Small but mighty versus the land of giants: The business model of small funds versus larger venture funds
by Samir Kaji, Allocate CEO & Co-Founder
LPs have correctly concluded small VC funds have the potential to drive higher top-end returns when compared to large VC funds, particularly when evaluating the upside case for cash on cash returns.
Unequivocally, the math is more straightforward for a substantial investment multiple in a small fund, given the impact a single outlier company exit will generally have. As such, many LPs have eschewed larger funds completely (even with access) as part of their venture construction.
Of course, like any investment, the potential of a top-end return does not guarantee it, and risk must be carefully assessed to determine the appropriate mix of fund types for a specific LP.
Large and small funds can coexist and have unique places in the ecosystem, but they serve fundamentally different products with very different risk/return profiles. Very few investors would compare Blackstone or Carlyle in private equity against a small, lower-middle market manager. In venture, a $50MM fund should not be compared to a $500MM fund.
There is an old saying in venture capital that refers to the fund size being the firm’s business model. Let’s evaluate this through an example:
Fund A:
$100M Seed Fund (30 investments, 60% of fund for initial investments, and 40% held for reserves to provide follow-on financing to a subset of the portfolio).
The business model for this type of fund is generally to maximize initial ownership at seed and then maintain or increase ownership in one more round of capital for a given company. Data from Primary Ventures shows that about 30%- 40% of seed-funded companies progress to Series A, but only around 15% reach a Series C (meaning that by Series C, the seed fund may have 4-8 positions left).
• Average seed check: $1.5M for 10% ownership.
• Follow-on: 10-15 companies at Series A.
• By Series C: 5-6 companies may still be active (others have either exited or failed)
• With minimal dilution (ideally less than 50% from inception to exit), a $1B exit for a VC with a 5% ownership position at exit (initial $1.5M seed + $2M Series A with 50% dilution) yields $50M, or ~15x on the investment, 0.5x of the fund.
Fund B:
$800M Early Stage Fund (30 investments, 65% reserves).
For larger funds, core positions typically start at Series A, with ongoing investment to maintain or increase ownership through multiple rounds of each company. The theory is that follow-ons at the mid-growth stage should come with less risk and shorter times to liquidity for LPs but also bring lower return multiples.
• Average Series A check: $12M for 15% ownership.
• Follow-on: Multiple rounds to maintain ownership.
• By Series C: 10-12 companies still active
• In a $1B exit where the VC maintains 15% ownership (initial $12M Series A + $17M total in B/C rounds to maintain ownership), the return is $150M (~5x on investment, 0.2x of the fund). Thus, larger funds must aim for substantial outcomes given that the cost-dollar averages up and typically requires $5B+ exits to return the fund. This is why many larger funds have become more active in seed (larger return on initial check + more shots at goal). By definition, firms that raise larger funds tend to be those with robust brands, teams, and histories, which generally provide them with an advantage of sourcing and winning deals (but the competitive forces are far greater than at seed, where many seed funds can syndicate with one another and get their necessary ownership).
In summary, the products are very different, with different business models. Our data supports that smaller funds come with significantly more risk/volatility but have produced higher top-end returns when successful (top 10-20% of funds), while larger funds present a tighter band of returns, with less range and deviation on the upside/downside.
Investors' risk tolerance and return expectations need to be assessed to determine what type or combination of fund types is right for them.