#28 - Michael Kim, Kelli Fontaine: Seed Investing, Small Funds

Today we have Michael Kim, the founder of Sandana Capital, a San Francisco based firm that specializes in investing in very early stage venture capital funds globally. Sandana was launched in 2010 and has over $2 billion in assets under management. Also with us today is Kelly Fontaine who is a partner at Sandana and joined about six years ago. Michael Kelly, thank you for joining and taking the time to speak with us today.

Thank you for having us.

Thank you.

Michael, let's start with your background. Would you tell us how your career transitioned from investment banking to tech M and A to venture capital and ultimately launching Sandana.

So I graduated Cornell, studied international relations, wanted to be a diplomat, so went to school foreign service at Georgetown for my master's degree, decided that I wanted to actually work instead of going through the government ladder and ultimately ended up at Chase Manhattan bank doing corporate credit analysis. And that was in the early 90s and decided I want to actually go into investment banking. Mergers and acquisitions sounded more interesting. So I went to business school at Wharton specifically to do that. And so I was a summer associate at Morgan Stanley. That was like my dream job and got, luckily got an offer full time. So second year of business school is a lot of fun. Started at Morgan Stanley in August of 1997 and my idea back then was I'm going to become a managing director and then I'm going to join KKR or Carlisle and thought that was my career progression. And sure enough, two months later there was an opening in San Francisco for the Tech M and A team and that's the group that was working with the technology companies in Silicon Valley. So I joined Morgan Stanley in San Francisco. Ultimately our office was on Sand Hill Road in Menlo park and I did that for three years from 97 to 2000. And that was really the first Internet bubble if you all recall. And you know, worked on a lot of transactions. You can see some of the loose sites behind me. And that was actually the first time I was exposed to venture capital. So we were working with venture backed companies. These were private companies, startups that had received venture capital and we worked very closely with them, sold a number of them and acquired for public companies some of the startups. So that was my first exposure to venture capital. A family office in 2000 decided to set up an alternative investment program. So I ended up joining that, that's the Chandler family in Los Angeles, sort of old school media family that owned the LA Times among other things and ultimately became the largest shareholder at Tribune. So I worked at that firm, it was called Rustic Canyon for about nine years, 2000 to 2009, and ultimately decided around 2009 and 2010 that I wanted to start my own firm. And part of it, and we can talk a lot more about this, but part of it was because there were new types of venture funds coming out, new funds that were smaller, focused on even earlier stage. And I thought that ultimately would become de facto early stage investing. So that's the genesis of Sandana. And I've been in San Francisco since 1997, so I've been through a few cycles here. And, you know, I think it's right now a very interesting time, that is for sure.

Well, we'll definitely get into that. Kelly, would you share your career path from school to Sandana and how your career has evolved?

Happy to. So I moved to San Francisco in 2005. The network I had made in college, most of the people I was close with from undergrad, business school were moving to San Francisco. And my first job out of college was at Capital Group, which is an amazing company. And then I moved to Credit Suisse. During that period of time being in San Francisco, the friends that I had that worked in tech were so passionate and loving their jobs that I wanted what they had. So I tried my hand at being a founder. The company I started was Point of Sales analytics for restaurants. This was pretty early. It was around when Square was founded. That did not work out. But right after that, I joined a company that was backed by some prominent venture capital firms, Kleiner Perkins and Charles river crv. And that company did ipo. And so that was a great experience, operating experience. And, you know, through that, a lot of data. So Point of Sales analytics, the company I joined, I joined in corp dev and corporate development and we spun out an insurance product. So actuarial models. So my theme in my career kind of became data focused. And I'd known Michael for 10 years personally through the ecosystem, the San Francisco ecosystem. And I'd gone to the annual meetings that Sandana hosted. I'd gone to the events, and it was back to that thing I loved about tech in general. Back in the early days of me being in San Francisco, there was collaborative, passionate, helpful, really great ecosystem that Sandana had. And so when I had the opportunity to join, Michael and Graham at that point jumped on it.

Yeah, it's certainly an exciting industry and we're going to spend a lot of time talking about that. Michael, you mentioned Starting in the mid-90s, there's been a lot of shifts and structural changes in the industry. Would you talk about some that you've observed and the ones that ultimately prompted you to launch your own firm and strategy. Focus on early stage investing.

Yeah, absolutely. So I started business school in August of 1995. That's when Netscape went public. And you know, with the, with Netscape browsers then the average person could access the Internet, the World Wide Web. And so that was a fundamental shift in technology and you know, sort of basically created what we know, the Internet, how we use the Internet today. And you know, through the late 2000s there's been, there were a lot of investing around in software infrastructure. You know back then it was called data networks. So you know, basically like companies like Cisco and others that were really building out the infrastructure part. And then of course you had the applications companies like ebay so that people can use and transact. And you know, I think obviously there was the Internet bubble. So the things went down from 2000, the bubble burst. But then, you know, in the mid 2000s you had the smartphones, you had the iPhone launch in 2007. And that's where ultimately every person who had an iPhone or a smartphone basically had a computer in their pocket with access to information around the world and the ability to transact. So those kind of seismic shifts really created a lot of value. And then of course today we have AI, which I would also put in the same category as say the launch of the iPhone. It's going to enable a lot of things. It in itself is not necessarily a technology that our fund managers would invest in, but you know, in general AI is going to permeate through all of software. And so I think there'll be a lot of interesting use cases for both enterprises and consumers. And then on the venture side, you know, I think fundamentally through the early 2000s to today, it became a lot cheaper to start a company. So you know, a person can start a company now with $500,000, they can start a software company because they, they can use Amazon web services, meaning you don't have to buy your own servers, open source software, which is free. And, and instead of paying for software licenses, so a founder can actually launch a company today with $500,000. At the same time you also had the traditional VC firms get bigger and bigger. You know, they're now multi billion dollars in size and you know, there's an opportunity cost for a partner at one of those firms to spend time on a small check. If you're running a multi billion dollar fund, you have to be writing 10, 20, 30 million dollar checks. And so that's what the, that's what created the opportunity for the, the type of funds that we look at, which are seed funds. And these are generally speaking sub $100 million funds that are investing are generally the first investor in a startup. So they are writing these small checks, they're getting good ownership, you know, 10 to 15% of a company when they write that check. And it, it's worked out where, you know, when I started Sendana, there are probably 20, 25 seed funds and today there are over 2500 in the US alone, probably another 2500 globally. So, you know, our thesis that these small seed funds would become de facto early stage venture and has played out well. And you know, I think for those who are familiar with venture, you know, in the early 2000s, you, you had new firms like Union Square Ventures, True Ventures, foundry. In the mid 2000s you had a firm like First Round Capital. And then the late 2000s, you basically had these angels, you know, individuals who are using their own capital to invest in startups, start to institutionalize. And what I mean by that is they started taking outside capital from endowments, foundations, family offices, and you know, starting these 40, $50 million funds. And you know, back in that day they were writing $1 million checks. They're getting 10%, 15% of a company and you know, today it's more like $100 million seed funds writing $3 million checks to get that same kind of ownership. So it's been an interesting ride to see how that's all developed over the past 20 years. And you know, I think it also says something about the efficiency of the market. You know, I think as capital is allocated toward the larger funds, another stream of capital went toward the smaller funds, which were more nimble. So that's the opportunity set that we're pursuing now.

That's great. I've really been looking forward to this conversation because, you know, working with clients and kind of being having my finger on the pulse of the investment world, there's so much interest in participating in the technological boom that we're living through, particularly today. And we know investors can easily buy individual stocks or invest in an index fund of publicly traded companies. And qualified investors can invest in private equity or growth equity through funds. Today we're going to focus on early stage venture, as you just described. So to start at a high level, would you describe the landscape for very early state venture capital at a very high level to put your area of focus in context?

Sure. You know, the traditional VC firms have gotten bigger and bigger, so if you look at a firm like Andreessen Horowitz, they started off at 300 million over 12 years ago. Today their current fund is 7.7 billion in size. And they have a number of strategies around that. So you have the traditional VC firms getting bigger. They're now called platform firms because they offer growth, they offer international, they offer mid stage, early stage. So they have a lot of vehicles, you know, maybe a crypto fund, an American dynamism fund, et cetera. I think at the earliest stages where we play, we think of it as two buckets. So we think of pre seed, which is very, very early stage. And just to give everyone a sense of what that means, that generally means a founder with an idea, nothing else, maybe a PowerPoint. And we actually have fund managers who work with founders at that stage. A larger subset is actually the seed stage funds, which I mentioned earlier. These are typically anywhere from 20 to 100 million, 150 million in size. They are writing $3 million checks, they're getting 10 to 15% ownership. But a seed stage company really is where they have initial product, market fit. What that means is they have an idea, they've created a product, and people are actually paying for them so that they actually have some traction. Traction generally means, you know, they have users, they have some revenue. So seed stage is not as early as pre seed, but those are the two buckets that we go after and then, you know, over. The creative destruction of venture is interesting. Meaning specifically, people will leave the larger firms to start their new firms. So there's always new series A funds, meaning, you know, sort of $200 million plus funds that are started by the junior partners or partners leaving the older firms and starting their own. So I think that's sort of the lay of the land right now, as we see it. And then of course, there's the non US venture capital world. But, you know, I think, I think what I just described also holds true for, for non us as well. Yeah.

And we've all heard the stories of the early investors in Apple and Google and Facebook and, and you know, the, the hundred thousand X, you know, returns that they've received. So that's obviously very attractive when you're living through this technological boom.

Right? Absolutely.

Before we dig in a little bit, could you just share some of the market data with us? How many funds are there in the categories, the size ranges, the return dispersion, particularly as it relates, we think of public equity managers versus, you know, this level where you have smaller funds. What, what are the losses like just, just to put some numbers around it. So we have context.

I think at the end of 2023, there's about 3,500 VC firms and there's about 300 billion in dry powder to be allocated to the space. So I think seed in context of that is prob 2,000 to 2,500 seed firms in the US focusing on the earliest stages. There is a huge dispersion in returns in venture. It's not like other asset classes. So it really is about manager selection. We do think that small funds outperform or have the higher chance of outperformance. You know the returns you just mentioned, those are outliers, right? Venture is known as power law. There's still the majority of exits are around 200 million in venture. So we look for funds where that exit can still be really meaningful to the underlying fund. And so when you look at that subset, it reduces that dispersion of returns because you are setting up a fund correctly to reduce the risk in venture, but still capture all the upside that venture offers with the power law. So, you know, I think the way we mitigate that dispersion is really through portfolio construction. And then, you know, the track record that we have really speaks for itself around manager selection because we are focusing on early funds, funds one through three. It's really identifying a manager that we know can return, can generate alpha. And so I think manager selection is extremely important and venture amongst all asset classes because of the dispersion that you do see. But again, the smart thing is to that Michael started with and is starting with portfolio construction as being the number one filter you use.

So obviously smaller funds can generate massive returns, but obviously they're more risky as well. Would you just talk about the loss side? Meaning I don't know if you have data or market data on the average returns of smaller funds versus larger funds and then the losses across those funds.

The average fund are higher. For the smaller funds and funds through the smaller funds, the average is higher and the top quartile is higher than the larger funds. I would say that the lower quartile is also lower. And so that's what you're talking about. And so that goes back to just the manager selection. But I do think the, the averages are not too far off. But the top quartile for the smaller funds and earlier funds is that much higher than the, the bigger funds and then that much lower as you're talking about the risk. So there is the higher potential. But again, we just think with the portfolio construction, you're reducing that bottom quartile that how low it can actually go. Because if you have the right ownership, which Michael has been talking about purchasing with the first check, if you're getting the right amount of initial ownership, you know, the loss of a portfolio is offset by being able to have even a modest exit, being able to return capital to the fund, a meaningful portion of capital.

Alex, let me give you a few real time examples. So just in the past four weeks, we had a company that was acquired for over 3 billion. And you know, that's a great outcome. That's what we call an outlier outcome. We don't count on billion dollar exits. That's not what our assumptions are based on. But of course, if the, if it happens, then it's great. So this company exited for 3.2 billion. Our fund manager owns 6% of it. So that's over $190 million return to that fund. That fund, by the way, is 45 million in size. So that exit returned over four times their entire fund. That's not even their best exit. They had a company that sold for 4 billion and they owned 7%. So they got 280 million and which is a great exit. But their fund was 12 million in size, so it was over a 20x fund returner. So those are sort of the outliers, right? We don't count on these. But the other example I wanted to give you, in the past few weeks, we had a fund manager who had a company sold for 150 million. Okay, not great, you know, solid exit. They owned, they owned enough of that company that it returned 40% of their entire fund. And so our strategy around the seed stage investing is that if you get the right ownership and you have a relatively small fund, you know, these sort of bread and butter exits at 100, 200, 300, it can return a material part of your fund. And if you get one of these outlier exits, it can return a multiple of your funds. But Kelly mentioned power law. And so for people who are not familiar with that, power law means that basically a handful of exits are going to drive the majority of the returns. So if you imagine a fund manager that has just to use round numbers, 10 companies, you know, six of them probably will fail, another three will probably return a good amount, but not a great amount. It's just that one company that the 10% that actually will return the vast majority of a fund, a venture fund's return. You know, we were at a conference in Sequoia, one of the leading venture capital Firms talked about their strategy and their results. And one of the things they mentioned was that over 60% of their initial investments fail. And they're proud of that. They want to find these weird companies that are going to be very different. And you know, if you think about a company like Airbnb, you know, they were the first investor in Airbnb. And think about it, if someone came to you and said, hey, we have this company where we're going to convince people to host random people in their house and pay you, you know, that sounds ridiculous. Or like Uber, you know, the car sharing service, you know, people originally thought that was a replacement for black cars. It was really the innovation around letting, you know, a individual use their car to transport other people and being paid for it. So I think those type of companies are what really drive a lot of sort of the popular anecdotes in venture. And it really also goes to show why the vast majority of the market capitalization today in the public equities are basically companies that were originally venture funded. And that starts off with Apple and continues on with Nvidia and so many others. Technology and innovation is something that really powers the US Economy. And I think there's always been an attraction around venture capital because there are these great stories of these founders who are suffering and the venture capitalist provides a little bit of capital and generally things don't work out. But for the ones that do really, I think, capture the, the imagination, it's pretty fascinating space.

And when you say, you know, six out of ten fail on average, three do okay, and one, you know, hits a home run, it obviously, it's hard to know which one that is upfront, which is why you buy 10 for every one that does well. And, and so let, let's, let's go into that a little bit more. You're, you're, you're in the business of selecting the managers who are picking the, the companies. And, and we'll get into how you pick those managers a little bit later. But is it, is it feasible to find the top quintile in advance as opposed to the bottom quintile? I know in, when investing in public markets, the dispersion is a little, you know, much tighter and it's not easy to pick the managers in advance. Oftentimes there's cyclicality and, you know, good stretches are followed by bad stretches and so on. How is it in, in the venture.

World, the difference is in venture there is persistence of returns in managers and so allocators and LPs typically focus on Managers that have had great performance. The issue with that still is, though, the performance came from a lot different fund size. So that's what we see as the issue. As they creep up in fund size, that could be the difference and what the ultimate outcome will be for those funds. Again, we think the number one driver is really portfolio construction, and we focus on that. And so their portfolio construction and what they need to return at a $7 billion versus $300 million fund is going to be very different. So the results will be very different. What is attractive about venture is the different halos people can have from their networks. So that is really what we focus on and venture. So they're sourcing. Where are they getting the deal flow from? What companies are they seeing? How are they seeing these companies, their ability to win, pick the companies they're going to invest in from that sourcing and win the allocation. So going back to the portfolio construction and ownership, it's important for them to be able to get enough ownership that it's meaningful to the fund. So is the founder going to give that manager that much ownership that they're requesting? And then supporting the companies is another thing, because how well they support those companies is. Becomes their reputation, right? So the founder. The best referrals managers can get are from other founders. So the referrals and how they work with those founders is extremely important for their reputation and their brand building. And so our job of how we really focus it on is really their networks starting there. How strong are their networks? You know, as Michael puts it, which ponds are they fishing in? Right, to understand what they're going to be seeing. Because a lot of times we can say, oh, you're seeing the most deal flow, but that's not the point. It's seeing the highest quality deal flow and the best opportunities and then being able to pick the right ones out of that best opportunity set and to be able to win the allocation. So that's really our focus on selecting managers is at that point in the market, are they. Do they have the right networks and do they have the right credibility to be able to win the allocation that they need for their fund size?

Thank you, Kelly. What you just described really is the difference between investing in public markets and in your. In your, in your space. Because the access, the reputation, the relationships, that is clearly repeatable as opposed to when you're investing in public markets, you don't really have those things. You have similar information as most others. And so you can see why there would be more cyclicality and manager returns.

Yeah, exactly Alex. I mean, I think it's pretty well known that the number of public companies have decreased substantially over the last 20 years. And so if you're a hedge fund manager, there's a smaller opportunity set that you're pursuing. Of course there's some managerial skill there in generating alpha, you know, excess return. But think about, you know, the seed stage investing. There's always new companies being formed and even within venture, the later stage funds, you know, the series B, C, later stage, they have a finite pool themselves. They, they kind of know their opportunity set. Whereas at the seed stage, and it really is greenfield, you know, there's a new company being started every minute. And so our, our job is to find the most amazing fund managers who can go out and access those founders at a very early stage in their company's life. Again, it may just be a founder with an idea which is pre seed or a pretty small team that's showing initial product market fit. What's remarkable, I think it's a real testament to our fund managers. We have over 4,500 companies in our portfolio since our inception and there are over 130 of them are unicorns, meaning that they're now valued over a billion dollars. And this is after 2022 and 23 when some of these companies were marked down. So today we have over 130. And that was all from the seed stage. And by the way, that would place us number three in the world for the number of unicorns. And you know, I think it is, it is very special that our fund managers are able to find these remarkable founders who probably don't even know that they're great themselves and being able to identify it. So it really is more about access and also being able to assess that founders ability to create something unique and you know, at the very earliest stages. Here's another way to look at it. Compared to the public equities, public equities, you kind of know there's a lot of transparency. So you kind of know how a company is doing. There's a lot of research reports, etc. You hear the management team at the very earliest stages of venture, you know, the other end of the continuum. It really is a people thing. It really is about assessing the person, the founder, whether they're going to be walking through walls to get their companies done and successful. And of course, you know, you have to care about what they're doing and what markets they're going to go after and how they're going to do it. But at the earliest Stages, it's really about the people.

How economically sensitive would you say seed investing is? Meaning is there a material risk in the vintage fund that you're investing in compared to, let's say something like more mature companies and private equity? Or is that less of a factor here because of the very long time horizon you have because you're very early.

In the company, it's kind of double edged. So like if you were a fund that invested your entire fund in 2021, which Inventure is viewed as a bubble year where evaluations were out of control, I think that fund will probably not do well. But the flip side of that, the other side of the coin is that you can never time technology innovation. It just happens. And so in a way you want to have exposure to venture consistently and not try to cherry pick certain years. And you know, you're ultimately betting on the fund manager to identify great companies and founders as I've described. But you know, does that happen next quarter? Does it happen next year? Does it happen the year after? You don't really know. And again, it also ties down to this power law concept where one company can completely drive returns. So there are times where we have fund managers who look like they have an okay portfolio and we're like, you know, they're okay, they're not great, and then suddenly one of their companies really breaks out and it becomes super valuable and suddenly our fund manager looks like a hero and is now one of our best performing fund managers. So in a way it is a long game. But you know, there are sort of little mini tactical things that one should not do, such as invest your entire fund in one year. I guess said differently, you want diversification. And I think what we offer is as a fund of funds, you know, we will have 20 to 30 core managers, we'll have 800 to 900 companies. We can talk a lot more about how we invest. But you know, we're also diversified by not only by count, but by geography, by sector, but also most importantly by vintage year. And what that means is our fund managers are investing over two to three years and we are investing in these funds over two to three years. So we actually capture five to six vintage years of companies. And so I think that kind of diversification is very important, especially because as you mentioned, Ventures is illiquid. It's a 10 year plus game. And unlike buying stock in Nvidia where you can just click the mouse and sell out of it, you can't really do that in venture. So you really need to have that diversification because to be honest, you're kind of stuck with that portfolio for a long time.

Yeah. And I guess you really want exposure to that market and recognizing that there.

Are a lot that fail.

The more diversified you are, the greater your odds of catching something that is like the next Uber or Google.

This is where I think we have done a good job and it's been something that we've done from the beginning. We want to be the lead investor in our portfolio funds. So what that means today is that we write 10 to 20 million dollars checks. We can be 20, 30, 40% of a portfolio fund's capital. So it's high conviction investing and we work very closely with our fund managers. Kelly can talk about how we engage with them, but it really is the fact that we are a very large investor in each of our portfolio funds. And as mentioned, each of those portfolio funds are getting relatively high ownership. So imagine where we're, let's say a third of a portfolio fund's capital and they own, to make the math easy, 9% of a company. So we are actually on a look through basis, we have 3% ownership in that company indirectly. And so contrast that to some another investor who puts, you know, smaller checks into these funds. Let's say they're like 5% of a fund's capital and that fund manager is just spraying and praying, meaning they're writing small checks into hundreds of companies. And let's say that fund manager owns, you know, I don't know, 1% of a company. So on a look through basis you're actually getting less than 0.5% ownership of a company. Contrast that to what I just described. We're owning 3% on a look through basis. So that's why I think we have a high conviction investing and that's why we look for fund managers that get relatively high ownership. Because each company amongst the 800, 900 companies in our portfolio can make an impact, especially if they're an outlier.

So let's say you have an investor who wants exposure to the seed market. Let's transition into how you can implement that. So you use a fund of funds approach. Many argue fund of funds are typically not attractive because of the multiple layers of fees. However, in seed it may make sense. I've heard you talk about an investor may be too large and they can only write significant checks, or they may be too small and they can't do proper due diligence. How do you think about a fund to fund structure from an investor standpoint?

I think over the years, when I started Sendana and was fundraising for it, a lot of questions were like, what is seed investing? Is this a real thing? And then I'd say about five years ago, we started hearing groups saying, hey, we can do this ourselves. We don't need you. We don't need to pay your fees. And then today we're actually hearing from a lot of investors. You're actually right. We don't have time on picking a few of these fund managers out of the 2,500 in the US or, you know, it turns out our venture portfolio, we actually is largely later stage because as I mentioned, you know, a firm like Andreessen, $7.7 billion fund, most of that capital is later stage, not earliest stages. So, you know, I think in general there's been a recognition that what we do is not easy and we provide a solution to someone who wants very early stage exposure. Again, you know, if you're a family office or an individual or even an institution, you can say, I'm going to build my own portfolio. And that's great, but is that the best use of your time? You know, venture probably is no more than 10%, 15% of an investor's total portfolio. Do you want to be spending an extraordinary amount of time focused on finding the best seed funds, or would it. Would you rather just outsource it? And we're very fortunate that a number of endowments and foundations and very large family offices have decided that we actually provide the better solution.

And I would add that, you know, we had previously spoken about persistence of returns and venture. And so by the time endowments and foundations and family offices are looking and have that data to say, okay, this is a manager I would like to get into. It becomes an access game, right? Do you have access to that manager? And there's underwriting capability. And so that's really where they focus their time and effort looking for the early funds. Where you don't have those proof points, it takes on average seven years for a company to really inflect. So as Michael just described, there's managers that may look okay, but hey, in two years, they're, they're, they could have the top performing fund because they had a company that became an incredible outlier. So I think these are all very early funds, when you're looking at the small seed stage, that have not become, you know, brand names yet. And so how do you catch these managers and how do you look for them? It's a different skill set than looking at funds and their performance and the typical underwriting. We live in San Francisco. Right. We have a partner in Boston, we have an associate in New York. We live in the geos of where there's the tech concentration. And we, our lives are ingrained in these networks and that's all we focus on is the early stage. And so the pattern recognition and our expertise is this area. And I, you know, I think we are a partner and Michael mentioned earlier how we work closely with our GPS. We work that same way with our LPs. So we work very closely with them if they are looking to build out a venture book. And we're very open and collaborative with them and look to be, you know, their trusted advisor and venture as well.

Yeah. So there's more alpha potential in this space in terms of allocating across managers because it's a different market. Relationships matter. Understanding it deeply and having the experience matters. So it's much easier to cover whatever that added layer of fees is relative to, let's say a fund of funds that invests in public markets.

Right. I mean, just to address the economic question, you know, we tell our LPs that we expect to generate funds 3 to 5x for them net of everything. And you know, the proof obviously is in the pudding. Our first fund is marked at 4x. Our second fund, which is younger, is marked at 3x. Our third fund, which is even younger, is marked at 2x. So we see that progression. And again, I think it really comes down to partly our picking, our pattern recognition, finding these amazing fund managers who are finding remarkable founders. But it also is a lot on our strategy, our investment approach. We want to be the largest investor in funds that get relatively high ownership. And I think that set of relationships translates, as I mentioned, into a look through ownership into companies that is very meaningful.

There's also another advantage of a fund to fund structure for seed. And that is you can get really well diversified. And we talked about in this area, the risk of going to zero is relatively high. So diversification is absolutely critical.

Yeah, I mean, just to address that, you know, imagine a continuum of risk and reward. So at one end of the continuum you have investing in one company. It may be the next Facebook. So high reward, but there's probably a 99.9% chance that that company doesn't do well. Imagine in the middle of that continuum, you have, you invest in one venture fund. So they might have 30, 35 companies. Again, power law, maybe one or two of them will be amazing outcomes. The rest probably won't. And. But you still are limited to 30, 35 shots on goal. And then at the other end of the continuum where we play as a fund of funds, as mentioned, we have 8 to 900 companies. So and diversified by, by time, by count, by geography, by sector. So you know, we would argue that, that that diversification means that we have substantially lower risk. But even with that lower risk, we are gunning for 3-5x and I would say that that's better than most venture firms.

Why don't we get into the way you pick managers? You referenced that a little bit earlier. So when investing in a fund, many investors often wait until Fund 3, 4 or later to see a track record. But you oftentimes invest in the first fund or the second fund. Would you talk through your philosophy around that?

So again back to the seed stage. The is about relationships, right? They're picking founders that do not know they're great themselves. Yet as Michael like to put really is the pull. We want to find people that pull founders. They're not out there having to push. We do want managers that have grit and are like walking through walls. But there's something about a manager taking the risk and starting their own firm that there's something unique about their career arc where that is the possible next step, right? Where they have the credibility in their networks to where they have enough opportunity to make a great this their next career choice. So it typically is, you know, I would say it's the seed stage. It's a different profile than you would get at later stages. At later stages there's more finance backgrounds, consultant backgrounds. But at early stage with the founder, the early stage founder, they tend to be ex operators or founders themselves. And so it really is that recency of experience that they're bringing into their fund one and two, right? They just left an operating role at a company they just left their startup they founded. And so there's a recency of experience in their networks that they're bringing to those funds 1 and 2. The other thing is, is it typically tends to be their smallest fund, right? So as they have proof of success and grow, their funds get larger and larger. And again we just think smaller funds outperform. So there's obviously that structural advantage. The other thing is if you look at their job again going back to it sourcing, right? Well, by the time you're on fund three or four, you are spending a lot of your time on supporting all of the companies that you had previously invested in. So now Instead of spending 70% of your time sourcing, you're now spending maybe 30% of your time sourcing. So we think it is a superpower of their time management in funds. One, two, of how they have a lot more time to be sourcing and then they have to switch and figure out how to scale their bandwidth around Fund 3 again, we go back to the recency of experience and the halo that comes around a founder, right? They're, they're a splashy founder and they start a fund. Well, by the six years later, there's a bunch of founders that are splashier than them, right. So how have they recreated their brand? You're having to recreate your networks and your credibility in your brand. And so at the earliest stages, we think there's something special about those funds one and two, where you've taken the risk in your career to leave a firm or a company that could be lucrative to start this and plant your flag. And we think that there's the credibility within your network that you'll be able to pull those founders and that people will want to work with you.

Yeah, Alex, let me describe this. One way that we think about what we have is a collection of networks. And so this again goes back to that phishing analog where we want groups to be fishing in certain ponds. And you know, I'll give you two examples. So one, we invested with Jack Altman. Jack is the founder of a company called Lattice. It's an HR software company doing over a hundred million of revenue. He was the founder and CEO. Company is valued at 3 billion. Most recently he decided that he was going to devote full time on investing. So he brought Sarah Franklin in, who was the president of Salesforce. She became the new CEO. So that should give you a sense of, you know, what, you know, the high quality company Lattice is. You know, Jack is a very well known operator. A lot of startup people want to work with him and he doesn't generally lead with this. But by the way, he's Sam Altman's brother, so very tied into the OpenAI and AI worlds. And so that's a special advantage that Jack has. He has great domain expertise. He's a super nice guy. Founders want to work with him. So that sort of hopefully describes the pool that, that a GP could have with founders, as Kelly described. Another example is a guy named Dita Van Loemen, you know, Dutch guy living here in San Francisco. He was employee 27 at Stripe. He was the first head of Stripe International. And going back to my comment about how we view what we have as a collection of networks, you know, we realized that we didn't really have anyone from the Stripe world. And similar to like PayPal and how all these different individuals left PayPal and started their own companies or own firms, we thought stripe is a very important part of the venture and technology ecosystem and landscape. And so we wanted to have someone who had amazing access to people who are leaving Stripe. And oh, by the way, he was also the co founder of a company called Commir, which most recently was valued at 6 billion. And so he has the operating experience not only at Stripe but also starting his own startup. And so you can imagine someone like that, you know, founders want to work with him, founders come to him. And so venture is hard, but if you have the right access and you have the right pool, I think you have a higher probability of succeeding. Now Kelly made a very good point about shelf life. You know, you could have the best operating experience, you could have the best networks, but you know, five years from now those are going to be stale. The operating experience and networks have a shelf life. So we also look specifically for fund managers who have that hustle. They are trying to build their firms, it's their own startup and, and they want to build market positions, they want to build brand recognition, they want founders to know that they're relevant. And you know, I think that's sort of the extra special sauce that we look for in fund managers. Not only their operating experience, not only their networks, but actually how much hustle do they have? Are they just relying, sitting back, waiting for people to email them or are they actively going out and looking for new opportunities?

I suppose that's another reason to focus on 1 and 2 fund, 1 and 2, because you come in, you have a great network, that's the low hanging fruit. Those are the first people you're going to call. And unless you can keep repeating that, that network and grow that network with time, your later funds, not only are they bigger, but it's harder to access some of the best opportunities.

That's right. And that's actually why larger funds, they bring on new partners because they're trying to bring in new networks to their own mix. And you know, there's another sort of risk around that. When you know, venture funds are over 10 years long, that's longer than the average U.S. marriage. Right. And so you know, when you partner up with someone, you're in it for 10 plus years at minimum. And that's why we think partnership risk is actually one of the bigger risks with these smaller funds because they are fragile, they're startups and you know Adding a new person to the mix can, can create different dynamics that sometimes aren't, aren't, aren't helpful.

When you're looking for newer funds, you're betting on the people more so than their performance, track record. And one of the intangibles I've heard you talk about, you just mentioned some now, but one that I've heard you talk about that I think is really interesting is you look for people who are actually nice to work with. Would you elaborate on that?

Yeah, this was something that Kelly wanted called out because actually I'll let her describe it, but you know, she, Kelly joined in January of 2018, started taking a lot of meetings with us and especially with our existing fund managers. And I think one thing that she remarked one day was, you know, all of your fund managers are super nice. There is a strategic reason for that. So I'll, I'll let Kelly describe that.

We talked about how venture is fun and sexy, but I do think it can be competitive and cutthroat at the later stages. Again, at the early stage, you're dealing with founders that are going from zero to one. There is no success or proof points that they're holding on to. Right. They are fighting day to day to make this company work. And so I think it's really important that the manager has the empathy and the strength to understand how to navigate those interpersonal relationships and has the EQ of when to press a founder, how to work with them, where their drive is and be that cheerleader, mentor, support and helping the business continue. Right. They're looking for founders with grit as well. Right. Hopefully every founder has that grit that can carry it through. But there's going to be hiccups and nothing goes linear up in venture. And so we really look for managers that have that EQ and personality that can support and I think Michael had been doing that. Again, I go back to the events and like why I joined Sandana. It was very notable that these people are all very collaborative and helpful to each other. And I think it's that pay it forward thing. If you are helping each other in return, you're going to be remembered and you know, will hopefully get returns through the same collaboration you provided other people. So, you know, it is, as Michael mentioned, a 10 year marriage that we're making with GPS when we sign up to work with them. And so we want to work with nice people. But more than anything founders, it goes back to that reputation with founders. If, if you wrong a founder or do not live up to your expectations or harm, with your words, a founder. That's going to go a long way for reputation and having access to deals.

Michael, you started the firm over a decade ago. How is your selection of managers and funds in which to invest evolved as you've grown and learned over time?

I mean, two things have remained constant. It's that we want to be the lead investor and fund managers that are getting outsized ownership now. The world has changed and it's a much more competitive space. What we were looking at as seed funds, you know, over 10 years ago today would be probably viewed as pre seed. And what I mean by that is, you know, 10 years ago, the seed round was one and a half million dollars at a $10 million valuation. Today, that's actually what precede funds are looking at one and a half million dollars at a $10 million valuation. Basically, the seed rounds have gotten bigger. So as I mentioned, you know, the average seed round in our portfolio now is 4 million. And basically a seed round is supposed to provide 18 to 24 months of Runway. And so you got to wonder, why has that number doubled? Why has it gone from, you know, a little bit under 2 million to over 4 million today? You know, I think it basically is because of costs. I think it's, it's, it costs more to hire people. If you think about like a developer that you want to hire, they may be, you know, offered $500,000 by Salesforce or Google or whomever to work for them in a cushy, comfortable corporate life versus taking that leap and working for a startup, which might end up being a zero for substantially lower cash comp. But, you know, I think what's driven the history of venture and innovation is sort of the equity ownership. So, you know, employees get stock options. Those can become ultimately very, very valuable. I just read the story where, you know, Facebook, when they were private, they hired this muralist to draw a mural on their wall. Instead of paying them cash, they gave them stock. That stock, which the muralist apparently held on, is worth 200 million. So you hear stories like that, but ultimately, and those are obviously outliers, but you know, I think it's important to recognize that, you know, ownership is important and it has, that costs have increased in venture for a startup. And so that's why we're seeing larger and larger seed funds, which we have a negative reaction to. So I'd say that's been sort of the, the, the changes over the past 10 years since I started Sandana. Actually at one point in 2021, we saw a lot of tourist fund managers. And what I mean by that is that, you know, someone comes to us and says, hey, my friend started a fund, I'm going to start one too. And I think that the tourists have been flushed out, but yet, you know, there's still a lot of seed funds out there, a lot of pre seed funds out there. And so our job is to find the absolute best ones, the ones that have the most amazing access. And then the, as Kelly mentioned, the credibility to write the check size that we think that they should be writing.

And as later funds are launched with success of prior funds, are there any warning signs that you haven't talked about yet that you look out for when deciding not to re up with the manager with the next fund?

I mean partnership risk is one. But I think the other main thing for us is that a number of our existing fund managers have gotten larger and larger and you know, we just think that it's going to be harder for them to generate a 10x fund return with a larger fund. You know, with a larger fund you need larger exits. And you know, over the next 10 years, you know, are we expecting a number of multi billion dollar exits? Probably not. And that's why as mentioned earlier, you know, we want, we want to be investing in funds that can still generate meaningful returns with very modest exits. So I think fund size is the enemy of returns. I think fund size determines fund strategy and our focus is on smaller funds. Funds. 1, 2, 3. We have a number of great fund managers who are raising fund 8 and 9. They're going to be raising 200 to 300 million. It's just no longer a fit for us. And so what we've been doing and we haven't talked about this, is that, or actually Kelly touched on it, we're very collaborative with our LPs. We want our LPs to invest in our portfolio of funds. And so we actively introduce our LPs to these fund managers and they can go in directly. So I think we continue on that relationship but in a different way.

Would you comment on the perspective that many feel to do well in seed or venture, you just need access to the top tier funds and everybody knows who they are and it's really hard to access them. Is that an accurate statement or is that more of a myth?

Again, there is persistence of return of venture. So I will acknowledge that if you look at the top performing funds ever, they're going to be smaller funds than those managers have. Again, their funds look very different. The platform funds size looks Very different. And we can look in our own portfolio and we have managers. One manager has a 200x fund. That would never happen at a billion plus dollar platform fund of where you're trying to gain access to. So I think if we look at the returns that our managers have been able to generate and the DPI that they've been able to have, getting over 10x is very difficult on larger funds. So you know, I don't think it's just an access game at the later stage. I think again the returns are where we focus at the early stage.

And dollar funds, I mean, just to emphasize that we've had university endowments come to us and say, hey, we have a great portfolio of venture funds, all the top tier ones that you can imagine. But when we actually analyze where they're investing and where the dollars are going, it's much later stage. And so the there, I think more and more institutional LPs are recognizing that they don't have very early stage venture exposure. And you know, I think we're a very good way of providing that foundational investment and access to the very early stage. And then the question becomes, well, you know, there are probably like the top tier seed funds and we are going to go access them and you know, an investor might, might think that it is hard to get into them. You know, we have a number of fund managers where they are way oversubscribed as a lead investor. We actually sit with them, go through their list of other LPs, what the allocations they want, and together with the fund manager, we pick the allocation that others are getting. Now we don't do that in every case. But I just wanted to give that example where we work closely with our fund managers. We're their trusted advisor and we actually help with allocation. So of course, if there's a Sandana LP who wants to get in that fund, we make sure that that happens. And so, you know, but in contrast, you know, if you're starting off building up a new portfolio of seed funds, you know, you can do that. There are 2500 out there. You can pick like 8 or 10. And the real question is, will those funds outperform, say what? We could build a portfolio for you. And our sense is that we've been doing this for over 12 years. We know what we like. We look, we have our own sort of reputation. As Kelly described, you know, great fund managers have pool, you know, founders want to work with them. I would say that because, because this is all we do and this is, you know, Our focus, we have the same kind of pool with fund managers. So the top of our funnel in terms of new fund managers coming to pitch us is very full. And I would go far as far to say is that if we were to be an LP in a, in a new fund, that's a strong signal to other LPs. And so we have many, many examples of where we were the first to commit to a portfolio, to a new portfolio fund and that, and we actively brought in LPs as well as help facilitate their fundraising. And so it's been hard, but over the last 12 years, we, we've built up a very strong market position in brand recognition.

You have a relatively unique portfolio construction process. You've touched on some of the points so far, focus on smaller funds and you've described why. You also emphasized writing large checks as a percentage of the total fund. Would you talk a little bit more about that and also how you think about diversification when you're writing, you know, large, large checks.

I also want to address another thing. Historically, venture capital funded funds would just simply re up with their existing managers. And so I wanted to have something that was completely opposite of that. So we, we, we think that we have a fresh portfolio. And what I mean by that is we, we also, in addition to our, our large checks, you know, we, we've been historically writing $1 million checks, which we call pilot. And those are to groups that we really like, but we still have some question about their geography or the sector they're going after. And then a few years ago, we started a program called Nano where we were writing 20% checks. So like $20 million fund, we'd write 4 million, really to go after these sub $20 million funds, these tiny, tiny funds. And in a way, both of those serve as on ramps to potentially becoming a core position. So in each one of our funded funds, we have new names, we have a number of new names, and we, we moderate that by the check sizes we're writing and we get to work with those fund managers over a fund cycle. And ultimately if they decide to become a bigger fund, you know, we, we can make that evaluation of whether we should write, you know, write them a $15 million check. So the bulk of our capital is going toward our core managers. But we do have these smaller checks that we use, I guess as Kelly would call them discovery checks. And being able to uncover new fund managers that we still have questions about, but you know, can be, can serve as an on ramp to be becoming ultimately a core position for Us.

And how do you think about diversification as you're writing the larger checks?

I think that we are diversified by the number of underlying companies. Right. So we have enough, you know, we have enough managers in the portfolio. But as Michael described earlier, we want to be a big enough percentage of the fund so that the underlying company is meaningful to our fund. So on a look through basis we have, you know, 700 to 900 companies in that fund, but there's enough ownership in the company itself to where it matters. So, you know, it is high conviction investing. We don't want to be allocating to a bunch of managers that we aren't totally convicted on it really. We want to keep it small enough to where the, our bar is high. And so we have a high conviction strategy of where we're writing a meaningful large check to the underlying manager.

And obviously that feeds into this ecosystem that you're building. And you've talked about the importance of building partnerships between you and the managers and the managers with the founders. Would you expand on that ecosystem, the Sandana ecosystem that you're continually developing and evolving?

I would say that in a number of cases we have fund managers who have invested together into a specific company. And when we did the analysis, those companies tend to be outperformers in our portfolio. So we actually encourage multiple fund managers of ours to go into companies. We help facilitate that. So like if there's a fund, if there's a fund manager that's looking at say a supply chain and logistics company, we can introduce them to our supply chain and logistics fund manager. And so, you know, we're actively being the human router where we're trying to connect relevant people together in order so that they can look at things. One thing that we did in our current set of funds was to bring on some strategic LPs. And so these include venture firms, later stage firms, secondary firms, and in each, each of those cases we are doing monthly calls with them and where relevant, we are showing them companies that are coming up for funding. And in a number of cases they've actually invested in the companies that we've made introductions to. And that's helpful to our fund managers and obviously helpful to the underlying portfolio companies. And it's helpful to our strategic partners because they're getting access to a differentiated set of deal flow.

Yeah, I think an important thing was since Michael was first to this space, he's always been the largest lp, but really a trusted advisor more than an LPAC seat. And we take that very seriously of wanting to Add value and help the managers. Because again, these are companies they're starting, they just have to happen to be investing. So we view ourselves as the lead investor and how, how we can help them. And so through that we have a Slack channel for all of our gps to, so they can ask each other questions directly. We facilitate experts coming on a monthly basis to speak to the entire group. We call it a monthly Noon Zoom. But I think a really important part of how we work with our managers is we do a 30 minute standing monthly call with each of them individually. So it's a no agenda call. It's meant for them to come to us with questions or things that they're working on. And hopefully we get intel on how the portfolio is progressing as well, which we do. But I think it's important. It's, you know, if they're thinking about hiring, what are comps in the industry, which other firms have hired for this role, how do they go about it, what has worked, what hasn't worked with adding this type of person to the team or if they are having an exit, how much should they keep and recycle and reinvest in the fund and how much should they distribute to LPs? So we want to be that thought partner with them on their investing, on their firm building. And so we want to be a text if they have a question away. So we want to be that first call and we really think we foster that relationship. So through that we always look for ways that we can add value to the group, to individual managers. And as Michael mentioned, the most recent form of that has been strategic LPs live events. I mean, as much as we do so much on Zoom now, there's really no substitute for the in person connections and serendipity that can happen in live events. So we try to host a number of live events around specific themes or the geos for our managers.

And that ecosystem has a virtual cycle because the more you do it, the more you learn best practices from the best performing managers, the more you can share that with other managers. And this is in a world where most LPs, limited partners who invest in a fund are passive investors. They're not really adding a lot of value other than just providing capital. So you make yourself a very valuable partner, which helps with access in the future and credibility even with those that you're not working with today, is that right?

Exactly. We're just very proactive with our LPs and our GPS. We want really to accelerate serendipity, you know, and I think that's hard to do if you're an investor that's not located in a venture ecosystem. I think it's hard if you're also very passive and just showing up to the annual meeting once a year. We're the opposite of that. We're constantly working on facilitating relationships. And in fact, last year we hired a director of Platform and operations, Hillary Tyre. And Hillary came from SVB where she was actually doing just that. And she was very plug and play in that. She knows all of our fund managers already and you know, she's on point to help fostering closer ties between our fund managers. And she's on all of our monthly calls with our fund managers and actively, you know, arranging meetings between them or with our strategic LPs and helping organize events, et cetera. So I think a lot of that is heavy lifting, but it's very worthwhile. And we, again, we have the data. You know, in a portfolio company that has multiple fund managers of ours, they tend to outperform at least by 1x.

Yep, 1x higher.

Yeah, 1x higher.

So obviously to keep your success going, you have a relatively high turnover of managers as they grow with success and they move on from the C level and their funds get larger. Do you need a large team to track, oversee and truly maintain expertise in C level managers?

It's a very good question. You know, when you think about like someone like Yale University's endowment, they're in New Haven, right? They're not, they don't have offices around the world, they don't have teams around the world. I think, you know, we have, where we punch above our weight. We're a team of nine. And I think, you know, that's buttressed and fortified by the fact that we do this is all we do. We focus on seed and precede. And so that is, as I mentioned, I think we do have strong brand awareness and market position. So the top of our funnel really isn't an issue. And we, we have a specific set of characteristics that we look for in fund managers and their portfolio constructions. You know, I mentioned 2500 seed funds. I would say 90, 90% of them are spray and pray. They're writing 250k checks. They're getting maybe 1%. That's not what we're looking for. So then, you know, we, we filter down to a subset of that 2500 that we really focus on now. They're always newer names coming out, so that makes our job exciting. But there is a certain, there is a certain set of characteristics that we look for. And I think that serves us very well partly to help mitigate our time management in that we're not meeting every single fund manager, we're meeting every single fund manager that could be a fit for us. So I think that's an important distinction. And you know, could we always use a little bit extra help? The answer is yes, but I think we have the flywheel spinning. You know, we have a number of fund managers who are sending us opportunities. You know, they might be working with them on a company as a co investor. They'll be like, hey Kelly, this is, this is a, this is a person that we really like. You should take a look. They're raising a new fund. We have our LPs, you know, they come across a lot of interesting opportunities and they send them our way. So I think, you know, through our LPs, our fund managers, we have a great advisory board of venture capitalists and people in the industry, we, we're getting a lot of interesting referrals. And so our job is to process through that. And again, it really helps us that we have sort of a defined set of characteristics that we're looking for.

I think there's a certain taste and so you can't spray the team too broadly without knowing the taste that we have in managers. But I would also add that, you know, we've spent a lot of effort on the data side and so as that data side expands, it's just easy for us to benchmark a new manager's prior track record. So we invest in first time fund managers, but not first time investors. There's always some type of angel track record, prior track record from a different firm to look at. And so we can easily benchmark that against our own portfolio and filter if they're fintech. Right. If they're focusing only on fintech, we can filter our entire portfolio for how it's looked every single vintage in fintech. And so I think utilizing the data and focusing on data also really supports our investment process and our investment team. And so I think that's been a big focus for us as well.

Would you talk about the ultimate exit? Has the landscape materially changed recently as we've gone from a period, almost three or four decades of either falling interest rates or zero interest rates to an environment or regime that's potentially higher for longer?

I mean, I think it's pretty clear that the IPO window is closed for the most part. So it's going to be difficult for companies who have the throw weight to be able to go public. But also quite frankly, a lot of later stage venture backed companies don't want to go public anytime soon. They've been staying private longer. And so people talk about this one example where Amazon went public in 1997 or 8 or sorry, 1999 and their market cap was 430 million. And so much of the value appreciation was attributed to actually public equity holders of their stock. Now today, you know, using Uber as an example, Uber stayed private until they were worth over 60 billion and, and then now they've gone public. There's been some appreciation for the public equity holders, but much of the value appreciation was held, was, was accrued to the private investors. So you have companies staying private longer like Data Bricks or like Stripe or companies like that. Now when you look at acquisitions, and this goes back to my old Morgan Stanley days, you know, Cisco acquired over 120 companies in the late 90s and that was basically outsourcing their R and D. They were acquiring interesting technology to help build their growth story. And we still see that although the regulatory environment right now with antitrust is very difficult. You see very large transactions kind of on hold or actually rejected by the FTC or the European Union. The example there is for example, Adobe trying to acquire figma for 20 billion and that ultimately got called off. So I'd say that the regulatory environment right now is a bit difficult for these large acquisitions. But you know, where I think we really benefit is that our fund managers can do secondaries. So what that means is that our fund manager can offer their shares or some of their shares to a new buyer. And that new buyer, they negotiate the price, they, they can buy, you know, 10, 20% of our fund manager's position that may actually return a material part of our fund manager's entire fund. And you know, in April, one of our fund managers had a company that most recently was valued at 11 billion. He sold, you know, 15% of his position in that company and returned half his fund. So, you know, I think there's greater degrees of freedom that early stage investors have with regard to secondaries. And I think we've been seeing that over the past five to eight years. I think we're going to see a lot more of it as the sort of public options have become a bit more difficult and also large acquisitions have become more difficult.

I'd love to hear some of your thoughts about the market outlook. You've zoomed in a little bit on some of the underlying companies in which the fund managers may invest. Are there any key Themes that stand out in terms of what looks very promising, looking forward.

I think when you look at what the key themes were and what the hype were, it never lines up with what the actual company that started that year. So typically once it's become a key theme, a company was founded three to five years ago, focusing on that and that becomes the winner. You know, we can talk about the sharing economy becoming big. You know, Airbnb and Uber were started years before that actually became a thing. So we were looked for managers who can see around corners is how we put it. So we don't know what the big themes are quite yet. But that being said, I think things that are interesting currently, you know, real world problems, so deep tech, hard tech are interesting. There's a lot more money going to those themes. I think health tech can be interesting. And vertical SaaS, because again, talking about where AI can be applied, it really is these vertical SaaS, applications and industries where the expert matters, the domain expertise matters as much as the technology being applied. And so I think those are interesting at this stage in the market.

What would you say is your overall outlook for seed and venture over the next few years?

Well, I think it's a return to normalcy. And what I mean BY that is 2021 and the first half of 22 were kind of bubbles. Valuations were out of control, the pace of investing was out of control. And I think we're beyond that now. You know, NASDAQ fell 33% in 2022. It was up 33% in 2023. And you know, we're basically at all time highs now. But that's really been driven by a handful of names, Nvidia, et cetera. In venture, what a return to normalcy means is that there's been greater discipline around valuations. And ultimately at the early stage, valuation is driven by how much are you raising and how much is the founder willing to give up. We would look in our data and the historic amount of dilution, you know, how much the founder wants to give up is ranged from 20 to 25% for that, for that round. And today the average seed round in our portfolio is 4 million on a $16 million valuation. So 20 million post. So 4 million is basically 20% dilution. Right. The founder is giving up 20% of his company or her company for that 4 million. But back in the bubble days in 21 and 22, that dilution fell down to 15%. And so that meant that founders had all the power because so many people were chasing after them and now I think the pendulum has shifted. The pricing power has gone back to the VCs and away from the founders. And I think in my mind that's, that's normal. I think we feel that, that valuations are, are. If you extrapolate where 20, 18, 19, 20 were and ignore 21 and 22, it's sort of exactly where it should be. The bigger question of course is yeah, of course you can get your seed stage companies funded. How about the next round? And so that's the Series a, those are 10 to $15 million rounds and say 50, $60 million valuations. These are done by multi stage firms. What's that market look like? I would say in the last six months, you know, our fund managers have been reporting that more and more of their companies that are coming up for Series A are actually raising very strong Series A's. They're raising top of the range and that's a little bit different than what they were reporting last year. So that's, that's very promising. Ultimately it's a question of how much dry powder, meaning how much unused capital is on the sidelines and how willing those multi stage firms are to writing checks into these new rounds. And we're starting to see that I would say that the next round after Series A, which Series B, is actually still a hard market because by the time a company's at Series B, they can't be waving their hands around describing their vision and their, their dreams and their, their future. They actually have to be a real company. And so you know, the economic environment has been more muted for software companies because you know, if, if a company lays off 10,000 people, that's 10,000 Salesforce licenses that went out the door. And so you know, I think companies, the larger enterprises are less likely to try new product solutions from startups. And so that's made a bit more difficult for, for startups to get that revenue traction they're looking for. But you know, venture is hard and ultimately we're looking for fund managers who find those remarkable founders who will walk through walls, who have created products that people will buy.

I would say for this era of seed, the lean startup was the book and big Trend Back in 2011, you know, when Michael founded Sandana and that kind of as all the platforms raised more and more money as Softbank etc came in with these mega funds that went out the window, right? Those philosophies on how to build capital efficient businesses, how to get to product market fit with the correct experimentation and building the right Talented teams that went out the window of just raise as much money and throw money at the problem and buy bad revenue. And I think with constrained capital, it'll make more efficient, better businesses. And you know, we focus at seed where we don't want to be diluted down a ton. We don't need, you know, our managers aren't investing that huge amount of capital or needing to put out a huge amount of capital into these companies. So I think it's a better environment for seed. And you know, we've touched on AI, but I think it's to be seen how it can really accelerate the zero to one. So, you know, 40 plus percent of the code written on GitHub is written by Microsoft Copilot. So it's written by AI, not the coders themselves, developers themselves. And so if you think that efficiency is happening on open source, like what can happen internally with these companies and I think the tools, we really haven't seen the efficiencies yet, but I think that's something that you should be able to see. And this and these next vintages of starting a company is efficiencies being able to be seen in house and building products because the AI can help them.

Yeah, that's an open question that we have right now is if AI is going to add productivity to developers. You know, you push a button, it does all your code for you in one second. Do you need less developers? Do startups need less capital because they get so much more out of using AI solutions with the, the, a handful of developers they have, we haven't seen that yet, you know, but it'll be interesting to see over the next few years whether, well, certainly developers will become more effective and productive. But the question is, will startups show some discipline around hiring people like that and are they still going to throw bodies at the problem?

There's been a noticeable trend of funds getting bigger and bigger. Is this in your view, sustainable while delivering high multiples for investors, or is this another cycle that will ultimately revert?

I mentioned that size is the enemy of returns and that fund size determines fund strategy. And as funds get bigger, you know, I'll give you an example. So, you know, let's say a $60 million seed fund owns 15% of a company. It sells for $100 million. They get 15 million back, that's 25% of their fund. Imagine a $400 million fund that owned 20% of that company, sells for 100 million, they get 20 million back, 20 million back to a $400 million fund is 5% of their total fund. And so these larger funds need much larger exits. And again it's power loss. So maybe some of these funds will be able to find amazing exits. And let's say they find a $10 billion exit and they own 20% of that company, you know, they're going to get 2 billion back and let's say their fund is 2 billion. So with a $10 billion exit, they just return one times their fund. Now I think, you know, there's rational economic reasons that these firms are getting bigger. It allows them, for example, to invest in LLM companies, you know, like the open eyes and anthropics of the world where they are raising billions of dollars. But you know, ultimately I think it's going to be a very difficult world where these funds are going to be generating 3 to 5x, you know. But, but, but economically let's, to use just a specific example, let's say you know, you have a billion dollar fund and you get a 2x on that. So you made a billion dollar profit and your carry is 20%. That's the percentage that the fund manager gets to keep. So they're getting $200 million, right. 20% of the billion dollar gain. That's pretty good even on a 2x. But let's say you're a hundred million dollar fund and you got a 10X, so you made 900 million of gain and you get 20%. That's 180 million of carry. So the larger fund that gets a average, you know, a below average 2x return, they're actually getting more in carry than that fund manager that generated a 10x return. So that's actually what, and then that, that doesn't even address management fees. Right. $1 billion fund is getting 20 million of management fees alone times 10 years. That's $200 million of management fees. So there are economic reasons that fund managers have gotten bigger. You know, I think the legitimate reasons is so that they can go after these larger opportunities. But from an investor perspective, I think it's going to be more difficult to expect, you know, anything better than a 2x from these multi billion dollar funds. So you know, that's why we don't focus on those, we focus on these tiny little funds, sub 100 million. We're 20 to 50% of their capital. We want them to get 10xs. And we, we and our investors do very well.

Yeah, we didn't spend a lot of time on fees, but to me we, I always go back to what business are you in, you know, when I'm talking to a manager, because we're underwriting managers as well, I always ask myself, what business are they in? And in. And I think of it as a continuum. On one end, business of generating returns for the clients and on the other end, business of gathering assets and charging the highest fees and maybe the largest carry $$ wise. And everybody will tell you they're in the business of generating returns, but their actions may not support that narrative. And, and I, and I could see the example that you just gave. You could see why there's financial incentives to get bigger and bigger and bigger. But the clients should be thinking about the returns, that's what they earn, not the fees that the managers are charging. So you do have that inherent conflict in the industry. And, and I guess that all goes back to why you focus on smaller funds.

Yes, absolutely.

We've had a pretty massive regime change from low rates to higher rates and that may permanently have an impact on this market segment. Or do you feel like the results are far more dependent on how well the founders execute on their business plan? Or is it a combination of both?

You know, and also presumably rates will come down, but no one knows when or by how much. Ultimately, I don't think we're going to be in a ZIRP era ever again. I think that's, I can say that with high confidence. But you know, the real question from an investor's perspective is am I, what kind of return am I getting risk free, right? U.S. treasuries versus what kind of return will I get from a very illiquid investment in venture? And I think venture long term, if you look at sort of like the Cambridge associates benchmarks, over 20 years, you know, has generated somewhere around 20 plus percent net IRRs. So that's annually that still is higher than public equities, certainly higher than fixed income. And you know, I think the real question is if you're deciding whether to do venture, you need to have, you need to have sort of a longer term horizon. And because ultimately if you're in with the right managers, you can generate those 20% net IRRs. That's what our funds are that our first few funds, our oldest funds are in the 20s. So you know, I think, but I can see from an investor's perspective risk free being relatively high versus the unknown of being an illiquid strategy like venture, you know, there's a trade off and you know, that really came home to us. Kelly and I were in Brazil two years ago and there are not many Very, not many very active Brazilian LPs in venture and partly because their local risk free rate was in the, you know, like 15%. So why bother investing in venture when you're getting risk free 15%. And oh, by the way, you don't have to deal with the US dollar currency fluctuation. So you know, it is a real thing, there's no doubt about that. And you know, I think as the markets were coming down in 22, you know, investors had a denominator effect, meaning their allocation in public equities was shrinking and then suddenly their private allocations were over the range, over the top of their range. I think that's corrected now because we are at market high equity highs. So, you know, you can argue almost that some of these institutional investors are actually underweight the private market portfolio exposure that they're looking for. And that doesn't even get into a number of new sources of capital like the Middle east sovereign wealth funds. They all want to be active in US venture. Callie and I were in Singapore a few weeks ago. There's been over the last five years, almost 2 trillion of $2 trillion of capital coming from Hong Kong family offices to Singapore. And they are all looking for U.S. venture. So fundamentally there are newer sources of capital that will drive U.S. venture. The real question of course is will U.S. fund managers accept that source of capital? For a variety of reasons, they may not, but it really is a trade off between the risk free rate and what venture can offer as a very illiquid asset class.

This has been great. You've been very generous with your time. I'm going to end with a question on AI because that's the hot topic today. So when we look at this market segment, should the focus be on companies that are learning to use AI to operate more efficiently and compete, or is it more about the companies involved in building the AI infrastructure that other businesses will need to add to their platform to grow?

Yeah, I mean, AI, obviously, I think, you know, let's just start off by contrasting that with cryptocurrency. You know, if you took the average person off the street and say name 10 use cases for AI, they can probably give you 20. If you took the average person off the street and say, what do you use web3 or crypto for? They probably couldn't give you more than one. So, you know, it definitely permeates the popular imagination people get, you know, play around with it. Right. And that's why ChatGPT3, when it came out in November of 22, was an amazing thing. It opened the eyes to so many people. I mean, even my mother was just asking me what AI is, and she called it a one. She's like, what is a one? What is a one? And we're like, that's a steak sauce. But you know, if my mother is talking about AI, then, you know, I think it's permeated the popular culture from an investment perspective. You know, we have three buckets in AI. We have like the LLMs, those are like the OpenAI's. That's where the big boys play, that's where corporates like Microsoft are putting $13 billion, etc. You have the software infrastructure space, which is what I think you were talking about. And we do have fund managers who are specifically focused on software infrastructure. That could be developer Ops, you know, DevOps, could be developer tools, could be crypto, it could be data inspection, etc. And so we have a lot of fund managers focused on that. And then the last layer is the application layer, you know, what people touch. So you have consumer apps, you also have enterprise apps. And our fund managers typically focus on enterprise, so they are seeing a lot of these vertical software plays, like HR software, et cetera, where AI is being used to enhance efficiency and productivity. So I would say that software infrastructure, but more on application and definitely not LLMs.

Yeah. So in other words, AI is everywhere.

It's everywhere.

This was great. Michael Kelly, I appreciate you taking the time and sharing your insights with us.

Absolutely. It's great. A lot of really good, thoughtful questions.

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