How Power Works in Venture Capital

The other day I was kvetching to my colleague Evan about a top-tier VC firm that has some junior employees who enjoy being trolls on Twitter. “Yeah...” he said, “but you gotta hand it to them, they have seriously impressive returns!”

And it’s true! They’ve made some damn good investments. Even though there’s scant public data to compare their true performance with competitors, the logos in their portfolio are evidence that clearly something impressive is happening there.

But what, exactly?

It’s useful when evaluating any successful business to ask what’s actually impressive, because it helps you locate the mechanism that actually causes success. If you understand this, maybe you can replicate it, rather than cargo-cult the inessential elements.

So what is impressive about top-tier VC firms?

Some people think venture capital is like soccer, where performance is mostly a function of how talented and trained everyone on the team is. They see it as a game where fund managers go on a playing field every day, and the smartest and hardest-working people win the best deals. Sure, some teams are persistently good, but that’s mostly because winning teams attract the best talent, which helps them keep winning. Once the team steps on the field, none of the structural advantages matter. You just have 22 people doing their best.

That’s not how VC works. Venture capital is more like Formula 1 racing, where the structural disparities between teams plays a more active role in determining the results of each race. In F1, as in soccer, winning teams attract winning players, but there’s also an additional important force: race performance depends on both the driver and the car. Even the best driver would rarely win if they were driving an average or below-average car. A huge part of the competition is not just between drivers, but between engineering teams.

The thing is, it costs a ton of money to build a car capable of winning, and some teams have much more money than others. To illustrate the disparity: this year so far, Red Bull has won 7 races, Mercedes has won 4 races, and Alpine has won 1 race—but only because Red Bull’s car was damaged and Mercedes made a rare mistake. There are 7 other teams in F1, but none have won a race yet this year.

Because of this disparity, even though Formula 1 is technically one league, fans view the top, middle, and bottom teams as almost like separate divisions. When someone from the bottom finishes in the midfield, it can be an even more impressive accomplishment than a top team winning.

This is more like how venture capital works. In fact, it’s how any industry works where some firms have significant power (or “defensibility” or “competitive advantage” or “moats” or whatever you want to call them). Winning when you’re powerful isn’t necessarily unimpressive. But it does mean we should be just as impressed with the overall system as we are any one component—including the player. That might sound harsh, but think about it: what’s the point of having power if it doesn’t make it easier to win? As Warren Buffett once said, “If you've got a good enough business, your idiot nephew could run it.”

But that’s enough about power generally. Let’s now focus on Venture Capital specifically. What systems create power for the top firms? How do they work? How can you build them?

Top VC firms have a similar power structure as elite universities, which strategy expert Hamilton Helmer described as “intergenerational network economies.” Startups want the most reputable investors, because their endorsement and support increases their chances of success. The most reputable investors get to select from a pool including the majority of the top startups. Some percentage of those startups go on to become huge successes, and the investor’s reputation is solidified, granting them privileged access to the next generation of startups. Top investors therefore become a kind of Schelling point where the most promising new startups and their potential trading partners (e.g. employees, investors, advisors, acquirers, service providers, and press) can meet.

There are a lot of little sub-loops that help reinforce this power dynamic. People are always interested in top companies, so top VCs get attention in the press, and get invited to speak at any interesting startup event. Average VCs have to buy tickets. People like to get involved with top companies, so top VCs have relationships with a wide variety of rich and powerful figures in business and beyond, which can help startups with hiring and partnerships. Average VCs can’t make those intros. Notice how everything here compounds. Existing relationships make it easier to form new ones. Once you get press, it’s easier to get new press.

All these advantages are compounded by the fact that, generally speaking, more successful investors tend to raise bigger funds, and bigger funds means more money to use to help portfolio companies succeed. This is the model pioneered by a16z and copied by many other firms, typically called having a “platform”. Basically they spend their management fees (typically 2% of fund size per year) to hire staff that helps founders with recruiting, press, and more. But remember, it’s not just the money here that counts: it’s the network effect enabled by attracting counter-parties wanting to work with top startups, and top startups wanting to work with the best counter-parties.

Unfortunately for top VCs, all this power over lower-tier VCs doesn’t translate into limitless bliss. In fact, life is not easy for partners at top VC firms. Just like in Formula 1 racing, it’s incredibly hard to be #1. Maybe if there was just one top firm life would be easy, but there are multiple, and they’re all fiercely competitive with each other. (So no, to answer the question in the subtitle, it is not easy to be Sequoia.)

But that being said, any top firm with a top reputation will have a much easier time staying in the top 10% than it would be for a new firm to get there in the first place. And to fall all the way to the bottom quartile, they’d have to really screw it up.

Speaking of which, you might be wondering, what forces cause top firms to fail? Am I arguing that the current titans of VC will stay that way forever? 

I am not.

One huge limiting factor for VC firm power is that the reputational network effects don't actually live 100% with the firm’s name. They get attributed to the individual partners that make decisions. This is a less powerful position than elite universities enjoy. If the president of Harvard wanted to leave and start a new university, nobody would care. But if a top VC spun out their own firm, founders and LPs would care a lot. Also, even if the top VC didn’t leave, maybe they just retired, some of that network and prestige retires with them. Try as they might, it’s tricky to pass it down to the new partners. I think the reason why Harvard has so much more power than Sequoia is the counter-parties are much more diffuse in Harvard’s case, with much lower information. Students and employers are an extremely broad group and they all already know about Harvard and it would be challenging to teach them about something new, but technology startups and LPs have much more information and it’s easier to get the word out.

Some VC firms account for this by explicitly not trying to be multigenerational. Homebrew, for example, is never taking on new partners, and is doing other things to help seed the next generation of investors. There’s also an increasing trend towards “solo capitalists,” where the person and the firm are one and the same.

Another problem top VCs face is the problem of network effects working against you. When you’re winning, it makes it easier to keep winning. But when you’re losing, word travels fast, and the problem can quickly snowball. If your name becomes a “negative signal” your dealflow can spiral quite quickly. Luckily for VCs, this usually only happens if something really crazy happens, like fraud. You can coast for a while if you don’t do anything actively harmful, like a satellite slowly losing altitude in an unstable orbit.

In reality though, most VCs and firms that gain power tend to keep it. So how does anyone new break in?

It’s hard for me to give advice because I haven’t done it. But my general observation over the past 10 years has been that the new successful VCs tend to be either network-driven or thesis-driven.

Network-driven VCs get great dealflow by virtue of who they know. Or, more precisely, who knows them. Sometimes this means the investor is famous (or Twitter-famous). Sometimes this means the investor simply worked in a hot, fast-growing company and got to know a lot of promising future founders. Either way it’s about relationships.

Thesis-driven VCs make a name for themselves by naming a trend early and owning it. You can do this in an emerging sector with little competition much more easily than something broad like “enterprise saas”. This is essentially a market wedge—similar in principle to Uber starting in SF or Facebook starting at Harvard. It helps to constrain your focus so that you can solve a chicken-and-egg problem inherent in businesses with network effects. One great example of this is my Means of Creation co-host Li Jin, with the creator economy. Over time, successful thesis-driven investors tend to become more broad and opportunistic as they attract dealflow beyond their initial thesis, for the same reasons that Facebook expanded beyond Harvard and Uber expanded beyond San Francisco—to make more money.

But inherently you should know that it’s super hard to build a reputation as a great investor. A lot of things have to go right. You need to identify a theme that will matter before most people see it. You need to become an expert in that space. You need to know lots of great future founders. You need to convince someone to trust you with their money, or have a lot of your own money you can afford to gamble. Then, you need one or two of your companies you bet on to become massively successful. This is how reputations are built. I have massive respect for anyone who manages to do it.

Once you do that, maybe then you too can build a power structure that makes it relatively easy for you to stay in the top 10%. And maybe you too will have junior employees who enjoy being trolls on Twitter, despite owing much of their success to the power structure that you built.

Ahhh, behold! The circle of life!