So, there I was hanging out in Denver airport again, reading the back-and-forth between Ben Horowitz and Fred Wilson on fat versus thin startups. They’re both cats that I respect and I think they both make carefully reasoned, nuanced arguments that have far more depth than a quick summary can articulate.
But all this talk of heft got me thinking about the Body Mass Index; those hip to the BMI calculation know that it's a measure of weight relative to height. Doctors tend to be fans because it's a decent indicator of body fat which correlates with increased risk of morbidity and mortality.
And BMI tends to work pretty well, except when it doesn't. For example, serious athletes tend to have more muscle per unit of height than the rest of us and thus have unusually high BMIs: Arnold Schwarzenegger's BMI clocks in at 33 (the "ideal weight range" runs from 18.5 to 24.9). Even George Clooney clocks in at 29, just shy of the "obese" cutoff of 29.9.
The beauty of muscle, though, is that it's so much more metabolically active than fat. That's why one can be heavy, but fit; the two are not mutually exclusive. And neither, necessarily, are capital efficiency and cash abundance in the startup world. Indeed, while I do find myself more firmly in Fred's "lean" camp, I am sympathetic to the notion that sometimes a
company with a lot of dollars on hand can pivot more quickly as business
conditions change, or scale faster to discourage new
entrants or build competitive advantages
that give them a leg up on existing rivals. Companies can be well-funded but hungry. I get it.
But here's my question: sure, bigger companies can earn bigger exits, but if they burn more cash on the way to a big outcome, isn't it almost inevitable that return multiples will be depressed? Indeed, there can be some positive externalities associated with a big outcome, but as an LP — the money behind the money — what I care most about is multiple on investment. I'm focused on the numerator and the denominator.
And then I started thinking about some of the cleavages of interest that may arise from fatter startups. Most directly, the dollar value of carry to a GP of 2x outcome on a $100 million investment is greater than that of a 5x on $10 million. I know which outcome I would rather have, but I'm not sure that a random GP's answer would be the same. Then you get into non-economic motivations: having big outcomes can help build a brand, almost regardless of the profits. Few people know what multiple Sequoia, for example, generated on Cisco's IPO twenty years ago, It could be a 100x, or it could be a 2x. Most likely, it's somewhere in between, but either way it's an awfully spiffy logo to have on the web page. Entrepreneurs, too, can get a lot of jazz from landing a big round of funding; it's an endorsement of their idea and the vote of confidence that makes for good press releases and generates respect.
Further, aiming to build a large enterprise fundamentally changes a startup's optionality profile. No longer are a wide range of exit scenarios compelling; suddenly, a happy outcome for all becomes limited to one of the handful of large exits that take place in a given year. With expectations of a modest number of IPOs (which I fear is a structural thing,) and a few dozen M&A transactions in excess of $250M, all those fat startups are like so many well-prepped high school seniors looking to land a spot at Top College. It's just tough arithmetic. It may be a fun ride for the entrepreneurs and GPs, but it can be nerve-racking for us LPs at the tail end of the whip.
And the risks are different, as well. "Fatter" startups imply either fewer portfolio investments or larger funds (or perhaps even imbalanced funds where a few large bets compete for GP time with many small ones). None of these are particularly positive outcomes for fund investors.
I could go on, but it would start to stress me out. And one of my sources of stress is that entrepreneurs and GPs are pretty well represented in these discussions, but we LPs tend to be distant observers. Who speaks for us? I wondered out loud. And just at that moment a little man appeared out of the breeze:
[With apologies to Dr. Seuss]
“Mister!” he said with a sawdusty sneeze,
“I am the Lorax. I speak for LPs
I speak for LPs for LPs have no tongues.
And I’m asking you sir, at the top of my lungs” –
He was extremely upset as he warned retribution –
“What’s that THING they have done with our cash contribution?”
“Look, Lorax,” I said, “it's easy to get crotchety.
GPs deploy billions; it sometimes still bothers me.
In fact,” I continued, “some think it’s a lottery.
A lottery whose tickets can be a new social network,
A diversion to give cube-dwellers ways to shuck work.
But it has other uses. No, we’re not out of the woods.
You can use it to serve ads or sell virtual goods.
Or crowdsource a date or find homes in new ‘hoods.”
The Lorax said,
“Sir! You are crazy from drinking the potion.
There is no one on earth who would buy that fool notion!”
But the very next moment we were shown to be wrong.
For, just at that moment, a ‘tween came along.
And she thought that the club we’d just ridiculed was great.
She happily subscribed for thirty-three ninety-eight.
I laughed with the Lorax. “You poor stupid guy!
You never can tell what some people will buy.”
“I repeat,” cried the Lorax,
“I speak for LPs!”
“All GPs are top quartile,” I told him.
“Those marks are a tease.”
Super LP 
HI,
I came to this site by chance. what is GP and LP ?
thx !
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Great post.
Most people have little understanding of nor think of the economics of the underlying investors.
What is interesting for LP’s is that in order to make the most of a fat company – they need to participate equally in the fattening of the company – which is great if the company starts thin and gets fat because they are making progress – but of course given any sort of positive outcome – the later round investments (assuming all up rounds) are going to produce lower returns – but perhaps excellent risk adjusted returns.
On the other hand, thin companies can produce great returns on capital – and great multiples of capital – but with so little capital employed – gross $’s returned are going to be lower.
This debate gets into the question of just how high the returns on the thin winners will be – and just how many winners employers of the thin route will bring.
VC is pretty much a slugging percentage game – and not a batting average game – so what you need as an LP is a slugger who manages to hit it big when they have an opportunity to fatten up a company. Everyone can point to EBAY which was a thing start-up and a huge return – and others – but the more likely case is a much smaller return off a much higher capital base. You hope for a Google – but you get a 3 bagger – that’s the reality if you are lucky.
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Chris,
Agree with the post and enjoy the creative spin. In my experience as a placement agent, I have noticed that very few GPs have any understanding of an LP’s world. This is particularly odd, in my opinion, because the LPs are their customers–and any GP in any segment of the PE market knows how important customers are.
With respect to capital efficiency, one of the biggest issues has to do with the ecology of the world of institutional investors as compared to the ecology of the venture capital world. The VC world has drifted upwards in AUM over time, but there is an upper limit to that process, regardless of whether the GP is committing big bucks or small to any given portfolio company.
This upper limit has as much to do with the structure and function of the VC organization. Venture guys are active investors. Their value-add can be nominal or significant, but each portfolio company takes a lot of time. There is an upper limit to the number of active portfolio companies any venture guy can reasonably handle. This limits the growth of the AUM to some number that’s relatively small in the world of institutional investing.
Even if the small fund of, say, $50 to $100 million is way more efficient with its use of capital, and even if that were shown to be a positive thing for the cash-on-cash multiples, these funds are simply too small to raise capital from many of the most actively allocating (read larger) institutions who do not want to be more than, say 10% of the pool.
On the other side of things, a larger venture fund that approaches, say, $1 billion in size, cannot effectively staff and manage small allocations to innumerable portfolio companies. So the push-pull of the ecologies of both the GP and LP worlds have a lot to do with how investments get sized.
Just my two cents.
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