Nearly all VC investors have an ownership percentage they are shooting for. For most large funds, it’s 20%. I’ve blogged about the mysterious 20% ownership threshold before.

If it seems arbitrary, that’s because it is. Usually, this ownership number is justified based on what would be considered an ownership that is “meaningful” for a fund. But that logic kind of falls apart when you consider that “meaningful” should be totally relative to fund size.

Here’s what I mean. Take an example of a company that exits for $400M (which is relatively heroic when you consider the vast majority of successful exits are far below this level). If a $200M VC fund has 20% ownership, this exit returns 40% of that VC’s fund. That’s pretty meaningful!  If that same VC were able to produce 5 exits of this scale, that would return 2X on the fund. Pretty good (but funny enough, still not spectacular considering that that is $2B in enterprise value).

But if that same VC is operating out of a $400M fund, those exits are HALF as meaningful. Each $400M exit returns 20% of the fund, and the 5 combined only return a 1X. Obviously, it gets worse or better as the fund size increases or decreases.  You would think then that this would necessitate that larger funds target more ownership, but that ends up not really being the case. Instead, those funds try to invest in companies that can be “bigger”, but at the early stage, it’s hard to differentiate companies that could be $400M exits vs. $1B exits.

The reason that larger funds can’t consistently target more ownership (say, 30%+) is because of competition in the market. There are enough players out there that ownership tends to settle at the 20% range for new series A investors (and often series B investors).

One weapon that large funds do have is more capital. This can be leveraged in a couple ways. First, a larger fund is more able to wait. The thinking goes “if I’m going to only get 20% ownership anyway, why don’t I wait until the next round, and then invest. I might have to invest more ($10-15M instead of $5) but I still get similar ownership and presumably a lot less risk.

The other thing larger funds are able to do is compete more aggressively on the series A by expanding round size. The large fund may say to the founder,” wouldn’t you rather just raise $8M instead of $5M for the same (or marginally more) dilution?” It ends up being a pretty compelling argument. Although cost basis does matter to all investors, in a world where you are probably only going to get 20% ownership, the difference between investing $4, $5, or $6M to get there isn’t that meaningful.

Investors also talk about the concept of “buying up”. This means increasing ownership in a company over time. Again, larger funds are able to do this better by using their capital as a weapon and leading or co-leading later rounds, trying to do super-pro rata in the next round, or buying secondaries. But these situations are pretty hard to predict, so it’s tough for funds to try to do this systematically.

Where “buying up” gets a bit hairy is in the seed to series A rounds. This is why investor signaling is an issue. Almost all large funds are trying to get to 20% ownership, and in truth, they are expecting (hoping) for more than 20% ownership for a company that they seed. But for funds that make smaller, passive bets at the seed stage (eg <$500K) they are likely to have much less ownership than their target. Thus, these funds will need to try to increase ownership significantly to hit their 20% bogey.

For example, if a seed round happens at $5M post money, and the VC invested $500K, that VC owns 10% of the company. This VC now needs to buy an additional 10% at least at the next round to hit their target ownership. This implies:

• If the big VC isn’t trying to buy up, there is a risk that new investors will wonder if there is something about the company that makes it less attractive (negative signaling)
• If you want a new outside VC investor, you will end up with an additional 10% dilution if you are trying to keep everyone happy (assuming other seed investors just want to take their pro-rata or less).

And most VC’s that employ a high-velocity seed strategy invest less than $500K, which amplifies the problem.

Ultimately, companies raise capital from good investors if they are working on a big problem and are showing exceptional progress. The dynamics around VC ownership come into play once a few different investors are interested in a company’s round. But in the final innings of discussions with investors and deal negotiations, I find many entrepreneurs to be pretty surprised at how ownership targets drive the dynamics of the deal. It’s a little arbitrary, but it pays to be thoughtful about this stuff because it can have meaningful downstream implications.