Episode #4: David Clark from VenCap Intl., Continuation Funds by TechCrunch, Neal Sarraf from Forum

I don't think you can flog a company into greatness if somebody's working on an idea that it turns out is not venturescale yelling at the person applying more pressure, it doesn't actually change the nature of the opportunity in front of them.

It's the week of October 14th. Welcome to the Learning Corner, a Precursor Ventures podcast.

Welcome to the Learning Corner by Precursor. I'm Mia Farnam and I'm joined by our GP and Managing Partner Charles Hudson, where we will be talk Looking through the articles and Goodreads that caught our team's attention over the past week, we've got a lot to talk about, so let's jump into it. Topic number one what should investors expect from the VC industry over the next three to five years? It's a LinkedIn post by David Clark, CIO of Vencap international, and the LinkedIn post elaborates on views that Rick Zillow from Equal Ventures shared on X. Both investors highlighted the increasing divergence predicted in VC fund performance over the next three to five years since something expected during economic downturns. Clark drew parallels to the venture correction that occurred following the 2008 crisis and how it was the top tier funds who dramatically outperformed the rest of their peers. He then goes on to share that this stellar performance was largely driven by three factors 1 backing a few high quality companies, 2 having capital availability and 3 having the ability to reinvest in tough times. Clark argues that it's more important than ever for LPs to have exposure to these small amount of winners that drive VC performance, while also calling out the fact that corrections are a feature, not a bug, in venture capital as a cyclical asset class? I think all of these thoughts are valid and make logical sense. But Charles, how do you think the concentration of capital among top tier VCs actually impacts innovation and competition in the startup ecosystem?

I've really enjoyed his writing. I think there's a bunch of other things he's brought up where people said small funds always outperform and if you want to go down that rabbit hole, I would encourage you to read his writing. I think it's some of the more thoughtful analytical work in that subject. I've talked about this with a team a lot that I think this concentration of capital in big firms has many consequences, the majority of which I think won't be fully visible for years. So I think if I were to take the bull case of this is how you do it. You look at a company like OpenAI, it's a very Expensive company to build. It started life as an expensive company and has R.E.M. an expensive company. And truthfully the only funds that can really afford to underwrite and invest in a company like that are people who have big capital stacks because it just the amount of capital required to build that company is something that only a select number of funds can afford and have the business model to do. Also, if you believe that large stable funds will attract repeat founders and if you believe that repeat founders are statistically more likely to be the one to produce the big outcomes, what you would say is in a time of capital scarcity, there will be a flight to quality both by limited partners, but maybe even more importantly by by the folks who take their capital, the entrepreneurs. They'll say I want to work with the big established funds because I know that they'll have capital too. I think there's probably some truth that there is a certain class of ideas that can only be funded by VCs who can both write a big initial check and continue to write significant checks through the life of the company. I don't think that applies for every idea. If you're doing defense tech, if you're doing space tech, deep tech, hard tech, I do think a large balance sheet is important. I can think of lots of other software companies where that was not a necessary condition. I also just think we live in a world where if enough LPs believe that only the biggest firms will have access to the best entrepreneurs for the next window of time and that bigness is a feature and useful, then all the money will go to those funds and it will become the self fulfilling prophecy. And I don't know, I'm of the mind that we're moving towards a world where there are certain types of businesses that only big funds can fund. And if those businesses turn out to be multi tens of billions or hundreds of billions of dollars scale outcomes outcomes, all of that money will find a good home. If it turns out that the thing that matters most is the scale of the idea, not the scale of the capital put behind it, it's very possible that these will end up being very expensive experiments that don't work out. But if you look at how valuable some of these companies are, like if you're in that peer set of big funds, it's hard to keep up if you're not in the top 10 companies. I think we're coming back to, as people say, ventures, power law. And yes, power law really has two meanings. Like one is a very small proportion of the outcomes drives the majority of the returns. I think everybod understands that. But perhaps the more important piece is that the scale of the winners is what really matters. So it's not just that a very small sliver of companies matter, it's the scale of that really small sliver of companies that really matters and determines how successful you'll be. And I think it's very hard to have a top fund if you're not in those companies.

In a time where LPs are just trying to snag whatever allocation they can. In some of the more established funds, I think that's a reality. What are the strategies that not even just emerging funds, but anything that's not a multi stage, multibillion dollar fund can employ to weather those economic downturns and also deliver strong returns? If you're not a multi stage, multi billion dollar fund, if you see one of those competing for a same deal that you're looking at, do you just go running? How do you remain competitive there? If that's what some LPs believe, it's interesting.

I just came from the emerging managers circle that the Equal Ventures guys put on. I told some folks at the event this, I think that the era of seed that we were in for the first 20 to 25 years of seed investing, it's essentially over. And I would characterize that era as one where the multi stage funds left seed to seed funds is that this is your thing. Like we're busy trying to help companies scale and go public. We don't need to be in this business. You guys are our partners and friends. You will route the best companies to us. I think most of the multi stage funds at this point are like we need to have a product in every category, seed as a category. And we think A we're good at this and B we don't want to just seed what's a really good money making opportunity to these people who are our partners and friends. We don't want to put them out of business either, but we're going to have our own footprint, our own shingle, whatever analogy you want to use, we're going to participate in this, this market and we're going to also take companies that come from seed managers, but we're going to see them ourselves too. I think there's so many times when I meet companies and I talk to people at multi stage funds and they go this founder profile doesn't fit what we're looking for or the stated size of this opportunity doesn't feel like it's a multi billion dollar outcome that we need to fulfill our fund. So I think where you see the rubber hitting the road already is repeat founders. I think there's a ton of repeat founders I meet who 10 years ago probably would have gone to a multi stage seed fund, probably were less willing to take on any signaling risk. A lot of the repe founders I talked to today are like, I want money from a multi stage fund. I understand the deal I'm making that we'll either clear their series A bar or we won't. If we don't clear it, it's not as if I would have cleared it at another firm of equal caliber. It means we just didn't execute enough. And those multi stage funds can pay higher prices. So I think we're going to go back to a world that will be multi stage type of seed deals which is going to be mostly high profile people. When the next person leaves OpenAI, they're not going to come to precursor because they're going to go raise $50 million on some really high valuation to go build something that le what they did at OpenAI. And there's a very small sliver of funds for whom that entry point and that deal structure makes sense and we're not one of them. And then I think we're going to have a whole other seed ecosystem which is going to be back to basics. It's going to be people where there's just less data about these people and where the initial fundraise ask is more modest and where maybe the sort of path to victory for that company isn't as clear. And I think seed managers can do very well backing those people. But I think we're going to continue to see this evolution of seed as the multi stage funds. I think they're a permanent presence in our category now. They're not going anywhere.

It's a good tale actually. Into the second topic. Speaking of new products that larger funds can create and different vehicles to deploy, GC is working on a continuation fund worth up to 1 billion. It was released by TechCrunch. For those who are unfamiliar, these funds allow VCs to keep managing stakes in their successful portfolio companies rather than selling them outright. It's a move that's gaining traction in venture capital, especially with this current slowdown in IPOs and M&A activity. So investors in GC's previous funds will have the option to either cash out or roll their stakes into the continuation fund, keeping exposure to potential future growth. This strategy benefits VCs by maintaining long term relationships with Portfolio companies and avoiding cap table disruptions. However, it also presents a trade off for limited partners as shares sold in secondary markets oftentimes come at a discount. So given the recent popularity of continuation funds in vc, how do you think this trend might affect a larger ecosystem?

One of our portfolio companies, Jeff, who runs a company called tap, he and I, two years ago he brought up continuation funds and I was like I don't know, this is a PE thing. This is like not coming for venture. I don't know like people are starting to talk about it. This is have you thought about it for precursor? And I said this turns out you should listen to founders. This is one of those topics that went from something I feel like very few people in venture were talking about continuation funds two years ago. Last year I started hearing rumblings that some of the bigger funds were going to do them and this year I don't know a single panel or conference I've gone to where strip sale continuation vehicles, some liquidity vehicle for LPs hasn't come up as a significant conversation topic and I think it's largely driven by the fact that like the principal sources through which limited partners get liquidity are IPOs and M and A, both of which are at record lows and neither of which really show any, as far as I can tell, sign that they are likely to bounce back in a meaningful strong way. And as we talked about as a team, a lot of limited partners, this is a self filling program. We take the proceeds and we put them back to work into the next funds and when those proceeds come back and for the last few years this one of my friends said distributions have been delayed. These delayed distributions are creating all this tension and so you would think what are your solutions as a gp? One solution is you go out and you sell the position, you go take all the shares and if you can find a secondary buyer, but then you're giving up all the future upside but you're producing liquidity for your LPs. The continuation vehicle has this like nice characteristic where you're selling the security to a new vehicle where the clock can start over. And if you're an LP who wants to stay in this position, you can roll with it. If you're someone who wants or needs the money back, it gives you a way out. Now when we talked about the retreat with, with our cfo, these things are incredibly complicated to price. You have to go raise capital for them. They're complicated. But if you look at the names that GC mentioned, I think it was Stripe and gusto. These are good private companies that are not public yet and will be public someday, but as far as I can tell it won't be tomorrow. And so I think as long as the M and A and IPO windows remain challenging for venture backed companies, I think there's going to be more and more pressure on GPS to find creative ways. I don't know what it's going to take to reignite the IPO market's enthusiasm for tech stocks. And some of the M and A overhang is clearly regulatory, but not all of it. I don't think regulatory explains everything and without favorable exit environments, I think GPS are going to look for things like continuation vehicles and strip sales and other vehicles to to get money back to LPs because our business is returning money to investors and it's been a tough couple of years.

On the distribution fund, do you think that it's the multi stage, multi billion dollar funds that will be able to pull together these continuation funds and market them to their LPs or do you think that basically anyone, if you have a sub $100 million fund, if you had a couple of bets you could lobby and successfully get a continuation vehicle going?

I think the challenge is like two things. Do you have positions that are big enough to make the exercise worth it? And for a lot of smaller funds, even unless you're owning like 10% of data bricks or something like that, the value of the position might not be big enough to warrant the level of effort required to do this. I think this is another place where like big funds and small funds are just in a different universe. For a $100 million fund, a $25 million position in a winning company might be a material chunk of your fund's nav, but probably isn't anywhere close to big enough to warrant spinning up a cv. My hunch is for most smaller funds the right answer is to do direct secondaries. So take your winning positions. Find a way to sell them directly. Return that cash to your LPs. Yes, you are giving up the future upside that you would get if you could continue to hold it in some kind of vehicle. But you're solving for the near term cash needs by selling those positions. And who knows, you might five years from now say gosh, I sold at a billion and it went to 50. Or you might say I sold it a billion and it went to 50 cents. But I think for most small funds you probably don't have enough premium assets at a high enough mark to bundle them together and do this, and we.

Did talk about this at length with our cfo, and there was at least a handful of slides that outlined what are the decisions you have to consider in order to bring one to life. So I'm curious to see how it all unfolds. Moving into the last topic Real Talk between Founder and VC over the Years I giggled at this one. It was a post published by Neil, Managing Director at Forum Ventures, that attempted to sum up the discussions and interactions between VCs and founders in the peaks of 21 and the more turbulent times in the past three years. The post is super brief, so I can basically recite it starts out with a VC in 2021 saying, Growth is all that matters. And then you've got the founder replying, cool, I'm going to stay focused on my customers. The VC then comes back in 2022 and says, Glad you're growing, but efficiency matters more now. The founder replies, cool, I'm going to stay focused on my customers. And VC in 2024 and beyond comes back and says, do you have a path to profitability? And the founder in 2024 and beyond says, cool, I am going to stay focused on my customers. And so the takeaway here is that while capital markets have changed, so did VC advice. But staying focused on customers stayed consistent from the vantage point of the founders. And Neil said oftentimes they know their business best and can steer the ship there. So of course this was a really fun summary, but I would love to know what you felt could have been inserted here either on the side of the founder or investor.

I read this and I I cackled. I didn't even giggle. I cackled. I thought it was so funny because it's so true. I spent a lot of time talking to founders. We do these monthly one on ones with them a lot of times. One of last questions they'll ask me is what's happening in the fundraising environment? And like for the last year I've been like, are you an enterprise AI company? If so, you will have a lot of interest. If not, like Godspeed, it's going to be hard. And what I tell people is the more dependent you are on the fundraising markets, the more you have to actually care what they value. And so if you're a company that like doesn't need to raise venture capital either because you're profitable or because you've got a big war chest or for whatever reason, the founder in this statement did the right thing, which is just to ignore all of that because it's Just noise. But most of the people we work with, they need to raise. And I think the challenge is sometimes people are out of step with what the market wants. I remember there was a period of time where all of a sudden, all of my friends who do consumer Seeds and Series A's were like, we're not doing any more consumer companies that don't have revenue. And a bunch of the founders were like, But I was like, I'm sorry, the rules have changed. You got no warning. I know this feels horribly unfair, but this is how the business works. And so I think as a founder, you have to decide what kind of business do you want to build. And we have a bunch of companies that were profitable when growth was the thing, and nobody was interested in those businesses because they weren't growing enough. And I think those founders were extremely frustrated in the moment that nobody cared about their beautiful, profitable businesses. And then profitability became invoked and everybody wanted to talk to them and they were like, oh, wow, that changed overnight. I tell people two things. One is, if you ever have a conflict between what you should do and the choices are, this is good for the business and this is good for potential fundraise. Choose the thing that's good for your business, because you probably don't actually really know what VC are looking for. And if you optimize for what you think they're looking for and you're wrong, you lost a chance to make your business better and you shot for a target that wasn't real. And the second thing is you should evaluate how dependent you want your business to be on future venture capital. You can't change the money you've already raised, but you can decide, hey, I don't want to run a business that's subject to the whims of these couple thousand people and what they read on X or what their LPs have told them or whatever's happening in their firms. I want to be independent. That's harder to do, but not impossible. We've lived through all of those worlds. We lived through the spend $10 to generate $1 in re revenue if you have to, because growth is all that mattered. And then I was like, whoa, everybody should stop doing that. We're all about efficiency and burn ratio, and we're going to talk math. And then last year, everyone was like, oh, should I like, stick AI in my pitch deck? Seems to be what you guys want to hear. I'm like, does AI better for your product? People were like, no. I'm like, then don't put it in your pitch deck. And I think this is an unbelievably difficult time to be a founder because it feels like between Covid and SERP and change in interest rates and compression of public company multiples, these founders lived through what normally takes a decade to play out has been compressed into two and a half or three years. And I'm sure it feels like whiplash. And I wish I could tell them it will get better and get different. I can't tell them that in good conscience.

It feeds into an existential question I have about venture from the investor side. I've found that throughout some of the more turbulent times I witnessed a lot of investors give really either wish washy or straight up bad advice to founders as a mechanism to push their own interests and assuage some of their anxiety about the broader market. And obviously it's inherent to the job of an investor to act in the fiduciary interests of our LPs. But I'm curious if one you also encountered this behavior and two, how do you strike this balance of being a true partner with all of our founders while also guiding returns driven counsel?

I can tell you what doesn't work. Going to a board meeting saying we need to grow revenue and cut the burn. I used to think that was like a joke. I actually was in a board meeting where someone came in and said we've got to grow revenue and cut burn. I was like, you did it. You said the thing. So I do think that makes it hard when you tell people to do things that are unambiguously, obviously good, but hard to do. I always try to tell people when we have this conversation, what kind of company do you want to build and what is your risk tolerance? We have some founders in our portfolio who I think truly are gamblers. They will do a low probability high upside activity because that's just how they're wired and it's not scary for them. We have other people who are very conservative. So I think first you have to know who the person is that you're talking to. And second, I don't think you can like flog a company into greatness if somebody's working on an idea that it turns out is not venturescale yelling at the person applying more pressure. It doesn't actually change the nature of the opportunity in front of them. So I like the way you asked this question Mina, because I always try to ask myself the following what is the real opportunity that we're going after with this company now that with each successive month board Meeting year, we've peeled back more layers of the onion. If anything, we should have a clearer picture about whether or not this is a big company. And I feel like the best thing I can do for the human beings running the company and for our fund is actually to make sure that we're aligned on that. That answer. Because if the company really is a slow growth company, that probably isn't going to be a venture scale outcome. I've told people, I was like, this isn't going to be one of those, so what do you want to do? And we had a founders, I like running this business, I want to continue to run it. And I was like, okay, then the advice I'm going to give you is the advice I would give to somebody who was running a slow growth business, which is probably we should get profitable and then we should try to figure out like what exit opportunities there are, if any. And maybe there's a mechanism through which you buy us out. We've had companies actually buy the preferred shareholders off the cap table so that they could run it in the way that they see fit. And those were not companies that I think aspired to be versus scale companies. And I think the problem is what you hinted at is sometimes people are like, I need this company to be successful for my career, for my promotion, or I need this company to exit for a billion. I'm like, we're not going after an opportunity that's going to yield that. And the question is like, how do you self regulate when you find yourself in a company where you're like, oh, this one isn't going to be what I thought it was going to be. This one isn't going to be what I told my LPs it was going to be. For some people, the natural tendency is to get frustrated with the company and take it out on the company. And I'm just like, oh, that's probably the wrong instinct, but I understand where it comes from. Or it's to deliver information without context. It's all of the companies in our portfolio have to get profitable. I'm like, this is a company that's burning $2 million a month. Why don't we start with like getting the burn rate down? Maybe we start there. And so I always think the founder job is so hard. I know very few founders who sit around doing nothing all day. Most of them are working as hard as they can to make the company as successful as they can. As I always ask myself, myself, what's the probability that the thing I'm going to mention to this founder isn't something that they've thought of already. If you put the people who run the company first and you think about them as human beings and you ask yourself, what am I asking these people to do? What are they capable of doing? I find you generally end up in the right place. There have been a few times I think I've felt conflict. I'm like, oh, we need to find a way to maximize the money we can get back from this company, and that might involve selling it and asking the founder to go work at a place where they're not excited to work. It's my job to explain to the founder why I think this is an important thing to do, and I take that seriously. If we do our job right. Right. The number of times where there's a conflict between what's best for us and best for the founder, it's not zero, but it should be very small.

We are all out of time today. Thank you, Charles, for jumping in. And then thank you for all of our listeners for tuning in. Subscribe and share with your friends and we will see you next week.