Cutting Through the Fog: The Brutal Economics and Hidden Psychology Driving Your VC

Welcome to “Coordinated with Fredrik.” We often talk about the strategies founders need to deploy to win funding, but today, we are turning the tables. We are deconstructing the individual Venture Capitalist—the person sitting across the table—to understand the economic “machine” they operate within. The core truth is this: a VC’s behavior, which often appears baffling or “irrational” to outsiders, is a direct, rational response to the structural and financial incentives that govern their existence.The VC’s 10-Year Clock and the Power Law TyrannyEvery decision a VC makes is governed by a defined fund lifespan, typically a closed-end investment vehicle of 7 to 12 years. This “10-year clock” is non-negotiable and fundamentally shifts a VC’s personality and risk profile depending on the fund’s current phase.1. The Investment Period (Years 1-4): This is the “hunting” season where the VC is optimistic and eager to deploy capital, actively “build[ing] the portfolio”. They can underwrite a 10-year vision for a company to mature.2. The Management & Harvest Period (Years 5-10): The focus shifts entirely to managing, supporting, and exiting existing investments to return capital to LPs. A founder pitching in Year 7 of the fund is meeting a “farmer” or “mortician” who cannot make a new investment requiring another decade to mature. They prioritize speed over strategy for their current portfolio.The financial structure is the notorious “2 and 20” model. The “2” is the management fee (typically 1% to 2.5% of committed capital), which serves as the firm’s “salary” to cover operational costs and salaries. The “20” (carried interest, or “Carry”) is the “real payday”—a 20% share of the fund’s profits that General Partners (GPs) keep. Critically, this carry is only paid after the fund returns 100% of the initial capital to its LPs.This compensation structure creates the “Tyranny of the Power Law”. Because VCs must return the entire fund before seeing a dollar of profit, they are mathematically forced to find “really. large. exits.”. A $50 million acquisition might thrill a founder, but for a VC managing a $100 million fund, that profit is a “drop in the bucket”. They need one or two companies to return $100 million, $500 million, or even $1 billion to “return the entire fund” by themselves. This forces VCs into an “all-or-nothing” or “growth-at-all-costs” mindset. A stable, profitable, $50 million-revenue business is often considered a “zombie” because it doesn’t fit the Power Law. VCs are incentivized to push founders to take massive, company-ending risks to become a $1 billion “unicorn”.The Partnership Hierarchy: From Analyst to GPThe VC firm is a rigid hierarchy, and where an individual sits on this ladder dictates their job and incentives.• Junior Staff (Analysts/Associates): These entry-level roles are paid primarily from the management fee (the “2”). Their job is a “50-60 hours per week” grind of “screening pitch decks,” “deal sourcing,” and meticulous CRM updates. The role is often an “up-or-out” 2-3 year position, functioning as high-energy, low-cost labor to “filter signal from noise” for partners. Most junior VCs never see carry.• Partners (GPs): General Partners receive the “lion’s share of the carry”. Their primary responsibilities shift entirely away from analysis to fundraising from LPs, making final investment decisions, and taking board seats. For these senior partners, their entire financial motivation is the large, leveraged bet on the 20% carry, which will only pay off 8 to 12 years in the future, if at all. They often make low base salaries relative to their potential carry, with their own “capital commit” (1-3% of the fund) showing LPs they have “skin in the game”.The “black box” of the partner meeting, where a founder’s fate is decided, reveals internal politics are intense. The decision often boils down to the “point partner” (the founder’s internal champion) successfully arguing against colleagues in a “Real Decision-Making Arena”. This internal political debate is crucial, as illustrated by the recent dynamics at Sequoia Capital, where strategic misalignment and cultural failures led to leadership change, emphasizing that founders are pitching a specific partner who must then win an internal debate.Sourcing, Bias, and the FOMO-FOLS DyadVCs are obsessed with “proprietary deal flow”—deals sourced directly that are “less competitive” and usually mean “better terms”. However, deal flow is overwhelmingly driven by “Relationships”, with around 60% of VC deals originating from an investor’s personal network or referrals. This network-first approach, while an “efficiency play”, is the “primary engine of systemic bias in the industry”. If a VC’s network is homogenous, their pre-vetted deal flow will be equally homogenous.When evaluating nascent early-stage companies where there are “no concrete financial metrics”, VCs rely on heuristics and pattern-matching. Team is consistently the most critical factor, often cited as 95% of the decision at the seed stage. With little data, evaluation defaults to “gut feelings”, seeking “representativeness” (does this founder look and sound like a previous winner?). This reliance on “gut feel” is often a euphemism for “similarity bias” and perpetuates exclusion, which is why companies founded solely by women receive only 2% of all VC investment.To mitigate this bias, influential VCs like Mark Suster advocate to “Invest in Lines, Not Dots”. A “dot” is a single pitch meeting driven by “limited thought, limited due diligence”. A “line” is a “pattern of progress” observed over time, where a VC meets the entrepreneur early and watches their performance over 15 meetings or two years. This approach replaces biased gut feeling with observed data on the founder’s “tenacity” and “resiliency”.The internal decision to invest is a tug-of-war between two primal psychological fears:1. FOMO (Fear of Missing Out): The VC’s “biggest fear,” driven by regret over passing on a company that became a “really. large. exit.”. This drives VCs to invest.2. FOLS (Fear of Looking Stupid): The “avoidance of scrutiny,” driven by the fear of LPs questioning a bad investment. This drives VCs to say no.A founder successfully raises capital when they manufacture more FOMO than FOLS, often by showing the VC that other investors are interested, triggering a “bandwagon” effect and herd mentality.The Rise of the Solo GPThe traditional VC firm model is being challenged by the rise of the Solo General Partner (Solo GP). These are single individuals who raise a fund and make unilateral investment decisions. Their advantages are speed and flexibility (”a motorcycle” that weaves through traffic while larger firms are “18-wheelers”). Many Solo GPs leverage personal brands and expertise—like Aarthi Ramamurthy (Schema Ventures) who uses her podcast as a sourcing engine, or Marc Cohen (Unbundled VC) who “build[s] in public”. This new guard is competing on transparency and personal brand rather than the Assets Under Management (AUM) and management fees of the old guard.The truth remains that the job of a VC is a “tough business”, requiring patience (carry takes a decade to realize), relentless networking, and the painful necessity of turning away 98 out of 100 opportunities.The Zombie Trap: Managing FailureThe founder-VC relationship, particularly after the check is wired and a VC takes a board seat, is where the Power Law is brutally enforced. High valuations create expectations for matching performance, leading to intense pressure to pursue “growth metrics over unit economics”. If a company doesn’t fail but also doesn’t “go big,” it enters the “VC Zombie Trap”.A “zombie startup” is profitable and growing, perhaps 20% a year, but will never provide the 100x return the VC needs. VCs are incentivized to kill their zombies because they cannot waste time, energy, or “remaining capital” on a company that won’t “return the fund”. This is a “feature and not a bug of the power-law driven venture capital system”.The candid reality, as noted by Fred Wilson, is that aggregate VC returns are often “disappointing,” sometimes underperforming the NASDAQ. VCs are forced to be optimistic hunters, yet their job is a massive, leveraged bet that only pays off, if at all, years down the line.--------------------------------------------------------------------------------The mechanisms VCs use to cut through the noise—reliance on networks, pattern-matching, and the psychological battle between FOMO and FOLS—are also the mechanisms that introduce bias and structural rigidities into the ecosystem. What does this mean for the future of capital deployment?We have detailed how the VC machine operates, but the conversation doesn’t stop here. If you want to dive deeper into the tactics founders use to navigate the partner meeting “black box,” the specific “unwritten rules” of the VC ecosystem (like the “frieNDA”), or how the new wave of Solo GPs is disrupting this status quo, let us know! This is a public episode. If you would like to discuss this with other subscribers or get access to bonus episodes, visit frahlg.substack.com

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