Exploring the Economics of Large vs. Small VC Funds

It wasn’t too long ago that billion-dollar startups were a rare species in Silicon Valley. Coined in 2013 by Aileen Lee, founder of Cowboy Ventures, the term “unicorn” demonstrated the mystique and rarity of these standout companies —  only 39 existed in the venture ecosystem at the time. Fast-forward over the course of a decade-long ZIRP era where low-interest rates provided a fertile ground for rising multiples, a once sparse herd has now swollen to over 1,300.

The surge in unicorns has been interconnected with the tremendous growth of fund sizes. Over the past decade, startups have raised funds at substantially higher revenue multiples and exited at increasing valuations. And by the time these companies hit the Nasdaq, much of their value had already been captured. Observing this trend, LPs recognized the potential for greater long-term upside by accessing venture-backed companies earlier, leading to increased capital inflows, which fueled larger fund sizes.

From 2013 to Q4 2023, the average VC fund soared from $84 million to a staggering $153.8 million. But as these funds balloon in size, they demand more substantial outcomes, throwing a wrench into the traditional venture model’s return calculus. Here, we delve into the economics of expanding fund sizes, exploring how various fund sizes and their associated strategies impact returns.

The Burden of Size: Exit Imperatives for Larger VC Funds

In venture capital, generating attractive returns largely hinges on getting the ownership math right — and fund size plays a major role in the equation. Smaller funds typically allocate modest checks across a wider array of companies, and by capitalizing on favorable valuations at early stages, they can still secure significant equity stakes at appealing entry points.

Typically, a lead investor’s stake in early-stage rounds ranges between 10% and 25%, with most early-stage investors participating in follow-on rounds to double down on their best investments and combat dilution. This puts them on advantageous footing from a return perspective, as these dynamics pave the way to proportionally large returns at exit for the early investors on the capitalization table.

Conversely, accessing early-stage VC rounds, where single-digit checks can yield double-digit ownership, has historically eluded large VC funds due to the impracticality of sourcing, evaluating, and monitoring enough seed-stage deals to invest the entire reserve of investable capital. Consequently, they primarily focus on Series A and beyond, targeting more established companies with positive signals, higher valuations, and greater probability of a liquidity event.

Increased competition in these rounds drives up prices, exerting downward pressure on returns. Investors entering at Series B and beyond must pinpoint companies with the potential for exceptional growth to justify their entry price. However, only a handful of startups are poised for 100x growth beyond this stage, and this scarcity often triggers fierce competition among investors vying for select companies that can deliver exceptional returns.

Consider a $50 million VC focused on leading seed rounds, investing roughly $3 million into 20 companies for 20% ownership. Even with the fund’s equity stake decreasing to 10-15% in follow-on rounds, a single unicorn exit can yield an outstanding result for the fund on its own.

In larger funds, the economics become more challenging, and firms need multiple unicorns in their portfolio to simply return the capital paid into the fund. Let’s say a $1 billion fund invests $50M into several high-performing companies and can maintain a 15% ownership post-dilution. Even assuming they maintain their ownership position, the fund would need to generate $7 billion in exit outcomes just to return the fund.

Instacart’s array of venture investors serves as a prime example of the challenges that come with larger, later check sizes. Many of the company’s late-stage investors were left with significant paper losses, while early-stage investors realized extraordinary gains. While much of the impact could be attributed to the severe valuation reset in 2021, the trend is still crystal clear that getting ownership on the cap table earlier for less capital can yield massive returns.

Larger Funds Require Significant Exits

All this begs the question: Can venture capital (VC) returns scale alongside the swelling size of funds? It’s a complicated answer, but at a minimum, the math certainly becomes harder. As fund managers continue to raise increasingly larger funds, they still underwrite to the same return — roughly 3-5x. Achieving these TVPI (Total Value to Paid-In Capital) goals with large funds, particularly those surpassing the billion-dollar mark, often necessitates multiple multi-billion dollar exits to make the fund financially viable and move the needle on fund returns.

In 2021, blockbuster IPOs like Airbnb ($100B), DoorDash ($72B), and Snowflake ($33B) made $10 billion-plus exits look easy, with many large funds willing to underwrite that level of outsized return. Today, investors face a much different macroeconomic landscape. Exits are broadly stalled, and stubborn inflation and higher interest rates have compressed multiples, challenging the return prospects of funds that were raised at the height of the frothy valuation market. Further, the managers that successfully raised mega-funds in previous years and backed those blockbuster companies are today experiencing a notable headwind with current fundraising efforts as a result of the cooled market.

However, new venture funds ultimately underwrite to exit volumes a decade (potentially longer) down the line. Looking at the steady growth of exit volumes over the past decade, it could be reasonable to assume that they will follow a similar path moving forward — from 2011 to 2022, median exit values increased by 66%, average exit values have increased by 83%, and importantly, the top 5th percentile exit values rose by 393%. Further, with major paradigm shifts like AI poised to unlock immense economic value, it’s plausible that the exit values witnessed in 2021 could make a resurgence or even become more commonplace.

Exit volume aside, VC managers still need to secure the right ownership to move the needle on fund returns, which objectively becomes more difficult with later rounds. Check out part three of our venture fund size series, where we explore the correlation between venture fund sizes, VC returns, and LP commitments.