Epistula #9: Heroic Assumptions vs. Heroic Outcomes
Building impactful outcomes through pragmatic venture strategies.
In venture capital, people often say that one’s fund size is one’s strategy. Typically, GPs raise as much capital as possible, then figure out how to deploy it – backwards, if you ask us. Here at Deciens, we flip this model on its head. Instead, we start with how to generate optimal returns with a set amount of capital, and only then do we consider raising it. But this begs a crucial question: what assumptions should we make to reach our targets?
This leads us to today’s topic: heroic assumptions and heroic outcomes.
A New Model for Fund Strategy: Building from Assumptions
When a GP prepares to raise a venture capital fund, they (should) design a fund model. Like all models, it will be inaccurate as soon as it is completed – because models are built on a set of simplifying assumptions and are, therefore, definitionally inaccurate. But it’s not about the accuracy. It's about the practice of planning, which should require the creators to come to grips with their own implicit and explicit assumptions. What they assume or not, make explicit or not, and optimize or not, reflects on the organization and its people.
We believe, without any irony or hyperbole, that a firm’s model should reflect the hopes, aspirations, and values of the GP guiding the firm, raising funds, and ultimately generating returns. We periodically refresh our model to ensure this alignment, and our recent refresh for Fund 3 sharpened our focus on both the rewards we seek and the risks we want or need. Implicit in this understanding of risk and reward is a set of assumptions.
As a team, we identified the need to:
Define which assumptions are heroic vs non-heroic;
Remove heroic assumptions from our financial, operational, and mental models or, where they remain, make them explicit and underwrite them with appropriate risk adjustments; and
Build a strategy to achieve heroic outcomes – such as funds consistently >5x+ net MOIC and 25%+ net IRR returns – without relying on heroic assumptions.
Another part of this exercise is developing a clear perspective on which assumptions – heroic or not – we can reasonably underwrite based on our unique capabilities. We want to lean into those assumptions where we have differentiated competency and away from those where we do not. We think that in building out a set of assumptions needed to meet a fund’s goals, intellectual honesty is key, and we need to have a clear-eyed understanding of our circle of competence. This is doubly true for the many things outside of any venture firm’s control.
Re-Evaluating Macroeconomic Assumptions
I want to focus on one category of assumption that we find particularly hard to justify being heroic about: the future state of the macroeconomic environment. I joke that macroeconomists are the only highly paid professionals less accurate than meteorologists. Yet most venture firms explicitly or implicitly take strong stances on many long-dated macroeconomic topics. And some do so in extremely heroic ways. It's odd to us that venture funds are acting as if they are highly effective long-term macro investors. And even odder is that LPs seem to either not recognize it or, worse from our perspective, not care.
Let’s look at three macro-related assumptions that often affect fund strategies: exit size, exit timing, and capital availability. We’ll dive into how we think about each and how we factor these assumptions into our process.
The Risk of Assuming Large Exits
One heroic assumption we see frequently is an expectation of enormous exits. Of course, as venture capitalists, we want our companies to go after (or create) the largest markets. But, empirically, there are very few $10B companies and even fewer $100B ones. Needing a company to have a once-in-a-generation outcome for a fund’s model to “work” is a heroic assumption. Needing $10B of enterprise value to be created out of thin air to have even modest returns seems like a recipe for disappointment. You’ve set yourself up for failure before the ink is even dry. Yet this is the norm. Along the way, the incentives and behaviors that come with needing heroic outcomes create a lot of suboptimal behavior that perpetuates the hamster wheel.
Assuming an exit will be large is problematic, in part, because the size of an exit at any given time is associated with the macro-environment at the time of exit. We invest in early-stage companies, which typically exit in 10-15 years. Believing that we can have any insight into the exit conditions at the end of a company’s journey is foolish, and we should be intellectually honest enough to admit as much. At best, we can assess if the current market is big or small and make educated guesses as to whether the market is likely to increase in size, decrease in size, or remain static.
The 15 years from 2007-2022 were anomalous. The zero-interest-rate environment inflated the size of exits, and they will contract as rates normalize. Yet, the idea that you can generate heroic returns without heroic exits seems absent from today’s discourse. We, on the other hand, would rather build an operating model that gets to heroic outcomes with more modest expectations of exit size.
Simply put, if you own 5% of a company in a $100 million early-stage fund, you need a $2 billion exit just to return the fund, or $10 billion in exits to create a 5x fund. With our approach, a $600 million exit returns the fund, and adding one $2.5 billion exit gets us to 5x. Although our investments target the same extraordinary outcomes, one relies on heroic assumptions to get there, and the other creates the potential for significant upside should we secure a heroic outcome.
Unrealistic Timelines: The Challenge of Exit Timing
Another common heroic assumption in venture capital is timing the exit. VC firms seem to think that they have agency in when a portfolio company can, will, or should exit. In our experience, VC firms rarely have any substantive agency in this process. This is especially true as the relationship between investors and founders has become more “founder friendly.” Founders, should they be in the fortunate position to have a bona fide offer on their company, are almost always in the driver's seat. Relatedly, because they erroneously believe that they have a deep understanding of M&A and IPO markets, VCs have given their LPs deeply flawed expectations for liquidity. In doing so, they have soured LPs on the asset class.
It is hard to predict what the M&A market will be on a rolling four-week basis, let alone next year. Secondary markets are fickle, rarely giving sellers pricing they are excited about when they want or need to exit a position. Buyers of all stripes, after all, need to generate returns for their stakeholders, too. Getting all the variables to line up is extremely hard and almost impossible to predict.
Again, we preach appropriate intellectual honesty. We are happy to sell any position in our portfolios on any day, at the right price, and on the right terms. At the same time, we do not know when or if companies will be able to sell themselves in whole or in part, on good or bad terms, at great or terrible prices. Selling requires willing buyers of our shares and of our companies. We have little to no agency over when, where, and how a willing buyer will come to the table.
Given the immense scale of what we do not know and most certainly do not control involving liquidity timing, we focus on what we do know and can control. We know that fast-growing, profitable (or, at least, break-even) companies control their own destiny. They never need to be sold, so they can patiently wait for the alchemy. We know there is a ready universe of buyers in the world of private equity sponsors. We also know that these companies can generate liquidity without needing to find a ready and willing buyer through dividends and dividend recapitalizations.
Instead of making extremely heroic assumptions about when and how a company will be sold, we’d rather the company just take matters into its own hands and create real and option value for its stakeholders whereby any of the above are options available to founders. Founders can then choose what is the best path for them while managing the liquidity needs of their investors.
The Myth of Ever-Present Capital
One last heroic assumption many firms rely on is the continuous availability of capital. In particular, they believe that capital will always be available. That is true for their own firms and for follow-on into their portfolio companies. And it is true across the capital structure, without regard to the quality of the underlying portfolio company, its prospects, or its ability to put capital to work in highly productive ways. And it is true in how they advise and incentivize their portfolio companies and management teams.
Believing capital will always be available is a heroic assumption and deeply wishful thinking. There are times when capital is simply not there, such as during and after the global financial crisis when all capital markets were shut. There are also times, like now, when venture capital (rightly or wrongly) falls out of favor with asset allocators. And within venture capital, capital ebbs and flows by sub-sector. Certain themes are hot (AI today, fintech in 2021, crypto in 2017) and attract the lion's share of the capital, starving the rest of the market. Consistent, smooth, easy access to capital markets for all companies, whether they are deserving or not, does not comport with even a cursory understanding of the history and facts.
We continue to advocate for a position of greater modesty. Operate as if capital markets will be shut exactly when a critical capital raise is afoot. Organize companies to exploit feasts and endure famines. Companies will invariably face both over the long period required to build and scale, and to believe otherwise is foolish. Conversely, operating as we advocate creates valuable optionality while avoiding the dreaded existential financing risk.
Additionally, GPs who believe that capital will always be available develop assumptions related to dilution. In a world with plentiful capital, many dilutive financings become easy to justify, the default, the norm. This is especially true for VCs with only one tool in their toolbox – equity capital. We, however, believe a financing round should be the exception. We want to fund companies that do not require many financings, regardless of how dilutive they are – companies that can compound LP capital quickly and with maximal capital efficiency.
Closing Thoughts: Controlling What We Can
We prefer to take a conservative approach, grounding our strategies in easily justified assumptions rather than reaching for heroic ones. While we’re always ready to invest additional capital in our highest-performing portfolio companies at favorable terms, we also bring value in other ways – such as leveraging strong lending relationships and providing a broad range of human capital investments that our team contributes daily.
If your strategy depends on rare, perfectly timed events, it’s difficult to see how you can rest easy. Our approach is different. We emphasize what’s within our control and influence: making modest assumptions about the macro environment that can yield great outcomes in both frothy and demure markets. By equipping founders with diverse capital structures and flexible exit pathways, we build resilience and drive meaningful value. This approach is not only what sets Deciens apart but also what positions us to deliver great outcomes for our stakeholders.
