Venture capital, as an industry, prides itself on being contrarian. Intuitively, it makes sense why that’s the case. If you’re a venture capitalist, and you fund a company that nobody else wants to invest in, you can own more of the company for the same amount of capital invested. That means that, if that company is successful, you’ll get higher returns.
In practice, though, we don’t see too many venture capitalists being contrarian. The startup world is governed by hype cycles and bubbles, with each bubble spawning well-funded startups that are questionable at least, and fraudulent at worst. In the 2020-2021 crypto bubble, companies like FTX and Celsius raised billions of dollars. In the current AI boom, companies like Stability and Character AI are doing the same. The same can be said for the hype cycles around defense tech and around AI chips.
If VCs are supposedly financially incentivized to be contrarians, why are we seeing so many massive rounds into companies that are more hype than substance? There are a lot of potential explanations, but the one that makes the most sense to me has to do with the maturing startup ecosystem. As startups have stayed private for longer, the goal of investors has shifted. The mark of success for startups is their ability to raise follow-on growth capital. In this new ecosystem, early-stage VCs are successful by investing in companies that growth-stage investors might want to invest in, too.
The growing number of “megafunds” -- venture capital firms with billions of dollars of capital under management -- exacerbates this problem. These large funds can pump so much cash into a company to ensure that it can survive until it reaches some form of exit. With hundreds of millions of dollars in capital raised, these companies can almost always limp their way to an acquisition or an IPO, essentially guaranteeing returns.
To understand how we got here, we first need to go back in time to before this was the case. Let’s look at one of my all-time favorite VC stories: the founding of Micron.
Potato Farms and Silicon
Micron was founded in 1978 as a design consulting company, but in 1981, they moved from consulting to manufacturing with the construction of a DRAM fab in Boise, Idaho. This fab wasn’t funded by venture capital, which was still in its infancy -- Sequoia Capital, one of the first VC firms, had been around for less than a decade. Instead, they raised the money from a wealthy potato farmer named J. R. Simplot. For a million dollars, he got a 40% stake in Micron.
Three years later, the company went public with a market cap of $29.4M. Even with inflation, that’s a smaller valuation than some seed rounds today! And this wasn’t uncommon in early Silicon Valley. Intel went public 3 years after its founding, in 1971, with a market cap of slightly over $8M. A couple decades later, in 1997, Amazon went public in only 3 years after it was founded, having only raised capital from friends, family, and angel investors.
These companies weren’t going public because they were mature, profitable companies that were totally ready to face the judgment of Wall Street investors. They were going public because that was the only way to raise enough money to keep growing. If you were a startup looking to raise a large sum of money, you had to go public, because private investment opportunities were limited. Funding rounds in the tens of millions of dollars were rare, and rounds in the hundreds of millions of dollars were unheard of.
This had a couple of effects on the industry. On one hand, it meant that companies that needed large amounts of capital were harder to start. But importantly, it also meant that venture capitalists made most of their returns after a company went public. Companies might 10x from their initial seed funding to IPO, but if a VC wanted a 100x or 1000x return, their companies would need to succeed on the public market.
In short, in the old days, the actual performance of a company really mattered. VCs were incentivized to find underappreciated companies who were capable of not only going public, but continuing to succeed while public. But in the 2000s and 2010s, that would start to change.
The Modern Startup Ecosystem
The startup ecosystem began to formalize more in the early 2000s. The dot-com boom in the late 1990s brought about the first large “Series B”-style rounds of funding. Webvan, the failed grocery delivery company, raised multiple rounds of capital from major funds like Sequoia and Softbank, totaling over $350M. And the bursting of the dot-com bubble didn’t end this trend. In 2004, eHarmony raised a $110M Series B, and in 2006, Facebook raised a $27.5M Series B. With larger private funding rounds available, startups could stay private for longer, relying on private investment rather than public offerings to raise growth capital. Facebook took 8 years to IPO, and it started a trend of IPOs happening later and later.
At the same time, another trend was forming in the startup ecosystem: formalizing the path startups are supposed to take. Y Combinator was founded in 2005, and with it came the first real playbook for early-stage founders. Early YC companies like Dropbox and AirBnB followed this new playbook, with multiple rounds of private funding between their founding and their IPO.
This was the “new normal”. Silicon Valley had moved past the era of chip companies funded by potato farmers going public in three years. Now, we had giant funding rounds and private growth capital letting companies stay private for years. But the 2010s was where this new model started to show its weaknesses.
The Rise of the Megafund
With startups staying private for longer, it was no longer the case that most returns came once a company was public. Instead, company valuations could increase by 100x while they were still private. At the same time, growth-stage investment became less and less accessible on the public markets. This created a new dynamic in the venture capital industry.
A new kind of fund emerged: large, multi-stage or growth-stage funds, with billions of dollars under management, who were capable of making large, $100M+ growth stage investments. These “megafunds” play the growth capital role that IPOs used to play in the 1970s and 1980s. These investors have lower returns than old seed investors did, but they can do so much more reliably; if a company raises hundreds of millions of dollars, it’s much easier to successfully get acquired or to go public, even if the stock ends up crashing after the IPO.
In the new world, seed investors who write small checks (from $100k to $10M) still exist. But now, they aren’t trying to find companies that can go public. Instead, seed investors are searching for companies that will be appealing to the megafunds. These megafunds are the gatekeepers of growth capital, and so seed investors are forced to focus their investments in areas that might attract follow-on capital later down the line.
Andreessen Horowitz, or a16z, one of the premier megafunds, raised a $300M cryptocurrency fund in 2018, and a second $515M cryptocurrency fund in 2020. With hundreds of millions of dollars in follow-on capital available, seed funding to crypto boomed. It didn’t matter if most of these companies might have questionable business models; as long as they can get to that huge growth round, they’ll get enough capital to limp their way to an IPO or an acquisition.1
This is why VC gets caught up in hype cycles. In the modern era, both seed and growth capital is provided by the same small group of venture capitalists. That means that VCs have to focus on finding companies that will be appealing to other VCs for later stages of funding. In essence, the VC industry isn’t about contrarian views anymore. Modern VC is about consensus.
What Now?
I think it’s important to point out that megafunds aren’t all bad. It’s great that companies are able to build large, complex, capital intensive businesses that might not be ready for the public markets after relatively small amounts of funding. But too many companies are getting massive funding rounds, getting to IPO, and then under-performing. In the years since going public, Docusign has under-performed the S&P 500, and they’re not the only ones.
I think the best way to solve the megafund problem is to embrace alternative sources of capital. Seed investors may be worried about attracting follow-on capital, but government grants aren’t. Debt financing can let startups grow without having to worry about figuring out how to deliver investors a lucrative liquidity event. Specialized venture studios can help startups get much further with less capital by offering engineering support. By combining venture funding with alternative sources of funding, the startup ecosystem can stop worrying so much about what a16z thinks, and start thinking for itself again.
It’s also worth noting that often, this route is good for founders, too. During large growth rounds, founders can sell some of their personal equity to investors, getting some cash in their pockets before the company goes public. For founders of companies who may not be able to withstand the public markets, these “secondary stock sales” represent a way to profit off of their effort. Plus, if a company was publicly traded, founders would have to disclose when they sold shares, which could negatively impact stock price.