The VC Trilemma

There exists an impossible trinity or trilemma in the venture capital that hardly anyone talks about, possibly because ever increasing fund sizes equates to ever increasing management fees.

In effect, VCs have only 3 possible options to choose from when making fundamental decisions on how to structure their fund due to the conflicting nature of the consequences of each option. Each option is made up of 2 of 3 points. You can imagine that the VC fund strategy forms the lines of the triangles and the fund manager picks a side to operate along.

Side A: Large Fund Size + Early Stage

VC funds that are large and decide to invest in early stages would end up deploying small checks into a very large and diversified portfolio. Even with larger management fees, the VC manager would struggle to maintain a large enough in-house talent pool to actively support the portfolio. This would generally look like an "index" type pre-seed or seed fund.

The challenge with Side A is that of access. Some funds build a name for prolific investing and startups know that the likelihood of getting a check from that fund is high to the point that access to dealflow is not an issue.

Fund managers should do their best in terms of evaluating opportunities but when strategy dictates to invest in every good deal, they either have a very large and expensive team to spot trends, or they would outsource that to partners in hopes they have the capabilities to do so.

In the former, the fund manager pays out large parts of the economics and the latter, the fund manager will likely not be the one making the investment terms, following a lead investor instead. Finding a balance to that is the challenge.

Side B: Large Fund Size + Active Investor

VC funds that are large and decide to actively support the portfolio would naturally have a more concentrated portfolio and deploying larger checks into each investment. This naturally shifts the investment stages to the growth or late stage where meaningful capital is deployed and enough attention can be paid to each portfolio.

Similar to buyout private equity funds that engage with consultants to "trim the fat" or increase revenues, active investors have their work cut out for them in all their forms. Think of Softbank Vision fund and how they are directly affected by news about a single portfolio company.

This works at the later stages where companies have proven themselves to be able to scale and overcome obstacles such as culture and language differences (in the case of startups in Southeast Asia)

Side C: Early Stage + Active Investor

VC funds that invest at the early stage and decide to actively support the portfolio would be deploying smaller checks into a more concentrated portfolio. The fund size would be much smaller but still provide sufficient management fees to maintain an in-house talent team to evaluate deal flow. support the portfolio and perform fund operations.

This might arguably be the choice with the larger volume of work to be done but also arguably the side with the largest return potential.

The risks of running a fund at Side C is that the thesis entirely misses the mark and the portended trend does not come into existence. That is a risk that fund managers and capital providers would have to weigh out themselves

Closing Thoughts

In our choice of market, Southeast Asia, the startup ecosystems are largely insular due to the differences in language and culture, not forgetting that several countries have large enough domestic markets that startups originating there do not think about international expansion till a much later stage.

Of course, there are other factors that contribute to which side the VC Fund Managers chooses to operate at be it prior experience, ability to raise large funds, access to quality dealflow, network with downstream investors as well as the risk appetite of stakeholders.

Each side comes with it's own sets of challenges and rewards, so to each his own.