Episode #22: Secondaries Across Venture, Stripe's Tender Offer, Knowing How Much Is Too Much Money

When you only have a million dollars, you can only work on a couple of things with a couple of people. And the pat answer to a lot of things is we can't afford to do that. And I'm a big believer that constraints.

Breed creativity it's the week of March 3rd. Welcome to the Learning Corner Precursor Ventures Podcast.

Welcome to the Learning Corner by Precursor. I'm Mia Farnam and I'm joined by our GP and Managing partner Charles Hudson, where we will be talking through the articles and Goodreads that caught our TE attention over the past week. Our first topic Strictly VC's latest podcast featuring Chris Farmer, founder of Signal Fire, to discuss how venture capital is facing a fundamental mismatch between fund structures, capital cycles and the long term nature of building great companies. He pointed out that while the best performing startups are taking longer than ever to reach meaningful liquidity, most venture funds still operate on a 10 year life cycle that hasn't evolved to match this reality. This misalignment has made secondaries a more important, though still inefficient tool for providing liquidity, with private to private stock sales gaining traction but often at a deep discount. Farmer also emphasized that venture firms need to take a more active role in capital markets, helping founders plan for M and A structured secondaries or alternative exits rather than relying solely on the IPO market. On the AI side, he argued that owning proprietary, continuously trained data is the only true long term moat as purchasing third party data sets won't provide a lasting competitive advantage. So Chris talked about how early stage investors now play a bigger role in shaping a startup's long term exit strategy. Instead of just writing checks, they can help founders line up strategic investors, set the stage for M and A, or even start conversations with private equity firms for companies nearing profitability. So how do you, Charles, think about this specific concept as it pertains to Precursor land?

I feel like last week was liquidity week. I don't know, there must have been something in the VC water cooler that had everybody thinking about. I think a lot of the things that Chris said are right and one of the things I've been thinking about and I don't have all the answers to this yet is I think for a long time as a venture capitalist, the relationships that were valuable to have were with the strategic acquirers in your category. So you know the big tech companies. Knowing all the corp dev and product leaders at those places was important if you wanted to get your companies acquired. Also having relationships with other venture firms that could fund those companies and To a lesser extent, if you were really playing the long game, having relationships with investment bankers who could eventually take your companies public, and I think with fewer IPOs and less M and A, those sort of relationships are less valuable. If I could wave a magic wand, I'd love to have more, stronger, deeper relationships with private equity buyers or even growth equity minority stake buyers. I think the people who provide liquidity for venture capitalists, it's going to switch and my sense is it's going to be less about M and A&IPO and more about secondaries and PE led buyouts and rollups. And we're going to end up selling to people who will probably continue to operate these businesses, whether it's selling to the next set of shareholders that come in. And look, I think there's one thing that private equity figured out that we don't do in venture. Private equity will sell a whole company to another private equity firm. And I think that's partially easier when you have controlled transactions, when you already control the company. But venture capital has historically been a minority ownership position business. So you don't actually own enough of the company in most cases to dictate a total sale. You're selling a portion of your stake, which is often small. Some of the things that Chris talked about, I think there will be an increase in the level of sophistication in venture when it comes to selling. And I do think he hinted at this. Our industry is going to become more involved in manufacturing and generating liquidity. I think he mentioned a mid aughts position that he's still in and it's 20, 25, you're going to be in these things, left to the company's own devices for 15 to possibly 20 years. The thing he didn't mention is I don't think most VCs are going to go back to their LPs and say, hey, you know this 10 year closed end fund that we've talked about with extensions, why don't you turn this into a 15 year vehicle? I don't think most LPs want to give most VCs 15 years without having to have a conversation regularly about should we continue to do this or should you work harder to find liquidity and give me the rest of my money back? I think venture capitalists are going to begin to manage their own portfolios more aggressively towards liquidity. Just being mindful of the fact that holding to maturity just takes longer than maybe some of their investors want this.

Kind of heavier hand for helping companies reach exit for a Portfolio of our size feels like a lot of back and forth and managing of communication. So how do you think about it as it pertains to our fund?

I think for us we have like a different problem than other people. We have a lot of companies where we have a small to medium sized ownership position and we're not on the board. So I think in many cases these liquidity decisions will be done in consultation with the board. The good news is if you're on the board, you'll see these things coming from a mile away. The bad news is you'll have to deal with all the complexities of making these things happen. And the challenge for smaller funds will be how do you make sure you're included and you take advantage of those, have less information than other people will. I think the other thing that's going to become interesting is, you know, we've spent 20 years talking about being founder friendly and being in it for the long run. Well, founders are already doing meaningful secondary in many companies that achieve scale and early stage VCs are as well. Some of the later stage folks and the bigger holders aren't because they're on the board or because they feel like it's really not their business model. And I think it's going to be interesting when we're in a world where everybody recognizes that everybody on the cap table might be a seller at some point and that probably nobody other than maybe some of the lead investors is likely to hold the majority of their position until the sale. I think it's going to create a different dynamic and a different set of conversations and also I think a different set of expectations between investors and founders, particularly around situations where founders are getting meaningful liquidity earlier in the cycle than VCs are. And I think those conversations are going to be very different.

Going along the lines of secondaries, we've been obviously talking about the rise of this, but it still remains to be inefficient as a process and often heavily discounted. So what actually needs to change about the ecosystem around secondaries for venture for it to become more mainstreamed and structured tool like, is it really just the rails aren't quite there yet or do we just need to have all our cards out on the table to be able to interact fluid?

Oh yeah, it's a great question. Yeah. I think the holy grail for a lot of people has been, well, what if we just had a NASDAQ like marketplace where at any point in time you could go and sell shares. I'm like, oh, you Mean like a public market with regular prices where one could buy and sell. I don't know, why doesn't somebody make one of those? But obviously part of the advantage of being a private company is you have a say over who owns stock in your company and under what circumstances you're willing to trade that stock. I think most of them haven't succeeded partially because there's this weir symmetry. In most cases the energy to buy is concentrated in a fairly small number of well known names. Here's why I think the next 10 years could be different. I think increasingly there are more series B and C rounds where the investor expectation is that if you were early there will probably be a secondary. But right now that secondary sale is oftentimes sponsored and organized by the lead investor. And so long as the lead investor has appetite for the shares and a big enough fund, they can do it themselves. There is more money than ever flowing into venture secondaries in terms of dedicated funds, which to me means there will be more people hanging around the hoop who can buy. And this is maybe a smaller thing that people don't appreciate because it's a little bit in the weeds. More venture capital firms have become registered investment advisors and they're no longer exempt. And for those in the audience, the difference is when you're an exempt advisor, you get a lighter touch relationship with the sec. You don't have to register, but it also means no more than 20% of your fund can be put into certain types of assets, cryptocurrency and secondaries. Because more firms are not registered, they don't have the same restriction on secondaries. And with the proliferation of new products, to me it's inevitable that some of these larger vendors, venture funds, are going to create their own in house secondary funds that will not only buy secondary shares in rounds that they want, but will also buy secondary shares in rounds where they were not primary buyers. And I think the amount of money chasing secondary buying opportunities in hot VC companies will 5 to 10x in the next 10 years. And it will be both an expansion of the platforms from people like industry ventures and the creation of in house captive secondary firms by registered firms. And just the normalization that in the B and the C part of the deal is you create liquidity opportunities for angels and seed stage investors and it will become normal and institutionalized as a best practice, but probably not as like.

A requirement, normal and institutionalized. Moving on to the next topic, Stripe has once again commanded a massive valuation reaching 91.5 billion in secondary stock sale this is a key signal in the environment where big name private companies are looking for liquidity while awaiting for the IPO window to fully reopen. So as a reiteration, this was a secondary sale, not a primary raise. Stripe didn't raise new capital. It just allowed employees and early investors to cash out. It's the latest example of late stage secondaries providing liquidity similar to what we've seen with companies like SpaceX. This move gives insiders an off ramp while Stripe stays private. And so we couldn't have teed up a better example. After our conversation last week questioning IPOs as the golden standard for exits, we talked about the allure if you are a founder at one of these companies, to stay private. But as an employee and an early stage investor, this is a clear mechanism to reward you financially for staying with a company with an elongated exit timeline.

I thought it was interesting that he said we have no plans to go public anytime soon. And I feel like Stripe is. Every time someone talks about the window, they're like, well, Stripe's going to go out. And I'm like, being private seems to be serving them just fine. I think there's another constituency, MIA that we don't talk about as much in secondaries. It's worth considering at a place like Stripe, which is departed employees who have vested options that they've exercised. And this is the other real reason that these tender offers, I think, change the employment decisions that people make. Because if you can be early at a company like Stripe Stripe, and you have low priced options and you have the financial resources to exercise those, or you can work with a firm that can help provide liquidity, you don't have to wait for that company to go public to get personal liquidity either. So you could work at Stripe for two or three years. This is not unique to Stripe, but in the old days if you did this at Facebook or Google, you still had to wait for the company to go public. Now you don't. Some companies have had prickly rules about whether only current or former employees can sell. So each tender is different, but at least there's a mechanism to value and potentially transact in the shares of a company where you worked, where you did an exercise and hopefully an 83B and you did all the good things from a tax efficiency standpoint and you can get liquidity. That's like a whole new thing. Twitter and Facebook were one of the first companies I can think of in the modern Internet where that was a thing, but that was narrowly restricted to one or two companies. A relatively small number of times before they went public. And those companies went public at a fraction of the price of Stripe's current private valuation. So I always felt like employees were the final frontier. They could to some extent agitate for an ipo, maybe successfully, maybe unsuccessfully. But these large tenders really do take the pressure off.

I think of all my friends who work at Google who they get to decide when they want to come in and out of their stock options here. This offer is basically the same thing. If you come in at the right time and there's a secondary or a tender offer on the table, that's something that you probably, to your point, wouldn't have ever dreamed of having the option of. It's a new dynamic.

I think it also makes this trickier because when you were forced to hold, you were forced to hold. Now you have to decide, do I want to sell my strike at 60 billion or at 90 billion or do I want to keep holding? Because I think it's going to go up and I think you're going to have very interesting distribution of outcomes, not just based on when people join, but when they decided to sell and how.

Much they decided to sell, what that means. More of a question for LPs investing in early stage venture funds. One, I guess with occurrences like this, what do you have to believe in order to support these types of transactions as healthy exits when you look at your fund portfolio? And then two, how do you spot the right types of fund managers that can lead to these types of exits? I used to think like, oh, this is very similar to just being able to spot your best companies that will be multibillion dollar exits. But now to our large thread of conversation that we have, this is a new skill set that you're flexing. From an LP's point of view, what are the things that you're looking for?

Beezer had some good comments on my last post and she basically was like, look, we've seen this sort of secondary selling thing work to generate meaningful returns for small funds, but we've never really seen it work for big funds. I think about Stripe and DoorDash as two examples. In my lifetime, those companies have compounded as, or even databricks have compounded as private companies wouldn't fault somebody who got out of data bricks at 10 or 15. How are you supposed to know it was going to go to 82? I had a friend who was in DoorDash at 1 and got out at 3 and felt great and then it went to 40. And so now the Trick is like well how do you know when to sell and how much to sell of your winners such that you maximize the returns for your LPs but don't miss out. And I think different firms have different personalities. I think there'll be some firms who just say hey look, I would rather lock in a 4x fund and be done than try to be legendary and end up with a 2x fund. We're dumping the whole thing. We've, we've locked in a Forex fund, we've more than done our job and whatever comes from here, so be it. And I think there's some funds that are gamblers that are going to say we're going to sell the minimum amount we think to make our LPs happy, but we really want to let this thing ride because we think we've got a generational Meta or Google. Like the truth is if you're in one of those companies anytime you sold you probably regret it now. Most companies aren't like that. Most companies do have some like effective peak where if you're still in them it's a muscle. But if you're in a Meta or a Google or an Amazon, you probably look back at any sale you've done and been like I wish I'd held it.

I've typically always thought about this relationship between LPs and fund managers and embarking on secondaries as a damned if you do, damned if you don't scenario. My question is really, will they actually support these types of sales and be okay with it if you forex down the road knowing that maybe you could have 10x?

My sense is for small funds this is going to become an essential skill and I think the LP expectation is going to be these secondary sales will be an important returns driver. The more I study this I've become even more convinced they're not going to be an important they're going to be the primary way and if they're the primary way, these decisions are going to become like make or break ELPAC level fun performance defining decisions. And most LPs I think are going to consult with a GP and say it is ultimately your call but don't screw this up.

Topic number three, it's on. A recent blog by Fred Wilson titled Drinking from a Fire Hose reflects on a long standing tension in venture Oversized funds lead to overfunded startups which often results in in poor returns, diluted ownership and undisciplined spending. He calls out that this is nothing new. Companies have been flooded with capital for over A decade. But with AI driving down the cost of starting and scaling businesses, this dynamic is becoming even more extreme. So while there won't be some sort of large scale resolution really anytime soon, some founders are opting out instead of chasing endless fundraising cycles. Some are choosing profitability, lean operations and sustainable growth. And while not every startup can or should bootstrap, Wilson suggests that this mindset shift may be become more common. So Fred argues that the combination of excess capital and lower startup costs due to AI is creating a bigger divide. Some founders are taking massive rounds while others are going lean. Do you, Charles, think that we're entering an era where bootstrapping or capital efficiency becomes a more viable or maybe even preferred path for certain founders? It's hard to actually imagine that right now, just in this time of AI, to be honest.

Well, yeah, I took the words out of my mouth. First of all, I just want to say, like, for those of you who don't read Yoni's substack 99% derisible. It's good. And Fred referenced post that Yoni had in his substack. It was well read. I think there's these two competing tensions and they've always been competing tensions in venture capital needs for companies and capital deployment needs for venture funds. I remember when everyone's like the cost of starting a startup is going way down. I'm like, yes, that is true. That is a T0 condition when you're starting. I think what we forgot is, and maybe it doesn't have to be this way, we've created a set of conditions where the cost of starting a company is very cheap and the cost of scaling a company costs hundreds of millions of dollars. Now you could say like what's the chicken and the egg? Does the existence of the large venture firms with lots of capital to deploy allow people to pursue ideas that are capital intensive because that capital is available? Or does the presence of ambitious people who need lots of capital induce venture capitalists to raise big funds to support them? Maybe this is cynical. I think the capital deployment needs of really large venture funds create conditions where people who have ambition can go and say, please give me $100 million to go build this thing. Say I can afford to do that for you. Which I think is great for ideas that really do require that amount of money to get started. Something I always attribute to Micah from Founder Collective. I don't know if he actually said this, but I've heard him say it before. He maybe I'd be the originator, which is that capital has no insights. And I often tell our portfolio company founders, money is great if you have something that's already working and you want to do more of it. If you don't have something that's working, the probability that money will solve that problem for you is very low and in fact might have a negative deleterious impact on the probability you'll find an answer. And this is why I focus so much of our firm's time on these small sub million dollar precede rounds. When you only have a million dollars, you can only work on a couple of things with a couple of people. And the pat answer to a lot of things is we can't afford to do that. And I'm a big believer that constraints breed creativity. And I even see it with our portfolio companies. Companies that were lean and efficient and scrappy and clever get money and suddenly they're like, well like we could just hire another engineer to solve that problem or the thing that's just below the priority line, we could work on that. And I think that people have this vision that you raise a buy a huge office and like you throw a rager. That was like the 2000s era of excess. What I see in startups is it's this little creeping lack of discipline. You hire more people than you need, you pay them all a little bit more, you're a little bit more lack on the cut line for what projects the company's gonna work on and you just slowly become bloated and less efficient. And it's not like you make some huge silly decision. It's a bunch of little decisions that make the company less interesting, less efficient. And as long as I've been a venture capitalist, there's always been a cadre of found who are like, I want nothing to do with venture capitalists and I want to do this on my own. And again, the truth is you can start a lot of things on your own, but it's hard to scale them. And so I'm a big believer that you should spend as little money as you can pre product market fit and stay as lean and small as you can. Because in my mind, that's the best way to find the answer. And then once you find the answer, you should raise as much money as you need to lean into the opportunity. But Mia, we have a whole media industrial complex, not to sound all conspiratorial inventor, that's like designed to talk about how much money companies have raised and at what valuation. In our portfolio, companies live in environments where sometimes they're like, wow, our competitor just raised $50 million from this really famous VC firm. Shouldn't we go do the same? And I'm like, do you think they're going to put it to good use? Are you in the same position? And oftentimes I'm just like raising a lot of money or pursuing raising a lot of money because you like to see your name in the headlines or because your competitors did it is not a very good reason to raise money. I tell people instead of thinking about as raising money, think of it as like I'm selling ownership of my company. That's what you're really doing. There isn't like a media publication focused on the amazing quarter over quarter or year over year growth of private low key bootstrap software. There's a few that are like quasi bootstrap, like Buffer. There's a few examples of companies that have been reasonably lean or have taken relatively little venture capital and continue to grow and talk about that experience. Fundraising is noteworthy and so I think the presence of large amounts of capital means that most companies will raise. I am very interested in this notion that I've heard Lemkin talk about it, I've heard YONI Talk about it. Companies that will raise modest amounts of money think 5 to 10 million dollars to get started and it hits on escape velocity, but beyond that point will be self financed and will control their own destiny. I'd love me though companies. We have a couple in our portfolio and I can tell you as a vc, it's hard to report on those companies because for a lot of limited partners the easiest thing to tell them is like we did an investment at time zero and two years later this big series, a firm that you've heard of came in and priced it and led the round at a 3x price. That's easy to understand a company where you're like, hey, they're profitable and they're doing 15 million a year in revenue.

And they'll never raise again.

Never raise again. That lp get back. So what do you think it's worth? And I'm like, I mean I can give you a bunch, I can give you a range, but it is attention. And I have a special place in my heart and at our firm for people who are interested in being more capital efficient. But I realized it's more interesting to us because we have a small firm.

It made me think about a blog post that you wrote a while ago. Getting off the VC train. Were any of the founders that you've talked to who are interested in getting off the VC train. Were they ones who raised tons and tons of money or are they ones who thought about it very efficiently and raised smaller rounds early on?

I think ironically that is the most popular post I've written in the last three years.

Yeah.

Which tells me a lot about where people's heads are. A lot of them are people who'd raised 10 or $15 million and are like this is a good business but it's not going to be what my VCs. What do I do? I know in my heart this is not going to be a billion dollar outcome for them. I'm interested in running this business as a profitable or slightly money losing growing concern, but my VCs don't care. What do I, what do I do? We don't have great answers for those companies yet, but we're going to have more opportunities to find the answer in the next five years.

Well, we are all out of time. Thank you Charles for stopping by. Thank you to our listeners for listening in. We will talk with you all next week. Please like and subscribe in the meantime. Thanks. Bye bye.