When I started my first fund, a long-time VC I respect asked me a question which still remains unanswered: “What’s your view of the world?”
Damnit. That question really stumped me. Still does. Partly, I wanted to have a good answer to respond to this person’s question. Mostly, as the years have gone on, I still think about the question and yet don’t have a great answer.
More likely, it seems, I feel like the Joker in The Dark Knight, a dog chasing cars — I wouldn’t know what do with one if I caught one. Jokes aside, it’s a discord I’ve struggled with — it appears from the outside that investors have to picture a future world and find investments that fit within that lens. But, what do I know? I don’t know how the world will unfold. I can understand how concepts can shift over time, how we may move toward decentralized networks after years of centralization, or how our economy may shift from consumption-based to sharing networks, and so on.
Many investors over the past few years have invested in these concepts — myself included. While I don’t know how the future will unfold, what I do know is that I don’t know. I have no idea. The best I can do is (1) survey the current landscape and (2) find markets which I believe will open in dynamic ways over the next 3-5 years and then, (3) put my money where my beliefs are.
Like the dog chasing cars, I find that while I can be seduced by concepts, I do like momentum, I do like to spot things that have their own organic kinetic energy — those things could be people, it could be markets, or it could be an approach to a type of product or service. When everyone has a startup, momentum may turn out to be a good differentiator. Put this way, my role could be reduced to trying to find these pools and pockets of organic kinetic energy before other people, and helping those technologists and teams to harness and focus it to create even more value over time.
So, as 2015 comes to end…
I find myself thinking about all of this again. At the end of year here, I try to identify a startup which has truly broken out into the mainstream or large enterprise value. The past few years those companies have been Stripe, Snapchat, Slack, and for this year, one could argue the likes of Zenefits, among others, but I’ve been struck by another phenomena: That the very best big, public technology companies are operating and executing at breakneck speed. They’re growing, and they’re already big to begin with.
Consider that the following companies — Microsoft, Apple, Amazon, Google and Facebook — are all at or near all-time highs in the public markets. Massive new networks like Airbnb and Uber lurk in the private markets, all but public companies themselves, save for a few years, and surely they will reach even greater heights at network operators with limited overhead and no inventory on the books. Of the seven companies, most are still founder-led and most CEOs here are quite young, relatively speaking. Each of the seven companies possess some kind of current (or future potential for a) network effect, which if they hold true, could compound their growth in the future. It used to be that asking a startup “What if Big Company X does this?” wasn’t a fair question because startups could fundamentally attack incumbents — but now, asking “What if Facebook or Uber does this?” is a very fair and real question for investors to ponder. These companies have tremendous resources and talent, and they know how to execute.
The big platforms have a soft lock on our behaviors, a hard lock on our data and as creatures of habit, a solid spot in the premium brand positions on our phones….How often do you change your messaging, commerce, social, transportation, financial and entertainment apps on the first few screens on your phone? Mine are locked in…If this is idea is true (and I think it is), if the innovation pipeline has shifted its access point and the consumer their propensity to adopt new brands, we are definitely in a brand new world…Can they get us to install another app tied to our credit card when everyone already has Uber installed? Can they be that much better to give them a spot on our front screen in transportation row?…How does this dynamic change the core promise of the web that it is indeed possible for an individual to change the world?
Hunter Walk reminded me that in a zero-sum world of only so many minutes in a day, blank spaces to absorb those minutes must come from cannibalizing other minutes, either from online or offline. When the smartphone was new, it was a lot easier to steal offline minutes and bring them online. Now, these opportunities are harder to find. Of course, there is a constant flow minutes from one app to the next, but FBs/YouTubes continue to increase their share of the ever expanding pool of smartphone minutes.
Fred Wilson recently wrote on his blog about the winner-take-all dynamic in network effect businesses:
This is an issue for society to ponder. As I have spent time in Europe this past month, it’s easy to see that the search engine they use here is Google, the social graph they use is Facebook, and so on and so forth. If the US produces the networks that win most of the market, that’s an issue for the rest of the world. The Chinese have dealt with that issue by protecting their market. The rest of the world (mostly) has not.
So, here I am, with 2015 coming to an end…
I’ve started investing out of my third fund, and with each fund, I try to again be that hungry dog searching for cars. Again, while I have no monopoly on knowing what the future will bring, I am ultimately judged, in part, years later about how well I pick today. Since I don’t have a view of the world or a crystal ball, the best I can do here is survey the current landscape and pick markets that (1) I believe will be open, in a big way, over the next 3-5 years and (2) markets that I have a personal, genuine, intellectual interest in — #1 is important because if I pick the right markets, the gravitational effect of those markets can lift up great teams to new heights; #2 is important because founders intuitively sense when they meet an investor who is genuinely interested in their sector, has an informed point of view, and can demonstrate the ability to invest fueled by conviction for the long-term.
The net result of all of this thinking — a glimpse into my brain works and refries itself — is that I have, for the first time in my short investing career, identified a few key markets I want to invest in for my Fund 3. I’m excited about this because I’ve never come to this level of focus before. I wanted to write it down to broadcast to the founders out there who are in these sectors, but also because I wanted it to cement in my brain, because I know investors are like baseball hitters in that they can go through slumps. Just this past summer, I lamented to a friend that I felt like I lost my ability to pick. Fast-forward to today, I feel much more confident about what I’m looking for and why. Those areas are:
One, The Industrial Internet Of Things: There are a few flavors of startup I’m investing here in this category. Some are defined by building low-cost, low-power distributed sensor networks which help heavy industry capture, analyze, and act on new data; the revenue models here could be thought of as monthly “hardware as a service” (e.g. Filament). Some startups in the Industrial IoT sell design, collaboration, or machine OS software to help with new areas in 3-D printing (e.g. Tempo Automation, Material), surveillance (e.g. BetterView), vertical-specific solutions (e.g. Compology), security monitoring (e.g. AquaCloud), and more to come.
I got more excited by this space because (1) it combined some trends I am interested in (distributed networks, sensor intelligence, cloud computing, data moats); (2) the founders it attracted were not only whip-smart, but educated in an interdisciplinary manner across engineering and design; and (3) with over two-thirds of the world’s parts and infrastructure not connected to the Internet, it struck me as a potentially massive market with a customer base who is most-certainly willing to pay for the right solutions.
If you’re a founder or early-to-mid-stage VC/investor interested in this space, please contact me ASAP.
Two, Enterprise SaaS: This is the bread-and-butter of traditional VC, and who am I to buck convention here? When so much money is being pumped into moving atoms in the real world and out-executing the competition that goes 5-6 deep, investing in pure B2B software seems like a good idea. But, it’s too easy to say “I invest in SaaS” because, deep down, everyone does. How does one go deeper?
I go deeper by adding very specific filters. I am looking for SaaS teams who are creating new categories (e.g. Tesorio), who can build their own data moats (e.g. SecondMeasure), who bring machine intelligence to their offerings (e.g. OneConcern), who are not afraid of going after big enterprise or the low-hanging fruit inside governments (e.g. AquaCloud). If you’re a founder building a new SaaS product and fit into one of these buckets, I definitely want to meet you ASAP.
Three, New Consumer Technologies: Like any balanced portfolio, I cannot forget about consumer entirely. But, given what I’ve written above, given the strength and operational abilities of the incumbents, and given the shift from minutes to dollars, I have to focus my consumer tech investing a bit more. To that end, I am looking for startups that can (1) siphon off, intercept, or help redirect consumer spending on healthcare (e.g. Remedy); (2) bring technologies to mobile messenger platforms, which are major containers of mobile consumer activity worldwide; (3) build critical infrastructure for emergent consumer behaviors around virtual reality (e.g. AltspaceVR); and (4) simply bring together teams and designers who are talented and have a strong point of view of how they’d like to change (or challenge) consumer behavior.
I am happy and willing to take more risks here. I don’t want the fund to be an entire cookie-cutter of startups, and as the dog who chases cars, I won’t know well enough to know how something will turn out. As a result, I look for specific concepts or teams or people or ideas or whatever works. Lucky for me, being an early stage fund now that’s a bit bigger with some experience, but not asking for big ownership, I can build a more diverse portfolio based on a mix of what I see out in the market and what comes my way. I may be quicker to say “no” as I evolve my filters and focus, but it also means that when I say “yes,” I can put a little bit more meaning behind it, and hopefully, one day, have a better answer for that nagging question: “What’s your view of the world?’
Over the last year, we’ve seen a few big, public market corrections; we’ve seen increased tech reporting and online chatter about companies being given lofty valuations ahead of performance; and we’ve seen even more early-stage investors entering the market to invest directly in private startup as traditional venture firms write larger checks. More recently, we’ve all witnessed a significant slow-down in investing across the board. We’ve designed this event to surface and address all the issues that founders and early-stage VCs go through as a result of this new, crowded seed landscape.
This all makes for great timing for this year’s Post-Seed Conference on December 1st in San Francisco. Check out the great agenda here. In addition to in-depth fireside chats with Sequoia’s Alfred Lin, Vinod Khosla, John Doerr of Kleiner Perkins, and a16z’s Scott Kupor — we’ve put together a packed agenda with great angels, seed investors, and traditional VCs to talk straight about market conditions today. We also have two distinct panels composed of founders/CEOs who’ve personally traversed the path from angel and seed funding to the Post-Seed world.
If you’re interested in attending the event, please get in touch with me directly. This is mainly an invitation-only event, where we are covering the costs for folks in our networks who genuinely would like to attend, participate, share knowledge, and to learn. I have already given out lots of tickets, and I have a few more for friends and readers. While we are asking professional investors to pay a modest price to help defray some production costs, we are not charging seed-stage founders so long as their companies have received seed funding. Please send me a note if you’d like to come and can make it on Tuesday.
A few years ago, Albert Wenger wrote about the concept of “Antifragile Investing,” based on the book “Antifragile” by Nassim Taleb. Wenger, who has occasionally written about the forthcoming dangers from climate change, suggested that as trends form (like a storm), it presents both chaos and also an opportunity to invest in what Taleb may call “antifragile investing.” Wenger writes:
the evidence around climate change is becoming ever stronger that human made greenhouse gases are the key forcing function for the next hundred years. The change appears to be accelerating in particular with Greenland melting at a faster rate than predicted by even the most aggressive models. These changes are receiving more coverage and with storms like Sandy taking place public opinion in cities like New York is beginning to change.
In Albert’s post, the protagonist is climate change. What if we applied that logic to a slightly less catastrophic topic — the retail sector in the U.S.? I’ve been thinking (link to tweetstorm!) about how all of this comes together for a while, after years of investing in the space and writing about it, but it all finally clicked this past weekend when I heard about Amazon’s new mobile app — Prime Now — and rushed to download. Over the past year, my own household’s experience with Amazon Prime has gotten better and better. In addition to the media bundles, inventory choice, and ease of ordering, deliveries were now often being offered for that same day, not to mention all the potential integrations with Amazon Echo. When we moved back to California in mid-2010, it felt like my wife and I went to Target 2-3 times a month; for the past few years, I can’t recall stepping foot into the store once.
Over these past five years, the rise of Uber has paved the way for other on-demand startups to offer both consumers and businesses items on-demand. Yet, as we all know, not everything needs to be on-demand. When I look at our own household’s behavior, Amazon Prime membership covers most everything we need. They have all the SKUs we’d need. There will always be a long tail for specialty retail, of course. The other items that would need to be on-demand, besides transport (Uber), are food-related — grocery and prepared foods. More and more, Amazon is building inventory in grocery and some in prepared foods.
Google is attempting the same with Google Shopping Express. I just visited their site again after a year had passed. It’s quite impressive. Their offering may rival Amazon’s in some ways (shops, etc.), but likely not in most others. It’s clear that Uber would want to get into this game somehow as well, but right now, I don’t see how either Uber or Google can beat Amazon’s core customer base and logistics for same-day against a huge inventory backdrop. If that prediction is correct, that will mean the next battle ground after CPG will be food, either grocery and/or prepared food. This is where things get interesting.
Grocery as a category is important for a few reasons. First, it’s a HUGE market in the U.S., almost $700B annual. Second, it’s often a weekly purchase for most households, and sometimes, more than once a week. Third, major big box retailers have invested a lot in grocery (Walmart, Target, Costco, etc.) as a means to eat more share of the household wallet, but also as a hook to generate more recurring foot traffic to their stores.
Prepared Food as a category is also critical (over $700B in annual consumer spend in the U.S.), but slightly more complex in that it comes in two flavors: Flavor A, which contain logistics-oriented companies like publicly-traded GrubHub and startups like Postmates, DoorDash, and Caviar (now part of Square) which offer a broad selection of local food merchants to customers with delivery; or Flavor B, which are vertically-integrated models that make and (for now) deliver their own food, such as Sprig, Munchery, and SpoonRocket. The benefit of Flavor A is that the customer gets variety and choice; the benefit of Flavor B is economic, where the company making the food itself can control the cost of goods sold and, therefore, the margin on each sale.
[As an aside, as I wrote about the forthcoming Uber IPO story line, I believe they will need a new vector upon which to show the power of its platform. I find it telling that it’s put the EATS button right in the middle of the app, not buried in the settings menu; and I think given how Amazon is executing on same-day delivery for Prime (and now with Prime Now) and given how Google can use its market power and cash pile to undercut, I don’t see Uber touching CPG for a while unless they make a very bold move. Therefore, there’s more riding on EATS, but just picking up and delivering food glosses over how complex these business processes are, not to mention the fact that many of the best startups in these categories have shifted models slightly to charge back the original retailer to enjoy a piece of every transaction. In this world, owning the customer relationship and the brand are the most valuable commodities.]
So, here we are. According to me — and I could be wrong — but between the potential leaders in “new retail,” Amazon is increasingly going to own CPG for the foreseeable future and will continue to penetrate grocery, but not prepared foods; Google will likely make a big acquisition to level up to Amazon in CPG and grocery (but not prepared foods); and Uber, sensing all of this, will focus on its own branded “EATS” to show it can deliver more than just people from Point A to Point B. (There are other things Walmart, Target, and Costco can do, of course. Instacart now works with Target and Costco; Costco itself has massive market power; Walmart is the retailer of choice for the majority of Americans and is recession-proof given its scale; a NY-based startup Boxed Wholesale is working directly with CPGs; and, of course, much-covered Jet.com has (in)famously tried its own membership-based model to compete with Amazon. That said, the manner in which Amazon, Google, and Uber are executing at scale combined with the stormy conditions hanging over retail overall would worry me if I was a large shareholder in the older guard.
And, this is where we come back to climate change and Antifragile Investing.
What if the storm brewing in retail could have not gradual effects on the old guard, but catastrophic consequences? What if everyone observing retail has underestimated these consequences, not only the depth of the them, but also the timing as to when the storm will hit shore? Earlier this year, Walmart missed earnings — that’s not a usual occurrence. And what if those who are bringing the storm don’t want to stop at CPG and food — what if they want to get more voice-controlled (Echo) or home security (Nest) or location trigger points (beacons) inside your home? What if they wanted to take a bigger swing in hyperlocal commerce and use terrific delivery for things you need always (CPG and food) and then bake in local services (like Thumbtack, Yelp, etc.)? When one applies the idea of “Antifragile Investing” in the way that Albert mentioned it above, all of the criticism of on-demand startups in a variety of verticals all gets cast in a different light.
Further adding to the crowd’s confusion is that while these are operationally-complex businesses, we are not talking about rocket science here — it’s more about what the average consumer and household needs and spends money on. It’s about creating a better channel from the company to the consumer, and given the consumer more choices, better prices, and most importantly, more time (and often money) back in his or her day. And as the storm continues to approach shore, with the combined market caps of Target, Costco, and Walmart hanging over $300B alone, I’ll leave you with the last paragraph from Albert’s post — where you can interchange the references to climate change with on-demand logistics:
What would be the best investment strategy here? Place a number of small bets in public stocks that are particularly beaten up with companies such as Amyris or Gevo and/or invest in some new early stage companies (which could include information systems for measuring and tracking carbon). Each of these is essentially a call option on an acceleration in climate change. From an options pricing perspective these options seem significantly underpriced because people are vastly underestimating the volatility of the overall climate system (which is highly non linear). This is a perfect example of an antifragile investment strategy.
Here’s something I believe will become more prevalent as angel and seed funds which lead deals scale up and try to help their portfolio go to the next level: The increasing importance of a signal created by an existing investor who wants and/or takes a “super pro-rata” position in the next round of funding.
As a brief background, (1) a pro-rata right is sometimes granted to very early-stage investors as a reward (though not without controversy) to maintain their ownership position as a company matures and takes on more funding. This protects against dilution; and (2) many angel and seed rounds have quickly graduated from friends and families and credit card debt to taking funding from micro funds managing under $100M.
Back to the tip. My view is that as Series As continue to get harder to get done, and as more and more companies which have been funded are running out of runway, there will be another one to two huge waves of seed companies that just flop over — not even very light M&A, but rather droves being washed up ashore overnight. As this funnel tightens, and as there are too many companies for all Series A investors to properly track, I believe many of them will look for the super pro-rata signal in the majority of cases where the investment decision is not a unanimous, slam dunk term sheet.
If I’m on to something — and, fair warning, I could be wrong — one way a founder could leverage this dynamic is as follows:
As you’re gearing up for Series A, go meet your lead and/or larger seed investors in person. Give them a proper update. Tell them about the past, present, and future.
As the conversation evolves and hopefully goes well, invite them to not only take their pro-rata (most early-stage funds are set up with reserves to follow into a good portion of those who graduate to Series A), but ask them if they’ll take a super pro-rata position. This is an invitation for them to gain more ownership in your company.
Now, assuming those early larger or lead investor will be either the source of an introduction to the larger VCs and/or will certain act as an important reference, your investor can talk all day long about how great you are and how great your company is, but nothing will likely speak louder than if he or she simply writes something like: “Not only did we take our pro-rata in the company; we offered super pro-rata, uncapped into the next round, to demonstrate how much we believe in the company.”
For the larger VC who sees this, it sends a very sharp, strong signal. It cuts through the noise and pegs the earlier investor to put their money where their mouths are. In a world where early-stage investors make intros to VCs ten times a day, this kind of intro will definitely stick out as high-signal.
However, there are some risks to this approach, but I would argue they’re healthy risks: The lead or larger investors may politely say “no,” which may force the founder to examine why. Or, the early-stage investors typically don’t follow-on (as part of their model), so there’s no real way to leverage this dynamic. However, if this works, and if you’re earliest backers want to invest in more in you and you can use that as part of the “proof” of why a Series A round is deserved, I feel strongly that it will put the founder in a great position to have his/her pitch taken seriously. The larger VC will likely interpret the signal as a specific type of social proof and, assuming they respect the earlier investors’ work and judgment, it will make them feel a bit more at ease that other investors will also have a strong, vested interest in the company’s long-term arc.
Finally, as a post-script, I don’t want this post to smack of “gaming fundraising.” I think of this move as uncovering a hidden dynamic into today’s environment that rewards founders with hidden gem companies and those who communicate well and build trust over the long-term.
After thinking about writing a book and then ditching that idea in favor of a much simpler and more rewarding weekly newsletter (signup here), I have used so many different sources and tools to keep track of all the news worldwide about Uber. Like Apple is a boon for bloggers by generating tons of traffic, writing about Uber and putting the word into a headline is likely to increase the click rate and lift on any article or piece of media. I feel as if I’ve now seen every headline related to Uber possible. This isn’t to say the company isn’t without room for improvement, but the headlines are getting tired now. At this point, the only story left to write of Uber as a private company relates to its impending IPO.
Speaking of IPOs and stories, I believe Uber will need a story alongside ridesharing to go public at the $100B+ valuation they’d likely seek and command. A few years ago, when Facebook was preparing to go public, analysts remarked at the then state of its mobile app (it was bad!). Facebook famously acquired Instagram before its IPO, a move that is now obviously so genius (and valuable) in retrospect. Part of that acquisition was inherently defensive, part was strategic, and part of it helped Facebook tell a bigger story leading up to its IPO.
This isn’t to say Uber needs to do something for its own sake, but I do believe these stories and narratives play a big part in the process of preparing an IPO, going on the road shows, and selling a vision that the broader public can buy into. So, this got me thinking, in the context of an impending IPO, what will be Uber’s Instagram?
The analogy breaks down a bit because, credit to Instagram, it could’ve really threatened Facebook in some deep ways. But if we focus just on the “mobile story” angle, the issue for Uber as it marches toward IPO is to show the depth and strength of its platform and brand to help move things other than people from Point A to Point B. Along the way, Google Shopping Express has tried to win share by offering steep discounts, while Amazon has quickly beefed up it’s Prime delivery with many available on the same day. Amazon’s execution here has improved dramatically, so much to the point where I don’t think Uber can compete right now on traditional CPG and e-commerce.
That leaves one thing: food.
We have to eat. If we are lucky, we’ll have three meals a day, and we’ll visit the grocery store once a week. As a result, startups have dug hard into this space, and the VCs have followed. I’ve written about all of this many times before, so won’t rehash it here. The issue for Uber is that while the unit economics are strong and network effect is insurmountable, some users may not use the app as frequently as they may others related to food. And, despite what you may see on Twitter, there are some startups in the food delivery space which not only have positive unit economics and plans to expand, they’re also on pace to haul in massive revenues. I know Uber likes to build things within (and EATS seems to be doing well), but I think in this case it’s a bit more complicated and requires a different flavor of customer service and software for the food companies that would take time to be built.
So, when I add this all up, my right brain says “Uber will make at least one, if not two, big acquisitions before the IPO” as way to tell a better story for the IPO, as a way to increase frequency of use, and as a way to bolster its bottom line and brand in the mind of consumers as it wages more war with Amazon and Google.
For those working in and/or observing the world of venture capital, this week provided some good fireworks, with two early stage powerhouses announcing power moves. It also happened to coincide with a week where investors in the Bay Area congregated at a small handful of well-timed annual events and fireside chats, often hosted by LPs (and very much off the record), so these moves became a big part of the backchannel conversation. In the press, on Twitter, and in many of these backchannel discussions, it is easy to see why an immediate reaction of a traditional investor could be one of disbelief or dismissal, or why someone in the press could tie this to the “disruption of venture capital.”
I’m writing this post to share my views on the news, and to make a slightly counter-intuitive point: The moves this week by AngelList and Y Combinator may not be great news for many VCs, but it is great for the VC “ecosystem” overall. These bottoms-up funds and movements show us all new examples of how atomized venture capital can work, how the next generation of founders may want to finance their businesses, and how software and networks can potentially provide more transparency and efficiency to each participant in the ecosystem of LPs, VCs, founders, and employers.
The moves by AngelList and Y Combinator shake the trees. These are good things.
First, we should acknowledge that LPs having more direct access to startups (as a mechanism to save on fees and/or gain more access) won’t necessarily work across the board. Second, there is a potentially perverse incentive in how Syndicates are currently structured with deal-by-deal carry (versus the pooled risk in a fund) that could lead to more syndicates being formed because there’s no natural governor to modulate it. All that said, I am not worried about those risks because (1) AngelList has implemented numerous controls to protect against this behavior; and (2) I view this as the first of many small steps in how venture capital is being reorganized and restructured (read Ben Thompson’s excellent breakdown on the similarities between AWS and AngelList), and it will take a long time to shake all the trees. These visible experiments help the industry step in that direction.
Second, a platform like AngelList is set up to help make the business of being an LP more efficient. By using software to automate many aspects of reporting, analyzing metrics, and streamlining back office administration, LPs can cut down on the cost of the capital they deploy while also gaining access to more real-time, standardized information about their portfolio, perhaps relative to what they have today. From the point of view of Syndicate Leads, AngelList in general and this new CSC Upshot fund specifically gives those with the early-stage eye and/or relationships the opportunity to invest with more leverage, to build an independent track record, and to leave behind the hassle of filling out rounds and fund administration to software and networks rather than costly human labor and way too much email.
The week also ended with a bang.
By Friday, news had leaked (though everyone in venture already knew about it) that Y Combinator was going to announce a $700m growth fund, “Continuity.” YC has always had a somewhat adversarial relationship with traditional venture, and this move to compete for growth rounds in the ecosystem is definitely a power play move. To date, YC has grown its network and brand by investing a little money but mostly their time and know-how to earn equity in a basket of companies it can pre-select from. In the YC model (to farm black swans), they can leverage their own network of founders, software, and global brand to attract about 250 or so companies a year, out of which they just need one or two to hit. It’s gravy if it’s more. At the same time, they are liberated from trappings that hold many VC firms back — YC can have a high failure rate, YC can invest in many companies in the same category (whereas VC firms cannot), and YC remains an “investor of record” with its brand in the winners.
This is where a challenge sets in, and where an opportunity emerged.
As a company progresses out of the YC accelerator, it can attract angel funds, seed capital, venture capital, and eventually growth capital or, lately, late-stage pre-IPO capital. Traditionally, YC wasn’t either able or interested to participate in the future financings of their companies, leaving an opportunity to traditional VCs. YC helped solve a discovery problem for VCs in a time when the cost of starting up decreased and the amount of new companies formed and new markets opened up increased (and continues to).
The critical components of the new “Continuity” growth fund are worth examining. First, the fund size: At $700M, the fund can follow the traditional Series A and/or Series B rounds where companies are valued around $500M, give or take. Second, the fund may lead (as it appears to be doing with YC alum Checkr) or it may follow-on where the terms are set by another lead. Third, $700M is likely just the beginning for an inaugural fund. I’ve heard from multiple sources who were directly considering an LP investment that the initial target was around $1.5B, and while the headlines grabbed that superstars like Mike Bloomberg and institutions like Stanford were offering some of the initial capital as an uncapped note into a priced round post-Demo Day, what isn’t reported is that some of the world’s largest institutions, sovereign wealth funds, and families were in play for the fund. Expect them to participate in Continuity II.
Let’s use Checkr as an example of how this near full-stack venture financing approach works in the world of YC. Checkr is likely funded by friends and families and founder money. They’re accepted into YC, and likely exchange 4-7% of common stock in exchange for joining the YC network. They also receive $100k-$150k in money (essentially grant money, but converts at a later round). Upon Demo Day, they receive Series A investment from well-branded Valley VC firms, and now with good metrics in a good space, get a lead investment from Continuity. YC has mentioned they won’t go after Series As and Bs to avoid signaling issues of not funding some of their companies, but let’s see what happens in practice.
Checkr is a very good company. Most Series B and growth investors may not have known the opportunity existed to invest in Checkr, and now with Continuity out in the market, it forces even more intense competition for these deals. Hypothetically, if Continuity came right out and offered Checkr a $300M post-money term sheet, it acts as a price floor for other traditional VC firms to beat either on price or by offering a more compelling partnership and/or services and/or network. If Checkr doesn’t like the other offers, it gets patient capital from a known quantity. It stays in the family.When you break apart the funding trajectory, YC can now create a disruptive price distortion in early stage (buying equity cheaply) and now late (by moving fast on asymmetric information on its own children). And, if we look into the future with a wider funnel of YC Research, YC Fellowships, the regular YC accelerator, and now YC Continuity, the funnel will get tighter and better for YC to be at one of the best seats in the world to see who and what our future will bring.
They say “bad things come in threes.” So, for someone in VC, what’s the third thing? I would argue, instead, that “good things in come in threes,” and that, counterintuitively, the news itself this past week from AngelList and YC are great forces to stimulate and maintain more health in the great venture capital ecosystem. That ecosystem is not just limited to VCs — it includes LPs, founding teams, and even employees. It is the third good thing.
It’s obvious that founders want many aspects of venture capital to change. Throughout history, most lenders of capital are not viewed favorably. But, spend some time with LPs and line-level employees at companies, and they too recognize that these bottoms-up movements like AngelList and YC, powered by new networks and software, inject a new level of transparency and efficiency into what was otherwise a very opaque business and business model.
Most of the immediate response, Twitter reaction, and backchannel chatter in reaction to this news was to point to how venture capital is being disrupted. Sure, it is in some respects, but why not also view these moves as opportunities? For instance, on AngelList, an individual investor who may have not been able to have a career in traditional investor could go directly to LPs and founders and make a name for him/herself, with a track record that can be verified by a ledger. Or, for example, with respect to YC’s Continuity, it may force traditional venture capital firms to focus their business on Series As and Series Bs where company building occurs. Firms which can credibly show a commitment to and track record of building teams, customer bases, and new market penetration can emerge to show real value outside what Continuity may bring, though of course they can grow that fund into a platform, as well.
When I write “shake the trees” it is a reference to the fact that the venture industry moves very slowly. When an institutional LP commits to a VC fund, they’re effectively committing for 3-4 funds (when those vehicles tend to get “sweet” and reap rewards), and perhaps even more funds for fear of missing a cycle and being cast aside forever by that fund. As a result, LPs don’t have great insight into all the funds they’ve invested in, don’t have much visibility into GP recruiting and hiring, and so forth. A platform like AngelList gives LPs worldwide a greater pool from which to evaluate potential investing talent. In the case of Continuity, it places more pressure on Series A and Series B funds which are tied to YC with a history of investment to forge greater partnerships with YC founders, though it’s worth noting that one can find amazing companies and drive returns in venture without ever touching a YC company or working through AngelList. It’s early days, however, so the future may be different, of course.
I’ll end this post by admitting that even me, as a very small, new investor, will face increased competition through these structures. Already, I missed participating in a seed investment in LA which went right through a Syndicate on AngelList (the founder didn’t want the overhead of meeting too many people), and then the founder went right past YC into getting a healthy Series A from a branded SF/Valley VC fund. That deal, which I found relatively early, in a sector where I have real experience and a portfolio to back it up, just passed me by. Whatever expertise or value I thought I had didn’t matter as much to the founder. The founder, in this case, wanted to minimize the noise fundraising can bring, he wanted to manage the lines on his cap table, and he used the networks and tools available to him to do so. Initially, feeling the sting of being late, my first reaction was to think his move to Syndicate 100% would backfire — but it didn’t. And, he was kind enough to invite me to his A round, which I ultimately decided not to participate in, though I appreciate the gesture. It’s a new world to adjust to, and I welcome the changes, because it’s those forces which motivate me to continue to refine the precision and speed with which I’d like to operate.
These are not bad things. These are all good things. And, I’m excited to see more of it, as it will force every investor to be sharper and more focused.
As I begin Haystack III, I wanted to write down and share the reflections I’ve had on seed investing to date. However, please note (1) I’m still learning; (2) I’ll make new mistakes; and (3) these reflections are for me, and not generally applicable to others — there are 101 ways to invest effectively and different things work for different people. And, ultimately, (4) it is a privilege for me to be even just a small investor, and it’s a privilege I take seriously, and am grateful for all the investors in my fund and founders I’ve gotten to work with — they have all taken a chance on me, and that is a very humbling set of circumstances to keep in mind.
With that, here’s what I’ve been reflecting on with 100 investments now in the portfolio, three years in. I don’t have a technology or investment background, so I wanted to invest in a lot of companies quickly as a way to speed up my learning, but I know in the back of my mind, there are no shortcuts and will be more learnings in the years to come. [I want to dig into some my stats (as I’ve shared on Twitter before), but I’ll do this in another post, as here I want to focus more on what I’m taking away as I move into Fund III.] Finally, I’ve had a tough time organizing my reflections in specific categories, so this may ramble a bit. Apologies in advance.
1/ Out Of Market, Out Of Mind
I made a small handful of “out of market” seed investments, some in LA, one in Canada, a few in NYC, one in Boston, and one in Europe. While I’ve been active with them, it is hard to keep in touch and requires a lot of extra work and communication. For Fund III, I’ve elected to keep my focus to invest locally in the Bay Area. I’m sure it will be tested over the course of this fund, and lo and behold, I met an entrepreneur with operations in Israel and parts of West Africa that I would love to work with, but I am not sure about the geographic divide. At the Series A level, I can see how a VC firm would invest out of market, but at the seed stage, I believe the financing risk is too high generally. I sense some people will take offense to this stance, and I hope local seed markets flow to other geographies. I know I’ll miss out on great opportunities, but for this fund, I’m OK with it, which brings me to the next section…
2/ I Can’t See Everything, And That’s OK
At the seed stage, there’s just no way to see every good opportunity. Company creation is so pervasive, I am not sure how wide one’s coverage at seed could be. By adopting more process constraints (like focusing on local investments, etc.), I’m implicitly saying it will OK to not see a company in another market or in a hot category, etc. It’s OK.
3/ Existential Risk Rules The Day
“Only the paranoid survive.” Or, any similar phrase will do the trick. Seed-stage companies biggest risk isn’t competition or a large company — it’s surviving, and often that comes down to securing future financing venture capital. Every seed stage company, whether they admit or not, strives to “reach Series A,” but we know most don’t make it, so we have an explosion of bridge rounds, or second seed rounds, or seed extensions…whatever you want to call them. While a select few companies will have VCs chasing them or boast insane metrics, the rest have to really fight it out, and it often requires a level of risk, sacrifice, and paranoia among the team to get the deal done, which brings me to the next section….
4/ Founder-Market Fit And Startup-Founder Fit
I have learned that I like to find some connection between what a founder is working on today and what they’ve experienced in the past. It could be a loose connection, but I strive to understand what those connections are and how deep they may be. It could be how they’ve been trained, or where they’ve spent their careers, or it could be personal like where or how they grew up. Additionally, I try to evaluate through conversation and reference checks the level of dedication one has to startup life — Do they have the willingness to take real risks, even if it’s reputational risk? Are they willing to sacrifice in pursuit of their goals? Do they exude a mix of confidence about their abilities and competitiveness to fend off all the copycats that will emerge in today’s startup culture, alongside a healthy paranoia that drives them to understand the next round of financing will be an uphill battle? Speaking of uphill battles…
5/ The Seed Round Doesn’t Really Count Anymore
Receiving an offer to invest early in the life of a company generally doesn’t mean much. Yes, it’s very hard to raise money, but there are so many seed stage financings every day, why announce them or view it as some kind of validation? It is not. Securing a seed round means a team has convinced others to believe in their potential. That is something to be proud of as the recipient, yes, but perhaps more of an internal high-five to one’s self versus broadcasting it to the world. I think what really matters are: Do friends and former colleagues want to work at your new company? Do customers find you and bring business your way? Does your product or service change the behavior of your users or customers in meaningful ways? Do any or all of these exist in your company to the point where a professional investor fights to invest in your company, to join your board, and to work with you on a long-term project? Those are the things that count in the long-term.
6/ What Does “Value-Add” Mean At The Seed Stage?
I’m a very small investor on the cap table. The biggest area seed stage companies ask for help with is, unfortunately, one area I can’t really help much on: Recruiting. Now, I have certainly sent a few ex-colleagues to startups in my portfolio and try to do more when I can, but as a percentage it’s pretty small. I’ve also helped “close” many candidates who are looking to join portfolio companies, which is definitely more effective for me. After a while, one kind of glosses over the standard requests like “Hey, if you know any good iOS engineers, send ‘em our way — we are hiring!” I didn’t want to turn into a recruiter (though I think it’s a very valuable skill), and I believe the talent fragmentation in today’s SF/Valley startup scene is so pronounced that being effective at this may be a waste of effort. Instead, I choose to focus on mitigating the risk in Point #3 above, and from that lens, everything flows.
7/ Being Helpful Via Push Versus Pull
With a larger portfolio and being so early, I initially decided to be available and approachable when someone needed any kind of help or just someone to talk to. To encourage this to happen more casually, I set a calendar alert to BCC email all the founders together on the 1st of the month with a short note to tell them what I was up to, to share where I was speaking, to share generalized opportunities I came across, and to add my phone number. From those more casual emails, conversations would emerge. And as those conversations progressed, I would start to ask about burn rate and runway, and if I gathered that the founder was potentially underestimating how much runway they really had, I would offer to work together on it. Many took me up on this offer. Some didn’t. There will be a higher number of things that don’t work at seed, so I focus on (1) trying to pick well prior to selecting an investment and (2) being in a position to help if it’s welcomed, but then not pushing beyond that. It is not my company.
8/ Investing Pre-Product Or Pre-Launch
Unless I know the founders previously on a personal level or it is someone who has successfully started companies in the past, there are way too many good investment opportunities on my desk for me to consider investing in someone’s concept or dream. In fact, I’m shocked how many people waste time trying to pitch someone about their concept when there are live products in the wild for investors to play with and test. It does feel a bit like people view this very early stage investing as a newfield area to go after, but to me it looks more like grant funding — now, there’s nothing wrong with grants, assuming those grants are made on some type of asymmetric information and/or prior evidence of application of talent.
9/ Leading Rounds Versus Catalyzing Rounds
Being a small investor, I cannot lead a round by investing the most money. However, on occasion, I have been one of the earliest investor in a seed round and then worked to catalyze the round by sharing it with a network of investors who enjoy co-investing with me from time to time. In these cases, so long as the founder is OK with it, I can have a bit more influence on the overall terms (what I think the clearing price will be) before sharing it with the wider network. This has been very successful to date — for both investors and founders I work with. Keeping in line with my views on the threat of existential risk, I focus on catalyzing rounds to make sure they get done versus trying to lead them with the small, inexperienced checkbook I wield. And, as seed rounds are never really closed and therefore this is rarely true urgency around closing a seed round, it is entirely manufactured without real teeth as founders may need bridge capital later on in the company’s life.
10/ The Good And Bad With Party Rounds
I have no clue, statistically speaking, if party rounds impact the trajectory of a company. It is intuitive to think that they do, given that more investors with a smaller share won’t care as much about the company, but then you can see some companies on AngelList which have over a 100 direct investors (not through a Syndicate), and it makes you wonder. Clearly for a founder, managing more lines on the cap table can be a pain, but ultimately, if every seed stage company faces existential risk, and if there are too many investors such that no one has meaningful enough ownership to care for and fight for the company in hard times, that composition may impact how the company fares. Philosophy aside, most rounds I see are split between having 1-2 leads with a few individuals and pure party rounds where the founder just scraps to get it done. For now, I’ve decided to focus on making the sure the round can close if I have conviction versus trying to make sure there’s a lead, though some cases definitely require a lead.
11/ Seed Investors Not Updated Often
I struggled with this initially, because one assumes people will update you. But, most don’t. I’ve learned to accept it for now, and if someone contacts me later for help, I may ask them for more context and an update in order to properly help. Some of the best-performing companies rarely or ever sent an update, despite the investor feeling he/she may want one.
12/ Conflict In Seed
Big VC firms can’t really invest in more than one company in a category, but some get away with it. Incubators and accelerators definitely can, and they take advantage of it. At seed, things are so early and people change course often, a seed investor with a larger portfolio can sometimes fall into a conflict. This has happened to me. On some occasions, there is a direct conflict and I don’t engage; sometimes it’s possible, so I try to ask current founders if it’s OK for me to talk to another company; and the tricky part is that sometimes I don’t see it at all, only to find later that a founder views a company as competitive. Things are so uncertain at the seed stage, I just try to be as honest as possible, but I am going to make mistakes here and have, though I’m not sure what I can do about it given how the market is evolving. At the end of the day, everyone is in conflict with everyone else.
13/ Seed Is From Venus, Series A Is From Mars
Oftentimes, all of this activity gets lumped into “venture capital.” It is not quite accurate. The lessons I’m trying to learn don’t all apply to Series A, which is much more of a zero sum game where investors have to enforce discipline on the system, where they can’t invest in more than one company in a category. (At seed, there is a bit more room to invest in a category, as I described above.) So, I’m hoping people don’t take this post as a proxy for what large VCs do — it is not. Seed is very different and this post can’t be extrapolated to other stages of investment.
14/ On Relationships With LPs
I wrote a series about posts this past summer on StrictlyVC about my experience in meeting, getting to know, and taking investment from LPs. You can read those here. Ultimately, traditional investors in VC funds like to write bigger checks than small funds can provide room for, and increasingly, many of them are looking to make follow-on or even direct investments in the portfolio companies of their managers. This is especially true at seed, where access to companies proves to be most difficult for larger investors to stomach. I learn more about the market, about LPs, and about myself each time I go out to raise — this time around, there were two surprising things: (1) Some LPs first move in diligence was to verify that I actually had a fund and that the fund held previous investments — I had no idea they would do this, but it makes sense; and (2) that no matter how well you think you can pick them as an investor, people will always question your deal flow and judgment. People will question how repeatable your previous record is, and they’ll want to dig into how you get deal flow, which is likely the same way everyone else gets into the flow of deals. As the manager of a small fund, for better or worse, I’ve chosen to meet as many LPs as I can and go into each conversation assuming what I’m doing is too small for them and to focus on building a relationship with them. I’m hoping that over the long-term, with time, that I can build organic trust with a small group of partners.
15/ Investment Pace Matters
This is a learned skill. When I started, I was bad with this, and it got worse being a one-person shop. I got a LOT of feedback on that, and I listened to it — the main change I made is that I have found someone to manage my back-office accounting who is very strict about setting a pace and sticking to it. For Fund III, to start, I can do two wires per month, and he has to have all the docs in place before initiating the wires — then I go into the account and approve them. It’s still my decision, but that little extra process helps with the pace. At seed, the temptation is to make lots of investments because no one is sure what will happen, but from an institutional LP point of view, LPs definitely look over your track record and try to measure and predict how selective an investor can be. Pace is a big part of that equation. Still, two a month for Fund II is still pretty high, but a slow down for me relative to prior funds.
16/ Deal Flow, The Mother’s Milk
Everyone wants to know “How does one get their deal flow?” It’s all the same, everyone is connected to everyone (for the most part), and if you’re seen as a good actor and valuable in some small way, people often share their deals and/or people make introductions. When there’s lots to choose from at seed, picking the right companies becomes more of a challenge, and those who have picked well may do so out of luck, out of process, or some combination. It’s very hard to say.
17/ The Biggest Mistakes I’ve Made: Weighting Concepts Over Market Timing
The most common mistake I’ve made to date (there will be more!) is being seduced by a concept and weighting that over even little signs of momentum in the company or sector. From afar, it’s easy assume investing like this as “people who invest in the future,” but for it to be effective (e.g. to return investments), the size of the market and the market timing are critical, especially when there are hundreds to choose from at any given time. Now when I’m evaluating an investment, I’ll try to find the overlap in a venn diagram of three circles: (1) Is the market huge and evolving in dynamic ways over the next 3-5 years? (2) Is the product or service being offered in that market compelling and defensible in some way (could be based on tech and/or people)? and (3) Do the founders, either veteran or first-timers, have a combination of skill and willingness to sacrifice to make a run at building a company? If the answer is “yes” to all three, then I dig in more for references and socialize it with my close network to get feedback.
18/ Counterintuitive Advice That Backfired
This is easy. I seeded a company earlier this year that started to pick up traction, much to my surprise. The founders immediately turned around and said they wanted to raise a Big A, but summer was approaching, so I shot back with “raise from big funds in the Fall, it’s hard to get a competitive process going in the summer.” Well, that was definitely the wrong advice I gave them, and I pushed it pretty hard. They completely ignored it, and they got their round done before Labor Day, and given how the market reacted then and thereafter, they were absolutely right. Lesson learned.
19/ Reputation, Not Money, Is The Currency
It’s easy to observe the ecosystem and assume all investors have tons of money. Well, many of them do, and even those that don’t write big checks. It’s a great job, no doubt. But, if everyone has money, and all that money is the same color and has the same worth, what differentiates it? Reputation. Reputation, it turns out, is the only real currency most investors have. In a competitive environment, reputation lets an investor see a deal he/she shouldn’t have, or lets an investor convince a founder to work with him/her, or lets an investor be a little extra persuasive when trying to coach a founder. It’s easy to assume investors are conferred power by virtue of having money, but the money isn’t always there and can go away for the next fund — reputation is the real currency, one that takes years to earn and can be washed away in an instant.
I am very proud the announce the first investment of Haystack III: OneConcern.
I met the founders through another friend at a fund, he was looking at the company and knew that I liked software plays that sold to national, state, and municipal governments. Most investors don’t like those sales channels, but I do. Why? Because I believe over time the budgets for certain things (health, emergency, climate) will balloon to meet societal needs while many others will fade and erode because we simply won’t have the money in the tax base to get it done. Those essential tasks then will have to be left to technology and software, and in my investing, I’ve found that once an entrepreneur figures out how to sell into governments and builds the right stuff, it is one of the best channels out there because words spread through different networks and it’s harder for a new entrant to cut in.
Anyway, I met the CEO at the request of my other investor friend, and I was immediately captivated by his personal story and academic background. The CEO, a structural engineer from Asia who came to Stanford to study the science behind earthquakes and other natural disasters. This is a tangent, but I enjoy studying the history of earthquakes and learning about how societies have dealt with them. I troll Wikipedia to give my brain a break and read up on these things, so when I met the CEO, I was actually excited to talk about big earthquakes and data, etc. What I came to understand from that meeting, however, was even deeper.
A few years ago, during the major floods in Pakistan, Ahmad (the CEO) was home visiting his family and was caught in the floods. He escaped to the attic of his family’s house and lived on or near the roof for over a week until he was rescued by authorities. I always ask a founder about how past experiences may shape future activities, but I never expected a machine learning engineer focused on building software to help states mitigate disaster response systems say that he himself was caught in a major natural disaster.
While I always try to spend time “in diligence” and vetting a company, I realize now in retrospect I probably spent too much time doing that with OneConcern. The beauty of investing at the seed stage is that I can work with tons of other investors to support companies who start out and have ambitions to grow bigger. Yet, much of the early stages — myself included — have become professionalized, often to the point of placing unrealistic expectations on new companies, new technologies, and new founders, when in fact it should just be about the identification of earnest talent and the relentless support of that talent. I may have conducted my proper diligence, but some things don’t need diligence; a product like OneConcern and an entrepreneurial story like Ahmad’s must be supported — it must be willed into the world, and just like I am trying to do with the creation of Haystack and my own family funds, it will be willed into world no matter what. The solution must exist, and the network of other investors will support it to see it through with their own sweat and passion. That is inspiring to watch unfold and be a part of, indeed.
Strong tweets, loosely held. I use Twitter as a dump zone to crystalize my thoughts around a topic in a specific moment, and it’s awesome that people read them, interpret them, debate them, and disagree with them. Lately, I’ve felt that either I didn’t use the most precise words and/or some of the interpretations of my words distorted the whole point I was trying to make, so rather than do that via Twitter, I thought I would briefly try to explain my point of view on three topics below:
On the “VC Drought” post:
A few days ago, I wrote a post titled A New Kind Of Draught In Silicon Valley, which ended up being widely circulated and cited. Many who shared it on Twitter concluded that VCs weren’t investing as much; that’s not quite right, they still are, but it’s not like the summer, for sure. Also, announcements that are made now were likely closed before Labor Day, so there is a lag in the press about funding rounds. I also fielded quite a few media inquiries, and most of the reporters tied my comments as a reaction to valuations. That is a bit distorted. My main point in writing this post was to highlight what many LPs have told me, which is: They see a lot more money going out of their accounts versus coming back in. That lack of liquidity concerns them, and many of them have encouraged their VCs and GPs who managed their money to be a bit more cautious about investing more before returns start to come in. Just like startups, funds have runways, too.
Facebook As A Trillion Dollar Company: Open this thread to see quite an interesting debate re: the future of Facebook. My two cents is that Facebook is, relatively speaking, underrated as a company and can execute at the highest level, so much so that I see the network growing to one day become a trillion dollar market cap company. Many people on Twitter countered that this is how things felt with Microsoft back in the day, or more recently with Google, and that something new we haven’t thought of may come along to disrupt Facebook. While I agree new things will always come along, I’d hold to my argument because (1) Facebook own’s the most premium, dominant suite of mobile software on the planet and (2) for any new mega-trend that’s emerging to challenge for Facebook’s relevance and attention (VR, Asia, AI, deep/empathetic web, social commerce, bringing the next 3b people online, video, etc.), Facebook not only has an answer, they are either right on or leading the cutting edge. They are distributing mobile software at a time when mobile is not only the largest market in the world — it is also growing.
Charisma In Fundraising:
The latest twisted war of words was today, when I tweeted that “Most assume “the next round” is usually a function of metrics, milestones, etc. when in fact it’s mostly driven by excitement, charisma.” I didn’t realize it at the time, but I believe now that the word “charisma” can be interpreted by many to have some negative connotations, in the sense that it implies by being “charismatic” that one is being inauthentic or fake. Let me state the obvious to be clear that I would never call for anyone to be disingenuous or to fake their enthusiasm like this. I hope that is obvious. Now, re-reading the tweet, if we substitute charisma for something longer like “genuinely engendering excitement about your company, product, service, team, and vision,” well, I would hope that would be OK. Ultimately, this distorted my overarching point, which was to point out in my experience (biased sample, yes), people who were pitching investors to partner with them largely overweighted the importance of metrics and drastically underrated the importance of genuinely conveying the excitement, the meaning, the passion, the vision to the point where their audience (investors) would actually get excited — I mean “excited” in the emotional sense in that they would even start to use emotion over logic to pursue an investment and partnership. The truth usually rests in the middle, and by that both are probably critical to an effective pitch. I just wanted to point out how so many people don’t give enough weight to that side, and how in my experiences, those who can get others (including investors) excited about the opportunity seem to be more successful in receiving larger investment offers.
This past summer, I wrote some columns on StrictlyVC on the relationship between LPs and VCs, and I realized I never cross-posted them here, so here goes. I reposted them here with subheadings. This may not be of interest to the regular reader, but really intended for venture investors and those who are limited partners in VC funds. Would welcome any feedback or commentary on the notes below, thanks!
In the few years I’ve been able to meet and learn from limited partners or LPs (those who invest in VC funds), I have noticed an increasing desire to co-invest alongside their general partners. This makes perfect sense. If I was an LP, I’d want to co-invest, as well. Yet, in the process of doing this over the past few years, I’ve found myself repeating some warnings to LPs who have grown eager to do co-invest at the very early stages of seed.
Typically, I cite three key warnings:
One, oftentimes the founders want to meet all potential investors who will be on their cap table. Even though a VC can offer syndication to the founder, that founder may not welcome the introduction and prefer to control the process him/herself. LPs can certainly ask for insight into a GP’s processes, policies, and histories around creating co-investment opportunities, but they cannot be guaranteed. Furthermore, what if a GP has two or three LPs interested in co-investing but there’s room for only one or two. How is the GP supposed to decide?
Two, when there is a real co-investment opportunity for an LP, sometimes the LP doesn’t have the proper resources at hand (domain knowledge, or network, etc.) to independently vet and diligence the specific deal in a few days. If the LP is a family office, they may have enjoy the latitude to quickly stress-test their network and then make a yes/no call; if the LP is a fund of funds managing other institutions’ money, they may have an incentive to seek these types of deals out given their fund economics, regardless of engaging in proper diligence.
And, three, whenever someone is the recipient of an investment opportunity, one should ask: “Why I am so lucky?” In a competitive deal, I often have to fight just to wedge in, and I am not always successful. These are the investments LPs would love to participate in directly as a co-investor, but such opportunities rarely surface. Yes, there are companies that go unnoticed for months or years before breaking out and becoming a sensation, but those aren’t a monthly occurrence.
Again, if I was an LP, I would want to co-invest. After all, LPs are looking for outsize returns, just like the rest of us. More, if an LP doesn’t get in at seed, the bigger VC firms won’t create room for the LP down the road. Still, I’d welcome more conversation and debate around this topic, both from GPs and LPs alike, so that we can all learn more about best practices learned and minefields to avoid. Dangling the opportunity to co-invest may help ink a commitment, but in practice, all that glitters may not be gold.
Naively, one of the most profound lessons I had to learn in attempting to raise funds from limited partners is that most institutions prefer to write large checks. By “large,” I mean commitments to VC funds that are equal to at least or oftentimes two to three times more than what a typical decent startup may raise in its lifetime. It is all rational. The time, attention, diligence, legal burdens, and administrative headaches of doling out smaller checks to more funds reduces a larger institutions’ ability to concentrate and, frankly, creates a roster of more egos to manage over a long period of time.
An LP friend and mentor of mine summed it up perfectly to me: “Semil, I like you, but you gotta understand, my friends don’t get out of bed unless they’re writing a $25 million check.”
To those who haven’t raised funds or been around fund formation, it can all seem inefficient. For the rash of micro VC funds that have formed (mine included), we collectively confuse, vex, and overwhelm traditional institutions, including because of our higher pace of investing, heavily reduced levels of ownership, lack of toothy pro-rata rights, and a host of other issues.
Luckily for micro VCs, it doesn’t really take that much money to get going. My first fund was $1 million. It was really hard to raise. Some people have access to wealthy folks, family offices, or corporations, but it isn’t a slam dunk to raise a small fund. The second fund was considerably bigger (relative to the first), yet was still too small for institutions. The third fund will be even bigger — perhaps just at the size where the larger institutions like to build a relationship and track, much like a large VC firm who drops a $100,000 check into a company with the hopes of monitoring its progress.
As other non-traditional LPs (companies, high net-worths, and even funds) have stepped in, it’s created a boon for entrepreneurs. People with the right networks and halfway decent concepts can raise as little as $1 million in a month, even in a category where every early-stage investor knows there are four or five nearly identical competitors working on the same thing. Many of these attempts won’t go on to raise traditional venture capital, and the institutional LPs know that.
So, while there’s a high cost of writing so many small checks, we will have to wait a few years still to see just how costly it is. On the other hand, the cost of starting up may, in fact, decrease during any kind of correction as talent becomes less fragmented and major cost drivers (rent, salaries, benefits) decrease. Founders who are in demand and who are dilution-sensitive may want only specific people on their cap table, and they may want $100,000 to start, not $10 million or even $1 million.
We are a few years away from that, but this is where I see the trend headed — that being nimble enough to be invited to the cap table is what will define individual investors and firms. Those definitions can’t really be bought with money, and that’s what will make the next wave of micro VC investing so interesting — that is the high cost of small checks.
The growth in micro VC funds is now well-documented. While there are many reasons to explain why this trend took hold, the more interesting question to ask is: What will happen to those funds which survive?
Grow the Team
A natural desire of any entrepreneurial endeavor — including starting a fund — is to keep growing it. In the context of small funds, traditional LPs will naturally hope this new crop of managers who emerge will grow a franchise, will add people to the team, and ultimately manage more money. Eventually, some of these franchises can grow to manage quite a bit of money per fund per GP and can, in effect, become a new type of Series A firm. This is the theory. It remains to be seen if more than just a few can make this transition, as the models at seed versus Series A are obviously quite different.
Stay the Course as Lone Wolf
While it may sound traditional to turn a good micro VC fund into a more traditional venture franchise, creating a strong general partnership is not a simple, check-the-box activity. Noting the difficulty, some micro VCs have opted to stay as solo operators longer than LPs had imagined. Some, of course, continue to outperform and earn the right to manage more money per fund (if they choose to). In this instance, the LPs aren’t able to invest more and more of their funds into the GP. In the same way a large VC fund may look for opportunities to increase their ownership in a great company in their portfolio in order to make its own economics work, a large LP will often have a similar desire.
Differentiate and Evolve
Just as investors may have “app fatigue” or “food delivery service” fatigue, LPs pitched by micro VC funds have their own flavor of fatigue. As a way to cut through the noise, many of them drill into what differentiates a GP they’re considering an investment in. This can nudge micro VCs to differentiate on the basis of sector (hardware, Bitcoin, etc.), or geography (focusing in emergent areas outside the Valley especially), or stage (pre-seed vs seed, etc.), and more. And the success of Y Combinator and the potential for more steady budgets for an accelerator or incubator could encourage more to let go of the traditional fund model altogether.
I know these choices because I have been faced with them. The LPs rightly ask these questions and conduct references to determine which way the micro VC wants to go. But the truth is that, just like most at seed don’t know how well a company will do at the very early stages, most of them also don’t know what the optimal path to take is. This can lead to an awkward discussion, where LPs may want or need to hear certain things to “check the box” in their processes versus having the raw discussion about what is working and what doesn’t. The truth is that most people don’t know, and in this market, which is changing year to year, the main value in these smaller funds is that their inherent nimbleness by virtue of being small gives them the right level of flexibility to adapt to a dynamic, ever-changing environment.
My cautionary post-script for any later-stage investor (click here to read it). This applies to traditional VC funds or LPs who like to be on the cap table.