Early Stage VC Incentives
Humans are addicted to short feedback loops. Make a post, and get likes. Air-ball a shot, try to adjust your shooting motion slightly on the next one.
But not everything can have a desirable, super short feedback loop. Think about parenting. It's hard to measure, and the measurement timeframe spans a lifetime. But, short loops are addicting. Naturally, humans look for proxies to shorten this loop. Grades in school, college admissions, and good jobs are all proxies parents could use as feedback on their parenting.
Venture capital suffers similarly from the blight of agonizingly long feedback cycles. Invest in a company and then wait 10-15 years to determine if it is a good investment. If you invest over 3-5 years, you have signed up for a 15-20-year journey to answer a basic question - "Am I any good at doing the job that I do?"
Naturally, this is a problem. Humans are not wired for this. Also, if a windfall isn't coming for 20 years, investors must keep investing to get normal-sized paychecks until the big payday arrives. Usually, that means reaching out to smart LPs and raising another fund.
Now, you are a human seed fund manager trying to convince LPs to send you a check, without ever having proven to send a check back. You could introduce a measurable proxy as an indicator of performance. Enter TVPI. The most addictive short-term feedback loop for early-stage VCs. Simply, paper gains. On paper, my investment is worth 3x, 10x, 100x based on the most recent valuation. It's not cash yet, but it probably will be in the future. All fund managers, especially managers in Fund I-III are raising on TVPI.
Invest in a company. The next round happens at a much higher valuation. The first investor marks the investment up 5-10x on paper. The market rewards them with more money to invest and more management fees. Yes, it's possible the company never becomes profitable or goes out of business a few years later. Yes, if this happens too often, LPs might stop investing in the fund. But that is 15 years from now. Until then, I get an extra 3-4 funds (and associated management fees). Plus, I get more at-bats, one of those might turn into a real grand slam.
Now, my intent isn't to frame these incentives in a "holier-than-thou" way. I am also addicted to TVPI. Hard not to be in this business. This addiction is stronger the longer the hold period. Public market investors have the shortest feedback loop - daily stock price. Late stage / PE are usually in 3-5 year hold periods. They rely a little on TVPI but usually have real DPI every other year to show real returns. Growth / multi-stage investors are in 5-8-year hold periods and rely on TVPI. Now think about seed and pre-seed. While the best funds in this category usually have insane DPIs in the long run, they are basically in the TVPI business for the first decade of their existence.
This context is necessary to understand motivations and incentives in your boardroom. Your earliest-stage investors (non-angel) are trying to maximize TVPI. They might set unrealistic expectations for valuations and push to raise at the highest price - makes sense that helps them raise money. Sometimes this will be divorced from the reality of the market. Founders are playing a similar game but with a few key differences. Yes - they also have 10-15 years before an exit (and a windfall). Yes - they would also love a short-term proxy and valuation is an ideal one to try to maximize in the short term. But founders are taking all the risk. The market might not accept their valuation expectation. Growing into the valuation might take too long. Employees might get inflated stock options that never materialize. Investors have 10-15 other companies in their portfolio to make up the difference in TVPI, founders and employees have one.
Investors pushing for a lower valuation have their own incentives. A lower entry price means a higher likelihood of better TVPI and DPI. The best founders nail their capital strategy by deeply understanding varying incentives. Finding the Goldilocks zone - getting close to the local maxima, without jeopardizing the global maxima over the company's lifecycle. Easier said than done, but it's just biology.