Small funds are in a better place to invest in new markets

By September 3, 2015Venture Capital

In a post yesterday VC Rob Go correctly identified that one of the most common reasons investors pass on investments is some version of “it’s not big enough”. He’s dead right. Most good VCs have a strong discipline of only making investments that can return their fund and that rules out a lot of potential investments.

If a VC has a $200m fund, a 20% stake in a $1bn exit will net them $200m and hence be a fund returner. $200m funds, therefore, should only invest in companies they believe are in markets large enough to sustain companies with an enterprise value of $1bn (assuming they will average 20% stakes at exit).

With the same assumptions $50m funds can invest in markets they have confidence can sustain $250m exits.

When new markets first emerge they are highly speculative with little to no evidence for investors to go on. Then over time evidence accumulates. First there’s enough to be sure there’s a tiny market, then a small, one and so on, until, assuming the best, several $100m+ revenue companies have emerged and all analysts everywhere agree the market is huge.

Small funds are able to take bets earlier in this process and are hence best placed to invest in emerging markets.


That’s why at Forward Partners we have kept our fund size small ($50m). We invest at concept stage when there’s often very little to go on with regard to market size and, just like Rob says, insufficient confidence in the scale of the opportunity is one of the most common reasons we pass. If our fund was any bigger we’d have to pass on even more deals.

When assessing opportunity size we actually look for two things. Firstly that there’s reasonable grounds to believe the opportunity is large enough to return our fund, and secondly there’s a chance that the opportunity will turn out to be much larger. Then we hope that as the evidence accumulates it will become clear that the company has the potential not just to return our fund, but to return a multiple of our fund.

  • alexanderjarvis

    I wonder a lot about how many VCs have truly internalized the implications of this.
    I do however know that startups find how the economics of VCs work as a revelation.
    One question, which I ponder in light of a past pitch I am still discussing with founders is, is do small VCs have the risk ability to back very ballsy ideas from inception that will require a lot of capital to scale therafter. Likely not, which is why ‘capital efficient’ is thrown around a lot. Occasionally something crazy comes along which could be huge, but requires a real leap of faith…

  • Rmicals

    I’ve always found this maths bizarre. If you’ve got a smaller fund you size your stake accordingly not your potential return. Why do you want 20% of a smaller company. Why not have 5% of a truly outstanding opportunity and fight for those deals. If you’re early stage and taking anything over 15% of a company you’ve probably killed the chances of it scaling massively as well as the entrepreneur will have little left to give and smart investors will think he hasn’t got enough skin in the game.

  • This comes back to the point we always differ on, namely how much entrepreneurs and investors should focus on big binary bets.

    To your questions, obviously we are indifferent to whether we have 20% is a smaller company or 5% of one 4x larger. But if you have 20% and then the business grows 4x from there then we’ve really won.

    It’s obviously critical that founders retain enough of the upside to stay interested, but I haven’t seen the effect you describe kicking in if early stage investors take 15%. Far from it.

  • Rmicals

    So I’m coming from the angle that it’s worth losing the obsession with fund returners and focus relentlessly on the upside instead. So this might mean taking 2% of a really early stage startup with a huge idea and high valuation and you layout a similar stake as you would for your 20% company. I disagree with vcs asking ‘will I be right or return my fund?’ and prefer the vcs who ask ‘what if I’m right?’. Most of these bets are binary anyway whether you like it or not. I feel the great vcs want you to convince them that you can show them the future and the others just want to see traction. Maybe one day we can chat at length about this! But I feel this discussion always digresses from the real issue which is the UK has the potential to have a Facebook or Twitter but the risk aversion kills it.

  • That’s true. Some ideas require a lot of capital up front and there’s nothing to be done about that. That accounts for a smaller and smaller percentage of startups though.