Rolling funds: An old frontier
What to make of a revolution in venture capital
February 5, 2020 was a big day in venture capital. AngelList announced a new way to raise capital: the rolling fund.1
The core idea is simple. Instead of a single fundraise establishing a committed capital base, venture capitalists can garner quarterly commitments, giving them fresh capital each quarter to invest. This is a radical departure from how traditional VC firms work.
The biggest rolling funds are actually quite sizeable. Sahil Lavingia, founder of Gumroad, expects to deploy $8 million a year — which is the size of a proper pre-seed fund!
Here is how AngelList itself describes its creation:
Similar to how SAFEs brought high-resolution fundraising to startups, Rolling Venture Funds brings high-resolution fundraising to venture funds. With a Rolling Venture Fund, fund managers can now accept new capital in the form of auto-renewing quarterly commitments.
These are big words! SAFEs were arguably the most important structural innovation in venture in the 2010s. Will rolling funds similarly live up to that comparison and be the transformative structure for venture in the 2020s? That’s the 130 billion dollar question.
So, a week after the anniversary of their launch, let’s review: how should we think about rolling funds?
What are rolling funds?
Rolling funds are based on a single premise: instead of raising a whole fund at once, fund managers can raise the fund one quarter at a time. This is where the “rolling” part comes in: the opportunity to invest comes once a quarter instead of being fixed in time with dedicated close dates and painful roadshows.
Technically, venture capitalist firms raise several venture capital funds — for example, Sequoia Capital will raise Sequoia Fund I, Sequoia Fund II, etc, and formally it is this legal entity that invests.2 The partners at Sequoia spent months (for less famous venture capitalists it can take years) talking to big institutions and convincing them to commit money to the fund,3 and they agree to manage the fund for a contractually defined timeframe. This process is extremely painful and a huge barrier to entry — to be a VC, you might need to be able to sustain yourself without receiving any income for years while you fundraise. And since you have to raise it all at once, if you don’t succeed at raising a huge sum you will not be able to successfully create your fund at all.
The traditional approach introduces three problems:
The fundraising barrier to starting a fund is extremely high
Funds are constrained by the legal mechanisms that enable this particular form
There is a lot of backend complexity to running a fund
Rolling funds solve each one of these problems, creating not one but three value propositions for fund managers:
A new capital structure that allows for much faster and flexible fundraising
A legal structure to accommodate this kind of fundraising
Backend rails to let fund managers invest without building a back office
Rolling funds are entirely managed through AngelList. Fund managers define their closing conditions, like the minimum investment size. Investors can also pre-commit to funding several quarters at once, giving star rolling fund managers something resembling a permanent capital base.
The way this is legally handled is not by a rolling close but a vast proliferation of entities. In other words, each quarter, AngelList creates a new limited partnership to manage that quarter’s commitments. This is necessary because if you invested in Lambda School in Quarter t, you would not want the investors who didn’t take the risk early on to be able to invest in Quarter t+8 and get a share of the returns.4
As you can tell, this creates meaningful administration complexity on top of the existing madness of running a fund. To deal with this, AngelList leveraged its experience with syndicates and funds to create a back office for rolling fund managers. You don’t have to leave their platform: they’ll create the legal entities, hold the committed capital, wire the funds for you, and more. They even have staff to, for example, provide common side letters. This last piece is rarely discussed but it’s essential — if the point of rolling funds is to decrease the overhead of running a fund, reducing the administration to zero through operational experience and technology is a critical piece.5 AngelList already had most of this infrastructure for its fund product and simply repurposed it.
Due to the low capital commitment and flexible investing structure, rolling funds are a sort of scout fund in reverse: a diverse set of investors who can provide support and deal flow to the whole portfolio because they would like to invest but probably couldn’t have met the bite size on their own. Traditionally, scout funds solved this problem by having a big, traditional fund with lots of commitments and contracting with relevant operators, promising some of the returns. Rolling funds also give operators the chance to play under a fund’s banner, but they solve the problem by allowing these same people to pool their money with checks that would be too small to be interesting for a big fundraise — and arguably, this is a little better since it makes the scouts have skin in the game.
By having commitments on a quarterly basis, rolling funds introduce an unprecedented amount of flexibility to VC. Because each fund closes quarterly, new fund managers can start small and build momentum. With the old fund structure this would be impossible because they would have to deploy the old fund, and if they started to see success they wouldn’t be able to capitalize on it quickly because of the cadence of a traditional fundraise. It also means that fund managers could have, for example, seasonal funds (say, a rolling fund manager who only invests in the summers) or take a break and regroup after a rough year or important life event, like a new child or a sick parent.
AngelList is perhaps the perfect firm to have invented rolling funds because they also commoditized the syndicate.6 In fact, you can think of rolling funds as an obvious expansion of syndicates: instead of people banding together over the internet to invest in a single startup, they now band together to invest in a single fund.
Who will this affect most?
Let’s talk about which slices of VC will be most dramatically affected by rolling funds.
The first is micro-VC, which is defined as early-stage VC funds with less than $50m. This is probably the most obvious. The traditional fund route involves a high fixed cost regardless of the dollar amount raised, both fiscal (plane rides add up) and psychic (smaller checks, same boot leather). In exchange for all that pain, you get what, $10 million after a year plus of fundraising? Plus a business structure designed for funds with much larger capital bases? No, thank you. With a rolling fund you can get just as much money, albeit with less certainty for the life of the fund. It makes way more sense at that dollar amount to just take the money as you get it and invest. For example, Cindy Bi, who is a super angel with a strong track record, has sung the praises of rolling funds and the massive increase in speed that they gave her fundraise. That also allows fund managers to establish a track record during the fundraising process, which can grease the wheels for larger, later closes.
The next big group to be transformed is operators. I wrote earlier this year about the rise of operator investors — funnily enough, just a week and a half before the announcement of rolling funds. Founders increasingly want other operators to be their investors. The problem? Operators usually don’t have enough liquidity to invest on their own, and they don’t have the time to raise a proper fund (nor could they; being a current operator is part of their appeal). Because of the flexibility and backend tools of rolling funds, operators don’t have to have the same time commitment they would need if they were running a normal fund too, which means that more operators will have the time to run rolling funds. That said, you already saw bigger founders like Rahul Vohra raising capital before there were rolling funds, so arguably the biggest barrier was the rails AngelList already provided.
And lastly, you have scout funds, which rolling funds will largely replace. Rolling funds aren’t in obvious conflict with the existence of scout funds since, ostensibly, the main function they serve is creating a deal funnel to larger VCs. Maybe so for the funds, but not so for the scouts themselves: their problem is lack of access to capital. Scout funds solve this by giving scouts enough money to invest, but the scale is quite small — 5–10 checks that are tiny and meant to be written at the earliest stages. If the top 300 scouts can raise small rolling funds that give them 2–5x the capital, it’s worth it for the scouts to jump ship. Scouts all want relationships with the top scout funds anyways because their ability to raise next quarter’s rolling fund depends on their ability to say they coinvested with a Tier 1, so scout funds can just keep their relationship with the top rolling fund managers by investing in their funds and remove a lot of their own overhead.7 Scout funds might just be better off becoming rolling fund-of-funds.
Rolling funds create incentive misalignment with follow-on rounds
Rolling funds are an amazing innovation that, as I’ve argued above, will produce a lot of good. That said, rolling funds come with a downside: a longer-term misalignment on follow-on rounds. This will create tensions between rolling GPs and their LPs and affect their ultimate returns.
Typically, the life of a fund is 10 years because it takes that long for the best companies of the fund to mature (which, as Scott Kupor points out in his book, is longer than the typical marriage!).8 During that time, investors need to measure and meaningfully compare the returns to other assets. What really matters is the cash-on-cash returns.9 In other words, when all’s said and done, how much actual money did your LPs make?
How do you get good cash returns? Once you move past the “invest in good companies” part, it’s by doubling down on your winners.10 You need to make sure as many of your dollars as possible are in your winning investments becaise the power law dynamic means that your top portfolio companies will outperform the rest of the portfolio, even at a later stage.11 You can get good returns without doing this, but it’s tough to get great returns without it, and it’s impossible to do so at dollar amounts that matter.12
The core mechanic that creates this problem is that rolling funds exacerbate the dichotomy between fund and firm. Traditional funds have a committed capital base that is full of institutional LPs who are investing lots of money over a long time horizon across several funds run by the same firm. When you have a long-term relationship with the same firm, it is not so problematic to concentrate on a single successful portfolio company, even if it is across funds. In other words, the fund/firm dichotomy matters less. With rolling funds, there is a new fund each quarter, each with a potentially widely different investor base, so that dynamic matters a lot.
Think about it from the perspective of the dollars. When each quarter has a different set of LPs, you want to maximize the performance of each individual dollar in order to incentivize new investors to participate each quarter, which means investments as early as possible to get a great headline that drives subscriptions. But if you are thinking about it from the perspective of a pool of dollars instead, the performance of each individual dollar matters less; what matters is getting as much of the pool as possible into your winning investment.
This can somewhat be mitigated by increasing the subscription term. Instead of quarterly, you may eventually see rolling funds raising for a year at a time. But once you’re talking about 2 year subscription periods you’re raising a fund that isn’t really “rolling” anymore — it’s just a regular, 2–3 years to deploy fund that didn’t have any follow-on reserves. LPs can also precommit to several quarters of funding, but since each quarter is a new LP there’s no way to know how much of it will be going towards follow-on investing. And since there’s total flexibility on the part of LPs, GPs don’t have that much predictability as to the follow-on capital they’ll have in 5–7 years when it’s clear who the big winners are.
There are other issues with the rolling fund dynamic that make it difficult to double down. You can’t guarantee the timing of your fundraise, for one, and you can’t guarantee that your LPs will be around to invest in future rounds. What if you have an amazing investment that doesn’t raise again for a few years so your LPs abandon you? You could also try to raise an SPV, but rolling funds are inherently less private, so you can’t put out a private note without risking jeopardizing the sanctity of the funding round itself, or prioritizing certain LPs, which would violate one’s fiduciary duties. Even superstar rolling fund managers will encounter this problem because even though they will know they can fundraise indefinitely they will not necessarily know the size of the fund each quarter.
We spent a lot of time in previous sections talking about the minimum check size, but in later, competitive rounds the main limitation is actually a maximum check size — the allocation. Good firms not only take their pro rata but are able to get over-allocations at the expense of other investors. With these issues it will be much harder to secure that.
A promising legacy
Venture capitalists often say they won’t fund “lifestyle businesses” that have no real way to scale to large returns — rolling funds actually enable, for the first time, lifestyle funds. They don’t need huge winners to be successful for all involved, and by allowing for an increase in the diversity of fund managers they mean that more lifestyle businesses can be funded too, improving the ecosystem overall.
But for rolling fund managers who want to make it big, they will need to secure follow on capital. It’s basically impossible to become even a hundred millionaire by just cutting a seed check in a unicorn but it’s quite probable if you keep writing follow on checks.13 Due to the follow-on problem, the rolling fund managers who truly want to scale will eventually have to abandon their rolling funds for a more traditional route.
What this means is that the biggest legacy of rolling funds might be as a new, decentralized talent funnel into the biggest funds. We have already seen blogging and tweeting as legitimate means to enter VC by proving that you can pick good startups. Rolling funds take that a step further by having a costlier signal. You actually put capital at risk and have to show that you can actually get into rounds yourself, not just talk about who you might like, without already having to be rich enough to angel invest or needing fancy credentials. There is no theoretically stronger signal, so rolling funds might enable a new class of fund managers to come from anywhere.
That would be an amazing legacy in itself.
Hilariously, AngelList has trademarked the term “rolling fund.” I don’t think it would survive a trademark lawsuit.
Technically, each fund is its own limited partnership. The entity that lives for decades is a management company (in the case of Sequoia, the actual company is Sequoia Capital Operations LLC). The management company has a contractual relationship with a general partner entity that it creates to manage each successive limited partnership.
To add a layer of complication, this money is technically not invested in the fund but committed to it. VCs send out “capital calls” asking investors to submit a portion of their capital commitments every time they make an investment. For big or active funds this can make the financial administration quite complex.
As an interesting technical aside, this means that a rolling fund manager who survives a few years will be technically managing more funds than even many large fund managers.
The cost of starting a fund isn’t just metaphorical. Probably the two biggest expenses are travel and legal fees. A good lawyer will run $250,000 for all the fund formation activities. While AngelList won’t replace your attorney, they do help make things much cheaper.
Syndicates have been around for centuries. But AngelList made it a more standardized asset class for investing in startups.
Scout funds do also provide some mentorship. Many of the best assign each scout to a partner, who reviews the deck with the scout and has to approve the investment. They can still provide this support regardless of the method of funding. There is also a signal to being a scout, but presumably the signal is stronger still if a major scout fund invests in your rolling fund.
This isn’t always true of course. Fred Wilson was the board of Return Path for twenty years!
“Cash” here means “liquid assets” so public stock disbursements post IPO count too.
Here, I’m thinking more of the firm as an institution rather than the performance of a particular fund. If you are an LP and you invested in a fund that invested in the seed round for Stripe, you might not be satisfied with just investing some portion of the fund in Stripe. You will also want to invest through SPVs and maybe a growth fund. This will probably be desirable even if the main fund can eat the investment to avoid concentration risk. But that means that the specific fund that invested in the seed will lose out on some returns even if the firm itself actually increases its performance as a result. For a committed capital base invested across funds this doesn’t matter; for a dispersed capital base it matters a lot.
You can even see this at later stages. In tech, the winners win so big that growth stage investments can outperform early stage investments in winners. For example, if you invested in Zoom’s last private round you made 100x, which is probably more than most successful YCombinator exits.
AngelList has a good research paper suggesting that seed stage funds should broadly index across startup portfolios. While the data suggests that this is a very credible result, what this does not account for is the long tail of startup returns. Under uncertainty at the seed stage, yes, there is an argument to be made for broadly indexing, but at the Series A stage and above when there begins to be clarity as to the winners this falls apart; there is a reason that the best funds reserve a lot of money for follow on. It is also of note that Warren Buffett has something to say about indexing: “Diversification is a protection against ignorance. [It] makes very little sense for those who know what they’re doing.”
In fact, Chris Sacca’s huge wealth originally came from the act that he quietly raised SPVs to buy Twitter secondaries prior to the IPO. In all, his combined funds became the largest outside shareholder of Twitter at their peak, owning more shares than even Jack Dorsey. As far as I know, in modern times only Jason Calacanis has managed to become a hundred millionaire on just angel investing (Uber) along with Elad Gil; the other angels who have achieved extraordinary wealth all became associated with funds with follow on capital, like Cyan Bannister (Founder’s Fund), Alfred Lin (Sequoia), Chamath Palihapitiya (Social Capital), and Naval Ravikant (AngelList).