In my post, How Much Capital You Should Raise: Entrepreneur’s Perspective, I described the conflicting incentives that entrepreneurs face when deciding how much money to raise from VCs. VCs also face similar conflicting incentives:

• Minimize portfolio concentration: Venture is an inherently unpredictable business. Markets can change, competitors can crop up and consumer preferences can evolve. This is especially risky for VCs since they never know everything about the companies that they are investing in (entrepreneurs know more about their companies). As a result, VCs are required to develop a diversified portfolio of investments to mitigate their exposure to any single company. This creates an incentive for VCs to minimize their investment in each company, building a large and diverse portfolio.


• Create option value: VCs also have an incentive to minimize the amount of money that they put into a company in each round, as it gives them the opportunity to decide to put the next investment into the company when they know more about the company’s prospect. In theory, if an extreme case developed where the company was no longer viable (let’s say the product became illegal or no longer needed) the VC would have the opportunity to avoid sinking more capital into the company.


• Obtain the opinions of other investors: VCs also have an incentive to minimize their investment in each round, enabling them to have as many other investors in the round as possible. More investors means more smart people looking at the opportunity, providing insight, reducing the odds that the investor is making a bad bet.


• Increase resources and knowledge of the board: By reducing their investment a VC can increase the number of investors in the round. A company with more investors typically has access to a larger sounding board, more ideas and a bigger aggregate rolodex.


• Maximize dollars invested for time invested: However, in contrast to the four incentives listed above, VCs have an incentive to put as much capital into a good company as possible. The amount of time that a VC spends conducting due diligence on each potential investment and working with each portfolio company is significant. As a result, to get the most value out of the time it took to find and research the company VCs have an incentive to maximize the amount of capital that they put into each company that they think is a winner. If they don’t put a decent amount of capital into each company that they like they will have to do more due diligence and sit on more boards to invest their entire fund.


• Maximize total return from each investment: Once a VC has identified a company that they think is a winner they have an incentive to put more capital into the company in order to increase the total return generated by that company.

In sum, like an entrepreneur a VC also faces conflicting incentives when figuring out how much money to invest in each round. These incentives are also weighed against the concerns that the entrepreneur faces (e.g., VCs don’t want them to spend all of their time raising money).

While both entrepreneurs and investors face numerous conflicting challenges good VCs who have substantial experience and understand the importance of building a strong reputation by doing right by people generally have a sense for reasonable round sizes. In my experience VCs often leverage this knowledge and help entrepreneurs figure out a reasonable round size.