An investor shared details of a deal he’s been evaluating. He loves the sector, loves the founder, and loves the product. He hasn’t done the deal because he has concerns around the cap table—specifically, how much capital has been raised from investors in previous rounds and how much is being raised in the current round. The company has an enormous burn rate of around $400 thousand monthly, hasn’t achieved product–market fit yet, and doesn’t have much revenue from customers. Yet, it’s raising a third multimillion-dollar round of capital.

The major concern of this investor is the amount of dilution at such an early stage. The CEO-founder will own less than 20% of the company after the current raise. If the company can raise the current round, find product–market fit, and raise additional rounds of capital at later stages, the CEO-founder could have a small ownership stake in the company. This investor sees the CEO owning less than 10% as a real possibility. If that happens, it will take an enormous outcome and many more years for the CEO’s small equity position to have a major financial impact on his life. Rather than go down that path, the CEO might leave and pursue something else with a more attractive risk/reward ratio. That wouldn’t be ideal for those who invested in the company.

This isn’t the first time I’ve had an investor tell me this, and it likely won’t be the last time this year. Raising too much capital too early can cause lots of downstream problems if the company can’t achieve significant traction. This story highlights the excessive dilution problem and why investors are hesitant to invest when the founders don’t have material equity ownership in an early-stage company.

If you’re an early-stage founder, keep a close eye on your burn rate relative to company traction. If the traction isn’t there (i.e., you haven’t founder product–market fit), don’t be afraid to adjust the burn rate.

Today I spent time reflecting on past investments. I thought about what I did right and what I did wrong. I’ve done this before and made mental notes, but I realized that wasn’t consistently preventing me from making the same mistakes. Today I created a “lessons learned” doc to capture in one place all the learnings floating in my head.

I’m glad I did this exercise. Seeing everything I’ve learned in one place helped me pinpoint the areas I need to work on more.

I’m excited to add to this doc as I reflect more and use it to help me improve my evaluation of investments.

Over the last few years, I’ve had the opportunity to invest directly in start-ups as an angel investor, invest in venture capital funds as a limited partner, invest directly into start-ups as a Partner at a venture capital firm, and help organizations do their due diligence on direct investments into start-ups with strategic value.

I’ve learned a ton from all of it—but I’ve learned the most from investments when my personal capital has been on the line. This includes investments in funds and start-ups.

I learn best by doing, and in investing, “doing” means investing my own capital.

A venture capital investor shared this article with me. I won’t go into all the specifics of it, but it says that private equity fund managers are selling pieces of their firms to raise cash. Instead of investing by becoming a limited partner in the firm’s latest fund, some investors are seeking to buy part of the firm to gain exposure to the firm’s current and future investments.  

This isn’t new in private equity. Neuberger Berman started a division in 2010 to focus exclusively on this strategy. That division, Dyal Capital Partners, merged with Owl Rock Capital Group in 2021 to form publicly traded Blue Owl Capital Inc. Blue Owl just announced the closing of Dyal Capital Partners V, a $12.9 billion fund focused on taking ownership stakes in approximately 20 private equity firms.

I’ve been closely watching the world of buying stakes in private equity firms for a few years, and I have some thoughts:

• It was only a matter of time before this trend reached larger venture capital firms. It’s starting to happen more now, as evidenced by Thrive Capital’s recent news.
• This approach could provide emerging venture capital fund managers with the runway needed to continually execute on their strategies.
• Venture capital fund managers early in their firm’s life cycle see selling part of their firm as having a negative connotation. This leads to many VC firm founders having a bootstrap entrepreneur mentality and the industry being a cottage industry (there are other reasons for this too).
• As more established VC firm founders realize liquidity by selling parts of their firms, more founders of smaller firms will be open to taking capital in exchange for equity so they can grow their firms.

It’s often seven or more years before a start-up has a material liquidity event such as an IPO or acquisition. Founders should be comfortable with a journey of that length if they want to pursue entrepreneurship.

I recently had a chat with a venture investor who considered starting his own venture capital firm. One of the main reasons he hasn’t is the realization that it will commit him long-term. It will likely take twelve to twenty-four months to raise the fund. Funds usually have a ten-year life cycle, so once he begins investing that capital into start-ups, he’s committed to managing the fund for a minimum of ten years. That’s an eleven-year-plus commitment he’s not willing to make. Instead of writing larger checks from a VC fund, he plans to write small angel checks. He’s putting more of his own capital at risk, but he wants to preserve flexibility over the next decade.

This investor has deep domain experience and a strong network in a particular sector. Any early-stage founder he works with will get a tremendous amount of help and is more likely to achieve product–market fit.

Listening to this got me thinking. I wonder how many seed-stage venture investors (current or aspiring) who could help companies find product-market fit avoid starting a venture capital fund because of the decade-long commitment.

The California Public Employees’ Retirement System (CalPERS) recently announced a $1 billion commitment to back emerging private equity managers. The goal is to foster more innovation and entrepreneurship in the investment industry by backing the next generation of managers. CalPERS, with around $440 billion of assets as of June 2022, is a juggernaut in the investment industry and can drive change.

The announcement references private equity, but this is a big deal for the venture capital industry. Venture capital is a subset of private equity and should receive some of these dollars.

Many studies have shown that emerging managers generate alpha, and the CIO of CalPERS recognizes this. This quote from her stood out to me:

It’s not about a diversity play. . . . It’s about generating alpha in a more thoughtful way, and leveraging partners we will work hand in glove with.

Can’t wait to see the impact that CalPERS’s commitment has on early-stage venture capital.

‍

Last week, Fred Wilson shared his predictions for 2023. Fred’s a well-known VC and general partner at Union Square Ventures. His thoughts on start-ups in 2023 were of interest to me. A few points that founders should take note of:

• 2023 will be a tough year for start-ups. As money-losing companies, many avoided raising in last year’s difficult environment. They’ll be forced to raise this year as their cash dwindles.  
• VCs have ample capital to invest but will be more selective. Companies with product–market fit, strong teams, and good unit economics will be able to raise. Start-ups that don’t have these things will struggle to raise, regardless of valuation, and many will fail.
• Valuations will return to the levels of 2015 or so. Seed rounds will be around $10m, Series A rounds around $15–$25m, Series B rounds around $25–$50m, and growth rounds capped at 10x revenue.
• Lower valuations will lead to flat rounds, down rounds, inside rounds, and lots of structure in the rounds. CEOs and boards should accept the pain of lower valuations over a lot of structure.

Fred’s predictions come from someone who’s seen a few VC cycles. Things won’t necessarily play out just as he’s said, but his predictions are something for founders to be aware of.

I’ve had chats with a few founders in the last week about their next funding round. Many have accepted the current valuation environment but haven’t processed what impact a down round or one with lots of structure will have on the cap table and start-ups overall.

I’m of the opinion that Q1 will set the tone for 2023. If the rate of decline in public markets we saw in 2022 persists, Fred’s predictions are more likely to be accurate. If public markets are flat to slightly up, I think conditions for start-ups could be slightly better than Fred predicts.

‍

Today it was announced that Vista Equity Partners will take Duck Creek Technologies private. The transaction values Duck at about $2.6 billion. Duck is a publicly traded company that IPO’d in August 2022. Its market capitalization (i.e., valuation) peaked around $7 billion in 2021. The company’s valuation was below $2 billion last week before this deal with Vista was announced.

This made me think about Vista buying Salesloft for $2.3 billion in December 2021. Salesloft was a private company doing somewhere in the neighborhood of $100 million in annual recurring revenue.

We can’t do an apples-to-apples comparison of the two companies. For example, Duck reported $80 million in revenue last quarter, of which $27 million was professional services revenue and likely not recurring. Salesloft is private, so we don’t know the details of its $100 million in annual recurring revenue. But the Duck transaction shows that Vista is buying a public company for around the same valuation they paid for a private company a year ago.

Last year, I thought that low valuations of great public companies would make them attractive acquisition targets. I didn’t see this play out last year, but I suspect we’ll see it this year if valuations stay depressed. Vista’s deal for Duck could get things going. If this happens, great public tech companies trading below a $2 billion market cap could see increased interest.

I love hearing company origin stories. It’s always interesting to hear what led someone to start a company. I’ve started asking for the origin stories of younger VC funds too. Emerging managers are founders too, and going from zero to one with a fund can be difficult. I love hearing why they made the leap. I recently heard a VC fund origin story that was different than any I’d heard before.

Venture capital and its outsize financial rewards have been known in areas like San Francisco for decades. A founder from another country was able to take his start-up public and reap a massive windfall for himself and his investors. This hometown story caught the attention of founders and investors in his native country, who wanted to know how they could support the next local founder who’d have breakout success.

A multifamily office in that country was repeatedly getting asked by the families it managed wealth for if it could find some early-stage investment opportunities. Its leaders realized there was no venture capital in the country and decided to start the first venture fund there. They settled on a hybrid strategy of investing in other venture capital funds and making direct investments in start-ups.

Fast forward a few years, and they’ve raised a few funds and had one of their seed-stage start-up investments go public. The fund managers are happy, as are the founders they backed and the limited partners who invested in their fund.

What an interesting origin story.

I watched an interview Robert Smith gave recently. He’s a billionaire and founder of Vista Equity Partners, a private equity firm focused on software companies. Robert was very open, sharing details of his childhood, his journey from engineer to investor, and his perspective on a variety of topics. He did a great job of explaining private equity, venture capital, and capitalization at different growth stages in a company’s life cycle in a way that many people can understand.

I’ve spent time thinking about the impact of knowledge gaps on a founder’s velocity. Robert shared his thinking about knowledge gaps and how filling them is core to his strategy at Vista. Here are a couple of things he said that stuck with me:

“You’re accelerating the corporate maturity of that business. It might take you 10 years to figure out what we’ve done 45 times already. Now I bring that intellectual property into the company.”

“You may not have figured out or may not figure out because you may not be in an environment or circle of people who have dealt with that before. That’s why the expertise we bring is often more valuable than the capital.”

Even though he’s a private equity investor, Robert is also a founder. He founded Vista over twenty years ago and built it to almost six hundred employees and almost $100 billion in assets under management. He was speaking from the unique perspective of both a founder and investor who’s had outsize success. I think it says a lot that he’s built an organization whose success is largely based on creating value by filling the knowledge and capital gaps of people running later-stage companies.

‍