As you might have heard before, fund investors are putting money in a VC fund because they are expecting above-average returns. The very best VCs have returns of their funds well above 20x. However, the larger the fund, the more do fund managers need to be focusing on really high growth startups. Hence, it becomes more difficult for fund managers to make the right decisions while only a very small number of startups actually qualifies.

Josh Kopelman has a nice post on his blog that pretty much summarizes my hypothesis. But what does that mean for you as a startup? Basically, it means that you should be more selective in who you are going to pitch to.

The VC Selection Criteria
Let’s run the numbers on this for the purpose of illustration. Let’s assume a fund has a size of $100 million and runs for 10 years. Should the fund managers expect to return 10% annually, they need to return 100 x (1,10)^10 = 259 = 2.59x. Hence, after 10 years the manager would need to return a total of at least $259 million at the end of the fund’s lifetime.
During its lifetime, the managers think of making 25 investments which means that the average size of investment is $4 million. Since the failure rate for early stage startups is pretty high, let’s assume that only 3 startups will actually become stars, meaning they will greatly outperform. So, actually these three must generate all of the funds returns or on average $ 86.3 million.
In an early-stage fund VCs tend to take something between 20% and 40%–let’s assume that the managers take 30% for the three investments above. In order to return the $86.3 million, each one of the startups need to generate a value of $288 million.

However, should only 2 investments materialize, each one needs to return $129.5 million–for a 30% stake, this means that each needs to create a value of $431 million.

History Shows
So, we have two categories: exit values of $288 million  and $431 million. Let’s have a look at the real world again: during the past 6 years, the number of exits in both categories has shrunk as the following table shows:

What this means for VCs
All of this is what tips the resentment that the VC landscape will change since larger funds will have more trouble making their investments as they need to be hunting for bigger and bigger deals, competing over the big buyers (who are the only one able to spend that much for a startup) for the largest returns and ultimately realizing their promises to their investors. Smaller funds, however, are much more likely to generate their returns as it will be far easier for them to make a sound investment and sell it off to someone for a reasonable price.

The Startup Perspective
So, instead of just sending your business plan to email-overloaded VCs and running the risk of becoming the latest rumor, it is probably wise getting some basic info on the firm you are sending your information to. And make sure you are raising the right amount of money. I am pretty convinced that the times for higher burn-rates and greater sizes in rounds are long gone. So, run your numbers and analyze how much you really need.
But, in general, it is going to be far more important to determine the true value of a VC: integrity, network, knowledge. Ultimately, the question will always be: do I want to have this guy on my board? And if he is, what value is he going to bring to the table? Nevertheless, some metrics will prevail (e.g. when will the fund need to exit).

After all, there are many more reasons, why smaller funds are more likely to be the future of venture capital. Larry Cheng has a (slightly provocative) post, summarizing those aspects. From my perspective this is neither good nor bad for the industry but might indicate where we are heading to: some really huge funds while the vast majority will remain small and focused.