Like many did, we spent much of this weekend watching Peter Jackson’s wonderful documentary of the Beatles making Let It Be, titled Get Back.
I enjoyed so much of the film, particularly the music, but the big thing I took away is the power of real partnerships. While this was the Beatles last recording session, what you see in the film are four partners working together creatively and wonderfully. I wasn’t really expecting that and I found it so enjoyable to watch.
I have worked in partnerships for most of my adult life, since I was in my mid 20s. I have spent 35 years in three partnerships, all of them “equal partnerships”, the kind where everyone brings their own ideas, they are worked on together, and there is mutual respect and admiration.
Partnerships are not easy. Everyone has to dial back their ego a bit and let others have their say on things. But what you get when you do that is an environment where everyone gets better than they would be on their own. And you can see that in the Beatles work. All of the four Beatles went on to have solo careers, but none of them produced a sustained level of work that the four of them were able to make together.
Watching Paul, John, George, and Ringo work together for a month to make an incredible record was a reminder that when we sacrifice a little bit of our self and commit to a team dynamic, wonderful things can and do result.
We have been seeing quite a few seed rounds getting done in and around $100mm post-money and that concerns me for a few reasons:
Seed stage is when a company has a good team, a good idea, but has not yet proven product market fit and a go to market model, and has not yet demonstrated a sustainable business model.
These investments have a high failure rate. In my experience, roughly half of seed stage investments fail completely, wiping out everyone’s investment, including the founding team’s.
There is a lot of dilution from the seed round to exit, in my experience, a seed investor will be diluted by around 2/3 between seed and exit.
A power law distribution exists in outcomes in any early stage portfolio and a seed portfolio is no differernt.
So given that I am jet-lagged and got up at 3:30 am this morning, I modeled this out to see how this all works. Here is the google sheet in case you want to look at my model.
Here are the assumptions:
Number Of Investments
Average Dilution from Seed to Exit
Top-Performing Investment Outcome
Power Law Number
Power Law Distribution Of Outcomes:
Given those assumptions, a $100mm seed fund that makes all of its investments at $100mm post-money will barely return the fund. And that number is gross, before fees and carry.
Total Value At Exit
Now all of this depends on a few important assumptions.
If you believe your top-performing investment, out of 100 investments, will end up being worth $100 billion, then the numbers change a lot. You end up with a 13x fund instead of a 1.3x fund, before fees and carry.
The dilution from seed to exit also matters a lot. If you believe the dilution from seed to exit is only 50% and your top-performing investment, out of 100 investments, will be worth $10 billion, then you will end up with a 2x fund, before fees and carry, instead of a 1.3x fund (at 2/3 dilution).
There are only several hundred companies in the world with market caps of over $100 billion and roughly a quarter of them have come out of venture capital portfolios in the last thirty years.
So it can happen, but it is very unlikely. In almost twenty years of producing some of the highest performing VC funds in the business, USV has never had a portfolio company become worth over $100 billion. That is a very high bar, too high to expect in your portfolio.
So, in a world where we are seeing more and more $100mm valued seed rounds, one has to ask the question what are the investors expecting? A $100 billion outcome? Doubtful. Less dilution, maybe. A different power-law distribution? Don’t count on it.
I think they are being delusional, comforted by the likelihood that someone will come along and pay a higher price in the next round. But it seems that person may also be delusional. Because when you model things out, the numbers just don’t add up.
I think a strong case can be made for seeds in the low eight figures. If you run that same model with a $20mm post-money value, you get a 6.667x fund before fees and carry. That’s a strong seed fund, probably a tad better than 4x to the LPs, after fees and carry. If you think you can get one of your hundred seed investments to a $10bn outcome, then paying $20mm post-money in seed rounds seems to make a lot of sense.
The exit values in VC have increased significantly over the last decade leading to escalating entry values. That makes sense. But the two things that have not changed materially over the last decade are the dilution from seed to exit and the power-law distribution of outcomes in an early stage portfolio.
The failure rates are so high in early-stage investing that the power-law curves are steep. If your best-performing investment, after taking significant dilution, cannot return your early-stage fund, then you are doing something wrong.
Update: I saw this tweet just now and thought that it makes a great addition to this post:
When you look at the recent Q3 numbers on seed and early-stage VC fundraising, you might think we are in the late stages of a VC bubble:
The words I would use to describe the current environment in early-stage VC are “fast and furious.”
And yet the thing that makes me think this could be the new normal and not the late stages of a bubble is the dramatic increase in the number of people who are choosing to work in or form new startups. It has never been easier to start a company, build a team, and build a product. And many people are choosing to do just that.
It could be that we are in an environment where too much money is chasing too many good deals.
NYC startups are getting funded at 2/3 the rate of Silicon Valley startups. That’s a huge change from where NYC was even two or three years ago.
It wasn’t that long ago that a NYC-based startup had to agree to move to Silicon Valley to get money from the VCs out there. I think that was still a thing into the latter part of the 2000s. Now a decade and a half later, we see NYC startups raising capital almost as much as Silicon Valley startups.
Back in 2005 Malcolm Gladwell wrote a book called Blink that was about how our subconscious allows us to make fast decisions that are often as good or better than slow considered decisions.
I was talking to someone yesterday evening about how the venture capital business has changed over the last decade and I explained that we used to have weeks, if not months, to make our investment decisions and now we have days or if we are lucky a week or two.
And I observed that the rapid pace of venture investing and decision making has not, yet, impacted the quality of our portfolio and that it may have actually improved it.
The woman I was talking to said “like Malcolm Gladwell describes in Blink.” And I nodded affirmatively.
There is another thing going on with our decision making at USV, which is that we are regularly taking the time to articulate to each other, and ideally the world at large, what we want to invest in and why.
That work, which we call thesis building, helps us make rapid decisions in the absence of time and information.
It is tempting to mourn the loss of careful and considered investing but from where I sit it seems gone for good, at least for early stage venture capital, so I think it’s a better use of our time to spend adapting to the market, as my partner Brad likes to say, and building the conviction to act quickly and decisively.
But there are also great benefits to working this way. As a team, we benefit from working together on everything versus having silos within our partnership and firm.
And as individuals, there is something quite helpful about moving back and forth between domains. It stimulates the mind in ways that going deep and staying deep on one thing cannot.
There are many ways to build a successful investment business. Specializing in a specific domain works well for many firms.
But I personally prefer being a generalist. Being able to meet founders in multiple different sectors back to back to back is really something special. It challenges and opens the mind in a way that really works for me.
I wrote in my 60th birthday post that my late career mantra is less hustle more conviction. It has been working for me and has kept me in the game.
But there are times, usually after an opening emerges, when a market moves so fast it is hard to stay on top of it all.
I don’t worry about missing out. That’s part of the venture capital business. Fear of missing out is a counterproductive emotion and I refuse to engage in it.
But I do worry about not understanding what is going on. When you stop understanding things, you are done. There is no way to be a great investor if you have no clue.
It is possible to surround yourself with others who can help you understand what is going on. I do that and I have terrific colleagues who keep me engaged in what’s happening. These colleagues are inside USV and also spread around many other firms too.
But at some level, you have to understand things yourself. Osmosis only works to a point. I find that you have to get your hands on the technology, use it, and feel it to understand it.
And that is the hard part when things go bananas as a market opens up. Less hustle works against you. And you have to find a way to engage in it all. That’s where I am right now.
I saw a statistic from one of our larger portfolio companies yesterday. They have had their offices around the world open for some time now with office usage optional. They are seeing office utilization rates of around “20-30%.” They are also seeing “flexibility” as the number one issue in recruiting new talent.
That was interesting to me because we are seeing a much higher office utilization at USV. We kept our offices open for much of the last 18 months and encouraged a return to the office once we were all vaccinated in early April. On most days, we see about half of our team coming into the office. I think that number was higher in the spring and will be higher in the fall. We also see friends in the VC business and startup world working at our office from time to time and that has been fantastic.
We have also seen that office utilization is much higher for our team members that live in NYC vs the suburbs, which is not surprising. This chart says it all:
We surveyed our portfolio companies last month on the topic of their work environment plans. We got 56 responses which is a tad under 50% of our active portfolio so this data could be off a bit. But it is interesting. Pre-pandemic, 75% of these respondents were fully “in office” with most of the rest using some sort of hybrid model. Very few were fully remote. Now the distribution looks like this:
That is a dramatic change from the pre-pandemic norm. I am sure that there will be some movement back to the office when we get to a new normal, whatever and whenever that is, but no matter what, tech companies have moved away from the “fully in-person” model and that will mean very different office utilization models.
We also asked our portfolio companies about “seat to employee” ratios and got these responses:
For those companies that will continue to have an office, it looks like the average seat to employee ratio nets out around 65%. And that is for the 75% of the respondents that plan to have some sort of office.
At USV, we are taking a contrarian approach to the office. We plan to build a new office that can seat 100% of our employees and we want to be able to host board meetings and other events frequently. We are also looking at other ways to invite the broader “community” to work and be at USV regularly.
But that does not mean we will expect our employees to be at the office every day. We understand that those with long commutes and children or parents at home need more flexibility and we have seen that providing that flexibility builds loyalty and commitment. So we will continue to support that way of working.
Startups and high-growth companies seem to have embraced fully or partially remote models for the most part in an attempt to attract and retain talent and leverage the increased productivity that comes from eliminating long and painful commute times.
But that doesn’t mean an office isn’t a good thing from time to time. It may be that organizations that support startups and high-growth companies, like USV, can step into the mix and be part of that answer. That is an interesting idea to me and one that USV is looking at right now.
I realized a long time ago that the VC’s customer is the founder/CEO/portfolio company and that our investors (called LPs in VC speak) are our “shareholders”. That was a very defining moment for me and has clarified what matters the most in a VC firm.
That said, we take investor relations very seriously at USV and always have.
This is our model:
1/ We are loyal to our LPs and offer them the opportunity to invest with us fund after fund after fund unless something has materially altered the relationship. That is very rare but has happened.
2/ We regularly provide our LPs with a lot of information on our portfolio. We send financial reports including detailed schedules of investments quarterly and we provide detailed one-page writeups on each and every portfolio company twice a year.
3/ We do two “quarterly calls” a year, one in the spring to review Q4 and Q1 and one in the summer to review Q2. These are now Zoom meetings. We are approaching our summer call which is what prompted me to write about this today.
4/ We do one annual meeting in the fall after Q3 results are out. These used to be in-person meetings in our office featuring several (3-5) presentations from a representative mix of portfolio CEOs. We like to have a wide variety of companies present (by stage, performance, etc) and absolutely do not do a “greatest hits” experience at these meetings. We did our annual meeting over Zoom last year and may continue to do that going forward as it makes it much easier for the portfolio CEOs to present and easier for our LPs to attend. If we do that, I will miss the in-person interaction we have at our annual meeting but also believe making things easier for everyone is very important.
5/ We don’t do splashy meetings at fancy places with our LPs. We believe in substance over form when it comes to investor relations and we believe that our LPs do as well.
The Gotham Gal and I are investors in dozens of VC funds/firms and there are many ways that VCs do this. Some provide little to no information and let the returns speak for themselves. That can work too. But I believe frequency, regularity, and transparency are the key factors to focus on with investors. It has worked well for us.
I recall when my partner Brad and I were raising our first USV fund, back in 2003, and potential investors wondered about my blogging habit. They asked if I was making a mistake telegraphing our investment thesis for everyone to see, including our “competitors.”
We strongly defended the practice and explained that the benefits of telling the world what we were looking to invest in, and why, strongly outweighed any costs. We explained that telegraphing would bring entrepreneurs to us.
And that turned out to be the case. So many of our top-performing investments over the years came to us because of our telegraphing strategy. It is hard to know who is working on a problem you are interested in. But if you put the word out far and wide, they will find you.