Episode #14: The Information, TechCrunch, LifeSciVC (shared by Jay Ripley)

In venture you get paid two different ways management fees which are really in my opinion alone against future performance. You will have to pay them back before you get carry and then carried interest based on the quality of the investment decisions you make. But as one of my favorite VCs told me once, management fees show up today and carry shows up ten years.

From now it's the week of January 6th welcome to the Learning Corner, a Precursor Ventures podcast.

Welcome to the Learning Corner by Precursor and Happy first episode of the year. I'm Mia Farnam and I'm joined by our GP and Managing Partner Charles Hudson, where we will be talking through the articles and Goodreads that caught our team's attention over the past week. The first article of the year is a recent event that happened over the holidays. From the information titled Accounting Startups Sudden Shut Down Ads to startup woes, this store story covers the unexpected shutdown of Bench, a well funded accounting startup which has since been acquired by a competitor, employer.com while there was somewhat of a smoother landing that Bench had, the highlights from the article spotlight another tale on how startups with significant funding nearly a hundred million in Bench's case, can still run into issues like cash flow mismanagement, market misalignment, or flawed growth strategies. So it's a cautionary tale for founders about scaling responsibly and maintaining that operational discipline even when fundraising has been successful. And it takes being fully immersed in the venture and startup world to truly understand this. But most people think that smoke and mirrors mostly happen at the earliest stages of investing, But I would actually argue it's in the later stages that have far more of that activity, because there is so much more to lose. Before the new year, Bench was responsible for the accounting capabilities of more than 35,000American small business owners, had raised 100 million in funding, split between debt and equity, which will get into a little bit later, and had over 600 people employed at the company. So my question for you Charles, is when are we as investors and founders able to exhale if at all?

Boy, I just remember I saw Natasha's article pop up and then I went to our Slack channel and immediately someone's like, have you guys heard about Bench? I was like, oh, what's happening here? And when I read the notice, there's only two reasons the company shuts down abruptly like that with no notice even to employees. One is like a Hail Mary M and a event that you thought was going to go through that fell apart and you just can't operate. And the Second one is some kind of debt or financial covenant that you've tripped and you've lost the support of your lender and they have decided to call the money immediately and you sent them the keys and you really don't get much notice with that. And I think Shiel from Better Tomorrow was the first person I saw online who was like, based on all of this, my guess, knowing nothing about the situation is a debt covenants issue. This is why I've always been very wary of recommending venture debt to our portfolio companies that aren't already very close to operational break even, or maybe even profitable. Because venture debt is a great tool until you get into trouble. And then it's like if you see a drowning man, you throw him a hose. It's like just as things are getting bad and you need more relief, things get tighter faster because lenders want their money back and they're more interested in capital preservation than equity holders who are looking for upside. And I think this is just another tale of a company that from all I've read, it sounds like got into a position where two things happened. One, I think there have been a lot of calls for these tech enabled services businesses that technology can make you more efficient and more scalable and allow you to support more customers. And it sounds like maybe bench hadn't quite gotten the tech to work to the degree that it needed to to be more efficient. And when you're playing with venture debt and you get to the place where you've lost the confidence of your lender, it's over for you. And I've had this happen for our portfolio companies where everything's been good on Friday and on Monday, we've come in and the company, we're sweeping the account, we're calling the loan and that's it.

And for folks listening to the podcast, covenants are a new term for them. Essentially venture debt, which is fairly common within growth stage investing. Like I find that that is kind of like a common split or at least something on the table that founders think about when they're raising subsequent rounds. But essentially covenants are legally binding agreements that you have as taking on this amount of money. The covenants, there could be anything from how much cash you have in the bank, what your revenue has to look like, to what your board looks like or specific invest investors who are going to come into the round. And so any sort of fault in confidence there could result in exactly what you said, Charles, of them demanding a complete repayment of the loan. Benj's shutdown Highlights how even well funded startups just aren't immune to financial struggles. And I feel like the natural question to you would be how do you make sure founders are able to scale effectively and forecast all these changes? But my real question that I'd rather ask you is how do you ensure founders are actually being transparent with you on the struggles that they're encountering and continued to share these in some of the more tumultuous moments in their journey?

I think it's really hard. I think it all starts with trust. If you can get founders to trust you. And I think you have to build trust over time. And as you've heard me say, almost every interaction you have with the founder, you're either building trust or destroying trust. It's very rare that that interaction is neutral. I do think it sounds like from everything I've read, the investors were like actually pretty involved is that the company got itself into a place where it was in quite a pickle for getting itself out. And one thing I always worry about is what the startup companies that doing things in bookkeeping or health care or insurance is. How many times can you have companies like this blow up before startups just say this is too risky? I think I'd rather go with maybe a less tech enabled, less sexy provider rather than take the risk on a startup. I think part of the reason I've always been skeptical of our seed stage companies taking venture debt is because the level of sophistication required to run the business with venture debt is really different. And if you start dipping into venture debt as a way to extend Runway or as a way to do other things things, you get into these situations where as you put it, you're closing in on a cash covenant or maybe you missed the revenue covenant. And very quickly the business is no longer yours, it belongs to the lender. And you're only able to operate as long as they believe that you and your investors will support the business and get it to a place where they're going to get their money back. And I think a lot of founders I've worked with quickly realized that debt behaves very differently than equity as you get closer to that zero cash date. And so I don't know, we've had a couple of cases where I'd say we've had founders who've gotten themselves into trouble because they genuinely didn't understand their financials and didn't understand the implications of things like venture debt or other types of loan vehicles. It's very rare that I've had People intentionally mislead me about the company's financial performance.

It reminds me about Rev Share loans, which I can feel the operator side of this being like, well, I took those vehicles because I was not getting the buy in from traditional Adventure and you told me to get more creative with how to raise money and so I did that because Venture was telling me to look elsewhere. But to your point, the more important part is continuing to be really vigilant on what you're looking at in terms of the dollars that you're bringing into the business and being really sure that you have the right amount of revenue, traction and chops to put it to work. Our second topic comes from TechCrunch. It's titled Silicon Valley is so dominant Again. Its startups devoured over half of all global VC funding in 2024. The article explores Silicon Valley's resurgence as the global epicenter for venture capital, with its startups capturing over 50% of all VC funding globally in 2024. It's a massive comeback after a few years of relative geographic diversification and funding. And so this shift highlights how emerging hubs struggle to maintain momentum as macroeconomic uncertainty kind of pushed back to the Valley's well established ecosystem. And the concentration of funding in sectors like AI, which have deep roots in the Valley, also naturally contributed to this recentralization. Charles, I'm curious how you interpr this resurgence of Silicon Valley's dominance. Is it a sign that innovation is best supported by concentrated ecosystems? Or do you think it's, you know, a temporary reaction to broader market uncertainty around Venture and wanting to return to something that they know is tried and true?

A couple of things are happening here. One is, I think when you look at AI, probably two of the most important companies in the AI ecosystem, OpenAI and Anthropic, are both based here. I think that creates gravitational pull. I think a lot of things happen YC went back to in person here in San Francisco. But it's interesting. I think while I've seen a lot of the return to office stuff that's happened has been led by the company leadership. My experience has been a lot of the recentralization in San Francisco has been led by founders, not VCs. About a year ago I noticed a lot of our top highest performing companies made the decision that people were going to come back in office here in San Francisco three plus days a week and a lot of them said anyone who doesn't want to do that we totally understand, but that's what we're doing. And I talked to A lot of them about this, about why they were doing this. A lot of them said that we don't feel like we figured out how to be as effective as a remote organization as we were in person. And then I started looking at the data in our portfolio and I was like, wow. Finding product market fit 0 to 1 is very, very hard. If you add distance to that between a team, you've taken something that's really hard and made it even harder. And if you take distance plus a lack of shared priors, you've taken something that's really hard and made it extraordinarily hard. I've been doing this experiment that I call like field trips where I've been bringing founders from other ecosystems to come work out of our office in San Francisco week. And it's been eye opening mia, because a handful of people have been like, I don't know what I'm missing. First of all, it's not the principal's office. You're not in trouble. I just want you to come here and experience what it's like to be here. And the most common thing I hear from people is I got more done in a week here than I got done in a month at home. And I'm like, why? They're like, well, I went to dinner with a bunch of founders at a restaurant in Hayes Valley. I told everybody I had a problem and somebody texted their friend at dinner and the next day I had coffee with that person and they solved my problem. Not only did they solve my problem, they introduced me to three other people who also could help me solve my problem. And I think you just can't beat the speed with which information travels in the valley. The connectivity, the proximity to capital. I just think, you know, a long time ago I told people, you can be an actor anywhere in the world. They make movies and plays everywhere. I just think it's easier if you're in LA and you know, I have some friends who are like hedge fund people in San Francisco and that works. But I think like the center of gravity for that business is New York. And every business has a center of gravity. I don't think this is unique to tech. Everything you're trying to do is easier when you're in the place where there's a density of connections, talent and information. And I think there was a hope coming out of the pandemic that we would end up with something more decentralized. And I think the pro cases, those non valley hubs, are healthier and better than they were beforehand in most cases because not everybody who went there left. But I think it feels to me like most people have concluded that the Valley is still the best place, not the only place you can start a great company anywhere, but is the best place to start and build companies. And I feel really strongly about that pre product market fit. And even our data has said like our portfolio has become more Silicon Valley centric again relative to what it looked like during the pandemic.

I mean, I'm a huge supporter of obviously New York, the ecosystems and emerging ecosystems, but it's impossible to not acknowledge how palpable it feels of time effectiveness when you're in the Bay Area. And I would actually encourage founders who are located elsewhere to do kind of like replicate a field trip and go to the Bay Area and try and feel it yourself of sitting in a blue bottle in Jackson Square and just having coffee meetings there. The amount of people that you find who are in your similar lane or in adjacent spaces that are getting coffee at the same time is much higher than most other spaces. I used to live in Denver and in Boulder. Of course there's like a growing and scrappy startup scene, but it's an hour drive from Boulder to Denver, which is where most people live. And some people aren't hanging around in the coffee shops as much as they are within Jackson Square or even like Calhalla, like Pack Heights where people live. Question you, Charles. Any advice that you have for folks who are tied to their emerging hubs?

The one thing I think we won't go back to is, you know, I walked past the Twitter building the other day and I was like, wow, Twitter used to have a lot of people in that building and I don't know if they all needed to be in San Francisco on 10th and Market. I don't. I think there was this thing where like not only did you have to start in San Francisco, you had to scale in San Francisco. I don't believe we're going to go back to an era where you need to be here for the entirety of your journey and for the entirety of your company. So I think pre product market fit when you're figuring things out. This is great, but I think we're going to have companies that start here and have hubs in New York and LA and Denver and Austin and it's going to be fine. I also think I meet more and more companies who just say, hey, we did our last company remote. It turned out really well. We all know each other. We have really good work, hygiene and practices. We can make this work and they will succeed. So I think there'll be more heterogeneity at a minimum. If you told me I have two choices. We could be in the Bay Area or we could be in the same place, but not the Bay Area, or we could be remote. It'd be like like being in the same place, not the Bay Area is probably the second best alternative because you get many of the benefits of the proximity with your team, but you don't get all the information spillover Our final.

Article is from the LifeSci VC blog by Bruce Booth titled Atlas 14 and Reflections on the VC Math Problem. So thank you to Jay at Global Endowment Management for sharing with the Precursor team. In the article, Bruce explores the unique challenges of delivering strong venture capital returns, particularly for large funds like Atlantic Atlas 14, which recently closed at 800 million. What's especially notable is that Atlas chose to raise a smaller fund with Atlas 14 than its prior fund was around 900 million. This is a departure obviously from the industry norm where larger successful funds often lead to even larger subsequent raises. Atlas made this decision intentionally, citing the difficulty of maintaining high returns as fund size increases and the need for discipline in deploying capital, all things we've talked about before in the podcast. The article also dives into this VC math problem, how a fund size, target ownership and exit multiples must align to deliver your top quartile returns. And so for those larger funds, the math becomes even trickier. So we've talked about this sentiment many podcasts ago where you only raise smaller subsequent funds because you have to. And so whether or not you believe in that sentiment, do you think that larger, more seasoned funds making the decision to size down subsequent funds will actually encourage smaller funds? Maybe Those raising Fund 2, Fund 3, Fund 4 to really think through the target size now that they're seeing some, maybe more seasoned veteran funds do.

So I hope it creates space for that conversation. This is a plug. Every quarter, Jay and the team at Global Endowment sends out five articles that are worth reading. And then I don't know if they take outside subscribers to the list, but it's really they're always amazing articles. And this one caught my attention because I think so many times we talk about the math problem adventure as being only a software tech VC problem. And it's not. It's a venture problem. And the thing I liked about this article is he talks about like, look, this is the scale of exits that we've seen in our category. So if you're going to raise a much larger fund, you have to believe that something about the future will be different than the past. Otherwise you're probably just going to have lower returns. And we could spend three weeks of Learning Corner talking about the different incentives between managing fees, carried interest, fund multiples, all of that stuff. Suffice it to say, in venture you get paid two different ways management fees, which are really in my opinion alone against future performance, you will have to pay them back before you get carried and then carried interest based on the quality of the investment decisions you make. But as one of my favorite VCs told me once, you know, managing fees show up today and carry shows up 10 years from now. So the incentives to raise a bigger fund are clear. I think it just like a startup that wants to show things going up and to the right. A lot of VCs want to show fund size up into the right because to some extent people offering you more money is a signal that they think you're doing something right. And I think in life and personal relationships and professional relationships, when you're explaining you're losing and in most cases when people raise a smaller fund, the first thing they want to do is tell you that it was their choice or that they made a decision. This piece felt like it was well thought out. So I think the market though MIA is also solving some of this problem for early stage managers. Because in 2020 I talked to a lot of people who are like, well, I'm going to do a $10 million first fund and I'm going to do a 50 or $100 million second fund. And I'm like that's not even the same business. I wouldn't recommend you do that. And the market I think has largely solved that problem for them. But I think a lot about what about our model changes kind of in increments of $25 million and we've run a sub $25 million version of Precursor, a $50 million version of Precursor, a roughly like 75ish million dollar version. And believe it or not, all three of those funds felt really different in terms of first check reserves, scale of outcome. We need to move the needle and that's at like relatively small gradations of difference. And it's sort of taught me that there's an optimal fund size for our strategy. And I don't really think we will push above that because I don' know what's on the other side. And I really hope that at some point we can decouple fund size and aum from ego. I would be lying if I said, I think that's going to happen anytime soon. But the thing I really liked is Bruce really does explain if you're going to raise a big fund, you have to really believe that the future exit scenarios for your industry. I look at all these multibillion dollar funds we have on the software side and I'm like if AI produces many more $25 billion plus software companies than or on PREM Software did, there is no problem. There's actually no problem. There's plenty of returns to run. If the future looks like the past, it is going to be much harder for all of those funds to do well because there won't be enough aggregate $25 billion plus exits for people to have the kind of returns they need. I just thought it was nice to read about like people in biotech and life sciences have the same problems too.

Going back to one of your earlier points, you know, I think think one of the parts about this article that's really interesting is that he's able to include all of this data on M and A activity across biotech, which is what they're focused on from a historical perspective, which is really key in laying the logic of why the fund is the size that it is in parallel. Exactly what you were saying before. While yes, generative AI has been around in theory since like the 60s, generative adversarial networks have really only been around for a handful of years I think since like 2014. And so there are many funds being raised with massive targets. It's without having historical exit data points to reference to quite yet. So to your exact point, we're almost like waiting for the validation on those fund sizes to make the math even math, like there's no math actually to reinforce that quite yet. I hope it all works out because that would be a big win for venture in general. I would hope that will reinstitute a lot of excitement about investing in the space and being excited about exploring new emerging markets. But I'm curious, how should fund managers balance optimism about emerging sectors with the discipline that comes with relying on historical exits and comps?

Dan, I just, I talked to one of our portfolio company founders who just raised a big round over the holidays and I really hope that this works out. It's a really great company, but it has already exceeded what I thought it would be worth at the end of the day and it's still private. So I think we'll find out, but maybe not for a couple years.

Well, we are all out of time for today. Thank you Charles for coming into the Learning Corner. Welcome back to all of our listeners. Share like and subscribe and we will talk to you all next week. Sam.