Two friends independently pinged me for my reaction to two recent social posts while I was on vacation, and I felt so strongly about the below that I had to:
- Respond to both of my friends while I was out, and
- Write this blogpost after.
Caveat: I don’t tend to write time-and-place ephemeral blogposts, usually evergreen ones, but I feel this topic has been the soup du jour for the last few months, and I need to get it off my chest. I still think a lot of what I write below will stand the test of time, but some parts may not age as well five years from now.
One friend of mine who runs her family office texted me last week and asked what I thought about Harry Stebbings’ recent tweet and Jason Lemkin’s recent comment:
To which, I responded:
I agree with most of what’s said. 99% of people don’t truly understand venture. They see one of two polar extremes. Either it’s the thing that will make them rich and it’s all amazing or it’s overhyped and way too risky. They’re both right and wrong at the same time. In the context of those investing in VC funds, most individuals and new LPs see venture through rose-tinted lens.
That said, what the world needs isn’t ‘do this’ or ‘don’t do this,’ but why and how. That requires education. Not an oversimplification of ‘VC good’ or ‘VC bad.’ There’s a lack of unbiased education right now, but public discussions of such is step one. We need to put illiquidity into perspective. Yes, it’s 17+ years. That’s 4, going on 5, Summer Olympics. Or one and a half zodiacs. That’s another 2-4 American presidents. And that’s over 50 Marvel movies and 34+ Marvel TV series, assuming they stay on pace with what they’ve been putting out in the last 2 years. That’s a long frickin’ time. Time enough for you to have a baby AND send them off to college before you get all the money gained back.
Illiquidity is also at an all-time high. Lots of funds are long in the tooth. LP expectations used to be 10+2. Fancy lingo for 10-year funds with 2-year extensions, opportunistically. Now that companies are staying private for 10-12 years, instead of the old 7-8 years, funds are now 10+2+2. In other words, 10-year funds, with a 2-year extension by GP decision, and another 2 years by LP advisory committee majority vote. But really, it’s starting to become 10+2+2+1+… You can guess where the rest of the numbers come from.
Secondaries are only really popular among the marquee names. For instance, SpaceX, Anduril, Stripe, and so on as of now. Everything else is sold at a discount. Which, 30-50% seem normal. But if a company has raised their last round pre-2021, I’ve seen 60-80% discounts.
GPs are also now expected to actively understand and manage exits. Most GPs don’t know how to. And neither are exits in venture a classically-trained subject. Before it was primarily, IPOs and M&As. Now, this includes secondaries. Ask GPs about their exit strategies. It doesn’t have to be foolproof, but they better have thought of it. And compare what they say to what their best-in-class private equity counterparts say. If there’s a lack of intentionality in the former, things may get really tough in the future.
Venture, sure as hell, is opaque. 75% of VC managers will tell you their top quartile. Who’s right? Who’s wrong? Samir Kaji recently wrote something that rings increasingly true today: “People forget that quartile rankings in VC never account or adjust for valuation methodologies used by the Gps in the sample set.”
Some GPs are liberal with their marks. Marks that put them in the best light. Some even accounting SAFEs as markups, which is bad practice. Pretty sure illegal too, but many new first-time GPs aren’t even aware of it. All that to say, in the first first 5-6 years of a fund, when nothing is noticeably obvious yet, it’s easy to game numbers.
And even if a GP is in the top quartile, top quartile in VC sucks. Ok, it’s not THAT bad. Median definitely sucks in venture though. It’s really not worth putting money in an average VC. But you can put your money in the S&P 500 or the NASDAQ for the same vintage. Dollar-cost average in, once a year in the first four years. And hold it till Year 10. And in many vintages, your public indices will be between a 3X and 4X. Which is as good as most top quartile vintages. If not, it’ll only lag slightly, ever so slightly, behind. Which is a small price to pay for being a liquid asset. If you’re an LP in VC funds, out of thousands of funds, you need to be in the top 20 funds per vintage. Hands down. Not top quartile. And arguably top decile may not even cut it.
And the truth is, just by the numbers, most individuals and new LPs won’t have good access. When your mom, your cousin, that one drunk uncle from Thanksgiving, are all starting their own VC funds, we now and will continue to live in a world where knowing a VC will be as common as knowing someone who wants to start their own company. Whatever that may be. And to have a chance to be good at VC, the average VC must have both a non-redundant AND an economically important network AND knowledge advantage, to borrow a framework that Albert Azout recently said on my podcast. Most do not. Most will fail to compete with the super-scale firms. If you haven’t checked out Gib Dilner’s recent recording on kinds of firms in the ecosystem today, I highly recommend it.
The truth is most large funds who will cannibalize smaller emerging managers don’t send their good deals to emerging managers. Although emerging managers do send their best deals to the large funds. Looks good for markups. Looks good at the annual meeting when they present to you. But clearly, this dynamic is unrequited. As such, it’s why I believe as an LP, you need to be in managers who go really, really early, where the large firms still cannot access or priced out of accessing. Managers who extend their thesis so that the net new checks coming out of their funds include seed and Series A (unless they can actively lead this and the next round):
- Lose out on access above a $250K check. These days, even above a $100K check. Because large funds want the whole round. It’s how they can make their economics work.
- Don’t have the war chest to provide the capital to founders so that they can weather the market. That said, a good friend of mine, Henry, created the Lean AI Leaderboard. It’s a great dashboard for companies who get to profitability with a lean team and often very little in external capital. And if they do, these companies are seed-strapped, meaning they raise a seed round with the goal of never raising another round again. For investors in these companies, the good news is that they retain most of their equity from entry. The bad news is that unless these companies have a clear exit path, your money as an LP doesn’t go anywhere. More so, most of the VCs investing invest on SAFE notes, with no maturity dates. On paper, revenue is up, but no markups and no exit path. After the $100M range, there are very few companies who would acquire any of these small players, especially after the AI craze. That said, it’s too early to tell. And I’m not sure I have the fortune cookie to tell you what happens next.
But also, as an FYI, if you’re investing in a large platform, don’t expect double-digit or even high single-digit returns, you’re likely going to get a solid 2.5-3X (optimistically), but it’s a stable machine. Still think if that’s the case though, you should be investing in buyout funds or private credit. If you don’t have access to those, just public equities.
Also, not every person needs to start a venture firm. Not every good investor needs to be a fund manager. Being a fund manager is tough. You need to worry about K-1s and reporting (yes, that’s chasing founders down for metrics even when you have information rights), fund admin, running a business, filing taxes, and knowing when and how to sell. It’s actually easier to be a great investor at another larger shop. It’s the same as not every smart person needs to start their own company.
All that said… I’m still bullish on venture. I think it truly is, one of the most promising asset classes we have available to us. And I mean venture in the raw, unfiltered first check, pre-seed play. Not the Series A+ play. At least for emerging managers. After the Series A, I can’t think of a sustainable way you won’t get outcompeted by the large ones. For true early stage exposure as first check, the large platforms often have no incentive to play. Given their large fund sizes, they’ve priced themselves out of that true first-check bucket.
Something that harkens back to a Chris Paik line. “Any company that is pure execution risk without any market risk is not a suitable venture investment.”
A few days later, another friend asked me if I saw this, and if I had any immediate thoughts. On LinkedIn, Pavel Prata had posted a reaction to Jared Friedman’s request for full-stack AI companies, saying that “80% of VC funds will be automated within 3 years.” To be fair, Pavel’s not wrong. Directionally, that is where the industry is heading. Having been to a few annual summits that VCs host so far this year already, every single — oh yes, I mean, EVERY SINGLE — one that I went to (I went to seven at the time of writing this post) talked about using AI to either or both source deals and/or qualify deals. Some also talked about supporting their portfolio using their digitally-twinned brain. Simply, AI is in.
That said, there were some things that Pavel suggested I disagreed with, or at least thought he was oversimplifying:
- “Process 100X more deals.” While there are firms that make investment decisions algorithmically, and while I do see this working past-Series A (where we enter growth), in true early-stage investing fashion, the best investors invest prior to data. Prior to traction. Prior to anything obvious enough to track. And while you, as a firm, can probably see and filter 100X more deals. As a human GP with only 24 hours in a day, and building a portfolio of 30 investments across 3-4 years, I still go back to a piece of advice I received early on in my career. “You don’t have to invest in every great company, but every company you invest in must be great.”
- “Maintain relationships with 1000+ founders.” I have my doubts here. Until I start seeing people build long-term friendships and happiness with AI, I’m still a strong believer that people trust people. And this rapid scaling of AI only further proves that. It’s hard to scale trust. To scale intimacy. There might be a world where this does happen one day. But I don’t think this is three years away. That said, I do think that you as a solo GP or a small team can support your portfolio as if you were a fully-staffed 20+ person team within three years though.
- “Deploy capital 5X faster.” There are some things in life where faster isn’t necessarily better. Like performing a surgery. Or simply, music. No one needs to listen to My Heart will Go On on 5X speed. Venture is one of them. While it’s unclear whether Pavel means shorter deployment periods or faster decision-making, to address both, shorter deployment periods may indirectly lead to more companies getting funded. Or more capital going to the same companies. We don’t need either. An LP shouldn’t index venture, nor should more capital go into companies where the preference stack exceeds the valuation of the companies or making companies financially impossible to 3-5X any of the companies’ investors. Faster decision-making may make sense if it’s a competitive round, but true venture is betting on the non-obvious. Most non-obvious bets don’t need capital 5X faster.
To be fair, I do agree with the vast majority of where Pavel thinks the venture industry will go.
Photo by Matthew Henry on Unsplash
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The views expressed on this blogpost are for informational purposes only. None of the views expressed herein constitute legal, investment, business, or tax advice. Any allusions or references to funds or companies are for illustrative purposes only, and should not be relied upon as investment recommendations. Consult a professional investment advisor prior to making any investment decisions.
