Adaptation And The Shape Of A Deal

As an early-stage private market investor, one of the many things I obsess over is how to design and manage the funds we raise and deploy. Ask 100 peers how they do it, and you’ll likely get 101 answers back. The problem is, as each fund and network is unique, different strategies and different pairings of variables can both lead to prolific or disastrous results. These conundrum has been swirling around my head, and as I need to do when that happens, I open up this composite box and try to work through it. So here, I am not sure if I’ll reach a conclusion by the end of this post. I may, or I may not. And, if you’ve managed portfolios like this and have a strong opinion, I would absolutely love to hear it.

“Ownership Really Matters” – This is a line often repeated by VCs and their LPs. Why does it matter? A few reasons. One, it’s not clear in the early days which company or companies will be the key fund drivers from a results point-of-view. On top of this, most portfolios tend to follow a power law curve, where the company which drives the highest return can be greater than the sum of the returns for the remainder. Given this uncertainty and randomness in distribution, having high ownership in a number of companies affords the fund a chance to return the fund (RTF) and hopefully drive a multiple in returns. Stepping back, ownership is important in early-stage funds because of no one knows which companies will be those fund drivers until years later, and no one knows how big they could be until the time of exit. These uncertainties combine to push many investors to hold high ownership in the companies they invest in, with larger funds needing to justify higher ownership levels.

“Entry Price Is Critical” – Many, but not all, investors will talk about valuation, or entry price as being critical to early-stage portfolios. This is often rooted in understanding how the power law curves look for size of eventual outcomes. It is really hard for a company to get a small acquisition offer. Most new ventures fail, sadly. Public companies can use a mix of cash and stock to buy startups for $100M and not have to publicly disclose those transactions. Acquisitions from $100-$500M in size happen but are significantly less frequent. As we approach billion-dollar exits and higher, those are incredibly rare. And, rarest are the companies that can go public and continue to accrue value — look at Shopify, which very few private investors truly paid attention to, went public a few year ago around $1B and is now almost a $100B company. Put all this together, and the only way to drive any multiple in a fund is to either be in a huge mega-winner early (like Shopify) or to invest early enough with lower prices such that, if there is an exit, the portfolio can benefit from the event. An investor’s entry price dictates the multiple early on, and then the ability to continually invest in subsequent rounds (to a point) helps further drive returns if the investor picks the right ones to do so in.

“Company Selection Is The Most Important Thing” – Surely, if an investor isn’t selecting good opportunities, all of this is moot. Let’s assume most managers are picking good founders — that still doesn’t mean those are necessarily good investments. And, the earlier an investor selects, the less data and information they have as evidence to support the investment. At slightly later stages, company selection is a bit more filtered but still uncertain. Those funds can theoretically own more as they can write larger checks, join boards, and participate meaningfully in future rounds. For even earlier funds, where much less is known, it is nearly-impossible to select based on future potential of the company, which is why these early investors focus so much on the prior experiences and technical insights of founders starting new endeavors.

All of these elements make up “the shape” of an investment. When investing early and building a portfolio, all of these elements need to line up. It’s so obvious when you write it out and this will be obvious to many reading this — but I’m writing this for myself as a reminder and for those in the early stages of their investing careers. It has taken a long time for these concepts to gel in my head, and even longer for them to combine into this “shape” analogy. I can only speak to very early-stage investing, that’s what I know. It’s so early, and so uncertain, that it is hard to get company selection right, perhaps impossible; as a result, it can be easier to manage entry price given the risk, yet the early-stage markets are flush with cash from angels all the way up to the platform funds; and as a result, smart founders are rightfully cautious about taking on so much dilution early on — this makes getting proper ownership for a fund quite difficult. And the bigger an early-stage fund, the more of a problem finding the right “shape” becomes. Prior to this pandemic, early-stage investors were comfortable operating in an uncertain environment given how little is known at the time of investment — fast-forward to today, and the process by which we early-stage investors make these “shapes’ and adjust fund sizes and portfolio construction will become even more important. This is the adaptation many of us need to make.

Goldilocks In The Time Of Coronavirus

Ever since becoming a dad in 2013, I’ve been obsessed with obsessing how I organize and spend my time. That obsession only intensified when our twin boys arrived in 2015. Ever since, it’s been hour by hour, each unit of time accounted for with as much precision as I can muster. And now, during shelter-in-place (SIP), this obsession has been taken to a new level to adapt to the micro (toddlers running around, sequestering in my home office, trying to concentrate) but also the macro (What is important? What deserves my attention, for real?).

For most decisions, I am pretty decisive. There are bigger decisions, and for those, I like to research, talk to friends/experts, then take a bit of time, but still decide on something and move forward. This behavior is both a blessing and a curse — a blessing because it keeps me productive, pushing things forward, not dwelling too long on small matters; but, can also be a curse, as I’ll plan out meals to cook days in advance, removing any spontaneous impulses to just cook what comes to mind in the moment.

Now full swing into SIP, I’ve noticed that, in a work context, it’s given me extra time to reflect on how we want to build a portfolio at Haystack. Portfolio Construction is a topic I thought I was obsessed about pre-pandemic, but that’s now been tested and taken to a new level because the stakes now feel not just higher, but different. While we have invested in a new company (in Toronto) in someone we met via Zoom only in the past few weeks, deal pace and processes have slowed down, somewhat intentionally.

I don’t feel in any rush to make a big commitment at the moment, but am entirely capable of making that commitment. Here, what I’ve noticed is that for that commitment, everything needs to be “just right.” Being good enough, or close, isn’t good enough right now. It reminded me of the fable from the story of Goldilocks:

The Goldilocks principle is named by analogy to the children’s story “The Three Bears”, in which a little girl named Goldilocks tastes three different bowls of porridge and finds that she prefers porridge that is neither too hot nor too cold, but has just the right temperature.

In the past two months, in a work context, I’ve had to walk away from investment opportunities that I wanted to make but didn’t feel perfectly right — on one, both sides couldn’t find a compromise; in another, it was to back a founder we love but at a later stage; in another, a founder I’ve known for almost 10 years, who is amazing, but I couldn’t get over the market fragmentation; and most recently, a simple but potentially big oversight on my part in someone I’ve known for years.

In each case, something was just a degree off for me, and forced me to make the hard call of not saying “yes.” I am pretty sure at least one of those decisions will haunt me over the next 5-10 years, but the SIP has reinforced to me the long-term and irreversible nature of early-stage investment decisions. In each case, through no fault of the founder on the other side (many of whom are also friends), things didn’t “line up perfectly” and therefore didn’t happen. It’s ok, in the grand scheme — but part of early-stage investing does relate to serendipity, the art of breaking rules or prior heuristics, having time in between meetings or at lunch or on the commute to work that my mind subconsciously filters noise for me before needing to make a big decision. With that processing time compressed to being at a desk and confined to the home, The Goldilocks Rule comes into greater focus — to move forward on a decision, like ordering takeout as a treat, or making a new investment that will be the start of a new long-term relationship, everything about the deal — not just the people — needs to feel just right.

Public Frenzy And Private Caution

Love it or hate it, the stock market is the sentiment machine for the United States. It is our nation’s Fitbit, Apple Watch, mood ring, tarot card, and more for getting a pulse of our economy today and a glimpse into what shareholders believe the future could bring. In the midst of America’s struggle with the COVID-19 pandemic and the induced economic coma set through government policies of sheltering in place and social distancing, we all know what has happened — an ice cold shock to consumer demand, unemployment levels not seen in over 50 years, and concerning uncertainty in everything from government policy, kitchen table issues, and public health. Yet, week in and week out, we see the stock markets holding their own, in some weeks gaining back points, and public market investors seeing opportunity while jobless claims hit 8-figures and rising.

What is going on, and what does it mean for startups? I’ll briefly try to explain the former, and dig into the implications for the latter.

Briefly, my impression of the U.S. stock market during this pandemic is as follows: The federal government is printing more money; there is massive stimulus into the economy, as well as cheap loans to protect payroll; interest rates are cut to zero; computers and algorithms are on the hunt for beta, executing trades, shorts, puts, and more; perceived value is shifting to digital technologies, cloud, streaming, in-home entertainment, collaboration tools, and more; there are glimmers of scientific hope with a race for a vaccine, increasing knowledge of frequent comorbidities, and recent hope with a therapeutic drug; and, institutional investors are not just observing consumer behaviors in different countries when governments re-open economies, but also going state-by-state in the U.S. and modeling what economic activities could recover as soon as June or July.

Public market investors have a lot of advantages in such a calamitous time. These days, besides huge pools of investable capital, they have access to global data, they’ve been following the 10-year plus bull run fueled by a massive technology revolution alongside globalization, and they can take advantage of the government’s recent moves with respect to monetary and fiscal policy. Perhaps most powerful, they can move in and out of investment positions with the flick of a switch or the tap of their phones. Howard Lindzon pointed out that even after years of holding Disney, one of his favorite stocks, he was quite bearish on theme park revenue and sports, so moved into Peloton.

All of this, of course, brings us to private markets, and specifically the world of starting new ventures and the venture capital firms that finance them. Unlike their public counterparts, private early investors have been considerably less active. Despite what you read on Twitter about being open for business and optimism for the future, there is an abundance of investment caution across the top tier of venture capital firms. The reasons are mostly obvious to those who understand the mechanics of these vehicles, as well as the patience required to hold illiquid assets for 7-10 years, and sometimes longer.

But, the key point for observers and especially hopeful entrepreneurs to understand is this — while the stock market gyrates up and down, the market volatility combined with layers of economic, scientific, and public health uncertainty create an environment where VCs have very little incentive to buy illiquid assets at this specific moment, especially when those relationships are so long-term, when the economy is frozen, and when prices have not stabilized. Whereas a public investor can go in and out of Disney based on today or tomorrow’s consumer sentiment, a VC has no such flexibility. Pegging a valuation on an early-stage startup today only to have to re-price it a year from now is not only not fun (and hurtful to the company’s morale), it may not be good investment judgement. This is why we’re seeing investors cutting smaller checks (seed rounds) and piling into known winners (like Stripe or Figma or Airtable, etc) — the pricing on the latter is more or less aligned with their long-term bullishness on digital transformation and collaboration at work, while the former represent smaller dollars and less intense commitments.

It is this key fault line — liquid versus illiquid — that makes venture capital in private markets react wholly differently than public market investors. VCs are taking a 3-, 5-, 7-, and 10-year view on economic fundamentals. That we will be flirting with 30% unemployment. That consumers will clutch their wallets and purses tighter. That massive sectors like travel will be brutally beaten up. That our society may not simply “re-open,” but more likely go through periods of “The Hammer and The Dance,” where the hammer is government-mandated SIP and social distancing, and the dance is our flirtation back into society in controlled, slower, and more cautious ways.

In the previous decade, as VC firms scaled, they tended to cut their first check a bit later (not always) than in previous eras — this makes good sense. It is not uncommon for a VC cutting a $10M check to want to see 1-2 quarters of data before making the investment. Similarly, they may be waiting to see 1-2 quarters of public market stability in pricing before being fully back in business. To be clear, they are still looking at deals and investing — allocating capital to winners in their portfolios, making seed investments in teams they know — but it’s the in-between, that new relationship that has a bit of data, the team is raw and unknown, and the manner in which these deals were prosecuted has been upended, not to mention a looming price readjustment that’s potentially on the horizon.

Ultimately, the VC calculus right now is very different than what’s happening in the stock market. As we go in and out of The Hammer and The Dance, public market investors can follow suit, buying up and dumping stocks on an hourly basis. For VCs, each wave of The Hammer and The Dance presents increased uncertainty and shakier economic foundations for the country overall. This is the difference between east and west coast today in 2020. This is Wall Street vs The Bay Area in methodology. Warren Buffett dumps all his airline stocks, while Bill Gates sees his stake in Microsoft continue to balloon. Even for me, as a small investor working to invest very early, I have to balance staying in market (yes, we have invested in the last two months) and understanding incredible founders will start new companies no matter the conditions on the field. But, in the back of my mind, as optimistic as startup investors want to be, we all follow trends for a living, and while the future can always be bright, the near-term presents significant, fundamental, deep economic wounds that may take years to heal, if they heal at all.

Enterprise Business Models and Distribution In A Pandemic World

For the past few weeks, I’ve been talking to 2-4 close investor friends/mentors per day. Often, it’s just to go out for a walk, or we talk about a company or two we are both investors in, or we trade notes on household management tips, or inside information we are hearing about the latest science or what’s happening to NYC, where we all have so many friends, founders, and people we love. With a few of them, I have also been trying to learn from them, to tap their wisdom of previous cycles, the 2008 global financial crisis, and the dot-com boom and bust.

For this post specifically, I wanted to share what I’ve learned from friends and mentors like Bilal Zuberi (the first VC friend I ever had, back in Cambridge, when he was at General Catalyst, now at Lux Capital), Ed Sim (20 years as a VC, perhaps one of the most on-fire enterprise seed investors out there now with Boldstart — link to our discussion on this topic is right here), Ravi Mhatre (20+ years as a VC and a co-founder of Lightspeed, where I’m a Venture Partner), and others. Below is a brief summary of what I’ve learned from these folks, and others friends, in the past few days, and my hope is to pass this along to other founders and co-investors so we all prepare for what is surely going to be trying and austere times. [Of course, as I’ve been doing with each post, I am reminding readers that I know challenges facing startups and investors is not anywhere near the level of pain that NYC and other cities will experience in April and May. That said, this is the real work going on inside companies and among investor bases, and so I am sharing this in the hope that it helps someone else out there trying to figure out the future for themselves and their company.]

Cutting Burn, Extending Runway – This seems obvious given the massive recession we are barreling into. The debate ultimately rests with “how much” cutting to do. The guidance from those with many years of experience has been to make deeper cuts that what may seem comfortable today. That is some hard stuff. The biggest costs for startups are usually salaries (ie headcount), but also real-estate — I suspect many leases will be renegotiated and/or smaller teams opting to go remote for a while or perhaps forever. This is the cost side — but what about the revenue side? For startups that were counting on revenues to come in to offset expenses, there will be at least 1-2 quarters, if not more, of big holes, misses, and maybe even doughnuts. Realistic leaders here will proactively reforecast what they can expect to earn as some business naturally churns during this period. All of this is immensely harder at scale, when a startup is growing fast, burning cash.

Business Model Anti-Fragility – I hope it’s obvious, but this post is geared toward enterprise/B2B startups; I cannot begin to imagine what most consumer startups are going through right now. Here, getting to some predictable cash flow is paramount. For each kind of business model and customer, it could be smart for founders to create pricing incentives to coax the customer into a longer payment cycle. For example, a business which charges customers annually may want to experiment with deeper discounts for multiyear contracts; a startup that charges monthly may want to do the same with annual contracts; and so forth — there are multiple ways to help secure the net present value of longer-term contracts. On the flip side of the balance sheet, a startup executive team should expect some natural churn as a result of the pandemic and demand shock, so basic human touches like picking up the phone, or proactively instituting grace periods and/or free months of service are moves which may pay off over time and stem churn. Similarly for B2B marketplaces, liquidity is king, so network operators who can stomach lowering rake to keep product flowing may be rewarded in the long run.

Go-To-Market In A Bad Market – No one would’ve thought when 2020 started that we would be here today on the verge of Q2 and questioning whether we will ever have live events, user gatherings, developer conferences, big dinners, and other marketing events in person again. Of course, I think we will — but when, and how, I do not know. No one knows. As such, founders are now scrambling to see if they can market their products and services via video demos, or through a self-serve offering, or through channel partnerships, or through developer networks, or through open source or open core models.

New Values On The Other Side – It’s hard to imagine, especially as we enter the peak month across various cities in our country, that we will come out the other side, maybe next year, maybe longer, where business optimism returns. What does that new world look like, and what will be valued in that new world? There are things that are valued today — metrics like Time To Value, Engagement, Net Expansion, High Margins, etc. — that will likely be valued higher in this new world. We saw glimpses of this pre-pandemic, with public markets valuing pure software with network effects like Slack and Zoom more than moving atoms around the world. Those differences may be held in starker contrast in the new world that’s yet to form. In that new world, headless software, bits over atoms, highly efficient and quick-value business models may separate themselves from “tech” broadly — that, in and of itself, maybe the one big change to startup parlance that marks the shift from one era to the next.

Portfolio Triage In A Pandemic World

Everyone is doing their own version of “triage” right now. Let me state upfront – I recognize using medical terminology to discuss non-medical emergencies during a public health crisis is not ideal. To be clear, it is not my intention to equivocate the portfolio “triage” being done now with the medical suffering going on around the world. However, this is the language many in the startup industry uses colloquially to discuss this activity, and so it’s in that spirit I’m writing in this manner. Thank you for understanding.

Over the past few weeks for those in the startup ecosystem – founders and early employees, investors, and limited partners — everyone has been conducting their own form of portfolio triage. CEOs and executives are scanning credit card bills, renegotiating contracts, learning about “force majeure,” bracing themselves for depressed sales and, even more painfully, increased churn. The worst, of course, is planning for reductions in force — for the past few weeks, every Monday and Friday generate rumors of pink slips. Limited Partners, the entities which provide the capital source for these companies, are undergoing their own triage efforts — it could be a nonprofit which needs to loosen funding for specific portfolio initiatives and/or can no longer fundraise via traditional in-person event channels; it could be a university which has sent students home, had to fire administrative staff, and may also manage funds for the school’s hospital systems; or it could any other large pool of capital undergoing simultaneous shocks from either public markets and/or commodities markets (like crude oil). While those limited partners are often more diversified with respect to risk than a startup founder, the same muscles are being used to conduct triage.

As a bit of word-nerd, I wanted to know specifically what “triage” means – “(in medical use) the assignment of degrees of urgency to wounds or illnesses to decide the order of treatment of a large number of patients or casualties.” This is what investors are doing, too.

Investors with portfolios across different vintages are currently inundated with responding to this shock by going through each portfolio, determining the relative health of each investment, what the potential value could be (now likely with a mark down). For funds with a history, the portfolios can be large enough that it could take a few full days just to go through the lists for a first scrub. The medical illnesses investors are trying to quickly assess relates to burn rates and runway, combined with methods to reduce burn while planning for lower revenue income. This double-whammy can quickly compress runway, and the rate of compression is faster for larger, high-burn (ie high-growth) companies and/or those which boast business models that are smack dab in the middle of this demand shock.

Once investors sort their portfolios by those companies deemed highest-risk, the hard conversations begin. We began our targeted outreach at Haystack today. Prior to this, we surveyed our founders, collected standardized information related to cash on hand, current burn, target burn, potential loss of revenue, and headcount. With this data, we loosely approximated which companies were at highest-risk levels of runway compression. Haystack is not a huge fund nor typically a lead investor (though in the past year, we have been leading more deals with stronger reserves), so sadly we cannot open up older funds (which never had reserves) or bridge someone for two years. We wanted to assign a rating of Level 1-4 (with 4 being highest risk) to our portfolio and began targeted outreach today. While these are investments we’ve made, these are not our companies, we are not control-investors, and in 80% of cases, these founders have taken much larger follow-on checks from much larger funds.

There will be hard conversations around these runway tactics. I do not envy anyone facing those. Over the past year, my two young sons have been obsessed with learning about dinosaurs. So, I’ve re-learned about dinosaurs with them. I didn’t really keep up with all the new discoveries since I was 5 years old. Going down the YouTube rabbit hole, my kids are obsessed with the large asteroid which slammed into earth that caused a massive explosion, earthquakes, and disruption to the planet, where a high percentage of species met the end of life. It is so random to think about how that situation escalated for the planet and the dinosaurs. I know our planet has had other pandemics and survived, but this current pandemic sort of feels like that asteroid in some ways — very few people could have even fathomed it, and when it hit, it hit quickly and life will just feel different after the fact. In our current pandemic, sadly we will lose loved ones, brothers and sisters; we will lose a mind-boggling number of small businesses, especially those in the services sector; and we will lose a bunch of very early-stage companies that won’t have enough runway to survive, or startups which are focused on certain industries which have just stopped outright, or startups poised to IPO this year or next who are burning lots of cash and can’t course-correct fast enough. The current pandemic feels like that asteroid to a degree, appearing from the sky in a flash, smacking into our world, and changing it forever.

And, so here we are, conducting triage in hospitals, in our local communities, in our households as we are on lockdown, on our balances sheets — at work and at home — and in the world of startups, for portfolio funds and startups. It is all a shock. People are reacting in real-time. CEOs, investors, and LPs will have to make some brutal decisions, where to focus efforts, where to cut ties. There are no great answers. It won’t be fair. But it’s going to happen throughout April and May, and the only thing everyone can control is to conduct those conversations with grace and thoughtfulness given the unprecedented circumstances. And specifically as it pertains to many early-stage dreams that were just getting off the ground, there will be a shortage of ventilators — some will get them, and others won’t. We’ll have to take these harsh decisions in stride — they are not as important as our collective public health, or what is going on in NYC, or what may unfold in Florida or New Orleans. For the foreseeable future, every day is about triage. Triage is the new normal.

Investment Decisions In A Pandemic World

This is a post for startup founders to hopefully better understand how investors and VC firms are adjusting to this new world. There are lots of tweets floating around citing “business as usual” and “we are open for business” — and while those proclamations and others may be true, there is a lot going on behind the scenes that I believe founders should consider as they plot their capital planning for 2020. [At the risk of stating the obvious, during this time posts like this are not as critical as what we can be doing within our own cities and towns to help our neighbors and local businesses.] I wanted to share these thoughts briefly after spending the last three weeks talking to tons of VC colleagues, from seed to growth funds, across the Bay Area and in NYC. With that, here are the real-time adjustments underway in the investor world:

Adjusting to WFH, with Children: With California and New York City on government-mandated shelter-in-place, investors are all home. Assume most decision-makers have kids. Schools are shut down. Like everyone else, they are scrambling to figure out how to support their kids, families, spouses, and concentrate on work and key decisions. For most, it is not an easy adjustment.

Portfolio Triage: An investor’s portfolio will contain some companies that are either directly impacted by the pandemic, such as companies which focus on travel, events, and other gatherings, and many that will be indirectly impacted because of this double-sided supply and demand shock. Companies with short runways will die, and even more jarring, companies that operate in certain industries could fold because of a foundational collapse caused by these shocks. If an investor is on a board and/or representing his/her VC partnership in a company, they have to report back to the mothership on a quarterly basis, so many of them are likely preparing for collecting and sharing negative news, and scrambling for ways to help CEOs cut burn, reduce opex, consider bridge funding, venture debt, and so forth.

Partnership Meetings and Hallway Chats: The manner in which 99% of VC firms operate — “the partner meeting” — is now a big challenge. Zooms work for sharing information and aggregating that audience, but the hallway chats and interesting tangent threads are gone. It is certainly cool to complain about partner meetings on Twitter (I have done this!), but having sat in institutional VC partner meetings for over seven years now across three firms, they’re certainly not perfect but they’re a terrific way to learn and get the pulse of a group. An interesting note on fund models like Founders Fund, for instance, which doesn’t have a partner meeting, may be less impacted in this way. Other VC firms will have to adapt to this but it will take some trial and error given institutional behaviors.

In Process vs. Existing Exposure vs New Relationships: Deals that were “in-process” before the day the NBA cancelled the season (that was a seminal day, I think) are closing and getting done. Sure, some folks will retrade deals, but maybe that number will be very small. Most investors know that going back on your word, especially under a time of duress, will ruin reputations. So when you see VCs say they just signed a term sheet, consider that deal may have been on handshake in February. Investors will also look into their existing portfolio and may offer to allocate reserves to existing relationships. You can bet these offers will be at “flat” prices to the last round, given how high valuations have been. Now, the key question for founders is new relationships — what if you were hoping to raise your A or B in Q2 or Q3? How do you meet and greet for a $15M check via Zoom or FaceTime? How will a VC be able to conduct on-site due diligence when the actual site is closed? I am sure some folks will adjust here and make decisions, but we don’t know yet whether that’s a good or bad thing. This is why I feel existing relationships will increase in value — psychologically, it is much easier for a VC to gain conviction in writing a check when he/she already knows the CEO, some team members, and so forth.

Existing Relationships Will Become Even More Valuable: I’ve touched on this in the post, so will just briefly repeat it as a separate point here because I believe it’s important on its own.

Angels, Syndicates, and Micro-funds: Angel-investing will continue, but some angels and scouts may have had their entire net-worth reshuffled this month; syndicates, which raise funds per deal, may suffer given the constant coronation costs they require; and micro-funds and seed funds, actually, will continue to invest early — the supply/demand imbalance is still in the founder’s favor here, so I don’t expect as much of an impact on valuations here versus at the Series A/B stages. We will know more over the next 4-8 weeks.

New Fund Management Precautions: No matter small or large, those who manage a VC fund are thinking about how this may impact various angles of fund management. For example, should pacing slow down? If a fund was planning to raise in Q2 or Q3, should they reopen their current fund to increase their runway and push out their own fundraise? Do they need to rethink their current reserves strategy to make sure key portfolio companies have the cash to weather this storm? The list goes on and on. When these questions pop up, it can logjam decisions to send cash out the door. I don’t think this is a major issue, but like the in-person partner meetings, will take a few weeks to settle.

The Money Source Is Stressed: This is a part of the startup ecosystem 99% of founders never see or grok. Most of the large VC firms raise money from large pools of institutional capital — pensions, nonprofits, universities, and endowments. The stock market just cut off 30% of value in less than 10 days. For most of these places, VC is a small percentage of where they invest, and they will continue to invest. But, consider for a moment nonprofits, many who rely on donations and fundraisers to keep operations going — the demand shock and travel restrictions will hurt these places in the near-term. Or, consider large universities which have sent students home and/or have medical/science or hospital systems which are on the front-line now to help their local areas combat the pandemic. All of these limited partners will stay in venture, of course, but they’ll also rely on their managers — the VCs — to be stewards of their capital as this downturn begins.

Weekly Information Likely To Worsen, Valuations and Economy To Follow: If founders take one thing from this post, I hope it’s this — While VCs are open for business, the overwhelming majority of folks I’ve talked to (nearly 75 by phone over last two weeks) are by no means stopping the pitch meetings, but they are going to be, in the near-term, slower in decision-making. It’s for all the reasons I’ve listed above, but also because they all know that with each coming week, more information about the pandemic and its effects will surface. Each week, that information is likely to be worse than the week before. And as the economy gyrates as this new information comes out, over the next 4-8 weeks everyone will have a better sense of what the impact is and will be — and so much can happen during this time, such as stimulus bills, industrial collapses, having a loved one get sick — that I believe most VCs will simply let this play out a bit more before making a big decision. Private round sizes and valuations have been very high. Most investors active today haven’t experienced the pricing pressure that occurs during a downturn, myself included. It’s important to remember, these decisions are mostly irreversible — the money going to a CEO or founder can’t be taken back. The firm name sticks on the cap table. Given that permanence, founders should expect the VCs they’re pitching and targeting to be readjusting at home, among their colleagues, and to the market overall before making their next big decision.

Shockwave

in a previous era, there was political speech about a campaign of “Shock and Awe.” The idea, in those times, was to use military strength and western idealism to win “hearts and minds” of innocent citizens in the Middle East to see the valor in America’s occupation. This blog isn’t about debating whether that strategy worked or not, but certainly one can conclude for themselves.

Fast-forward to 2020, and we are all living in another moment of “Shock and Awe,” but in a very different context. The “shock” here today is largely, in my opinion, focused on the searing effect the current public health crisis will have on aggregate demand — especially consumer demand. And the “awe” is related to the unprecedented scale and scope of how wide this will be.

For anyone following the news, it’s obvious to imagine what will happen to the economy — consumers will lose income, they’ll be forced to limit their outdoor/outside activities, small and medium businesses will see a huge drop in activity, and so forth. Consider a company like Lyft being valued by public markets at around $5B this week, and they have $2B in cash on their books. Consumer demand is going to run so dry, it could literally topple a company which was otherwise on decent footing with room to grow.

The shock to consumer and business demand will also create derivative shockwaves. It’s like when you throw a big rock into a still lake — after the splash, you see the ripple effect of the concentric circles forming and, if you sit around to watch, those circles get huge. It starts with someone getting fired. Then their company fears missing payroll. Then they cut vendors. The liquidity of money moving around and multiplying as dollars are passed around stops. Perhaps nothing embodies this more than the fact that Las Vegas’ casino strip is shut down indefinitely. The federal response to date has been to use monetary policy to pump paper back into the company at large, but there are going to be millions of people who won’t make rent, may not be able to put food on the table, and may quickly face undignified choices unless they’re given direct relief by federal and state governments.

I’m writing this post because I’ve read a bunch of commentary from smart people who suggest that this could be a. “2-3 quarter thing” and things will snap back into place. I am not so sure. There is no trusted, central authority that will make consumers (and individuals in general) feel comfortable that “hey, it’s ok to take the train to the ballgame, to stand inline for a hot dog, and sit around 60,000 other fans for an afternoon.” When will that level of pubic trust ever come back? This situation has forced all of us, overnight, to adapt and change behaviors of things we’ve been accustomed to our entire lives.

The switch has been so drastic and so quick and done in a period of rampant mis- and disinformation that I am not confident it will all snap back to normalcy. Instead, I see a future now where much of the American economy (especially on the services side) is re-ordered in a brutal ways. The identity tied up in starting, owning and building a small business that surprisingly has to lay off staff, turn into a cloud kitchen, and then try to restart again will crush some folks’ spirits. Households with kids who have to keep them home and work at the same time will be skeptical of their own spending habits. If and when we get back to some level of normalcy, my strong belief is that the deep-rooted behavioral responses we are having today won’t go away — rather, the wound will cut deep, so deep it will alter consumer spending.

I can’t sit here and prove it will happen. I could grab a few articles and a paste a few fancy graphs here, but that doesn’t mean anything. I wanted to write this to share my intuition about this and share the warning for business leaders, households, parents, kids in college, and so forth. Aggregate demand will eventually come back, I’m sure, but the road to get there will take time, and the behaviors around spending will be drastically different. I sincerely hope I look back at this post years from now and declare “Wow, was I wrong!” but I believe it’s more likely this is the beginning of a new consumer paradigm we will all have to adjust to.

Semi-Lazy Sunday Afternoon Musings On Reserves Management

Each weekend, I like to write a short post about a topic I’ve been learning in fund management. The topic for this weekend was originally slated to be “reserves.” However, now the world is very different and we are all readjusting to a terrible reality. I hope this is obvious, but clearly the immediate priority is our public health, social distancing, and staying away from other people as much as possible. Beyond this, for those with means, we should be thinking about local merchants, friends who may lose jobs, and even worse — the economy is going to unravel in a way none of us have ever seen before.

And with that gloomy introduction, let’s tackle what “reserves” mean for an investment fund. I’m going to write this in a way that’s targeted to founders and CEOs who seek to raise capital, rather than my customary approach to write to fund managers on this topic. So, here goes… Say you’re the CEO/founder of a startup, and you’ve taken venture capital from an institutional venture fund, they’ve likely raised a lot of money and have institutional investors. In order to manage investments over a long period of time, the most experienced and sophisticated funds will set aside “reserves” for each investment. Some funds reserve at a 1:1 ratio, and some reserve 2:1, and so forth — a 2:1 reserve model means that if they invest $5M in your Series A and take a board seat, they’ve set aside 2s that or $10M for follow-on investments. Now, it’s easy to think that $10M is entirely for you — it is not. It is at first a mechanism to force a partnership to play a longer-game, to make decisions about investments over a longer horizon, and to pace the speed of fund deployment.

There are generally three types of reserves: (1) for offense, to plow into companies where there’s a breakout and/or high conviction; (2) supporting, to keep future rounds humming without signal risk and/or to maintain pro-rata ownership percentages; and (3) defensive, to apply in bridge rounds, or pay-to-play rounds where either the market or newer investors for investors to protect an initial investment.

The topic of Reserves Management is now, as the world has changed, a major topic of discussion among investors, especially lead investors on cap tables. There is no doubt in my mind that even great companies right now will have their business operations and bottom lines altered by the shift in the economy. We’ll make it out of this, but that will likely not be any sooner than 2021, at the earliest. And VCs who are in lead positions will have to begin to make tough decisions about where exactly to allocate the reserves they’ve been setting aside. Say a company isn’t performing and/or doesn’t have a strong relationship with their lead — hard to see how reserves get deployed here. On the other hand, say a company is lean, low burn, and showing a path to sustenance over the next 12 months — their investors may lean in to bridge the company and get rewarded with more ownership in a rough economy.

Investors will not tweet about this publicly because it is part of the sausage-making of how a venture capital fund works, but you can surely bet that they will be having these discussions. Most firms will use some quarterly or bi-annual “Monte Carlo Simulation” to both approximate winners, leaders in a portfolio, and struggling companies, and as part of that go into “Reserves Management” (make sure to read this post by Fred Wilson, please) where the individual investors will be asked to forecast which of their own portfolio companies will need what over the next year. Some will get what they want for Company X, but not for Company Y. There will be lots of internal debate about where to allocate funds. The broader public always sees the very first investment by a VC firm into a company, but they often don’t realize it’s the 2nd and 3rd check decisions that are most crucial and hostly contested internally,

If I was a startup CEO and I knew this, I would plan to approach my board about this some time in April or early May. This week may be hard. And I would have a broader discussion about capital planning for the next 12-18 months and I would try to learn about how my lead investors were thinking about reserves. Existing relationships now inherently have more value. VC firms have been built to allocate the capital of their limited partners. So for any CEO going down this path, it would be wise to get smart on reserves and have this conversation earlier rather than later. Best of luck out there and I hope everyone’s families and friends are doing OK.

A Quick Guide To Startup Fundraising In A Pandemic World

After lots of conversations this week with both founders and investors (from early to late), I wanted to quickly jot down my thoughts as they relate to what startups can expect in 2020 when raising funds. The first disclaimer here is, obviously, capital financing for new ventures, while certainly important to some people, is not as important as good public health, resources, and information. The second disclaimer here is, again I hope obviously, is that this post is geared entirely toward how a founder may consider responding to the current environment and in no way seeks to offer any health information or advice. Apparently a bunch of folks feel investors have shared dubious information online as this public health issue unfolds, and I am not qualified to opine on such matters.

So, with those disclaimers out of the way, here is a list — in no particular order — of what I think founders should be aware of when it comes to early-stage fundraising, not just in the short-term, but likely through the end of 2020:

Business Models and Go-To-Market: A big component of what gets investors excited about an investment is the potential for efficient distribution. For startups that boast business models which are dependent upon activities such as travel, or events/gatherings, or top-down sales models, or systems that require on-prem setups, or getting into the consumer wallet share, it would be wise to anticipate questions from investors around these topics. They may not say so on Twitter or in the meeting (which makes this topic subtle but important), but behind closed doors when they are evaluating models someone in the room is bound it bring it up. By contrast, API-driven, or self-serve, or upfront multiyear recurring revenue models will be seen as more valuable, where product-led growth could be a premium. Some may want to consider having a slide dedicated to this in pitch.

Early-Stage Investing is a People Business: So much of early-stage investing is dependent upon face-to-face interactions. There are lots of funding sources out there now, and more investors today are comfortable having relationships and communications entirely by video or phone. Again, this is what most people will say on Twitter or to you during the pitch process. However, so much of the very initial, raw, emotional sentiment is forged in a face-to-face meeting. What does that mean for founders who do not want to take live meetings right now? What does that mean for founders who were talking to 6 investors last week, but today, only 2 of them want to meet in person? What does that mean for founders outside the Bay Area who are either hesitant to travel here or now face a contracted audience? I don’t know the answers here but it feels tough.

Categories Matter: While so much of early-stage investing is about the people, as the checks get bigger, larger investors will certainly have opinions about category selection. Going back to business models and GTM, there are now entire new industries thrust into the limelight because of the sudden shift in work and consumer behavior. Look at the rise of Zoom’s stock price over the past few weeks. Video, for instance, may now be both pervasive enough and important enough to verticalize further, where we could see an explosion of “Zoom for ____” happen. I’m sure it already is. Other areas like work collaboration, social media tools, homeschooling networks, and more are suddenly now imagining the prospect of new opportunities. Fair or unfair, behind closed doors there will be categories that are currently out of favor, so it would be best to anticipate these objections and perhaps even address them head-on. These will ultimately get reflected in valuations for the deals that do end up getting done.

Zooming Out: Zooming out a bit (sorry), investors may begin to segregate “fragile” versus “anti-fragile” companies, models, and categories. In the Taleb framework, what is truly anti-fragile today? Should those assets be worth more? Should some value shift from newly-deemed fragile entities to anti-fragile ones? We may be seeing this in the public stock markets, with airlines suffering but Zoom rising. Safe to say it could happen in startup investing, too. In terms of countercyclicality, what could be in-favor today that wasn’t a few weeks ago? Company location and cultures will matter — will remote be seen as a competitive advantage now for recruiting and anti-fragility versus an accepted model from a few months ago?

This double-sided economic shock is going to be here for a bit. Investors will still invest. They will say nice things on Twitter and in the meetings. The ways deals that get done now go down will shift back a bit toward a more normal cadence (it has been out of control for a few years), but it will still be a great environment for good founders, absolutely. As a founder, it will be good business to anticipate what may be side behind closed doors and to fine-tune those pitches accordingly, at least for the duration of 2020.

Lazy Sunday Musings On Dilution

One big topic newer fund managers won’t likely appreciate in the early days is the effect dilution can have on an early-stage investment. I know this because I had no clue about it when I started. Even when other investors would ask me about it, I knew what what it was but I didn’t realize how it would effect me.

The big disconnect here occurs because for many early stage investors, there is no “price per share” or PPS of a company or investment. So many early-stage investments happen to be done on convertible notes or SAFEs, which only “cap” the valuation — there are no priced shares, per se, at this time. Those notes convert during an equity round, usually the Series A, but often newer managers don’t have information rates, back office administrators, or audit requirements that would give them a chance to know their PPS for each investment.

Another reason dilution pops up is because most newer early stage fund managers either don’t know how to manage reserves, or have reserves at all. Without reserves, the earliest investors will suffer dilution with every future equity round, and perhaps even be wiped out in more aggressive recapitalizations. And even with reserves, early-stage managers may not have enough clout or positioning to follow-on into competitive VC rounds. Also, dollar-wise, newer managers may be writing smaller checks into rounds.

So, all of this compounds. As a rule of thumb, I’ve found that in a future equity round, an investor who doesn’t hold pro-rata can expect to be diluted 18% on average. If you were the seed investor via a convertible note in a cool company that’s gone on to raise Series A and B equity rounds and you were not able to follow-on, you have preferred Series A shares (with a PPS) but your ownership percentage would have been diluted by the B round.

Dilution isn’t the end of the world for an angel investor (using his or her own money) or a very small fund (which can get into the carry quicker), but it can be disastrous for funds as small as $10M and up. One way to combat dilution is to invest much more upfront, “to get more ownership,” but that’s very hard to do in seed rounds and most newer managers want to have more shots on goal given the randomness of early-stage investing. Another way is to keep and manage reserves and work to earn the right to keep pro-rata, a topic I’ll write about next weekend.

One lesson I learned the hard way is that, when you start investing in startups, you think in absolutes. You seeded a company with a $250K check out of your fund at a $6M valuation, and the Series B round was done at $96M post-money, giving you a gross multiple of 16x. But, you likely don’t know the PPS for the shares at the A round, or what the compression is after the B round because you don’t have information rights or a back office to parse them. It may be easy to think that $250K check has appreciated 16x, but assuming 18% dilution at the Series B with no follow-on funding, the net multiple would be just over 10x. That’s still great, but if it’s the best deal in your fund and the fund is larger, it can really pinch the fund returns. Hitting a multi-billion dollar rocketship will heal any dilution wounds, but those are tough to come by. Absent one of those, in a world with more dilution, piling in upfront and positioning to invest at least one more time early is the only way to give these early a funds a chance to drive returns.

Quickly Unpacking Intuit’s $7B Acquisition Of Credit Karma

This weekend saw the news break of yet another big M&A “tech startup” deal, with rumors flying that Intuit is about to acquire Credit Karma. It’s late on Sunday night and I’m tired, so I’m going to cut right to the chase on this one and quickly unpack what the key takeaways are for me from this news item:

1/ Fintech On Fire: Another week, another major fintech exit. Wasn’t it just last week that Visa bought Plaid, or that PayPal bought Honey, etc.? Fintech as a sector is beyond red hot – it is magma layer hot. This is not news for any builder or investor focused in this area, but it does seem like the broader tech ecosystem is realizing the scale of the impact — to the point where, when we are all said and done with this era, that fintech market caps and exits worldwide may be greater than the tally for social networks,

2/ Industry Consolidation: An old friend once remarked to me that “capital has a tendency to aggregate.” Well, that is certainly happening across the fintech sector. Recent large acquisitions include Plaid going to Visa for $5B+; Morgan Stanley buying E-Trade for $13B; Ally Financial buying Cardworks for $2.6B; PayPal and acquiring Honey for $4B. Barring some unforeseen economic event, there is no reason to think these trend will slow down — if anything, it may accelerate as large incumbents watch what their competition is doing, they have mountains of cash now, and may be motivated to use a mix of cash and stock in this bull market to buy a piece of the next frontier for fintech services.

3/ Owning The Customer Relationship: It’s common knowledge within startup world that figuring out how to efficiently acquire and retain customers is critical to one’s success. In fintech, it’s particularly hard to acquire customers given the high costs of targeting them and/or signing up new users. The giants use their cash heaps to drive up ad prices and marketing effectively. Credit Karma, which has over 80M users and gets paid in fees when it surfaces recommendations for financial products that convert, spent the past decade building a brand recognizable on and off the Internet, driving users back to the site, and acting as a front door for new products built by other providers, mainly credit cards and loans. Now for Intuit, the $75B public company famous for accounting and tax software, they’ve used 10% of their value during a bull stock market (and their largest purchase ever) to expand their surface area and potential for new consumer-facing financial products in the future.

4/ VC Returns: As always, when a big exit occurs, insiders want to know “Who invested?” You can see Crunchbase for the list, but worth noting Ribbit (focused on fintech) was there, along with QED, Tiger, SV Angel, and Founders Fund — and most notably, Felicis Ventures (also in Plaid!) invested across multiple rounds of Credit Karma out of earlier, smaller funds.

5/ Looking Around The Corner: All of this recent activity begs the question, “What is the next fintech startup to be acquired in a blockbuster deal?” Will someone scoop up Chime, which truly broke out over the last 12-18 month? Will E-Trade going out at $13B set the floor for a potential bid on Robinhood? And, what about all the neobanks worldwide which are also growing? And, we can’t forget about all the trading and investment infrastructure products and services out there, too — those could be gobbled up for hefty sums. Perhaps most earth-shattering would be a bid on Coinbase? It wasn’t too long ago that Facebook bet 2% of their market cap at the time on Oculus — that may or may not pan out. Regardless of your politics regarding cryptocurrencies, there is no denying that Coinbase boasts incredible market position and high transaction volume helping millions of people buy and sell Bitcoin and other select tokens. Coinbase has had the revenue for a few years go to public, but it is in a very new category — and could be a fascinating takeover target. If that happens, I expect Twitter to break and I’ll be there for it. Ok, off to bed.

Late-Night Musings On Portfolio Construction

Without a doubt, the concept of “Portfolio Construction” was the most difficult VC fund management concept for me to get my arms around. To be clear before I write this, and before you read it, by no means do I mean to suggest that now I have that subject mastered — I am sure I will learn more just in the feedback generated by this post. However, as I’ve been talking to newer managers on their first or second funds, the topic is coming up so I thought I’d briefly share my two cents on what “Portfolio Construction” means to me, and in what context it matters.

Number 1, “Portfolio Construction” is what us, as GPs, are in the business to ultimately produce — it is our core job. The job involves other cool things, like hearing pitches, helping founders when we can, etc. etc… but at the end of the day, or at the end of the particular fund, what is built is a portfolio of (hopefully) uncorrelated assets. Each fund ideally owns a significant ownership percentage of each core company in the portfolio, including (obviously) the very best performing companies. So, at the risk of stating the obvious, it is a GP’s job to study this concept for as long as it takes to be highly conversant in it.

Number 2, Knowing “Portfolio Construction” as a concept is basically required to raise funds from institutional LPs. If a GP is talking to an LP and things progress toward a potential partnership, a sophisticated LP will chime in “Tell me about your portfolio construction.” The absolute worst response to this is some combination of “Geez, I don’t know what that means” and your hands flailing all over a messy Google Sheet. You can basically bet this will throw ice water on the deal. So, if you’ve read this post now, you do not have an excuse — don’t make the same mistake I did by not digging into it earlier!

Number 3, “Portfolio Construction” can be quite varied depending on asset class, investment stage, and fund size. For that reason, this post is specifically written for venture capital funds that are, say, below $200M (ie. not growth or mid-market funds). For early-stage funds, company ownership percentages are of critical importance given the sheer number of startups that are created monthly, and the high loss ratio these portfolios are bound to suffer as a result of today’s funnel of driving toward a classic institutional Series A investment or an accretive $100M+ exit. To quote Mike Maples’ famous line, “Your fund size is your strategy,” and applied to seed, there are unwritten rules of thumb for the check size one needs to deploy relative to fund size. The guideposts I use (which are imperfect, but…) are a $100M fund needs to own 15%+ of their best companies at exit to have a shot to return their fund; a $50M fund needs to own around 10% at exit; a $25M fund needs to own around 5%; and so forth.

Number 4, “Portfolio Construction” often requires sophisticated reserves management. There are many problems with this for newer managers. Again, I know from experience. Most new managers don’t even know what reserves are. By the time they figure out, they’ve been burned a few times. Ultimately, to boost ownership in the companies with where the GPs have the highest conviction, it either requires getting very high ownership upfront (which most people cannot do, and founders resist) or doubling-down on a smaller handful of companies in the basket. The danger for early stage GPs is that they may be forced to do so when they still have the least information about the performance of the company. To put this into practice, a $10M micro-fund which started off with some reserves may have to write initial checks of $100-250K to start (that’s a lot, and a good topic for another post), and then may have to pick 3-5 of those startups to really lever up into, perhaps even before a Series A round.

Number 5, “Portfolio Construction” for the GP could be broken down into other sub-categories, such as geography, stage, and sector. I’ve met early-stage managers who loosely try to have a mix of Bay Area and east coast startups in each portfolio; or they’ll allocate some percentage to seed versus Series A; or they’ll try not to have more than 2-3 businesses in a similar sector to mitigate any sector-specific risk they may be indirectly taking. I am sure there is no correct method here, but creating and imposing some loose guardrails here is helpful, I’ve found. This mix for Haystack is still evolving and changes with each vintage. (This is a good reminder to write on this, too — perhaps when we move from Fund 5 to Fund 6.)

Number 6, “Portfolio Construction” is critical to master because, as I wrote a few years ago, “Your Portfolio Is Your Path.” it’s worth re-reading this post quickly. The decisions we make today stick with us for many, many years. The relationships evolve, linger, strengthen, and fade away. Learning the concept of portfolio construction is one of the few things investors can do to impose some stylistic design on their path — so even while the path is mostly random, a GP can shape it a bit along these vectors. And if done well, it actually has a real shot of working out nicely for everyone involved.

Shots On Goal

The politically-correct line to use when making a startup investment is that it’s based on “conviction.” As an investor, in order to make the investment, you have so much belief in the founding team, or the idea, or the category, or the traction, or some combination of the aforementioned, that you are hereby convicted to make that investment. I am sure some investors in specific cases are struck by conviction as if it were a bolt of lightning; but, I am more certain those instances are not the normal course of action. As someone once remarked to me about a startup investment — that one should feel equal parts excitement and terror in making that investment, or otherwise the investment itself may not be interesting enough.

Once investors reach some level of security in their firm, they can play for upside. They do not need to increase their chances of finding something great in an optimization funnel. “Shots on goal” diminishes in importance. But, for most investors at the beginning of their career — and especially newer micro-funds of today which have scraped together $1M or maybe a bit more, the concept of “Shots On Goal” is absolutely critical.

These new investors need enough “Shots On Goal” in order to (in their mind) give themselves a chance to find one, maybe two, stellar investments in the lot. Of course, this randomness is most intense for those who invest at the early stages. There is simply no way to know the shape of a company or financial outcome when the earliest investments are made. Having enough “shots” is important because, at a primal level, newer fund managers or investors within firms need to demonstrate the ability to find a few good deals to parlay into the next fund or as evidence for promotion.

There is a cost, though.

Increasing “Shots On Goal” comes at the expense of concentration. As most early-stage investors eventually realize, obtaining and maintaining (or even increasing) ownership in a basket of investments is of utmost importance. The theory goes as follows — 1/ most startups don’t make it, no matter how smart the team and/or noble the effort; and 2/ given the high loss ratios of early-stage portfolios, and given that most portfolios follow a power law curve, an investor building a portfolio needs enough shots to find those 1-2 companies which will drive the returns. Therefore, investors care a lot about ownership, should a portfolio company be acquired or go public — maintaining high ownership can help smooth the harshness of the loss ratio in the event of a large exit.

As an aside, “Shots On Goal” can help newer managers by increasing the likelihood they can demonstrate “interim metrics” in the absence of real returns. I know this because I did it myself, not fully appreciating the fallacy of the concept. As a new investor, it can be exciting to co-invest with a great partner and/or to have a premier fund follow a deal you’re in; or for a company you’ve backed to raise a huge amount of money. While the company will ultimately be judged by its underlying metrics, newer investors need enough shots on goal in order to increase the surface area for these interim metrics to emerge.

But, a funny thing happens as an investor matures. They start to slowly realize that those interim metrics don’t mean much. They’re the vanity metrics of investing. And, as life unfolds, as folks get older, as people get married, have children, begin to limit their new relationships, those investors realize taking more shots on goals comes at a cost of not just concentration, but also of becoming a slave to those false metrics. To be clear, newer investors need the shots on goal to have a chance to catch fire, but over time, the way to generate returns is via concentration, by having conviction, and by taking on more portfolio risk.

I’m writing this now because the concept of “Shots On Goal” has come up more and more in my chats with newer managers. The reality is that shots are important early because you need to increase your probability that you can catch something great. Then, over time, the number of shots will likely decrease — partly due to life, and partly because you will realize that’s how you ultimately get paid. And, most critical, it is how you preserve the time and bandwidth to build a deeper relationship with the founding teams you back.

Those teams you back… those teams, if you select wisely, do not have “Shots On Goal.” They don’t have side funds or side hustles. The company you backed is their one shot on goal.

While you may have 15-20 eggs in your basket, they do not. Sure, most won’t work out, and as the investor, you have hopefully built a portfolio of uncorrelated investments that somewhat insulate you from potential collapse. But, the startups do not have this luxury — so while the concept of “Shots On Goal” is important to consider, it is not as important as what I’m going to write here — that while we may get paid because of the 1-2 successes in a portfolio, our reputations as investors solely rests on how we handle the relationships with the remainder of the portfolio. Some shots do not go into the goal. Some players only get once chance to kick the ball into the goal. For those folk, when an investor can, we must help pick them up and help them get into position to take another shot on goal, in whatever share or form that may be.

Misconceptions About The Path To Get Here

This is squarely a very personal post, and I will try to keep it short and sweet. As a disclaimer, I do not intend this post to be read and/or interpreted as talking down to anyone or being disrespectful. Yet, I need to make this point clearly because I hear it a lot directed at me, and I think it leads others to drawing the wrong lessons and conclusions from my experience. With all that, here the few misconceptions I hear often lately:

1/ “Twitter must help you make investments.” NOPE. I have been using Twitter heavily now for over 12 years. It is how I navigate across the web. In the past decade, it has become an unofficial system of reputation and social record in the startup tech ecosystem. But, having an active and engaged Twitter presence has nearly zero impact on how investment opportunities come to me. Founders I want to work with do not care one bit about what happens on Twitter. Rather, the medium helps me share ideas, meet other folks (many friendships have been started on Twitter), and learn from others. Taking out the act of making investments, I do feel Twitter is critical for most startup investors, and participating in the network in a genuine way takes time, investment, and giving back as much as you take. A subject for another post, perhaps.

2/ “You used writing and content to enter the VC sector.” NOPE. While I was working in various startups, I would write because I was interested in a variety of topics. The act of writing helped me understand the new worlds around me. It just so happened that over time lots of LPs and VCs would subscribe to my work; then I would email with them; then I would meet them; then I consulted with a few; and then I thought one of them would surely hire me. That did not happen. Yet, I have people coming to me (or recommended to talk to me) about using writing as a wedge into VC. My response back is that one should write if there are interested in the craft, but thinking that writing a post or sending a tweet can be a strategy for getting into an investment career is simply not realistic.

3/ “You made great early investments, and you must know what you’re doing.” NOPE. In the first two Haystack funds, there was tremendous success, but there was no way to know at the time what the shape of these companies would be. Absolutely no way. What I did do, however, was focus on relationships and people. I built relationships on Twitter for many years. Then I forged them in real life. And then I tried to help tons of people, and tons of people helped me. I can’t think of another ecosystem in the world where super smart and experienced folks will meet you and guide you. I would have 30+ of these types of meetings a week for long time while I was struggling to find my way. But the only way to get really going is to get into the game with a small foot in the door, and then you have to get lucky and show enough value to get invited into the room to learn by osmosis. It can’t be engineered, in my opinion. It’s not fair that it isn’t open to everyone, but helping out others constantly is a good way to increase the amount of opportunities that may come your way.

In the last year, I’ve had lots of people knock on my door asking for advice about getting into venture. It is a humbling thing now to have someone knock on my door. And when they come inside, often I hear some or all of these misconceptions about the path to get there by looking back at what I did. But the story isn’t this way in reality. Twitter won’t help you get into VC or get better at making investments — neither will writing a blog post — and neither will being seen as an expert or company builder or operator or fill-in-the-blank. The only thing one can control is the goodwill they put into world, how they handle the people they meet, how they help others, and how to monitor the serendipity of the Bay Area ecosystem to notice the point at which it may tip in your favor.

Truebridge Capital Fireside Chat On VC in 2020 with Keith Rabois

Everyone in the tech ecosystem knows of Keith Rabois, or online just as @rabois on Twitter. Like many others, I’ve had the fortune to spend a lot of time learning from (and debating) Keith. You can search some of the old tech chats we did back on YouTube. I feel as if I know most of what he thinks about the VC industry by now — yet, last night, he was in a fireside chat with Truebridge’s Mel Williams, and their discussion teased out new angles on VC that felt entirely new. I wanted to *briefly* share with you all the few tidbits that have stuck with me the day after. Note, these are listed in no particular order along with a bit of my commentary:

1/ The early stage is when a startup is a “liquid form of concrete” – Keith gently warned professional VCs of getting involved too late in a company reduces the ability to course-correct. Eventually, the company hardens, or becomes “concrete.” But for an active investor who wants to take an early-lead role, seed is the place to play. Note, Keith defined “seed” as the first meaningful capital a company raises — not the pre-seed, per se, but the first time a few million are aggregated from people who are not your friends or bosses.

2/ There are challenges to doing seed within a larger platform VC fund — Keith breaks down these challenges as (1) opportunity cost of time; and (2) the signal risk for both the company and the fund. On the fund side, he guides larger funds who do seed rounds to be mindful of the conversion rate to larger checks because one $50M check in a scaling company that’s doing well can cover a lot of seeds.

3/ What’s changed in seed market over last 15 years? Keith answered this one quickly: (1) valuations off the charts at seed, sees no immediate change there; (2) explosion of seed funds, says he gets one deck a week for a new seed fund (he’s only invested about 15 personally over last decade); and (3) Series A and platform funds are investing in talent earlier. All this said, many seeds are not competitive despite what you see or hear in the market.

4/ Osmosis is most critical for learning VC — he said for junior folks in the room, those who are developing into check-writing VCs over time — there are two critical things to keep in mind: (1) You need to be in partner debates to learn, and it takes time. Osmosis is how knowledge is transferred. (2) A vital skill for junior VCs to master is knowing what to flag for a senior GP. Those who don’t learn how to sort and flag key issues with judgment will never have a chance. [Aside, on point #1, I feel very fortunate that for my entire investing career to date, I’ve been able to sit inside weekly partner meetings at Bullpen, then GGV, and now at Lightspeed for the past two years.]

5/ Seed investing is like the Major League Baseball draft — In the NBA, the top picks are known to be the best talent usually. In MLB, most are drafted out of high school and quite often the evaluators miss talent. This is like seed investing. It’s ok to have mistakes, part of the game. Now comes the great insight from Keith — biggest mistakes looking back were choosing not to take a first meeting. In a world of thousands of startups and finite time, this is a very hard problem to solve — who to pick to meet in real life.

6/ A huge benefit of Founders Fund not having partner meetings — they can meet more companies. Founders Fund partners meet once a month for an hour. So, Keith says on a monthly basis on Mondays, he has 8 more hours per Monday than his competition, or 40 hours more per month, not even counting all the other meetings VCs at most funds are dragged into.

7/ And finally, Y Combinator — this was very interesting. Keith has seeded or invested in many YC companies. Yet, as a founder-driven investor, as YC has scaled in size and demo day is more of a production, he can’t get to know the founders, so in those cases, at a big fund like Founders Fund which can write a $100M check later, he prefers to wait. This is absolutely what many other funds say privately about YC, and thanks to Keith for putting it out there.

The VC Industry Norms Which Changed Over The Past Decade

Having spent time around and then in the world of VC in the Bay Area during the last decade, I’ve been reflecting on how different norms in the industry have changed. At the start of 2010, there was some unwritten VC industry conventions that have been tested, challenged, and upended in the last decade. I also want to be clear that there are other things that should (hopefully) change in the VC industry. That is for another post. In this post, I want to focus on what has been accepted over the past decade. So, what specifically has changed for Bay Area VC firms?

Acceptance that leading VC franchises can’t just invest in their backyard. I recall many Sand Hill firms stating a preference or requirement to invest only in the Bay Area. To be fair, not all of them held this view and many of them were investing nationally earlier, but as we flip over to 2020, there is a general acceptance among Bay Area VC partnerships that they need to be able to invest across the country, not just NYC and LA or Seattle.

Acceptance that leading VC franchises needed to be multi-stage and global. The AUM of many VC funds has increased dramatically. Depending on where you sit, it makes sense or is a recipe for disaster. To me, it makes sense, because “tech” is no longer a vertical – it’s seeping into every sector horizontally. Firms like Sequoia, Accel, Lightspeed (where I am a venture partner), Bessemer, have franchises their brand in other key entrepreneurial geographies; firms like GGV (where I used to be a venture partner) have a dual-country strategy in place from day one; and other firms have opened satellite offices in NYC, or send partners weekly to LA and Seattle. Beyond location, these firms accepted they need to view their access to talent like Facebook or Google would — for certain entrepreneurial talent, price didn’t matter as much as access does, so they’ll invest earlier (seed) and raise funds later to go big into winners and/or defend their best positions.

Acceptance of lower ownership thresholds in the best companies. I don’t have the data, but I’d bet the “minimum ownership” requirements VC funds started 2010 with have gone down dramatically. This impacts portfolio construction and possibly returns, though on the flip side, end-markets are larger and outcomes can be greater — look at Datadog, for instance.

Acceptance that leading companies expect some level of platform services. No doubt, a16z changed the game here. While I don’t think founders expect a SWAT team to show up and build their startup with them, they do expect some high-leverage support in business development, executive recruiting, and capital formation. VC firms have had to respond to this competitive dynamic by evolving their own operational model, which is not a strong suit of most VC partnerships. This also eats into the time and fee income those partnerships generated. While no one would cry for them over this (nor should they), it is now accepted as table-stakes for a top flight VC franchise.

Acceptance that firms and partners need to actively market themselves. While VCs have blogged and tweeted often before 2010, some still resisted being too forward with their point of view. What a difference a decade makes! Today, Twitter feels like it’s oxygen for VCs; firms spend thousands even millions on their websites, content strategies, marketing departments, events teams, PR workshops, and so forth. We even have folks who used Twitter to help raise their first funds and put them in business.

Acceptance that they face legitimate competition from the below and above. There are too many startups to keep track of. There are too many angels, accelerators, scouts, and seed funds who are giving them checks early, potentially diverting deal flow. There are larger firms who were traditionally only focused on growth who realize the power of holding early equity in tech and are coming down-market, even to the seed stage. It’s 360-degree competition, and that’s the new world VC firms live in.

Moving forward, in the next decade, my belief is the value set which entrepreneurs look for in VCs will change. In a previous era, it may have been more about familiarity or the perceived knowledge an investor held. Recently, the awareness a large VC brand can confer on a startup is coveted by some. In the future, I believe founders will be drawn to investors who market certain values that align with their own worldview and/or aspirations. That could be as broad as “sharing economy” funds, or as specific as investing in solutions to combat climate change. If I’m right, the next thing investors will need to accept is this — that they’ll be valued by the market for what they believe, and how they convey it — they will not be valued what they know or claim to know.

Quickly Unpacking Visa’s $5.3B Acquisition Of Plaid

Earlier today, the news leaked that Visa was to acquire fintech startup Plaid for $5.3B. Plaid is known within the startup and VC community as a strong company, but it is also a relatively quiet company in terms of its own PR and social media chatter. Startup exits are rare, and as the number of startups increase, large exits will become even more rare percentage-wise. So, when a major public financial services company plunks down over $5B to acquire an asset, everyone in startup land takes notice. Windfall events are almost required to extend one’s lifespan in the Bay Area these days, and this acquisition certainly qualified as one for those involved. It’s late tonight and this armchair correspondent hasn’t eaten dinner yet, so let’s briefly unpack the key takeaways from this event:

1/ The FinTech is already red-hot. Now it’s scorching. By now, folks realize how hot the “fintech” sector is. Arguably, after the rise of Facebook and social networking, fintech has been the biggest consumer and enterprise trend within startups — consider hyper growth companies ranging from Square to Coinbase, from Robinhood to LendingClub, from Affirm to Faire (Lightspeed portfolio companies), and so many more. FinTech valuations have already been on the rise in private markets, most recently with breakouts like Chime, and we should expect that trend only to intensify given this exit size. Consider recently PayPal paid $4B for Honey; Prudential bought Assurance for $3.5B; and Fidelity paying $35B for Worldpay.

2/ API FTW. There are folks within the startup world who know this secret as obvious, but it is not as widely-accepted. How could Twilio become a public company with an API-driven business model? Could Stripe grow that big with its architecture? As we have too many browser tabs open and are inundated with more SaaS applications, it would only make sense that going a bit deeper in the stack and empowering developers to build the next suite of solutions, as well as doing the heavy lifting of building thousands of integrations to help add value (much like Slack did for its platform). Plaid fit into this category broadly, and timed things perfectly as more and more fintech companies would use their services to help onboard their own users.

3/ Strategic fit trumps financials. I saw a tweet lamenting the acquisition price of Plaid as “crazy” because it was 35x revenue. What the journalist doesn’t appreciate is that as the private markets have expanded and given companies like Plaid more runway to stay private longer, it affords these companies the chance to maximize their value in this manner. The value of Plaid is totally different: Consider a platform which connects fintech developers, financial institutions, and consumers. That’s valuable. Visa values Plaid more (or to keep out of the hands of competitors) than public market investors might, and startups and their investors have and will continue to take advantage of that dynamic. For a company like Visa, owning Plaid gives them even more surface area to tap into new transaction streams.

4/ Lightning strikes twice for Spark GP. A small point and not central to the story, but this appears to be the second company where Spark Capital’s Santo Politi was on the board as an early investor that’s generated a multi-billion exit (previous one was Oculus to Facebook). To get one deal like this in a VC career is statistically almost impossible — to get two in a few years is a dream.

5/ The Haves And The Have-Nots. We ended 2019 with questionable performance from new public tech companies, and we’ve started 2020 with very public layoffs announced at big private startups. Influential folks are warning others on Twitter about the tide going out. This bull run can’t last forever. But, then there’s Plaid. The others were have-nots. They did not have enough runway or enough strategic value. The startup was also relatively capital efficient, raising less than 10% in venture capital of the final exit value it received from Visa. Plaid may have looked at that environment, looked at their cap table (which includes Visa, MasterCard, and Goldman Sachs, among others) and smartly whispered to them about what it would take to join forces with another company — and given their strategic value, their API-first strategy, the weight of the fintech sector, and the smart minds around the table — they engineered an incredible exit with impeccable timing.

Why Seed Funds Have Scaled

For those following this blog and the seed market over the past decade, you may have noticed that every year, we see increases across the board — more investors, newer funds, and funds that get larger. Much has been written about the fact that traditional seed stage funds have grown in size and dollars under management. Here, I wanted to step back and consider “why” this has happened from my vantage point. If you’re reading this looking for data and hard numbers, charts, and footnotes, you’ll be disappointed. Rather, this short blog is filled only with my own observations from being in the middle of the evolving seed market since 2013. So, with that Disclaimer, here are the main reasons seed stage firms have grown in size over the past decade, along with some risks and opportunities these conditions create:

1/ Catching Ambition – When some seed stage funds started, perhaps they didn’t know what their fund would turn into. Some are gone now, and some caught fire and the creators decided they wanted to grow into an investment firm, not just a fund. This is sort like when a tinkerer builds something for a few years but then it starts to work maybe 2-3 years later and they decide their want to intensify their approach to building around it.

2/ Financial Considerations – When investment firms grow, so do fees. But, I do not think this crop of seed funds is entirely motivated by more fees, but rather it’s industrial situations (which I’ll explain more below) that’s driving this. As valuations have gone up early, the cost of ownership has also risen, and in an early-stage fund where the loss ratio is likely to be much higher, high ownership has been increasingly important to these funds. Getting that ownership is one thing (and it costs more), but then defending it with reserves in future rounds is also increasingly important and another reason these funds have scaled up (usually with opportunity or overage vehicles).

3/ Industrial Atmosphere – I like to say that “tech” over the last decade went from being perceived as a vertical sector to now being horizontal, where tech has or will permeate most if not all industries. As a result, the venture industry has exploded — either to meet that opportunity, or because of low interest rates, or both. Over the past decade, many newer LPs (those who back VC funds) have entered the market, and as those LPs get more comfortable with their GPs, they may also want to put more money to work with them, especially when they get a taste of early stage returns. At the same time, the classic Series A funds and Sand Hill Road institutions have scaled up into the billions, creating more space at the early stage for seed firms to theoretically straddle the seed and Series A stages. There are also newer angels and new funds created almost weekly, so raising more capital as a seed fund can be a weapon to win deals.

4/ Social Forces – As seed stage funds grow and mature, the GPs grow and mature too. Seed funds often co-lead deal with another fund they enjoy working with. If their friends are growing, they may want to, as well. If it used to be traditional for each fund in a seed deal to co-lead with a $750K check 5-7 years ago, but now the check required for the same ownership level is now $1.5-2M per firm, funds may want to grow so they can keep co-investing with their peer group. Also, as investors themselves age, they may want to increase their ownership in a round as a reflection for what they feel they bring to the table, and they may want to concentrate their relationships in fewer, stronger opportunities — much like one may do in life with friendships, too.

These are the main four reasons behind *why* seed funds have grown in size over the last decade. With any change, these forces present risks and opportunities. The opportunity ahead is clear — more fees, more ability to own and defend that ownership, and having a storefront for pre-seed, seed, and Series A deal participation. In the right company, that can be life changing. There are risks, of course — new investors and funds are entering the market with smaller funds, novel Twitter strategies, and a hunger and desire to get ahead of the best founders. They may not only intercept the deals seed funds should be doing, but then may pass them along to the larger institutional funds, who are also happy to write a seed stage check, bypassing the traditional market. If the 2010’s were about the institutionalization of seed funds, I believe the next decade ahead will be a test of who can stake out their territory as these forces rise from the bottom and cram down from the top.

Time Diversity In VC Portfolios

A topic that’s been on my mind a lot in 2019 is “time diversity” in venture capital funds. There’s more about this topic all over the web, but the basic gist is — when building a VC portfolio, many investors prefer to have some “time diversity” baked into the mix because 1) prices can fluctuate and a longer time period can increase the odds that a portfolio is built when prices are lower and 2) it can help the investors “pace” their initial capital deployment and reduce the risk of investing too quickly and too loosely.

From what I’ve gathered from LPs and VC mentors, in previous eras, the initial deployment period of a VC fund (not including reserves for follow-ons, etc.) used to be around 5 years. Today, it’s rare to find a 5-year fund. I know of one. I can name a few 4-year funds on one hand. Three years seems to be a standard and acceptable period today. That said, some of the very best funds are doing two-year fund cycles. These are firms that have returned capital at scale.

This topic can trigger some heated debate. There are valid points on both sides. For those firms which have a strong foundation and history of returns, one could argue they’ve earned the right to judge the investment climate and march forward. On top of this, technology is no longer a vertical sector — it is entirely horizontal and spreading outward into global markets and new industries. On the other hand, those portfolios may not catch lower prices in certain vintages or potentially be investing so quickly, the bar for what makes an investment could go down. And, the more funds that are raised, the more fees VCs can collect, which are contractually guaranteed in limited partner agreements.Only time will tell which approach is best or optimal.

When I started Haystack, I had no idea about any of this. I only learned about this as a concept maybe in 2017. I’d speculate that most VCs actually don’t think about this topic. So, I spent years trying to learn from other VCs. Here are the initial deployment periods for the Haystack franchise: Fund I (1.5 years); Fund II (1 year); Fund III (2 years); Fund IV (2 years); now just opened Fund V (targeting 2.5-3 years).

What I learned from talking to mentors — mainly would single out Mike Maples here, who really hammered on this topic with me, as well as Fred Wilson and Roger Ehrenberg — is that for me as an investor, pushing the fund to increase time diversity would be a good thing. That doesn’t mean Haystack needs to be a 4-year fund or longer, but it also doesn’t mean that what’s best for me is what others should do. I think the key point is — folks managing third-party capital should go on their own journey to learn this topic and figure out what the best flight plan is for their own fund and LPs. Like portfolio construction, simply the act of thinking deeply about it, coming up with a plan, and sticking to it has been very valuable to me and something I think about now daily.

Looking Ahead, Predictions For 2020

With a bit of reluctance, I share this forthcoming “Predictions For 2020” post with you. Initially, I wasn’t going to write one because I figured it is hard to know what will happen even with lots of thought applied, and that it may not be valuable to you as a reader — despite the fact my Predictions for 2019 post was pretty spot-on (but 2018 was not!). But then I talked to a mentor who reminded me this blog usually was and should still be a medium for me to think out loud, and that this act of constantly thinking should be valuable to at least me. So, with that caveat, here we go…

As 2020 is nearly around the corner, what’s on my mind? What am I preparing for in my little world of technology, startups, and venture capital?

The Venture Capital Ecosystem: The public markets are soaring. Private markets are bigger than ever. There is so much dry powder alone in the Bay Area (well over $50B contractually committed to funds), it’s hard to see that just drying up overnight. In my role as an early-stage investor, I can’t worry about what will happen in public markets, and there is so much capital in the private markets, it means that 2020 is setup to just be a continuation of what 2019 was — and that means a bifurcation of seed rounds, with some seed rounds being very competitive pre-product Series A rounds, and other rounds being smaller, more on the fringe, perhaps out of the Bay Area. The entire seed market is wholly different from when I sent the first Haystack wire in March 2013, and with every fund comes a new game to learn to play.

The Technology Economy: Technology is proliferating into new sectors, new geographies. End-user markets are truly global and can support multiple $10B+ companies. But, consumer investing is getting harder because the cost of acquiring, engaging, and retaining those users has tipped over to a point of no immediate return. I operate as if this trend will simply continue until “the next thing” comes along after the web and mobile. I do not see that happening in 2020. Perhaps the first taste we’ll get of that is in a few years with Apple’s AR glasses, but who knows. I do see newer generations of founders focusing on larger problems with their startups — healthcare, climate, and the like. I see fewer folks coming through on crypto, so while that sector has cooled, there are real dedicated VC funds that focus exclusively in this area, which is great for LPs and founders alike. I appreciate the vision and the ambition and I do sincerely hope these efforts pan out, so I eagerly await to see what will come of these in the years to come.

The Political Economy: I actually believe the current President will be convicted by the Senate and removed from office. I have been following the proceedings and evidence, and the corroboration is overwhelming. My hunch is The Speaker Of The House will hold articles long enough to ensure the 2020 State Of The Union address is not delivered before a trial can be concluded. I also believe more information will come out that will force the current Senate majority to break ranks. No matter the outcome here, I believe the Republican Party will be in a strong position to win the November 2020 general election given the electoral college map, the tech-fueled economy, the Republican Party’s methods, media, and organizational tactics , and the numerous, incongruous, warring factions within the Democratic Party.

Predictions For Me, On The Personal Side: Well, this is more of a “resolutions” section of what I hope will happen in 2020. This is the first year where Haystack funds have so much dry powder ahead of them, I can focus my work time entirely on selecting and helping portfolio companies. It’s been a nearly 10-year slog since I moved back to the Bay Area in 2011 and meandered my way into the world of venture capital. That period of life was extremely frustrating in those early days, and it was incredibly hard to earn the trust of institutional LPs to eventually build a VC fund. Along the way, that hard work and patience was met with incredible luck. I sometimes worry if I tapped the “well of luck” too early. Now, the fund is a real steward of capital and needs to play a slower and longer-term game. The first phases of this video game have been about luck, survival, being nimble, moving quickly — now as 2020 is around the corner, I feel rested enough to vigorously apply the lessons of investing and fund management I’ve picked up in the last decade, to welcome risk in the companies we invest in, but also to move a bit more slowly in terms of capital deployment, reserves, and opening new funds. I also hope to get back to my roots and write more here, as I did when I started this new career — and I hope you’ll stick around to read what I have to say. Happy New Year to you and yours!