Episode #6: Pitchbook NVCA Venture Monitor Q3 2024 Report

There's almost no correlation at seed with unicorn picking. Unicorn picking is like actually pretty distributed at seed, which tells me that good companies come from everywhere, but most people are only going to find a handful. I just worry about the out of favor thing, the non obvious thing, the thing that doesn't need a lot of capital. Who's going to step in and fund that?

It's the week of October 28th. 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. This week we're spending the entire episode diving into the Q3 2024 PitchBook NBCA Venture Monitor report that was just released. The report outlines key highlights and statistics from across the investment landscape and venture to provide a snapshot into where the industry has seen developments in the past quarter. And there's a lot of content in here, so let's get into it. First topic, the stalemate in dealmaking and fundraising. So the report highlights that VC deal activity has pulled back significantly. While the number of deals completed in Q3 reached 3700, it's still well below the highs of 2021. The overall deal value is projected to reach around 1 75.2 billion for the year, surpassing 2020 levels but still far off the highs during the ZIRP era. So Charles, what's your take on this CA investor behavior? Are you seeing this shift towards quality over quantity and an increased focus on due diligence, which is what the report mentions? And how does that impact early stage investing?

That data pretty much matches what I've experienced, which is that there seems like there's more money going to fewer companies. So definitely feels like quality over quantity feels like more dollars concentrated in certain themes like AI that are just more popular with investors right now. And I think the other thing that you highlighted is I think investors feel like they have more time to get to know companies. I think there was a lot, maybe you call it drive by investing in 2021, where you meet somebody and halfway through a zoom they tell you, hey, I know I just met you, but I've got a term sheet. I have to make a decision by the end of the day. No, I don't have time to meet with you. No, I don't have a data room and I think things have just slowed down. And so the the amount of time you have as an investor now to get to know a founder and more importantly I think to get to know the business, it's Just much greater. I think it's healthier for all sides. I think I've been dealing lately with some companies who maybe in sort of the speed dating era of investing, picked a partner who now that things are a little more challenging, maybe they're realizing they're not as aligned as they thought they were. This feels like a more normal investment pace, a more normal time on deal making. It feels weirdly like healthy. Probably doesn't feel great if you're a founder, but from my side of the table, it feels like this is a more normal, healthy, sustainable pace.

To your earlier point, this could feel different for founders. What are maybe some of the strategy shifts they should consider heading out into this fundraising market.

You know, we track the time from sort of kickoff to close, conditional on success. It hasn't changed much. It's been pretty steady over the life of the firm. At about three months, it's ticked up to closer to four. What I would say is for the companies in our portfolio that raise their experience isn't that much different than it was before. It's maybe an extra month or two of process work. What I will tell people is I used to say, ah, if you have 40 or 50 names in your funnel, the probability that the person who's going to do your round is on that list is high. I think now I'm seeing people build Investor lists of 75 to 100 hundred people per fundraise. And the process of going out and talking to people and just sussing out who's interested is just taking longer. So what I would tell founders is doesn't feel like the back end of the process has gotten elongated. It's really that front end discovery of who's interested in what you're building, who gets you, who's got capital and who's ready to invest that product. It seems like it's taking a lot longer for founders.

This pace, to your point, is more the norm. Obviously no one wants to be drab for a long and extensive diligence process, but there are pros of that for the founder wanting to make sure you have the right people on your cap table and not rushing to just take capital for the people who are pushing it your way the quickest.

I also just think we're getting to a point in this cycle where there will be almost nobody whose last fundraising experience was zirped. And I think in 2022 and 2023 you had people who were coming back to the market whose last fundraise was sort of the go go zirp. Covid zoom era and they were sort of very surprised by the level of inquiry in the style. Now I think there's prob who haven't raised since that era, but I think even those folks know that the next raise will look and feel different.

Do you feel like second time founders let's keep AI out of this, but do you feel like those types of founder profiles are exceptions to this or do you feel like they're going through these same trends as well?

I think most second time founders are having a this is going to be a very specific answer. They're having a harder time than second time founders normally have, but they're having a much easier time than your average first time founder. And I think what's different is there have been times in my investing career where the bias towards second time founders is so great or repeat founders that if the idea is at all reasonable, you just do it. And the level of scrutiny applied to what they're building is much lower. I found that there's more scrutiny applied to repeat and second time founders and some of those folks are having investors who backed them before say no, not because they don't think the founders are great, but because there's something about the idea or the space or the pitch that they don't like. And I think a lot of people's experience as repeat founders has been once you've done it, once you go back, you can kind of raise money for a ham sandwich, so to speak. I don't think that's the environment we're in right now.

Moving on to the next topic within the report, it's the lack of distributions and its ripple effects. So one of the standout insights from the report is the lack of distributions back to LPs which has been almost as low as during the global financial crisis. The cashback rate has been in the single digits for eight consecutive quarters compared to the 16.8% average rate seen over the past decade. This has obviously created a liquidity crunch that is pressuring VCs and the lack of ex just making LPs cautious about reinvesting in new funds. We have talked a lot about this on the pod, so no need to belabor something we've already delved into, but was curious to ask you what have been, if any, some shifts you've had to make in your conversations with LPs in this time?

I think this is probably the central issue in venture right now. You know, a lot of LPs I talked to say, hey, we rely on distributions from you guys to fund the next fund. So without distributions, our hands are tied, no matter how much we love you. And I don't think it's posturing a positioning. I think it's, it's real. I think also this prolonged drought has reminded LPs that VC liquidity tends to come in bunches. And I think they got used to something that felt more like peanut butter. And so I'd say there's two big changes I'm seeing. I'm talking to a lot of funds who are saying how can we build out systems or programs where we can provide more reliable, consistent liquidity to our LPs? Because we think that's going to be an important thing that will set us apart from other managers. I think they're right. What I've been thinking about is the best way to increase the probability that you're going to have good numbers to show on the DPI front before you go back as an early stage fund is actually extend the time in between funds. And so, you know, most of our life we were raising a new fund every two years. And in a world where LPs weren't particularly fixated on liquidity, that strategy worked pretty well. In a world where both liquidity and you couple that with slower time to graduate for companies, you don't get as clear a picture in two years on a brand new fund as you used to. So I think one solve is just take more time to deploy the fund. Go back to what used to be the Norman Venture three, maybe even four years. And if you do that, by the time you come back to market, you'll have more data on the companies. Also, we have a ton of really interesting companies that I saw a chart, I think it was. I don't remember who had made it, but Jason Lemkin had shared it. Just showing a bunch of the most promising SaaS, companies like your stripes of the world that'll go public. Those companies are going to be 15 or 16 years old by the time they go public, if they go public on the schedules that other people are forecasting. But then you have to add in six months for a lockup if they go public, plus some kind of orderly distribution. So let's tack on another 12 to 24 months. It might be 17 or 18 years before the funds that are in those companies, barring secondary sales, are largely out of those positions or have sold down the public holdings to a place where they're comfortable. That's like double the fun life that's on the COVID for most funds. That's really different. Now look, my, my hope slash expectation is the magnitude of those distributions from the winners will make LPs say it was worth it in the end. I got distributed out companies that were worth 50 to $100 billion when they went public and maybe they go up from there. I hope it's worth it and I believe it will be.

Are there any things that maybe funds 1, 2, 3 and even 4 that you kind of are like, we don't need that, that now looking ahead, Fund 5 and beyond, you're like, Ooh, LPs are asking for this. Maybe I should think for our first.

Few funds, I'd say Most of our LPs, not all of them, but many of them were like, you should just hold everything to maturity. Like, you should just maximize. And they're like, look, it's a small fund, you know, holding things to maturity could really spin the multiple on you and could get you to a place that's like very attractive. Also, we didn't have very many big checks in Fund 1. So most people are like, the amount of money I've given you, I'd rather get back a big multiple of it later than a little along the way. The newer funds are bigger and the checks that people wrote are larger. And I think in general, LPs liquidity preferences for money now versus money later have shifted. And I think the challenging thing as a fund manager, is this a permanent shift? Is this a forever shift where LPs are going to just want more money sooner? You think, who wouldn't want money sooner? I'd argue the person who wants the most money later maybe doesn't want money sooner. And second, if it's not a permanent shift, how long will we be in this era? I think it's very possible that if we have in the back half of this decade a big IPO haul, people might go back to saying, like, venture is great because it compounds for a long time. Look how great it was that these companies stayed private for 15 years. The same ones that people are complaining, complaining about that won't go private today. We operate on a 10 to 15 year cycle. And so I'm always asking myself, are we going to make a decision right now, in this moment that makes sense today, that we will deeply regret five years from now? And I think on the way up, my feeling was selling out of some of the companies that are ramping is going to hurt our relative returns because the people who hold those companies and stay in them are going to have better returns. And I'd Say, probably one of the biggest evolutions I've had since I started the firm is the balance between absolute performance and relative performance. And I think the 2019-2022 era was a lot about relative performance. I got a lot of people saying 5x is the new 3x, but if you're just like, hey, I know that I'm competing against crypto, I'm competing against people who have funds that are really ramping, like 3x suddenly didn't feel that impressive. And so I think keeping some balance between, on an absolute basis, doing a 3x fund in any, almost any environment puts you in the winner's circle versus worrying about, well, what does top quartile unrealized performance look like this quarter? I think I've, I've shifted over time to focus. How do we just focus on absolute performance? The chips on relative will follow. They will. But if we focus on absolute performance, we'll probably make better interim decisions too.

Moving on to topic three for the report, Fundraising Challenges. It's a good leeway into what we were just speaking about. Another key Insight is that 80% of the capital raised so far in 2024 has gone to established fund managers, with smaller or newer funds struggling to raise capital in the current environment. This is largely due to, again, LPs being cautious with reinvestment and preferring these established managers as they wait for the liquidity crisis to ease. So we touched on this actually last week quite briefly. But how do you think this concentration of fundraising in a few hands will impact the venture landscape in the next couple of years?

I think when more people have money, you get a wider variety of ideas. I probably never told you this. Probably five years ago I was talking to someone who's like, there's too much money in venture. And I was like, no, there isn't. There's too much concentration in venture. And he's like, what do you mean? I go, well, look, imagine a world in which one venture firm had all of the money. In our industry, you would only get the companies that that one fund thought were interesting. Now, if that fund had like, perfect, excellent judgment, it wouldn't matter. But no fund does. Now, if you take it to the extreme, imagine like every venture firm had a dollar. You'd get like the wildest set of ideas. So I think there's some optimal distribution on there, where I think you need concentrated large funds to fund things like LLMs and space and to fund some of the expensive defense tech. So there's absolutely a role for big funds in venture. But I think the beautiful thing you get when you have many small funds is you get people with different points of view, different networks, different interests, funding like their own version of the future. And I think it was maybe Sapphire or maybe it was Sandana. Someone published something that basically said there's almost no correlation at like seed with unicorn picking. Like unicorn picking is like actually pretty distributed at seed, which tells me that good companies come from everywhere where but most people are only going to find a handful. I think it's really interesting. And so I think it's going to have impacts on what gets funded because more of the dollars are going to follow the interests of the big firms. And look, those firms are very good at what they do and they will pick the things. I just worry about the out of favor thing, the non obvious thing, the thing that doesn't need a lot of capital, who's going to step in and fund that. And I also have just talked to a few emerging managers who are just like, is this the new business? Does the new business? Basically a very small handful of big firms with 80% of the dollars and the remaining 20% of the dollars goes to quasi established emerging managers or emerged but not established managers. And those folks have to decide how much of their investing should be influenced by the preferences of big funds. The positive case is this is cyclical and that as LPs get more distributions and the risky nature of venture feels good, that they will sort of pivot back to small funds. I think the bear case is a lot of these LPs were structurally capped at how much money put into the very big funds that they wanted to get into. And those funds are now two to 10 times bigger than they used to be. And so if you really wanted to put money into one of those big franchise funds and you were capped, you might now be in a position where you can put more money in and you might just say, you know, if my choice is double down on a big established fund that I've done the underwriting on and that I believe in, or stay flat with that fund and do the work of meeting new managers, I think some people are going to just say, shouldn't I just give more of the money to the big funds?

There is a subset of LPs regardless of all the data points that you gave and the arguments for distributing dollars to more fund managers who just believe that the bigger, more established funds get to see everything and they only want to invest with those types of funds. How do you respond to that and when do you know when not to place any effort in those discussions to chart forward with those relationships.

I've met some people, particularly on the pension side, who need to put hundreds of millions of dollars to work per year in privates. I have a very hard time arguing with those people that they should spend the underwriting cycles to write a $3 million check. And it turns out they agree with me. So those conversations are pretty easy. I think what's likely to happen is there's going to be an LP base for smaller emerging managers that might be more family office fund to funds, small endowment, and that more of the big dollars are going to go to the big platforms. I often talk to LPs about this very topic and ask them, you know, one of the things I often ask people is like, tell me about your venture program. If someone says we have a very mature or established program, that tells me they're probably in Sequoia Founders Fund, they're in a bunch of really good managers who've done very well for them and they, they don't necessarily feel the need to add more. And to their credit, I think the big funds have done a better job in the last few years of covering more of the ecosystem. I think all the really good firms I know are like, well, we're not going to just wait for the great series A companies to find us. We're going to go find them at Seed, we're going to go try to find them when they're leaving their job. We're going to work harder. And ironically, I think it's because if you think about it, it's sort of like great powers competition. Those firms are not competing with precursor, those firms are competing with each other. And I think those firms are trying to figure out, you know, how do I beat the other mostly dozen firms in my peer set. We're all going to fight over kind of the same companies, mostly repeat founders, a lot of high profile, like we're going to fight over the same pool. So how do we win more of this? And I think it is zero sum competition for them. And I think all the one people I know, those big funds would describe it as such, like if there's a deal we want and someone else gets it that we lost, there may not be an equivalent quality deal that comes through our office again this year. And they think of it as, it does feel a lot like geopolitical rivalry. There's maybe something to be learned there. Whereas I think for Seed, it's really about can you find things that will be consensus good in the future but are not consensus good today. And I think there was a period of time where as a seed manager you could also do consensus good today deals as 25 to 50% of your diet. And I don't think that's true anymore. A lot of people have told me please don't say that or I disagree with you and they're entitled to their opinion. And I just think the big multi stage funds have gotten good at sussing out the consensus obvious good seed deals. They're going to compete for those deals and they're going to win a lot of them, not all of them, but they want a lot of them. So in some ways seed is back to the basics of the job. Can you find things that other people don't understand or don't believe in yet and be right? We're going back to like what the whole reason like that seed needed to exist was there were companies that the big funds like they didn't know what to do with them in their current state. I think we're just going back to that, that and that makes me really happy.

It's a good test on fund managers too. Of like did you go into this with a very unique idea on how to drive capital into the market or are you more in the consensus side and trying to aspire to pile into deals that probably you won't be able to compete in on price? Well, this is great. We are all out of time today. Thank you Charles for jumping in. Thank you to our listeners. Please like subscribe and share with friends and we will see you next week.

Bye.