pitches in the last few weeks, and still has not talked to a firm that will actually lead a round. That's just nuts, but where we are today.

If there is a silver lining, it is that the vast majority of investors are pretty transparent on whether they can lead a round or not. It would be great though to see more people become confident in their own abilities, and actually make the bets we are supposed to make rather than trying to build an ETF for startups that will ultimately limit the potential upside of investing in venture in the first place.

Image Credit: Bering Land Bridge National Preserve used under Creative Commons.

Discussion

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