Podcast Summary
A return to normalcy in the VC market: The number of VC deals and deal values have decreased significantly, signaling a healthy correction from the overheated market of the previous years.
The venture capital market is experiencing a return to normalcy after a period of excessive investment and deal-making. According to data presented on The This Week in Startups podcast, the number of deals and deal values have both decreased significantly from their peak in 2021 and 2022. The deal count is back to around 3,000 per quarter, and the deal values are around $40 billion per quarter. This is a reversal from the frenzied pace of the previous years when over 5,000 deals were happening per quarter, and over $100 billion was being deployed annually. Raja Dodala, a venture and growth executive at Churchill Asset Management, noted that this correction is a healthy sign as things were getting overheated, and investors were forgetting the risks and realities of the venture capital business. The danger, as Stig Brodersen warned, is the allure of venture capital leading people to put too much money into startups without proper consideration of the J-curve and the long-term risks involved.
Inefficient use of resources and talent in the VC industry: The VC industry's focus on large investments during exciting times can lead to inefficient resource allocation and unrealistic expectations, particularly for early-stage companies.
The venture capital industry, particularly during periods of excitement and high valuations, can lead to inefficient use of resources and talent, resulting in suboptimal outcomes. This was evident during the dot-com, web 2.0, and current AI eras. Despite some signs of a return to a more boutique approach, there are still concerns about excessive valuations and deal sizes, particularly in the pre-seed and seed stages. These larger investments can lead to founders receiving larger amounts of money, potentially skewing the market and creating unrealistic expectations. The challenge of B2B marketing adds to the complexity, as long buying cycles and difficult-to-reach decision-makers make it harder to target and convert potential clients.
Leveraging LinkedIn for B2B Marketing and Investment: LinkedIn's large executive user base offers unique opportunities for B2B marketing and investment. Demonstrating a product and real traction is crucial for securing funding, and LinkedIn can help build relationships with decision-makers for high returns on ad spend.
LinkedIn is a powerful platform for B2B marketing, especially for targeting senior-level executives. With over 180 million senior-level executives and 10 million C-level executives, LinkedIn offers a unique opportunity for B2B companies to build relationships with decision-makers and generate high returns on ad spend. According to LinkedIn's data, B2B tech companies see a 2 to 5 times higher return on ad spend compared to other social media platforms. Pre-seed funding has evolved, and investors now require more than just an idea or a business plan. Founders need to demonstrate a product, even if it's in beta testing, and preferably have paying customers or real traction and revenue. Seed funding has become more competitive, and investors are looking for a smaller stake in the company, often without the need to lead or join the board. Overall, LinkedIn's large executive user base and the evolution of funding stages make it an essential tool for B2B marketing and investment.
Identifying predictable customer growth and cohorts in SaaS businesses: Investors seek a few customers with similar contracts to determine product popularity and predict future customer acquisition. Waiting for a sufficient customer base increases predictability and leads to higher valuations and larger investment opportunities.
The key to a successful investment in a SaaS business lies in identifying predictable customer growth and cohorts. In the early stages, investors look for a few customers with similar contracts to determine the popularity of the product within a specific segment. As the number of such customers grows, the predictability of future customer acquisition increases, leading to higher valuations and larger investment opportunities. Founders, eager for recognition, may push for larger investments earlier, but investors must exercise discipline and wait for a sufficient customer base before committing larger funds. The investment strategy involves balancing risk and reward across different stages of a company's growth, with pre-seed and seed stages focusing on company creation and series A through D stages catering to more established businesses.
Focusing on a few marquee managers and investing in seeds: VC firm invests in 10 marquee managers, allocates resources to seeds, and aims for $3-$10M investments in smaller funds for potential high returns, while managing risk and volatility.
The venture capital firm invests the majority of its committed dollars in a concentrated number of managers for series A through D, while also allocating a significant portion to seed and pre-seed investments. The firm aims to have around 10 marquee managers and a long tail of smaller managers, investing between $3 to $10 million into each smaller fund. This approach allows the firm to potentially reap higher returns, but also involves risk and volatility. The firm spends a considerable amount of time and resources evaluating smaller funds, recognizing that some may not graduate to larger funds. Despite the effort required, the firm believes it's essential to invest in the seed and pre-seed stage due to the potential for high returns. The firm also seeks to co-invest in outlier companies and build strong relationships with managers, allowing for additional capital infusions and potentially lower fees. Overall, the firm's strategy is to maintain a diversified portfolio while focusing on managers with a proven track record and the potential for high returns.
Historically typical exit values: Despite lower recent exit values, $70B in total exits in 2023 is typical historically. Most exits were under $100M, requiring VCs to aim for significant exits to meet fund goals.
While the current exit environment may seem challenging with lower exit values compared to recent years, historically speaking, the total exit value of around $70 billion in 2023 is not too far off from what was typical in the late 2010s. Moreover, 87% of all exits over the last decade were less than $100 million, highlighting the power law at work in venture capital. To generate the desired return on investment, VC firms need to aim for significant exits, but creating $4 billion in exit value over a decade for a $1 billion fund is no easy feat. By using services like Mantle, investors can reduce risk and potentially secure larger returns.
The importance of rare and massive exits in venture capital: Achieving significant returns in venture capital requires rare and massive exits, but smaller funds can still aim for a 3x net return with careful management and a well-performing portfolio. Building a reliable business and a strong team can also contribute to success.
Achieving significant returns in venture capital requires rare and massive exits, with only a few companies reaching the billion-dollar mark in the last decade. To hit the necessary exit values, a fund may need to invest in a large number of companies, with one potentially reaching a $40 billion exit. The likelihood of such an exit is incredibly rare, with only a handful of companies reaching that valuation in the last 10 years. For smaller funds, the goal of a 3x net return can still be achieved without a billion-dollar exit, but it would require a well-performing portfolio and careful management. Additionally, building a reliable business and assembling a product team can be a crucial step towards success, and partnering with a development team like Dev Squad can help quickly build a complete team and reduce costs. Understanding the importance of rare and massive exits in venture capital and the role of a well-constructed portfolio is essential for both Limited Partners and General Partners.
Shifting Exit Values in VC: Acquihires and Political Climate: Despite smaller exit values from acquihires, VC investors face challenges from political climate, potentially disrupting the innovation cycle and economic growth.
The venture capital industry has seen a shift in exit values, with many small acquisitions leading to seemingly high numbers. However, these acquisitions, also known as "acquihires," often result in a small return for investors, with the majority of the funds going to the acquiring company for talent acquisition. This can be frustrating for investors, but it's an inherent part of the venture capital world. Additionally, the current political climate, with a focus on anti-capitalistic approaches, has the potential to further limit large exits through mergers and acquisitions. This could disrupt the innovation cycle in the US, which is crucial for economic growth. In the long run, it's essential to find a balance between protecting consumer interests and maintaining a competitive market for startups and venture capital investments.
Impact of Tech Industry Decisions on Companies and Investors: Tech industry decisions like acquisitions and IPOs can lead to significant financial gains for companies and investors. However, the dominance of large American tech companies raises concerns and the importance of portfolio construction balancing creativity, patience, and risk management is emphasized.
The decisions made in the tech industry, such as acquisitions and IPOs, can significantly impact the financial success of companies and investors. For instance, YouTube's acquisition by Google and Instagram's acquisition by Facebook have led to massive returns for the acquirers. However, there is a debate about the implications of these large American tech companies dominating the market and the potential consequences of blocking such acquisitions. Moreover, portfolio construction is an evolving science and art, requiring a balance between creativity, patience, and risk management. Smaller funds and larger funds serve different purposes, with smaller funds offering more creative opportunities for certain types of Limited Partners (LPs). The tech industry's landscape continues to change rapidly, making it essential for investors to stay informed and adapt to new trends.
Mega funds vs. Traditional VC: Different Strategies: Mega funds aim for 7-10% IRR with potential for higher returns, while smaller funds focus on higher multiples with shorter horizons. Seed funds identify potential winners and make strategic follow-on investments for impressive returns.
Mega funds and traditional venture capital funds have different investment strategies. Mega funds focus on absolute dollar returns, aiming for 7-10% IRR with the potential for higher returns from occasional home runs. These funds have longer investment horizons, typically 10-12 years. On the other hand, some investors, like those managing smaller funds, aim for higher multiples (3-5x net) with a shorter investment horizon. They achieve this by combining fund investments with direct investments in winners. Seed funds, which invest in early-stage companies, have their own advantages and challenges. While they may not have large reserves for follow-on investments, they can identify potential winners based on growth signals and fundamental metrics. By focusing on seed investments and making strategic follow-on investments, these funds can achieve impressive returns, even if they don't hit every home run. The amount of reserves a General Partner (GP) should keep in a seed fund depends on their strategy. Some may choose to make fewer, larger investments with follow-on investments, while others may make more investments with smaller reserves, relying on the potential for high returns from a few investments. Ultimately, each strategy comes with its own risks and rewards, and investors must carefully consider their goals and risk tolerance when choosing a fund.
Doubling down on investments in likely winners: Investing in likely winners and increasing ownership percentages can lead to 3 to 5x returns and make investors better full-life cycle investors.
Investing in venture capital, particularly in seed and pre-seed stages, requires significant investment in the companies that show potential for exponential growth. Adam Fisher from Bessemer Ventures noted that most of a company's value is created in the last 18 months before exit. The speaker in this discussion emphasizes the importance of having a mentality that identifies likely and definitive winners, and making additional investments in those companies to increase ownership percentages. Based on their current portfolio, the speaker's investment team aims to have at least 10% ownership in 2 dozen likely winners and 15% ownership in 5 definitive winners. The data shows that in 10% of their companies, they have already made a second investment, and their ownership percentages in those companies range from 8.5% to 14%. The speaker agrees that this strategy of doubling down on investments in likely winners is crucial for achieving 3 to 5x returns, and it also makes the investor a better full-life cycle investor.
Understanding LPs' Preferences for Public Market Investments: Private equity managers must communicate effectively with LPs regarding public market investments, considering their preferences for equity distribution. The advancement of technology and return of normal venture practices may bring significant liquidity, but LPs will need to demonstrate ROI and prove the readiness of AI tools for prime time.
As a private equity manager, it's essential to understand your Limited Partners (LPs) and their preferences regarding public market investments. Some LPs may require you to distribute equities, while others may prefer holding them. The decision-making process can be complex, especially when dealing with a large number of LPs. The speaker shares his experience of distributing equities in their firm but notes that it comes with challenges, such as high costs and complications. The next few years are expected to bring significant liquidity to the market due to the advancement of technology, particularly AI, and the return of normal venture investing practices. However, there may be a period of disillusionment as people overestimate the impact of AI in the short term. LPs will be under pressure to demonstrate ROI and prove the readiness of AI tools for prime time. Ultimately, it's crucial for private equity managers to communicate effectively with their LPs and make informed decisions based on their unique circumstances.
Navigating the Early Stages of a Technological Revolution: Practice time diversification by deploying capital over a longer period to ensure exposure to different economic cycles, technology maturation, and incumbent failures or advancements in early-stage venture capital.
We're currently in the early stages of a new technological revolution, with companies like Microsoft, Nvidia, and Snowflake potentially better positioned in the next few years as incumbents improve their products. However, it may take several more years before we see the true game-changers emerge, as the first movers in the space may face challenges and eventually be surpassed by new technology. For investors, especially those in seed and pre-seed rounds, it's crucial to practice time diversification by deploying capital over a longer period to ensure exposure to different economic cycles, technology maturation, and incumbent failures or advancements. This is particularly important in early-stage venture capital funds, where underwriting involves scrutinizing a fund's deployment history, entry prices, and investment rationale. It's essential to look beyond monthly numbers and consider a 3-year strategy to effectively allocate resources and maximize opportunities in this dynamic technological landscape.
Investing in a large portfolio with disciplined approach and effective communication: Seed stage funds can achieve top quartile returns by investing in a large portfolio of 200 companies, focusing on top 20, and communicating effectively with portfolio companies. Consider liquidity and secondary sales to manage risk and create value for LPs.
For seed stage funds, investing in a large number of companies with a disciplined approach and communicating effectively with portfolio companies can lead to top quartile returns. The speaker suggests that a portfolio of 200 companies with meaningful investment in the top 20 could result in one or two successful exits. However, it's essential to consider liquidity and secondary sales to manage risk and create value for LPs. The speaker encourages GPs to think about liquidity and set expectations with founders, allowing for partial exits to create liquidity and shorten the J-curve. This strategy, known as "idiot insurance," can protect against potential losses and enhance returns.
Venture capitalists trust GPs and avoid interfering, but may help sell shares for personal reasons: VCs support GPs' expertise and maintain collaborative relationships, occasionally assisting founders with share sales for essential purchases.
Venture capitalists generally avoid interfering with their portfolio companies' operations, as long as the GPs deliver on their promises. The venture capitalists trust the GPs' expertise and prefer to maintain a collaborative relationship. However, there are situations where founders may approach the venture capitalists to sell shares, often for personal reasons like buying a house. In such cases, the venture capitalists may facilitate the sale, ensuring it's within reasonable limits and not for extravagant purchases. This approach not only alleviates founders' financial stress but also encourages them to continue their entrepreneurial journey after several years, eventually returning to create new companies.