Episode #25: Startup Media Hype Circles, 11x Tech Crunch Article, Market Arbitrage in Venture

If you're working on this company because you enjoy it and because you like it, and because it's personally meaningful to you, by all means keep going. If that isn't the case, we should talk about other ways for you to spend your time, because time is the one thing as a founder you just don't get back, and spending a bunch of time on a business you're not interested in that isn't going to have a big outcome just isn't a good use of your time period.

It's the week of March 24th. Welcome to the Learning Corner Precursor Ventures Podcast.

Welcome to the Learning Corner by Precursor. I'm Mia Farnam and I'm joined by our GPA 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. Topic number one in a really thoughtful LinkedIn post from this past week, GP of Flybridge, Jesse Middleton reflects on how the venture ecosystem often values optics over nuance, especially when it comes to fun or flashy startup announcements, or reminds us that success often comes with years of grind and quiet resilience. What specifically resonated with me is his example of founders feeling like they have to hold out for this giant valuation or sale. Perhaps it is a better long term decision for their team, investors and even themselves to sell earlier or just consider less grant landings. Jesse mentioned he always wants his founders to shoot for massive success, but oftentimes the more tangible winds and landings can be overlooked because everyone is trying to keep up with, I would say, almost imaginary benchmarks. Wanted to get your take on how to balance those conversations and expectations with founders.

I think the venture model in some ways is like clear and cruel at the same time. The goal is to fund companies you think are going to have massive outcomes and I don't know very many VCs who regularly back companies where the expectation is that there's going to be a small outcome. But once you put your money in, you start working with the team, you learn about the people running the company, you learn about the state of the market, and sometimes the only conclusion you can reach is this isn't going to be a huge outcome. Then the question's like, well what do we do with this company? And I think oftentimes it depends on what the founders want. Sometimes the founders are like, hey, and we've had this in our portfolio. I like running this profitable version of this company. I'm going to continue to operate it and I will either find a way to get your money back through the profits we generate, or I'm going to keep running this because I think there's something on the horizon that's going to change, that's going to make the business more valuable in the future than it's perceived to be today. And I always sell founders. At some point, I'm like, look, you don't owe me anything. Usually somewhere around year five or six, if the business hasn't broken out and the founder's still working on it, I'll often go to them and say, if you're working on this company because you enjoy it and because you like it and because it's personally meaningful to you, by all means, keep going. If that isn't the case, we should talk about other ways for you to spend your time, because time is the one thing as a founder, you just don't get back. And spending a bunch of time on a business you're not interested in that isn't going to have a big outcome just isn't a good use of your time period. So I spent a lot of time talking to founders about that. And you have to be careful about being mindful of when you have permission as an investor to even initiate that conversation. So that's one. And then I think on the other side, I see a lot of people who are like, oh, you know, like, why are people making these blog posts and articles about Aqua hires? Starting something is really hard. And while not every venture exit that gets announced in the press made money for founders or investors, I've just become very sympathetic over time to the desire for founders to frame the last few years, in some cases, maybe even decade of work in a positive light and have the opportunity to be lauded and, you know, congratulated by the community for landing the plane. Because as me, as you know, most of the companies we invest in, there's nothing that comes back when they don't work out. So, as I tell founders, like, getting anything back puts you in pretty rare air. Now, I do think it's sometimes a little strange when I see people doing the victory lap tour for an Aqua hire that returned 5 cents on the dollar. But, like, it's not for me to judge. I think the same thing is true of fund announcements. You know, I've seen people in our business who announced oversubscribed funds because they cut the target in half. And I'm just sort of like, I don't know. For some people, being able to say our fund was oversubscribed is really important. And again, I feel like that's not for me to judge. In this environment, raising any money is super difficult. And if that's something people want to celebrate, whether it was exactly what they planned to raise or not, I think it's tough. But I think from the outside looking in, I'm sympathetic because you read some of these announcements like, wow, that company must have sold for a billion dollars with the amount of people that were thanked in the LinkedIn post. And then you realize people didn't even get their money back.

Do you feel like those conversations talking about softer landing are easier to maybe grouch when it's earlier on in the startup journey when maybe they don't have maybe the public commenting?

I think the hardest situations are ones where the founder has a big public profile and the business simply isn't working. And then when I say big public profile that can be on X, on LinkedIn, on whatever social media platform is of choice, if they've tried to sort of build a personal brand or a following around being successful, sometimes I've seen in our portfolio that makes these smaller acquisitions or soft landings harder because the person's built themselves up in the public as someone and they have to reconcile that with the outcome of their company. So there's that. I think the other thing is it's very hard to have these conversations if you're not sure that the founder himself or herself is also at the same point of realization about the businesses you are as an investor. Sometimes I'll explicitly ask people like, hey, I'm not sure we're on a venture scale, are you open to talking about alternative paths? And I think right now we have in the venture business a bunch of unicorns that were minted in 20 and 20 and 2021, which may or may not ever be worth their last rounds valuations. In some cases those companies aren't worth anything. In some cases they're probably worth something, but less than they were valued. And like, how do you navigate those conversations? Because you know there are VCs whose careers are tied to those high rounds and those high marks. There are founders whose egos and unfortunately maybe in some cases even self worth is tied to those marks. And in many cases they no longer reflect reality. So that's why I think this unwinding takes long.

It's also just the nature of venture and startup ecosystem. I feel like so much of it is just sharing publicly via content. That's just something that's inherently part of our ecosystem, which is wonderful because you get to see what other people are doing. But so much of it is a storytelling exercise. The best piece of advice to just not keep blinders on, but just have the wherewithal to just focus on what you're doing.

And I've even talked to founders who've been like, oh my God, one of our competitors got acquired. What does that mean? Because in venture most private deals, the amount never gets announced, the structure never gets announced. I'm like, well, that company that you thought was like your big bad competitor, they just got Aqua hired. Yes, I know what the announcement said. Yes, I know what the company blog post said. I have some information about the actual transaction that you should know about. And I think that's the other thing that's hard when you're outside looking in. There's almost never numbers mentioned unless they're very big. And so the reader is left to wonder, was this like a teeny, tiny Aqua hire? And I've seen some things that sounded like Aqua hires, and you peel back the coverage, you're like, oh, no, that was actually a meaningful transaction on the part of the buyer.

Some investors commented on Jesse's post saying that a call to more transparency is needed across all points along the startup inventor training to essentially make it easier for founders and their investors to call it the right moments. I'd agree with this, but also would say it takes participation. Buy in everyone. Your founders, your investors, your board members, LPs, journalists, even. Where do you think the greatest tension might live?

I think we go through these moments where you get these, like, really great postmortem posts from people and those, you know, I feel like once or twice a quarter somebody will write one goes viral, and everyone's like, wow, that sounds painful for you. I just think there's more attention and energy and interest in things on the way up than on the way down. And I think practically speaking, it means that, like, people are much more excited about reading about good news. Look, I think salacious bad news, you know, corporate espionage or CEO misbehavior, tech tabloid stuff, but just generally like, hey, this company raised a bunch of money and isn't that successful through no misdeeds of its own, just misestimated the market. Those stories take a lot of nuance. We have a handful of journalists who I think are good at writing those pieces, but we don't have as much of that. And I really do think as an investor, if you try to have this conversation prematurely, and by prematurely, I mean before, you have kind of like permission to have it with the founder. I've done that before, mistakenly. A few times. And it's really hurtful to founders, I find, when they're just like, oh, so you don't believe in my company? I'm like, you're right, I probably should have prepped you for this conversation rather than springing in on you. But yeah, you're right. Like I don't when I say I don't believe in it, mean it is not going to have the scale of outcome that will have a material return to my fund. Which doesn't mean I won't help you find a landing spot. But it means that in my mind I've concluded that this isn't going to be one of the 10 or 15% of companies that really matters to us from a fund return standpoint. And I think when you can have that conversation with people, which is like, look, I'm going to help you land the plane and find a home, mostly out of respect for the sacrifices and energy you've put into building this, and less so because I think going from 0.1x to 0.22x return is going to make a difference. You do it out of respect for the level of effort and commitment people have put into building the business.

Next topic In A piece from TechCrunch written by Dominic Midori Davis and Marina Temkin, it's reported that once hot AI sales automation startup 11X, backed by larger funds, falsely claimed major customers and traction throughout its lifetime. 11X offers an AI driven tool designed to automate sales tasks. The company is part of this broader wave of startups merging in the fast growing category of AI SDRs. Founded in 2020, 11X was one for Starlet, claiming to have gotten close to 10 million in ARR only two years after inception and raising 75 million apparently in one month. The article shared comments from ex employees and customers which shed light into the usual red flags of a house of cards startup, creative revenue forecasting, toxic workplace anecdotes, false customer endorsements, and more. One of the things that was shared in the article was that 11x was raising money and sharing traction off of contracted ARR, which is not a word you would expect that this means signed, sealed and delivered contracts between customers and 11x. 11x apparently made it difficult to exit pilots and instead asked customers to enter into one year contracts with a clause to terminate if need be. So as these customers churn instead of just adjusting the revenue, 11x apparently rolled these original contracted numbers as ARR numbers. So in the article it says that investors board members were aware of how this was accounted with all my standard.

Disclaimers, I'm not an investor in 11x. I've never looked at investing in the company. I don't know anything about the inner workings. I will say this. I've had a bunch of my friends who are in the sales business say that these AISTR tools make big promises and don't deliver. And I'm like, well, how do I separate your self serving desire for that to be true as a sales leader and the fact that you are also probably the person who's close to this? So I think rather than talk about the specifics of 11x, because I don't have any information beyond what I know from talking to folks, I do think it's important to remember that whenever investors create a metric or a measurement, there's this like short window of time where it's useful and then it starts to get game. Like I was joking with someone over the weekend, tongue in cheek. I was like, well now that AI investors are focused on revenue per fte, how long before startups start making people contractors? So I think startup founders are smart people and I think once they realize that there is a metric or a data point that investors care about, many of them are smart. When I read the article I was like, well I get it. Contracted ARR is a widely understood term and contracted ARR is not really supposed to be at risk. It's supposed to be money that is to be collected but hasn't been recognized. That's how I've always thought about it, like oh, we've got a three year deal, it's a million and a half contracted, but we're only going to recognize it 136 of a time. So there's the equivalent of a bookings backlog or it's some way to talk about the difference between what you're recognizing and what's under contract. I think technically speaking it's not wrong to book a one year deal with a three month out as a one year deal because you wouldn't presumably book the deal if you didn't think that the customer was going to keep the contract. The part I find puzzling and I don't know if Elephant X actually did this. The notion that once somebody exercises their break clause and decides not to continue, that should be backed out. Unless you have some weirdly punitive thing where you can break the contract but you're still on the hook for the whole thing, then you can book the whole thing. Then I don't even know what the break clause means. And again, so many Investors were like, we hate pilots. We ha trials because it means we're going to do work to have to evaluate. So in some ways, if you recast the trial as a one year contract with the 90 day out, you kind of get the benefits of looking on the surface like a one year deal and not having to have the questions about pilots and churn for at least 90 days. And if you're growing really quickly and adding a ton of customers, you're always going to have a bunch of new cohorts of customers who don't yet know if the product works for them. And even if they conclude that it doesn't, they're going to stick with you for a while. Again, I'm very hesitant to like suggest that this was an intentional deception, but I will say we've created a set of incentives in venture that push people towards annual contracts with big numbers on them. And when you have that set of incentives, there will be companies that say, I want my company to be presented in the best light to investors. Which means this subset of numbers need to look really strong for me to get investor intention. The other perfect storm is when you have companies that are growing that quick, there's pressure to maybe assume or trust that the investor's understanding of what a word means and the founder's intention are tightly aligned. And so I don't work at Andreessen Horowitz, I don't work at Benchmark. I don't know what was presented to them. I also know that in competitive hot deals, sometimes you put your trust in the fact that contracted ARR has a really specific meaning. And if that's what they're telling you, that they understand the convention. So I don't know. I think it's a good reminder that in the this AI world, things can change quickly. And I will also just say this, the logos thing. I've certainly seen companies sometimes out of laziness, forget to update their website and take down customers who are no longer customers. I've also seen people strategically leave up customers. And when I read through that article, it sounded like all of the customers had at some point tried the software, but either hadn't bought it or had churned their logos probably should have came down again. I don't know why that didn't happen, But I think AI to me feels very 2020 companies are growing quickly. People have serious FOMO about missing out, which means you have to do quality diligence in a short period of time. And people not having a shared understanding of what numbers or words mean makes that really hard.

When I was reading the article, I felt like it was a story more of like an early stage startup who was scrappy and wanting to win customers and things were falling through the cracks. But not because it was intentional, it was because they were growing so quickly, which obviously can replicate in a higher growth scenario. It reminded me of memorial health. Like one health startup recently just sold for 30 million in a fire sale but was valued at one point at $430 million. Similar thing like had pilots going on and then folded in that revenue into a contracted ARR basis even when those folks had fallen off. Again, I'm not part of either team that was brought in here. But it's funny, I read the article and felt like I can imagine how everything led to where it was today. On the other side of the spectrum, I know that there are founders in our own portfolio who actually are much more conservative, and I would sometimes argue that they should be even more bullish on their forecasts and forward looking roadmaps. Obviously there's a massive difference between predicted numbers and claiming true revenue. How do we draw the line though between founder optimism and an actual misrepresentation?

Look, most VCs assume that even your conservative forecast is wildly optimistic. So if what you're presenting is truly conservative, it's still going to get discounted by 25%. I find there are certain sub populations of founders, women and people of color in particular, who tend to be, I think, quite intellectually honest in what they think the business will do. But they're presenting against people whose visions of where the line between optimism and likely is just set at a different standard. So often tell people like present the numbers that suggest what will happen if everything goes right, because whatever you put in that forecast is going to get discounted back by investors. So if you're adding in a discount on top of that by being overly conservative, you're actually not helping yourself. I just think it's really hard to go to an investment committee and be like this company gave me a forecast. It requires no discount. I believe that they're going to hit this plan. Your partners would be like, how long have you been doing this? Nobody does that. Of course they're being optimistic. If you don't realize that, then you haven't figured out where the optimism is baked into this plan. It can be anything from like they expect CAC to go down over time or expect LTV to go. There's always something you can fiddle with and I think getting people to understand I think this is still the big divide is founders put all this time into putting information together and VCs have 100x, 1000x the pattern recognition reps. So they take all the information you give them and then they munge it up themselves and try to figure out what does this all mean. Which is why I think a bunch of firms I've talked to just ask for the raw data. They're like, just give us the raw cohort data, give us the raw financials. We know how we want to torture this data to get it to tell us the answer we want. And we'd rather do it our way than have you present it in a way where we have to then also go back and double check and understand the assumptions.

And I would say for founders who are just in the beginnings of their journeys, you can have open conversations about that with investors without discounting success that you feel for your company. I think having those more transparent conversations and showing different scenarios of growth, like that's what we're going to be doing on the back end anyways. So preparing yourself for those types of conversations is important because they're inevitably going to come up. Especially again, for example, if they're asking for the raw data, it's going to be sliced and diced in seven different ways. So being prepared and armed to have those conversations is actually the best thing that you could possibly do. Our last topic is a great, really well researched essay from Jordan Snell substack titled Venture Manager Selection Capitalizing on Arbitrage Windows. Ultimately, the ideal scenario of leveraging an arbitrage market window is that you can come in on deals at great prices with misunderstood but strong founders, without as much competition and more room to breathe and grow while everyone else eventually catches you years later. Jordan mentioned a common thread. GPS from these funds quote have been thinking deeper and more granularly about a very specific founder profile than most any other investor. The thesis is that this founder profile translates across markets and sectors enough to move in and out of them without diverse selection. So wanted to get your perspective.

I thought it was a really well written article and as someone who's raised a number of funds, as a general, I get all of this pushback from lp. So we like specialist funds and I always go, but for how long? And I didn't have the language that this post has because I would tell people like hey, if I think about emergence, one of the firms I really admire, they had a window of time where most people were like, we don't understand this, like renting software. This SaaS before predictable revenue, before we had this whole business, there was a period of time where most people were like, I like the old enterprise sales model where people buy software and pay for maintenance contracts. They understood a business model transformation that others didn't, and they had an amazing run. And now every multistage big fund and small fund does SaaS. So being a SaaS specialist is sort of a weird decision. I think about when Forerunner really figured out some of these early consumer products and consumer companies. Everyone else is like, well, that's not Venture. Well, Venture doesn't do that. Turns out Venture does that now, maybe does it less than they used to. But there was a moment of time where a lot of other firms said, oh, we want to be in on this too. And the ability to sort of be first in line and see the best founders the earliest and pay reasonable prices is good. I think the people who've got this right is Union Square. They didn't stick with social networks and network effects as a theory forever. There was a period of time where they understood it in a way that everyone else didn't. They didn't get every great company on that thesis. But at one point there kind of like, okay, we're moving on to the next thing. And I think this is the thing I've always been perplexed by. When LPs tell me they like specialists, I'm like, me too, but probably for one or two funds. And there's a few funds that have been able to perfect this very rare dance, which is to be specialists and then rotate into a new specialty when your original specialty is no longer unique. I think it's very, very hard to do. And then I think about people like my friend Nabil Hyatt, who's been able to become a specialist in really specific areas for interesting windows of time, but has also had wis to say the time to exploit that is over. And this is funny, I was thinking that's how I got into African Fintech was I started meeting these companies in yc where I was like, oh, no one takes these companies seriously. No one thinks you can build anything big on the continent. And then there's a period of time where everyone was like, oh, I want the stripe for XYZ company, I want the coin. And then I was like, oh, well, this is now a consensus good idea. So it's probably not the domain of a specialist. And I think the irony is that by being a generalist, you get to be a specialist in a bunch of other weird new areas and If I think about some of our best companies, they were profoundly not consensus when we invested. Whether it's carrot, everyone's like, fertility benefit. I mean, you had progeny as a public company also, it's not really a thing. The employer's not going to be in that. If I think about pair eyewear, people are like, Warby's all like, bobby, baby, there's a theme here. These were all very out of favor venture categories. And I was just like, well, we made money on them because we found these awesome people before everybody else thought they were great. And I think everyone's like, there's only one way to make money in venture, be consensus. And I'm like, no, you can also just be the person that the very best people choose. That's actually another way to make money in venture is to just win the consensus good deals consistently. And so I think this was the best sort of framing because I think LPs are always like, well, specialists have it easier. I have friends who were running AI focused venture funds five or seven years ago, and they were way ahead of the curve. Most people were like, this is not a theme around which one could build an entire fund. Now AI is venture in the same way that SAS was venture five years ago. And I think, you know, I'm on the IC at screen door, and sometimes people like, we're going to be an AI focused fund. I'm like, why would you do that today? It just doesn't make sense. Like, it's a consensus good idea. And I think that's the challenge either for us. So I always tell a piece, which problem would you rather have? Being a generalist and trying to figure out how to get in front of the most interesting people working in new areas, or be a specialist, where you're constantly watching the clock on your arbitrage opportunity and wondering when you'll have to pivot to the next thing. I would much prefer to be a generalist who's trying to find where are the new areas of interest. Like, we saw a lot of crypto stuff earlier. I just didn't understand it. In some ways I still don't understand, but, like, there's very smart people working on these interesting problems, and they're just not problems that I'm interested in partnering with people to solve. And there have been other categories where I'm just like, ooh, this is a thing. It's not well understood. We should invest in it. And now people come to me, oh, we're doing such and such benefit through the employer channel. I'm like, well like that was like a cool thing seven years ago. It's not done. It's just much harder.

I'll ask you this one last question. Every fund claims that they do non consensus deals. They all say in market that they're all into non consensus areas. But then you probably see a bit in their portfolio and you know that they joined some specific rounds within companies that are very of the hot topic of today. What's your perspective on that?

It's funny, there's a handful of funds I know who are like, we just compete for the hot consensus deals. And I've noticed they're honest and they've been a lot more honest about that with me in the last probably 12 months. That hey, we haven't given up on our ability to compete with and defeat the big multi stage funds or to beat other seed funds competing for hot seed deals. We're okay fighting for those deals because we believe we can win them. And then there's other people I've met who are like, well we, we like consensus outsiders. We back people. Berkeley too. And I'm like, okay, so it's like I was like, oh, I thought you were going to say something really revolutionary. And you know what I tell our LPs is I'm very focused on finding individual contributors and people who are earlier in their career because I think venture's pretty efficient with repeat founders. Those people know who they want, people who are looking for them find them. I find there's this pool of people who are individual contributors earlier in their career. Don't have a ton of relationships, don't have a ton of track record. I just think we're bad at underwriting those people. And I have a point of view about what we're looking for in those people and what makes them successful. And I think that transcends category. I think Hunter said this before, like your portfolio really reflects what you do. You can have all stuff in your website but you just go to someone's portfolio and say what did you actually put money in? That tells me a lot about what you actually think good looks like.

Well, we are all out of time today. Thank you Charles for joining in and thank you to our listeners for listening to Learning Corner. Please like and subscribe and we will talk with you all next next week. Thank you. Bye bye.