One of my recent favorite soundbites is Rich Paul‘s. For the uninitiated, he’s the agent behind LeBron James and Draymond Green. And in his recent Tim Ferriss episode, he said: “Some people define the business card and some people are defined by their business card, and so I don’t carry a business card.”
Some of the most exciting conversations I’ve been having as of late have been in the world of family offices. There’s this shift in generational wealth transfer, but often times without sufficient knowledge transfer. At the same time, there are many next gens leaning more into risk and philanthropy. Many want to increase their exposure to venture and private equity as an asset class, but are still learning how to underwrite such risk.
My conversations echo a lot of what Citi’s been seeing as well. Two in five family offices wanted to increase their exposure to illiquid asset classes, namely the PE and VC asset classes. And while many bucket VC and PE in the same asset class, the truth is the assets operate very differently. Even within venture, underwriting the risk and performance of a sub-$40M fund versus a $40-100M fund versus a $100-500M fund versus a $500M+ VC fund are completely different. Some LPs may disagree on the exact benchmarks (for instance, sub-$100M funds and everything else), but the reality of assessing an emerging manager and an established manager are different. But I digress.
The rest are either rebalancing or figuring out their re-up strategy. Yet, as I’m sure GPs are seeing today, that shift in strategy, requires time, research, and confidence before family offices can pull the trigger. Many are waiting to Q1 next year, but engaging in conversation today.
I’ve also written before about one of my favorite lines from Engineering Capital’s Ashmeet Sidana, “A company’s success makes a VC’s reputation; a VC’s success does not make a company’s reputation. In other words to take a concrete example, Google is a great company. Google is not a great company because Sequoia invested in them. Sequoia is a great venture firm because they invested in Google.”
And I’m seeing a similar vein with family offices. The next gen don’t want to be defined by their predecessor’s goals and records. They want to define their own legacy.
There’s also the saying: If you know one family office, you only know one family office. So any broad-stroke generalizations are loosely correlated at best. That said, anecdotally, having talked with about a hundred or so family offices, here’s what I’ve come to notice.
My crudely drawn 1D scale of whether venture capital is an asset class or an access class
Smaller and/or emerging LPs see VC as an access class. Larger and more sophisticated and established LPs see VC as an asset class.
The Mendoza line — the line that separates the emerging LPs from the established ones —seems to be around 20-30 managers or over 6-7 years of venture data. For the latter, that means, you’ve seen Fund I’s and II’s graduate to Fund III’s and IV’s.
So the question for many of the next generation leading family offices has flipped from: Are you defined by your surname? To: Do you define your surname?
For those that pursue the latter, they’re a lot more proactive than previous generations. They participate in communities. Go to events. Seek education on the matter. Network with their existing managers to discover new ones. Some have also built covenants to co-invest in their manager’s breakout winners. Quite a few are building emerging manager programs or would like to. They’re hungry. Hungry to learn.
The problem I’m seeing with many managers is that they’re seeking transactional relationships. The urgency to get to their first or final close leads them to optimize for LPs who can close fast. And I get it, that’s been the game historically. But it’s leaving a massive opportunity in the market for those who have the time and are willing to educate their and prospective LPs. Who are willing to spend time building a relationship through giving first.
Stay up to date with the weekly cup of cognitive adventures inside venture capital and startups, as well as cataloging the history of tomorrow through the bookmarks of yesterday!
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.
“Magic is just spending more time on a trick that anyone would ever expect to be worth it.” —Penn & Teller
Five years ago, back in 2018, I would have never guessed. But I fell in love with the soles of another person’s feet. And I knew this was going to be one of the most tenacious people I’d ever meet.
I was introduced to “Ben” by a dear friend with one line, “No one can outhustle him.” “Ben” grew up with an insatiable appetite to learn, in a village located on the outskirts of Cairo. He would spend many days and nights in conversation with village experts and the village library, until one day he noticed he learned all he could have.
It just so happens that there’s a two-hour bus to Cairo that comes once a week. And that was how he found the libraries in Cairo, where he realized his interest in AI. But due to the bus’ odd schedules, instead of riding it, Ben chose to instead walk ten hours to Cairo every week. He’d then download, read, and print (to bring back to his village) as many Stanford PhD research papers on AI as possible. Sleep overnight at the bus stop. Then the next day, walk ten hours back to his village, where he’d continue with his reading for the week with all the loose leaf papers he had.
Needless to say, he had the feet to show for it.
I shared that story with a friend two days ago at the perennially-packed Superhot. We were chatting about the traits we look for in founders we back and the questions we ask to get there. The latter of which I’ve written about before. And at the early stages, the chief thing we look for is grit. There’s a tweet I stumbled on this week summarizes that rather nicely:
The problem is it’s so hard to see if a founder has the qualities of a “white belt who never quit” in just one meeting, even a few meetings. So, instead of sharing what questions we ask founders — most of which I know are designed to be reveal tells of grit, and are at least to my friend and his team, proprietary to some degree — I’ll share why grit matters, not just as a founder trait, but as a variable in the fundraising process, and a story that I hope will inspire you.
Candy versus the meal
One of the frameworks I love thinking about is the difference between how people think and what people talk about. This is by no means original. I actually stumbled across this when watching Malcolm Gladwell on Masterclass. For instance, when people watched the most recent Avatar movie, they didn’t say “Here’s the plot of the movie.” They talk about their favorite scenes or how great the performance capture was for underwater sequences. Neither is all-encompassing of the movie, but it gets people excited. That’s what word of mouth is.
Malcolm Gladwell calls it the meal and the candy, respectively. The meal is how people think — what people take home. They sit down with it and take time to process. The candy is what people talk about. The parts of the narrative that are easiest to share and remember.
From a go-to-market presentation I did earlier this year
Candy without the meal is clickbait. A meal without the candy means no one will talk about the good work you do. So you need both.
Similarly, in the world of venture, when I, like most other investors get excited about a deal, assuming it’s a good one, don’t talk about the whole pitch deck. Neither do I get super excited about sharing the one-liner unless it’s actually something unique. Like when a bike-sharing company pitched their one-liner as “We make walking fun.”
What I talk about is what’s cool and what stands out. That’s the investor’s word of mouth. And that’s how you fill a round. Or get people excited to help you find investors who will. Things I shared before include:
“That startup that hit 130% net retention.”
“Customers literally write love letters to the founders.”
“That founder cold emailed a Disney exec for 300 days straight to inevitably close their first enterprise deal.”
“This founder started a podcast as a growth engine to 1/ secure his first 10 customers, 2/ bring on one of the best advisory board I’ve seen to date.”
As you might notice, it’s almost impossible to guess what each company does above with just what I shared. And it sure as hell doesn’t get investors to conviction with just that. But they’re powerful enough for investors to take a second look at and talk about. Among the above, the absolute favorite thing investors love to talk about with each other is a founder’s ability to hustle. And subsequently, their Herculean efforts that demonstrate grit.
Years later, my friend on Wednesday was still talking about a founder he backed who waited in the cold outside an exec’s office until he got a meeting. Then found unique ways to turn 20 minutes into 30 minutes into hours into their first enterprise client.
The thing is it’s rare to see this. Most people promise that they will, but the best founders have demonstrated this grit time and time again before, against seemingly impossible odds. And they’re only “impossible” if you’ve set lofty goals in the past and you did nothing short of your best to try and achieve it. I’ll give another example. One that I knew if he was to start another business, you knew he was going to make it happen.
Spoiler alert: He did.
From losing everything to acquisition
I first met Anthony at 1517 Fund’s quincentennial “anniversary” summit back in 2017, designed to bring together the world’s most divergent thinkers.
The first thing you notice about Anthony is that he had a small frame. A demeanor that belied his life experiences and the courage it took for him to share them. Yet, he has a way to command the attention of his audience.
He started his business back in freshman year of college delivering food to his fellow classmates at USC. It started off as a side hustle to earn some spare change. Something he didn’t expect would become something greater, until one day Mark Cuban came to USC to give a talk.
As the fireside chat ended sooner than expected, Mark polled the audience, “What if we did a live Shark Tank?” Anthony explained that while unsure if it’ll work, but not wanting to let a once-in-a-lifetime opportunity go, he decided to pitch this idea he’d been working on — which at that point, was not even an app, but just a series of text messages between friends who ordered food and friends who were willing to deliver them.
To his surprise, Mark loved it. Soon that snowballed into Anthony dropping out of school to focus on the business full-time. They got into 500, and he became a Thiel fellow. But one spring later, amidst the hype of a party in Vegas, he miscalculated a dive into the pool. Fractured his spine. And became paralyzed from the neck down.
In the ensuing months, his top priority was not to grow what became EnvoyNow, but to breathe, to drink water — to survive. His co-founders had promised him they would look after the business and that he should focus on recovery. So he did. Months passed. And while Anthony still sat in the occasional company meeting, he was focused on mobility and feeding himself.
A few more months passed by, and one day, his co-founders decided to visit him while he was still focused on recovering. And they broke the news. The business was stalling. Investors had lost faith. Moreover, both his co-founders had already lined up new opportunities and wanted to close the business down.
As I sat listening, I couldn’t help but wonder what I’d do in that situation. Anthony instead decided to go back full-time to the business and win back his remaining team and investors. He said, “I went back to our investors. I shared where we were at, which wasn’t good. And asked them to believe in me once more. They did once before, and as long as I showed I was still passionate about the business, I was banking on the hope that some will still continue to support us.” Luckily, a small handful did.
With renewed drive and determination, and a tough situation to get out of, within the year, they expanded to 16 schools and employed 1500 students around the nation. The rest is history. They sold to JoyRun. And Anthony went on to found more companies, including his current one, Vinovest, which he started 2019 and raised an A in 2021.
If you’re curious about the additional details to the story, there’s also a great 2017 Fortune piece cataloging his journey. I love the line Blake Masters, President of the Thiel Foundation, shared in that piece, “Good luck finding something that will hold [Anthony] back.”
In closing
There’s a fun little thought exercise a couple investors I know used to do (maybe still do). They first posed the question to me when I first jumped into venture, which is:
If you had two young founders… One went to MIT, graduated with a 4.0 GPA in computer science, and was summa cum laude. The other is a high school graduate, and instead of paying over $200,000 over 4 years, took every single MIT computer science course on Coursera in one year. All else held equal, who would you invest in?
Naturally, the answer biases towards the latter. Yet, in the past few years, or at least since I’ve been in the world of VC, there’s been a bunch of logo shopping and chasing the idea of “signal.” While no one says is explicitly, logos have become more important than the hustle.
Today, we’re in a tough market. One where we haven’t seen the light at the end of the tunnel. Hell, we don’t even know when we’re at the trough yet. Or at least, the lagging indicator that we are is a massive slowdown or lack of layoffs. Yet, we recently saw Google, as well as Microsoft and Amazon, go through cuts.
And so, it no longer matters who you’re backed by or where you’ve come from. As Engineering Capital’s Ashmeet Sidana said, “A company’s success makes a VC’s reputation; a VC’s success does not make a company’s reputation. In other words to take a concrete example, Google is a great company. Google is not a great company because Sequoia invested in them. Sequoia is a great venture firm because they invested in Google.”
What matters is that you can make it out the other side. What matters is that you’re inventive and creative, that you can tighten your belt and put the pedal to the metal, and do what looks in retrospect as superhuman.
And that requires perseverance and the ability to learn. That requires spending more time on something than anyone would ever expect to be worth it. As you do so, you embark on what VCs call — insight development.
Stay up to date with the weekly cup of cognitive adventures inside venture capital and startups, as well as cataloging the history of tomorrow through the bookmarks of yesterday!
Any views expressed on this blog are mine and mine alone. They are not a representation of values held by On Deck, DECODE, or any other entity I am or have been associated with. They are for informational and entertainment purposes only. None of this is legal, investment, business, or tax advice. Please do your own diligence before investing in startups and consult your own adviser before making any investments.
Seemingly, everyone these days – from Twitter to podcasts to blogposts (including mine) – talk about buying and investing in startups. What are best practices for investment theses? How do I pick the best companies to invest in? Conversely, how do I get picked or get allocation into hot startups? But people rarely seem to be talking about selling positions. So, if you know me, I hit up two of the smartest people I know – one early-stage, the other growth-stage. Both of whom might be familiar faces on this blog. So I asked them:
How do you think about selling a position? How much does DPI matter for your investors?
The below insights include minor edits for clarity.
The notice that you’ve all seen a million times
None of this is investment advice. This content is for informational purposes only, and should not be relied upon as legal, business, investment, or tax advice. Please consult your own adviser before making any investments.
Shawn Merani (Parade Ventures)
Shawn was instrumental in my early career growth in venture. When I met him years ago, he was still running Flight Ventures, where he wrote early checks into Dollar Shave Club and Cruise Automation and was one of the first syndicates on AngelList. There he led a network-based model of syndicate leads, which I’ve heard been described by others as a “venture partner program on steroids.” Now he’s the solo GP at Parade Ventures, a seed stage venture fund investing in enterprise-themed companies.
“I would preface all of this with the fact we have never fully exited a position before a traditional liquidity event, but more so, have managed our position given the duration of our ownership and to generate returns for our LPs and manage risk.
“We talk to founders all the time, and foster a relationship that grows. When I was writing check sizes for 1-5% of ownership, my engagement then is very different from my engagement with founders now, where we take more concentrated bets.
“When it comes to selling, it’s about influence and information. The larger our ownership, the more information we have access to. And if a company is doing well, we don’t think about selling. In fact, it’s the exact opposite; we buy more. If things are working, we take our pro rata. In some cases, we take more than my ownership target. And founders are willing since we’ve been helping them from the beginning. We know when there’s going to be a 3-4x uptick every 12-18 months. Compounding is powerful.
“Our investors back the fund because they trust us. They don’t talk to the founders as often as we do. They trust our decision when we say we should buy more or keep our shares. There are two ways to talk about DPI:
1. Making money for your current investors, and 2. Telling the story.
“Selling is really a case-by-case scenario, and it really depends on my relationship with the founder. All the equity in which I sold so far has been before Parade. But if we know the company is doing well, we buy more. There are also holding periods to consider under QSBS, which has huge tax benefits.”
For those that are unfamiliar with the terminology, DPI means distributions to paid-in capital. Effectively, how much money you actually return to your investors versus “paper returns”. QSBS, or qualified small business stock, tax exemption allows investors in qualified businesses to avoid 100% of the capital gains tax incurred if they hold their stock for more than 5 years.
Ratan Singh (Fort Ross Ventures)
I posed the same question to someone I’ve been a huge fan of the day I met him – Ratan Singh, Partner at Fort Ross Ventures. He’s an investor in some of the most recognizable businesses today, including the likes of Rescale and Clearcover, as well as holds board seats at Blueshift and Ridecell. You may remember Ratan from a previous essay about speed as a competitive advantage for investors. And you’ll likely see him a lot more on this blog. He summed it up best in our chat when he said, “There are two reasons why an investor needs to care about DPI: time horizon and fund strategy.” Both of which are variables, not constants, between early- and growth-stage investments.
“The true metric at the end of the day is DPI. DPI is turning in money to your investors. And there are two reasons why an investor needs to care about DPI: time horizon and fund strategy.
“Let’s start with time horizon. For a seed stage fund, as you get close to the end of your fund cycle, that’s when DPI matters. What type of vintage is the fund in? In 2021, it’s going to be the 2010 and 2011 funds.
“For the majority of the time, you want to ride your winners. At the end of your time horizon, ask for a one- to two-year extension. Usually LPs want more money or their shares distributed. They’ve already waited 10 years. Two more won’t make a difference, especially if you have some big fund returners in the making.
“For fund strategy, did you meet the objectives for your LPs already? If you have, and you want to sell some of your winnable deals in your portfolio to help raise your Fund II because those are the same LPs that would re-up in your next fund, then you might consider selling.
“The worst reason to sell is that you want to take the wins you currently have since you think the market is overvalued. ‘I’m at the peak.’ Or ‘I want to take chips off the table because there’s something bad that will happen, but that is very hard to predict.’
“There were a bunch of funds at the beginning of this year that sold their entire positions. They were desperate to lock in a win. They sold because they thought the market was at the top. And, they were wrong. I’m against it. Selling early doesn’t fully realize the strategy you have put forth. For us, at the growth stage, we shoot for 48 months to an exit. If it takes longer, did we underwrite it wrong? But even if it does, the case may be that the company is growing a little slower than expected.
“At the early stage, all funds will say 2 to 3x cash-on-cash in the LP presentation. Most funds return 1 to 1.5x, on average, with most funds total DPI at 1.2 to 1.5x, which barely returns the fund. Before your time horizon, everyone likes to cite unrealized gains and mark ups because TVPI’s all they have.
“DPI matters most for funds in the top quartile – the top returners, funds with more than $500 million, or nowadays, $1 billion mega-funds. For the bottom majority of funds, early DPI won’t matter. They would be limiting their upside.
Author’s Note: Notice that 65% of financings lost money for their investors. Source: Correlation Ventures
“The new interesting commentary is that – where the job is getting harder – a lot of crossover funds are making binary bets. Finding the one deal that’s the next Salesforce – the next industry-defining company. And putting a lot of capital to find that one or two companies. Tiger and Coatue, still maintain that 10-12% IRR, but spend a lot to find the company that’ll be the next Databricks. Every generation has their industry-defining companies. And, they’re willing to lose it all to find that one.
“You usually don’t see this at the growth stage. It’s bad for innovation. Everyone is trying to find investments that are scaling. 1000 investments in the past year became unicorns. And there are 3000+ unicorns. Yet, the top five to seven companies are still undercapitalized.”
In closing
As we closed the selling part of our conversation, Ratan shared a great quote from an Economist article:
“Flush with cash amid a deal frenzy, what is the industry to do? One option would be to liquidate portfolios, that is, to sell more assets than it buys, in effect trying to cash in some chips when prices are high. As yet, however, this does not seem to be happening. Take the figures for three big managers, Blackstone, Carlyle and KKR. So far this year for every $1 of assets, in aggregate, that they have sold, they have bought $1.30. Although Carlyle is being more cautious than the other two firms, these figures indicate that the industry overall thinks the good times will roll on.”
In fairness, as the saying goes, the high risk, high reward. Data does show that the funds with the greatest track records have more deals that lose money than those make them more money than they invested.
Interestingly enough, there’s also a huge differential between the world’s most valuable and most funded startups. According to Founder Collective, “the most valuable companies raised half as much capital and produced nearly 4X the value!” All of which echo Ratan’s words. “The top five to seven companies are still undercapitalized.”
The public often looks towards invested capital as a proxy of startup performance. But the data suggests that isn’t the case. In the words of the team at Founder Collective, “capital has no insights.” One of my favorite lines from Ashmeet Sidana of Engineering Capitalframes it is still: “A company’s success makes a VC’s reputation; a VC’s success does not make a company’s reputation.”
But when DPI boils down to selling on multiples at the end of the day, I often reference Samir Kaji‘s tweet on the return hurdles expected of different stages of investors. As you might guess, the return expectations of each type of fund varies based on fund strategy.
Since it was asked, return hurdles for LPs are for different types of funds:
Nano-Fund (<$20MM)- 5-7X+ Traditional Seed Fund – 3-5X+ Series A: 3X+ Growth – 2-2.5X+ Crossover/late growth – IRR driven – 10-12%+
As all things in the world, exiting is just as nuanced and complicated as entering. Hopefully, the above insights will be another set of tools for your toolkit.
If this essay has inspired more questions, here are some further reading materials, courtesy of Ratan:
Thank you Shawn and Ratan for reading over early drafts.
Stay up to date with the weekly cup of cognitive adventures inside venture capital and startups, as well as cataloging the history of tomorrow through the bookmarks of yesterday!
Not too long ago, I quoted Phil Libin, founder of All Turtles and mmhmm (which has been my favorite virtual camera in and most likely post-pandemic), who said: “I think the most important job of a CEO is to isolate the rest of the company from fluctuations of the hype cycle because the hype cycle will destroy a company. It’ll shake it apart. In tech the hype cycles tend to be pretty intense.”
Hype is the difference in expectation and reality. Or more specifically, the disproportionate surplus of expectation. A month ago, Sarah Tavel at Benchmarkwrote: “Hype — the moment, either organic or manufactured, when the perception of a startup’s significance expands ahead of the startup’s lived reality — is an inevitability. And yet, it’s hard not to view hype with a mix of both awe and fear. Hype applied at the right moment can make a startup, while the wrong moment can doom it.”
Right now, we are in a hype market. And hype has taken the venture market by storm.
We’ve all been seeing this massive and increasing velocity and magnitude of capital deployment over the last few months. Startups are getting valued more and more. In the past, the pre-money valuations I was seeing ranged from 2-on-8 to 3-on-9. Or in not so esoteric VC jargon, $2M rounds on $8M pre-money valuations ($10M post-money) to $3M rounds on $9M pre-money valuations ($12M post-money). These days, I’ve been seeing 5-on-20 or 6-on-30. Some of which are still pre-traction, or even pre-product.
Founders love it. They’re getting capital on a discount. They’re getting greater sums of money for the same dilution. Investors who invested early love it. Their paper returns are going through the roof. When looking at IRR or TVPI (total value to paid-in capital – net measurement on realized and unrealized value), higher valuations in their portfolio companies are giving investors jet fuel to raise future funds. And greater exit values on acquisition or IPO mean great paydays for early investors. Elizabeth Yin of Hustle Fundsays “this incentivizes investors to throw cash at hyped up companies, instead of less buzzy startups that may be better run.”
Sarah further elaborated, “In the reality distortion field of hype, consumers lean in and invest in a platform with their time and engagement ahead of when they otherwise might have. They pursue status-seeking-work, not because they necessarily get the reward for it relative to other uses of their time, but because they expect to be rewarded for it in the future, either because of the typical rich-get-richer effect of networks, or just in the status of being an early adopter in something that ends up being big.” The same is true for investors investing in hyped startups. It’s status-seeking work.
Frankly, if you’re a founder, this is a good time to be fundraising.
Why?
Capital is increasingly digital.
There is more than one vehicle of early stage capital.
There are only two types of capital: Tactical capital and distribution capital.
1. Capital is increasingly digital.
Of the many things COVID did, the pandemic accelerated the timeline of the venture market. Pre-pandemic, when founders started fundraising, they’d book a week-long trip to the Bay Area to talk to investors sitting on Sand Hill Road. Most meetings that week would be intro meetings and coffee chats with a diverse cast of investors. Founders would then fly back to their home base and wait to hear back. And if they did, they would fly in once again. This process would inevitably repeat over and over, as the funnel grew tighter and tighter. And hopefully, at the end of a six-to-twelve month fundraise, they’d have one, maybe a few term sheets to choose from.
Over the past 18 months, every single investor took founder meetings over Zoom. And it caused many investors to realize that they can get deals done without ever having to meet founders in-person. Of course, the pandemic forced an overcorrection in investor habits. And now that we’re coming out of isolation, the future looks like: every intro meeting will now be over Zoom, but as founders get into the DD (due diligence) phases or in-depth conversations, then they’ll fly out to meet who they will marry.
It saves founders so much time, so they can focus on actually building and delivering their product to their customers. And,
VCs can meet many more founders than they previously thought possible.
This has enabled investors to invest across multiple geographies and build communities that breathe outside of their central hub or THE central hub – formerly the SF Bay Area. Rather, we’re seeing the growth of startup communities around the nation and around the world.
2. There is more than one vehicle for early stage capital.
While meetings have gone virtual, the past year has led to a proliferation of financing options in the market as well. Capital as jet fuel for your company is everywhere. Founders now have unprecedented optionality to fundraise on their terms. And that’s great!
Solo capitalists
Individual GPs who raise larger funds than angels and super angels, so that they can lead and price rounds. The best part is they make faster decisions that funds with multiple partners, which may require partner buy-in for investments.
Rolling funds
With their 506c general solicitation designation, emerging fund managers raise venture funds faster than ever and can start deploying capital sooner than traditional 506b funds.
Micro- and nano-VCs
Smaller venture funds with sub-ten million in fund size deploying strategic checks and often leverage deep GP expertise. No ownership targets, and can fill rounds fast after getting a lead investor.
Equity crowdfunding
Platforms, like Republic and SeedInvest, provide community-fueled capital to startups. Let your biggest fans and customers invest in the platform they want to see more of in the future. With recent regulations, you can also raise up to $5 million via non-accredited and accredited investors on these platforms.
Accelerators/incubators
Short three-month long programs, like Y Combinator, 500 Startups, and Techstars, that write small, fast checks (~$100K) to help you reach milestones. Little diligence and one to two interviews after the application. Often paired with an amazing investor and/or advisor network, workshops, powerful communities, and some, even opportunity funds to invest in your next round.
Syndicates/SPVs
Created for the purpose of making one investment into a company a syndicate lead loves, syndicates are another ad hoc way of raising capital from accredited investor fans, leveraging the brand of syndicate leads and deploying through SPVs. Or special purpose vehicles. I know… people in venture are really creative with their naming conventions. In turn, this increases discoverability and market awareness for your product.
SPACs and privates are going public again
Companies going public mean early employees have turned into overnight millionaires. In other words, accredited investors who are looking to grow their net worth further by investing in different asset classes. Because of the hype, investing in venture-scale businesses tend to be extremely lucrative. These investors also happen to have deep vertical expertise, high-value networks, as well as hiring networks to help startups grow faster. More investors, more early stage capital.
Growth and private equity are going upstream
Big players who usually sat downstream are moving earlier and earlier, raising or investing in venture funds and acceleration programs to capture venture returns. And as a function of such, LPs have increased percent distributions into the venture asset classes, just under different names.
Pipe
Pipe‘s existed before the pandemic, but founders have turned their eye towards different financing options, like Pipe. They turn your recurring revenue into upfront capital. Say a customer has an annual contract locked in with you, but is billed monthly. With Pipe, you can get all that promised revenue now to finance your startup’s growth, instead of having only bits and pieces of cash as your customers pay you monthly. Non-dilutive capital and low risk.
3. There are only two types of capital: Tactical capital and distribution capital.
There’s an increasingly barbell distribution in the market. Scott Kupor once toldMark Suster that: “The industry’s gonna bifurcate. You’re going to end up with the mega VCs. Let’s call them the Goldman Sachs of venture capital. Or the Blackrock of venture capital. And on the other end, you’re going to end up with niche. Little, small people who own some neighborhood whether it’s video, or payments, or physical security, cybersecurity, physical products, whatever. And people in the middle are going to get caught.”
Those “little, small” players have deep product and go-to-market expertise and networks. Their checks may be small. But for an early stage company still trying to figure out product-market fit, the resources, advice, and connections are invaluable to a startup’s growth. They’re often in the weeds with you. They check your blind side. And they genuinely empathize with the problems and frustrations you experience, having gone through them not too long ago themselves. Admittedly, many happen to be former or active operators and/or entrepreneurs.
On the flip side, you have the a16z’s and Sequoias on their 15th or 20th fund. Tried and true. Brilliant track record with funds consistently north of 25% IRR. Internal rate of return, or how fast their cash is appreciating annually. LPs love them because they know these funds are going to make them money. And as any investor knows, double down on your winners. More money for the same multiples means bigger returns.
The same is true for historical players, like Tiger, Coatue, and Insight, who wire you cash to scale. They assume far less risk. Which admittedly means a smaller multiple. And to compensate for a lower multiple, they invest large injections of capital. By the time you hit scale, you already know what strategies work. All you need is just more money in your winning strategies.
You find product-market fit with tactical capital. You find scale with distribution capital.
Product-market fit is the process of finding hype. When you stop pushing and start finding the pull in the market. Scale is the process of manufacturing hype.
The bear case
But there are downsides to hype. Last month, Nikhil, founding partner at Footwork, put it better than I ever could.
If I could add an 8th point to Nikhil’s analysis, it’d be that investors in today’s market are incentivized to “pump and dump” their investments. Early stage investors spike up the valuations, which leads to downstream investors like Tiger Global, Coatue, Insight, and Softbank doubling down on valuation bets. Once there’s a secondary market for private shares, early stage investors then liquidate their equity to growth investors who are seeking ownership targets, or just to get a slice of the pie. This creates an ecosystem of misaligned incentives, where early stage investors are no longer in it for the long run with founders. Great fund strategy that’ll make LPs happy campers, but it leaves founders with uncommitted, temporary partners.
Sundeep Peechu of Felicis Ventures has an amazing thread on how getting the right founder-investor fit right is a huge value add. And getting founder-investor fit takes time, and sometimes a trial by fire as well. After all, it’s a long-term marriage, rather than a one-night stand. Those who don’t spend enough time “dating” before “marriage” may find a rocky road ahead when things go south.
By my count, ~30% of Felicis companies that have done well had trouble raising Series As in some fashion.
As an example, Matterport which went public last week had little appetite at the A. Non-recurring revenue, hardware business and selling to real estate was a triple whammy.
On a 9th point, underrepresented and underestimated founders are often swept under the rug. In a hype market, VCs are forced to make faster decisions, partly due to FOMO. With faster decisions, investors do less diligence before investing. Which to the earlier point of misaligned incentives, has amplified the already-existing notion of buyer’s remorse.
When VCs go back to habits of pattern recognition, they optimize for founder/startup traits they are already familiar with. And often times, their investment track record don’t include underrepresented populations. To play devil’s advocate, the good news is that there is also a simultaneous, but comparatively slow proliferation of diverse fund managers, who are more likely to take a deeper look at the problems that underestimated founders are tackling.
What kind of curve are we on?
When many others seem to think that this hype market will end soon, last week, I heard a very interesting take on the current venture market in a chat with Frank Wang, investor at Dell Technologies Capital. “VCs have been mispricing companies. We anchor ourselves on historical valuations. But these anchors could be wrong.
“We’re at the beginning of the hype and I don’t see it slowing down. VC has been so stagnant, and there hasn’t been any innovation in venture in a long time. Growth hasn’t slowed. And Tiger [Global] and Insight [Partners] is doing venture right. Hypothetically speaking, if you invest in everything, the IRR should be zero. They are returning 20% IRR because they seem to have found that VC rounds are mispriced. So, there can be an arbitrage.
“There will be a 20% market correction in the future, but we don’t know if that’s going to happen after 100% growth, or correct then grow again. The current hype is just another set of growing pains.”
Part of me is scared for the market correction. When many founders will be forced to raise flat or down rounds. The fact is we haven’t had a serious market correction since 2009. It’s going to happen. It’s not a question of “if” but rather “when” and “how much”, as Frank acutely points out.
Investors who deploy capital fast win on growing markets – on bull markets. Or investors who deploy across several years, or what the afore-mentioned Mark Suster defines as having “time diversity“, who win on correcting markets – bear markets. Think of the former as putting all your eggs in one basket. And if it’s the winning basket, you’re seen as an oracle. If not, well, you disappear into obscurity. Think of the latter as diversifying your risk appetite – a hedging strategy. More specifically, (1) being able to dollar-cost average, and (2) having exposure to multiple emerging trends and platforms. You’re not gonna lose massive amounts of capital even in a bear market, but you also will be losing out on the outsized returns on a bull market.
Only time will tell how seriously the market will correct and when. As well as who the “oracles” are.
In closing
At the end of the day, there are really smart capital allocators arguing for both sides of the hype market. Like with all progress, the windshield is often cloudier and more muddled than the rearview mirror. As Tim Urban once wrote, “You have to remember something about what it’s like to stand on a time graph: you can’t see what’s to your right.“
And as founders are going to some great term sheets from amazing investors, I love the way Ashmeet Sidana of Engineering Capitalframes it earlier this year. “A company’s success makes a VC’s reputation; a VC’s success does not make a company’s reputation. In other words to take a concrete example, Google is a great company. Google is not a great company because Sequoia invested in them. Sequoia is a great venture firm because they invested in Google.”
Whether you, the founder, can live up to the hype or not depends on your ability to find distribution before your competitors do and before your incumbents find innovation. Unfortunately, great investors might help you get there with capital, but having them on your cap table doesn’t guarantee success.
Nevertheless, the interpretation of hype is always an interesting one. There will continue to be debates if a market, product, or trend is overhyped or underhyped. The former assumes that we are on track for a near-term logarithmic curve. The latter assumes an immediate future looking like an exponential curve. The interpretation is, in many ways, a Rorschach test of our perception of the future.
Over the course of human civilization, rather than an absolutely smooth distribution, we live something closer to what Tim Urban describes as:
If the regression line is the mean, then we’d see the ebbs and flows of hype looking something like a sinusoidal function. As Mark Twain once said, “History doesn’t repeat itself, but it often rhymes.”
It won’t be a smooth ride. The world never is. But that’s what makes the now worth living through.
Stay up to date with the weekly cup of cognitive adventures inside venture capital and startups, as well as cataloging the history of tomorrow through the bookmarks of yesterday!
In the past month, I’ve doubted myself and my abilities more than I have in the past two years combined. Half from putting myself intentionally in tough conversations, half from pursuing new opportunities to see them turn belly up. The latter is merely a fact in life. But coupled with the former, I can’t say I was always the happiest camper. So, when in one of the former’s conversations, someone asked me: “Are you worth anything in the startup world?”… I hesitated for more than a day, before I had the courage to give myself an answer. While it was a rhetorical question then, it is a question I need a companion answer to now.
Nothing. Without entrepreneurs, I am useless in this ecosystem. On the flip side, if there are entrepreneurs that I can help find product-market fit and grow, I’m a percentage-based function of their growth. Let’s say as an investor, I own 10% of a company. If the company’s worth $0, then I am too. If it’s not zero, then I’m worth whatever 10% of the whole is worth. Is that a representation of my true market value? No. It’s merely an assumption that for, say, $250K for 10%, I am worth, in the long run, at least 10x of $250K to help founders move faster on their journey.
Something. How much? I don’t know. My job is to help pair founders with the knowledge, skills, and relationships that will transcend the outcome of the venture itself. They say entrepreneurship is never a zero sum game. Even if your idea doesn’t find its product-market fit, the time you spend hustling is cross-applicable to any other industry. Can founders find the knowledge, skills, and relationships without me? Most likely. There are so many resources online via YouTube, Medium, Substack, Quora, just to name a few, that it’d be silly of me to think I’m essential. What I can do is expedite the journey towards their goals. Hopefully even alleviate some stress. And even when I do so, I’m only truly useful in one chapter of their journey rather than the whole novel. But if my worth is just to reduce the friction it takes to get us one step closer to live in the world we want to live in tomorrow, then so be it.
I’m reminded of what Ashmeet Sidana of Engineering Capitalsaid recently. “A company’s success makes a VC’s reputation; a VC’s success does not make a company’s reputation. In other words to take a concrete example, Google is a great company. Google is not a great company because Sequoia invested in them. Sequoia is a great venture firm because they invested in Google.”
Stay up to date with the weekly cup of cognitive adventures inside venture capital and startups, as well as cataloging the history of tomorrow through the bookmarks of yesterday!
