Episode #5: Euclid Insights, Strictly VC

I'm a big believer that no amount of ownership can fix bad selection. I would always rather be a 1% owner in a fantastic business than a 20% owner in a mediocre business. I would take that trade 100 times out of 100.

It's the week of October 21st welcome to the Learning Corner a Precursor Vengers Podcast.

Welcome to the Learning Corner by Precursor. I'm Mia Farnam and I'm joined by our GP and Managing partner Charles Hudson, and we will be talking through the articles and reads that caught our team's attention over the past week. Topic number one the Seed Stage Reckoning Another read by Euclid Insights and the Seed Stage Reckoning discusses the current state of seed stage investing, highlighting a shift in the market where founders and investors are facing even greater challenges as it's become harder to graduate to subsequent rounds of funding. The essay cautions against investing across fast growing or hype centric markets, or case studies across fintech, crypto, et cetera that show it's incredibly difficult to foresee the end of the upcycle and inevitable underperformance in investments. They also walked through their strategy, investing in a small number of founders each year and going all in to garner 10% equity ownership upon this first investment. So when an exit comes about, it's fun making Charles, you got multiple shout outs throughout the article referencing a previous blog post you wrote. The Euclid Insights team specifically applauded your one quote Dilution is our enemy too. We will make the majority of our financial returns from our first check and investment decisions. And while we can all agree on your quote, if you're a fund manager of truly any type at Precursor, we actually have a different strategy than Euclid in that we write far more checks per year and our size can vary. So can you share a little bit more about that and how it still succeeds? Its Reckoning Age of Seed stages we'll.

Write 30 to 40 new full size checks a year so think like 80 to 100 per fund. Much different portfolio construction than most venture funds. It works for us. We're generalists, we're investing pre product market fit oftentimes pre launch. I think there's just a lot of ideas that I think are worth pursuing at that stage and so it works for us. Also our funds are pretty small and over time like you could we've we're approaching 7 to 10% ownership on entry. But I think the smaller your fund the less you need to own of great companies to make the math work. And I'M a big believer that no amount of ownership can fix bad selection. So I would always rather be a 1% owner in a fantastic business than a 20% owner in a mediocre business. I would take that trade 100 times out of 100. And so I think our whole strategy is predicated on finding really awesome to be discovered, misunderstood, zero to one companies investing at a valuation that is fair to us and fair to the founder and being right. And I think most people though are like, it's easier to find a small number of things every year where you think you're right and go big on those. And I actually really admire people whose brains are wired that way. Mine, mine just isn't. That isn't the way I invest, that isn't the way I've been successful. And I keep coming back to a couple of things that to me just are fundamental about seed. I was telling my friend this over the weekend, seed is mostly a long only business. You're going to buy something and you're going to hold it essentially until maturity or until somebody's willing to buy it from you. Which means if you make a mistake, you're stuck with it. And this has always been like my one question about some other strategies is if I have a vertical specific fund and the tide goes out on my vertical, what do I do? Because I'm holding a basket of illiquid, long dated securities in a theme where there's like literally no demand. And if I think about our portfolio, because we're generalists, we lived through the wave of like nobody wanted to fund CPG anymore, nobody wanted to fund consumer, nobody wanted to fund consumer fintech, nobody wanted to fund digital. Like almost every subsector we invest in has had. I mean, we don't do crypto, but crypto obviously has its winners and summers. And I just have always been terrified as a fund manager of having a concentrated book of business, a category that's on, that's like basically unfundable. That's why I think our strategy works well for me, the thing I keep thinking about is I told our team this, I've told everybody this. Graduation rates foresee are coming down. And also I feel like the compression of hype cycles is real. Like everything that's happening in AI to me feels like it's happening though faster than what happened in crypto, which felt faster than mobile. The scary thing now is like people are putting a lot of money to work with a belief that they have a point of view on the future. And we just don't know if they're right yet. And the velocity of capital is high. And I think this is particularly problematic if your strategy is to try to pile into winners and you misidentify a winner. And so one nice thing about having light reserves is I can only do so much damage with reserves. The majority of our money is going to be in first checks. And if there's a company that appears to be taking off, there's only so much we can pile into it, which, yes, if it's a super compounder and it's amazing, we will wish we had more money. But it's also a check for us on becoming too concentrated in a company that gives you an early false signal.

In the days of crypto, when it was in their summers, did you find yourself having conversations with LPs and then pushing back on you not wanting to move into that market? And do they mirror the kind of discussions you have now with LPs who are questioning, questioning you not wanting to rush into B2B AI?

I think the conversations were similar, but different in one important way. The crypto thing pretty quickly. And I was like, oh, there's a lot of money to be made here, but it's also liquid and it's also tradable. So why do you need to pay me if you want to hold coin? Unless there's some reason that your organization can't custody the crypto and you need me to buy it for you and hold it. If you want to go buy $10 million worth of Bitcoin, like, why should you do that through me? There are mechanisms for that. I had a bunch of questions about the ultimate use cases for crypto, but I was like, this isn't a place where you need us as a manager. The AI piece, it's harder. I just think this stuff is going to take a lot longer. It's very hard to talk to LPs and have a point of view that's contrary to what most of the really smart people that have come into their office have told them is the future. So I've now started telling them I agree with their view on the future. We're just arguing over the timeline. And I think if you're an early stage venture manager, being early is being wrong. I keep thinking like I worked at Excite in the early 2000s. Almost every good idea someone had that failed then works now. I order groceries on the Internet, but I don't order them from webvan. I buy movie tickets, plane tickets, I basically do everything on the Internet. But I do very little of that activity with the first couple of companies that tried because the tech wasn't ready. There were so many things that had to fall in the place. And when I use a lot of these early AI products, I feel the same way, which is like, oh yeah, I can see how with a few more cycles of iteration, this AI will solve this problem or we'll largely address it. But in a lot of these cases I'm like, but not today. And if not today, like, why this company? Why not somebody who starts it later when the technology is more capable? Why won't that person win? I think it is hard to go into a room with a limited partner and they're like, every other GP who's coming here has told me that they're all in on AI. It's one of the only things they're investing in. And I'm like, yeah, we're not doing that. And people are like, why not? I'm like, well, here's why not. And they're like, wow, well, who's right? You or them? I'm like, we'll find out. Maybe both of us are right.

An early question that I wanted to ask you. It's really a double click on the broader SaaS valuations that the Euclid team did here on the fundraising environment over the years. And so according to CARTA data, SaaS seed graduations are at a historic low, yet SaaS seed valuations are at an all time high. So the Euclid team attributes this money needing to, quote, work its way through the system with perhaps a glut of capital held in the seed stage. This could be due to boom era fund manager behavior where diligence was infrequent, traction was overlooked and the deal piece was really unsustainable. So in short, more companies got seed stage funding than they should have and those who were funded received more dollars than they should have. And I wonder, is this paralleled foreshadowing as it pertains to a just seeing the pace of deals that are being done for AI with little to no traction and underwriting mechanisms I haven't quite figured out myself.

I suspect the answer is yes. But depending on which companies you're in, it might not matter. If you're in the few that like, get through the eye of the needle and win, does it really matter? But I don't see how it can't end in a similar way because there are a lot of these categories, there's 20, 30, 40, 50 seed stage companies pursuing the same idea they can't all win. Also, I think people forget sometimes there's no winner, everybody loses. Like that is an outcome that can happen in a category or for a product type. Like there can be no winner. I think about that a lot because I think if you open your mind to the idea that like this is a category that might produce no winners, you think differently than, oh, there will be a winner here. My job is to select and identify that company. And I think some of these categories, there just might be no winner because the technology is not fully up to the task or the customer's not ready to turn that over to AI just yet. So we'll see. I think the other thing though, mia, is seed used to be a very upper out investment stage. You got your seed round and then you went to do an A. If you couldn't pull off a series A, maybe you got a little baby extension or a bridge to go try and raise again in two quarters and usually to address or fix some very specific shortcoming in the business. Now seed is a phase, to quote Hunter Walk. It lasts four years. Now you get oftentimes two bites at the Apple. We used to get answers on seed stage companies much faster. Now it just takes longer to get answers. And the question is, will taking longer to get answers answer is, will it work in the end, does it just mean, oh, we're still going to have reasonably high graduation rates, it's just going to take four years to graduate instead of two, or graduation rates are just going to go down because graduation rates are fundamentally a function of the supply of series A capital, not the demand from startups. And we have in the last 10 years dramatically increased the supply of seed stage startups because of all the new seed managers that are out there, including us. But the amount of series A capital has not grown at the same rate. I think it was. Thomas Jung Soo had a post a while ago that was something like, seed company formation is up five times more than Series A dollars are up. And I'm like, well that suggests to me that like those dollars are going to become pickier. And even if they weren't pickier, there's just not enough money for all of those companies to get funded and graduated. And the question is like, well, how does that pain get distributed? And I think this year the scary thing in the first half of the year was like, okay, there's less money and a disproportionate chunk of that money is only looking at enterprise AI. So if you are not an enterprise AI company, you are fighting for a very small sliver of available Series A.

Dol since the market has become picky, er, is it the responsibility if like our focus is on precedency to help and lobby and push and advocate for our founders who are going up to Series A more and more. I feel like Precursor threads the needle quite well on trusting founders to do things that founders are best positioned to do. And sometimes that means fundraising. But in this environment, what is the balance we have to strike?

I think our job is to explain to people what the terrain looks like. We got to have good binoculars. We have to be able to stand on the hill and look out and say, oh, if you decide to go fundraise, this is the environment you're walking into. And I feel like when it comes to our co investor partners, like my job is to listen to what they're telling me. Like I had a bunch of people who are just like, our firm is only doing enterprise AI. I'm like, seriously, that seems weird. He's like, I think it's weird too, but I'm just telling you this is all I can get through right now. So if you send me stuff that like, is not in this box, the probability that like anyone's going to care is very low. I'm like, well, how long do you think this is going to be the case? And this person said, until it isn't. And I was like, okay, this is like actually information I need to share with our portfolio. And the nice thing is I tell people having a big portfolio can be a feature or a bug, depending on what you do with that. We try to make it a feature. And we have so many companies that are fundraising at any point in time. We get a lot of feedback and signal from people. And I've tried to convince people sometimes to see the world a different way, but I'm like, you know, you people at your firm have spent a lot of time talking to each other, coming up with a strategy and a thesis. I'm going to take that as like a made decision and not one where you're looking for input or influence. For me, I'm approaching these meetings as this is a chance for me to learn what's happening at your shop. What do you want to see? And I find that oftentimes what people want to see is not what you read about. It's usually something different. So I'd say the biggest thing I've become more attuned to is as the market's gotten pickier, the allowances that VCs will give for any hesitations they have about the founder have gone way down. And this makes me kind of sad because there were people who got funded in 2020 and 2021 who needed some grace in the early days to figure things out. And they weren't perfect, but like a more accommodating capital environment gave those people like room and space to learn how to manage and be good. And I just think there are fewer people giving founders that opportunity. So I've tried to both be much more demanding in my assessment of founders, but not lose the optimism that people who don't have everything figured out yet that can't become successful. And it's, it's been hard honestly to like hold those two things at the same time and still pick the kind of founders that I think reflect our firm's values and strategy.

It feels like if fundraising for a founder was like a road of which to be traveled by a car. We can't drive the car for you as an investor, but I can point out all the potholes, hopefully that can help you navigate the road a little bit smoother. Moving on to topic two, General Catalysts layers in financing to boost its fortunes by Strictly VC So in this episode of Strictly bc, Haman and Pranav from General Catalyst discuss how they are layering financing into its strategy to bolster its investment portfolio's long term success. This includes moves like acquiring other seed funds, buying a hospital system and creating unique financial instruments and beyond. And so this feels very PE focused. And the interviewers actually ask GC in the beginning essentially, do they consider themselves a venture capital firm still with all the different strategies that they are deploying and their response is more or less along the lines of time will tell. GC is one of the most recognizable funds across venture and in true fashion, I always find that investors love to mirror and follow behaviors and herds. So Charles, do you think more funds will try and follow suit and try to mirror this type of diversified investment and management strategy?

Yes, in the simple. The simplest answer, MIA is yes. And I think the motivations will be different. But I think if you zoom out, venture capital is like not a very elastic asset class. So if you're a firm that is growing and LPs want to give you more money at some point you're like, well, I have all the money I can deploy against first checks. I have all the money I can deploy against growth. What other problems in the ecosystem of finance can I solve for the founders that we work with? And I think the history of almost all finance Is that big firms get bigger. If you look at the buyout world, you know, the big buyout firms used to be big, now they're enormous. You look at almost any segment of finance over time and venture is going through this now. And I think it was interesting, the direct lending thing, like just hearing them talk about the rationale was like, hey, we had companies that we were meeting that were spending a bunch of money in a way that we thought was an inefficient use of. I'm paraphrasing, an inefficient use of equity. And we thought we could offer them a better product. And I'm just fascinated that like it feels to me almost overnight venture capital went from this like weird corner of finance finance where we don't do anything that the other people do. We don't do secondaries, we don't do continuation vehicles, we don't do dividend recaps, we don't have all these other exotic products. And then one day I woke up and everyone's like, haha, just kidding. We do all of those things now. And I think it's just fascinating to watch our industry, which I feel like has always been a part of finance and apart from finance, at the same time start to adopt more of the behaviors of our colleagues and peers in the broader private equity ecosystem. And this is all new for us. Maybe not for all of us, but I'd say as a group these are new things for venture capitalists to introduce. I think the big funds are uniquely able to try these things because of their unprecedented access to capital. GC is also buying a hospital. I think it's really cool. He might like walked a bunch of us through the logic. I thought it was like an interesting argument for maybe the easiest way to show people the promise of digital health technologies. Instead of like arm wrestling with the hospital CEO about why they should deploy this stuff, just buy a hospital that you control and deploy the stuff yourself. That wouldn't have been a solution that people would have pursued previously. So I'm just fascinated by like what's the limit? And how much non venture stuff can you do and still call yourself a venture capitalist? And even more interesting, at what point would a firm like GC be better off not calling itself a venture capital firm? At what point is the venture capital moniker or label actually limiting to your firm's ambition and like limiting in terms of like the things that you'd like to get into?

For the listeners, what Charles was touching on was GC's customer value strategy vehicle It's a funding model where the firm will pre fund a company's customer acquisition costs, essentially assumes the costs of sales and marketing and exchange. GC takes a capped return based on the customer value generated from that initial investment in lieu of equity, and they actually bear the entire risk in an underperforming market. So this is created to help companies create a stronger cash flow and then grow, scale and ultimately return DPI to investors. Guess one more question for you. If this strategy ends up being carried out more frequently across different funds, how am I as an investor supposed to now look at those metrics? Am I supposed to ignore the fact that sales and marketing is placed off of the balance sheet? Like, how do I actually think about progress in metrics now?

I have been struggling with this very question. I don't know. I. This is one of those things where I was just like, well, what would I do if a company with this structure walked into my office? I think we saw a little bit of this when sort of cap, chase, pipe, when we had this sort of revenue based financing. And I think for most investors it was kind of easy to understand because oftentimes the underwriting for those things was coming from previous financial performance and people were like, oh, this is like money that still needs to be paid back. And I think there was some understanding, but I think this is really different and I think it's going to impact like how companies think about raising equity capital. And if you have this vehicle, like, does it change the way you think about how much equity capital you need? So venture capital is becoming more financial, which is something I just didn't think was going to happen. Five years ago I was like, we're this like little weird kind of industry that's like more psychology than finance. And that's that era maybe is also coming to a close.

Well, we are all out of time. Thank you Charles for hopping in. Thank you for all our listeners for popping by the Learning corner. Please share and subscribe and we will all see you next week. Thank you. Bye.