Episode #8: Bowery Farms, Sapphire Partners, Patricia Halfen Wexler

My experience has been when people raise money, they spend it, and so I'm pretty sympathetic to teams who just say, gosh, whether you had $2 million or $200 million, if only we could go back in time and spend less money on this thing. It always seems to be the case.

It's the week of November 11th. Welcome to the Learning Corner, a Precursor Ventures podcast.

Welcome to the Learning Corner by Precursor. I'm Nia Farnam and I'm joined by our GP and Managing partner Charles Hudson, where we'll be talking through the article. Good reads that caught our teens attention over the past week. We're lucky to be in a single setting this time, so we're excited to give it a go. Kicking it off to topic number one Wilted Greens How a Leaf Eating Pathogen Failed Deals Brought Down Bowery Farming Our first article this week is from Pitchbook and the recent collapse of Bowery Farming, a once vertical farming giant. Despite the early hype from celebrities and VCs as a tech forward solution to food scarcity in 2021, Bowery made headlines with its $300 million Series C LED by Fide Fidelity, valuing the indoor Farms network at $2.3 billion amidst the heavy R and D spend and unsustainable cash burn. It was actually a challenge that was more esoteric, a pathogen that wiped out massive amounts of Bowery's produce and was the final straw for the company. Following the end of partnerships with massive retailers like Whole Foods and Albertsons, an announcement was made to all employees at the end of October that all operations would cease. I've been going down some rabbit holes reading statements from previous Bowery employees from the earlier days, and there is some debate that if cash was better managed throughout the brighter days at Bowery, while the pathogen definitely would be a setback, lenders or investors might have gathered around the company to save it. So from your perspective Charles, and there's a couple nuances here and the differences of how we invest and where Valerie sits. But how do you make the call as an investor to free up reserves, to invest defensively? And when do you feel confident to make the toug call to not double down boy.

I mean, I don't know, we've done a handful of these hardware investments that are like big R and D projects. I think the hard thing is oftentimes you have to build everything, even if you're like gosh I wish somebody else would solve this. And it's easy to talk yourself into sort of building a full on end to end system and I remember when I first heard about the vertical farming industry, I was like, someone's going to have to build all of this stuff from scratch. And so that's no small feat. And I can understand why they waste all of that money. For me, the big takeaway was oftentimes the things that kill startups, particularly complicated integrated system startups, it's not the hard thing. You go and thinking, gosh, R and D, how are we going to deal with irrigation, lighting, scaffolding, and it ends up being pathogen. And so it's also, for me, just a good reminder that most startups do, I'd say, a pretty good job of ensuring against things that are obvious risks and they spend a bunch of money on R and D. But oftentimes by solving problems, you create other problems and by creating a really powerful closed loop system, you create a system where introducing something harmful actually hard to get out. I'm a big believer that startups tend to spend the money that they raise. Everyone says, oh, we're going to raise these, this big pile of money, but we're going to pretend that it doesn't exist and we're not going to spend it. My experience has been when people raise money, they spend it. And so I'm pretty sympathetic to teams who just say, gosh, looking back, we wish we'd done something different with the capital and we had it. I'd say that's true of 90% of the startups I talked to that don't work out. They usually look back and say, whether you had 2 million or 200 million, if only we could go back in time and spend less money on this thing. It always seems to be the case.

There's a lot to unpack in the Bowery Farms story, and I think I actually want to talk a bit more generally about the reasons that companies can fail and how some of these reasons to this exact example can be almost impossible to foresee and prepare for. So Charles, how are you able to be realistic on what levers are easy to manage and control versus the things that are truly out of your hands and might be a poor use of time for you to mitigate or manage?

I think Overall, founders and VCs are pretty actually quite good at identifying the things that are likely to go wrong based on what's known at the time that you invest? The challenge is you have to continue to revisit those assumptions. I'll just give you two examples of things that were hard to predict that like negatively impacted our portfolio companies. We had one company that was Building a hardware device that was very dependent on an imported part from China. And when import tariffs on that particular product, which the founder argued was like misclassified by the government and shouldn't have been subject to a tariff, it made the whole thing uneconomic. That part was so valuable and so critical that the increase in price essentially made the hardware device economical. Now we had in the back of our head said, you know, it's possible that we won't get a Chinese supplier, we won't be able to get the price we want. No one around the table had thought, oh, there will be a change in basically the tariff regime that will make this product suddenly prohibitive.

And whose fault is that?

I guess it's the same thing. We've had a handful of companies where I just think about during COVID I'm sure every VC has a story like this, but we had a company that was doing really well. They provided revenue optimization software for boutique fitness studios. So think like High End Yoga Spin Wellness. If you think about the most dangerous place to be during the early days of COVID was in a small contained space sweating with other people. And I talked to that founder and I was like, we don't know how long Covid is going to last. But even more importantly, we don't even know if on the other side of this, the people who own those wellness studios will be in a position to reopen them. And I don't see how we save this business. And again, of all the things we worried about, competition from mind body, competition from class task, the one thing we didn't know is there was going to be a global pandemic that was going to wipe out 99% of his customers. The thing I always ask myself is, as these businesses evolve, what are the new risks? Like, we have a CPG company in our portfolio that had one really critical relationship with a supply chain provider. And when the company was small, that supply chain provider was a great partner and there was no existential risk. But as that business started to scale one day I talked to the founder. I was like, well, if that one partner went away, we essentially have no plan. So something that was not a risk and not a problem when we started the business and wasn't even a problem or a risk a year ago is now kind of existential. And that founder, her head was already thinking about this issue and they took a pretty bold step and decided to essentially vertically integrate into a part of their business. And I think for me, the big lesson was this isn't something you Just do. It's something you have to kind of continuously ask yourself, where are the dependencies in our business? What are the things if someone took that thing away, where it'd be hard to bounce back? And I'm always asking myself that. Sometimes it's a key partner. Sometimes we're totally dependent on one platform for user acquisition. Sometimes you're dependent on a person in an organization who's got a bunch of secret knowledge or has a bunch of expertise. So I'm always challenging myself to say, like, given where the business is, what are one or two things that are existential? But I don't know that the pathogen thing would have been a high bingo card.

Right. One last point, I guess before the pathogen issue, within Bowery Farms, the cost of just doing business were pretty expensive. And so at one point in the journey, Bowery Farms identified a pretty niche market that they were able to kind of own, which was within the kosher foods industry. And so I guess at that point, if you're an investor on the company, is that where you say, oof, this is a lot smaller of a market than we anticipated? And is that when you kind of pump the brakes and start asking, is this company worth the amount that we all have it written up for? What do we do as investors to get on the right track or do not?

It's really hard to do that. I. I've been in those rooms oftentimes what happens. And this was my, this is my perception. My sense was everyone said, wow, this is going to be a blockbuster opportunity. Just think about the ability to grow food closer to where it's consumed without needing land. I mean, what a. What a promise. I'm sure the deck said, what if all the produce in your local grocery store were grown five miles away, indoors at night and trucked to good for the planet. Less food weights, less transportation costs, less intensive use of the land resources that we have. And it turns out many good ideas turn out to be far more complicated and far more expensive. And when you add in hardware, all you're really doing is just cranking up the difficulty level. So I think sometimes you get into a business and you realize, oh, our current market is too small. In many cases, people say instead of pulling back, oftentimes people say, let's step on the gas and find something that will justify kind of the valuation that we've assigned to the company, rather than accept that maybe this isn't as big of an opportunity. Those things are tough. I've been there before, and there's a couple of calls I wish I could take back.

Right. If we could all fight hindsight bias.

Style would be a lot easier.

So moving on to topic two, titled Dirty Secret Venture Reserves are not always a Good Thing. It comes from Sapphire Ventures. It's a deep dive into the world of venture reserves and argues that holding too much in reserves can lead to a misalignment between VCs and founders. Over reserving can result in a lack of follow on capital and under reserving can force difficult decisions about what companies to support. So there was a quote here that near blew my mind. Sapphire mentioned how for their early stage funds that are hovering around 5x, they share that the top company in each fund's portfolio is held at an average of 90x with the second best company at around 25x and then the average benchmark for remaining investments in these portfolios at 1x. I think there's this misconception that when you have reserves it means you plan to invest further across your entire portfolio. When in fact if we follow these numbers, a reserve strategy truly only pays off when you're doing it incredibly selectively. So Charles, we have over 400 companies across our fund.

Yeah.

Without dumping an incredibly complex question. Curious to get your take on reserves.

And it's funny because I just recorded a video for our portfolio company telling them how we think about reserves and the TLDR that was our reserves are for the top 20% of our portfolio. And if I were to think about my own journey with reserves when I started the fund I was like listen, we're going to do these really early precedent investments. The checks are going to be small and the fund is going to be small. We're not going to hold enough in reserve. Like we're going to focus on deploying think like 80, 20, 75, 25. A lot of LPs said well why aren't you 50 50? So many of the other seed managers we talk to are 50, 50 and you're not going to end up owning enough of your winners. You're going to get diluted down. I think reserves in practice and reserves in theory are essentially different. I think you make the spreadsheet, you go here's what's going to happen. We're going to invest in some companies. I the all knowing vc, I'm going to properly identify the winners in my portfolio and either through pro rata rights or through relationship, I will be able to continue to invest as much money as I want in my best companies. And the truth is like that doesn't happen for most people, unless you're a big multistage fund that can take a 20% position and effectively box people out in subsequent rounds, what most people find is some combination of the following problems. You are unable to identify your winners early. Two, you're able to identify your winners early, but you are not able to concentrate enough money into those companies. Third, you identify companies that you believe are winners but turn out not to be winners and you end up overallocated into those companies. I've always been the belief if you segment money, you will use it for its segmented purposes. So if you say we're going to take 50% of our fund and we're going to put it in reserves, you're going to think 50 cents on the dollar is set aside and I think the temptation is to use it. Similar to what the Sapphire folks said, we just had our annual meeting today. Top 10% of our portfolio is by far the value drivers in the fund. And the top five of the top 10% is really where all the action is. To their point, the most important decision you can make is how much of your money in your fund did you get into your very best companies? And you know, per the Bowery article, you will sometimes have a company that you think is a winner that gets really far in its life and doesn't work out and there's no coming back. So I'm of the mind that the best time to deploy reserves are when you know more about the company than the next person. And so I would say at Pre seed, instead of waiting for the A or the B, I'm like, we should deploy all of our follow on capital between the Pre seed and the A because that's a period of time where we have the most access to management, the most information about the company relative to other people and where we're most likely to actually get our dollars in. And I've had many conversations with LPs and said, what about the series B? I'm like, well we got in at 5 and the B was done at 200. I have two choices with that marginal dollar. I could try to put that marginal dollar into a company at 200 posts with the belief that there'll be some upside there, but there's less risk of doing. Or I could take that same check and get 40x the punching power at 5 posts knowing that there's still many things that could go wrong. And my view has been that for our fund strategy, the best thing to do is keep most of the dollars in the early stage and not worry about trying to buy into series B and C rounds of companies where we're just not as close to the teams. Then if I think about our evolution as a fund, in the beginning, my view was, oh, you should always do your parada. If a company's raising, you should do it. Then I was like, hmm, maybe that's like not such a great idea. Maybe we should instead be a little bit more selective. But when we do it, still write a full size check. And then based on some of the analysis that the team has done, when we started looking at, well, this check was one we felt great about. It felt like offense, this was a check that felt not so great. It was defense. Maybe we shouldn't write the same check size. So I think I've gone through this evolution of just always follow on whenever you're presented with the opportunity to try to be a little bit more selective, to then try to classify like what kind of check you're ready. And in the end I've landed kind of where this article is, which is the best thing you can do is try to keep the majority of your reserves for the companies where you have the highest confidence. And if you do that, the probability that you'll end up concentrating more dollars into your best company is much higher. But it also means you have to have a lot more awkward, uncomfortable conversations with people you've already funded. And I think sometimes reserves are a way to avoid that conversation or to kick that can down the road. And I made the decision a couple of years ago that if we're going to be long term partners, people, we have to be able to tolerate awkward.

Conversations going along the lines of targeting how to feel confident about following on. There's logic around the value of reserves in that it allows investors to invest deeper into companies with more data points on the company, ideally de risking the entire investment when compared to the first check for a fund that maybe comes in at the series A and then decides whether or not to re up for the B. There are tangible things like revenue margins, cac, et cetera that you can use to ground the judgment for a place like Precursor where we come in as early as you possibly could. In most cases between pre seed and seed, there are not the same types of metrics to quote unquote, de risk the investment when the company just started to see revenue or the launch just happened. So at these earlier stages, how do you think about reserves and where it makes sense in our fund model?

I think the beauty is, as I tell people, the companies we invest in they don't leave footprints. And so the beauty is kind of the only way to figure out what's happened in that company is to have some kind of regular touch point with management and be able to say, all right, are these people on track? You know, we do 30 to 40 new investments a year. As you mentioned, we've made 400 investments. I think we're pretty good at determining where in the distribution is this company based on performance after our first year. And oftentimes, as you know, we'll evaluate companies six months in and say, hey, this company's had money for six months. We've worked together. What have we learned? And I find the companies that are in that top 20% that you want to put more money into, they kind of jump out. And it's usually because they've made more progress than their peer cohort. They've de risked the business usually more in a philosophical way. Usually there's some existential question that they need to solve and they've solved it. You learn more about management's ability to hire, to execute, to make good decisions and you're just like, this is a company that feels like it's well run and is headed in the right direction. And it is much more qualitative, which is I think our whole edge, which is like making sense of this qualitative information. So the other thing that was hard in the beginning for me to get RLP's head around was a lot of the follow ons decisions we're going to make are going to be preemptive offers from Precursor to put more money into company in between rounds or based on performance. It's not going to be waiting for someone else to come. Because by the time we wait for someone else to come, there's usually enough external signal that this is something they should do.

At Precursor, I know we think about follow on checks in kind of two categories, offensive and then a defensive thinking about it defensively, which I'll let you elaborate on that. Is there maybe an argument to be made? Like if you're making a defensive check, why make it at all?

I have this argument with myself. Offense is we are running this check because we are unambiguously enthusiastic about the company and we believe that there's a real opportunity to make money with this investment. There's little to no reservation. Defensive checks are usually checks where I'm like, you know, we're writing this into a bridge because we are confident or hopeful that the things the founder has told us will happen will come to pass. Or the company sort of hit product market fit fairly late in the game and in order to turn over another card, we need to fund the business for another six to nine months. Or in some cases I'm like, the company is going through an M and A process and they need enough capital to keep the team together and see the process through. And I believe that they will both be successful and that we will at a minimum get our money back with this check. And it turns out there's a couple of reasons to write defensive checks. Sometimes it's worth it to buy more time. But for me, the big lesson from our research project is when you write a defensive check, you should write as small a check as possible to accomplish your objective. And a few years ago I was like, well the answer for a defensive check can also be zero. And that was like a big mental shift for me to say. Like there are cases in which the right amount of money for us to offer a founder is zero.

Moving on to topic three the future of Venture Industrialization or Back to Basics. It's our last article for the week and it's by Patricia Half and Wexler on medium. Wexler hypothesizes on the future of venture one where top tier fund managers are those who have the unique skills, abilities and ecosystem wide relationships to make bets that result in outsized fund returns versus Aum heavy funds with the ability to make bets wherever and at whatever pace and price. She shares the drawbacks of raising massive funds, calling out the fallacy of widespread VC beliefs that no longer stand as Aum balloons. Patricia actually makes an interesting comparison between the restaurant industry and the venture world, and in this comparison, McDonald's resembles massive funds that can allocate checks or meals at incredible scale, and Michelin star restaurants are funds that take more time and care into each individual meal or investment. She goes on to argue that venture requires a Michelin star approach to make fewer bets that are incredible every time. I'm sure that massive funds would argue that they are equally scaling up team operations, platform, et cetera to ensure that they are able to make surgical bets across industries and essentially be Michelin restaurants at scale. So curious to get your take on that view. And I guess the article as a whole.

Patty's article was great. It echoed a lot of things that I've been thinking about myself. Just to be clear, I think running McDonald's is hard too. Yeah, it's not like a simple operation to consistently put out hamburgers and fries that taste the same across space and time. It's just different work. The way I think about it is ventures going through, I think, this big seismic shift where the biggest funds in our industry have gotten much larger than they used to be. I saw a chart, it showed the largest venture funds by AUM. Number one was Sequoia, number two was Andreessen. Andreessen's a 12 to 15 year old fund. And so I think in a world where the biggest venture funds were a billion dollars in size, if you think about it doing venture math, raising a billion dollar fund means you're going to give your LPs back for 3 to 4 billion dollars over some period of time. And if you own 20% of those companies, that exit, which to do, we're talking about creating 20 to 25 billion dollars in exits. That's no small feat, but that was sort of the realm of, of what was possible. And the question is like, well, how do you, how do you do that? How do you return? And the only ways I can see is one, you have to find companies where the terminal scale of those companies is 20 to 25 billion dollars. You have to find the data bricks and you have to find the stripe. But those companies are like few and far between. And the question is, does the presence of more venture capital create more of those opportunities? And I'm on the like, great companies are created independent of the amount of capital. Otherwise it'd be great if we just double the amount of capital, we double the amount of amazing companies and we would just do that forever. I don't have to get rich that way. It also means if you're running one of these big funds, the only way to have competitive returns is you must, must, must be in the most important companies in your category. I just think if you're an OpenAI, I don't know many other $160 billion private companies. So if you're an OpenAI, you have an advantage from a return to performance standpoint that's almost impossible for your, their competitors to replicate unless they can find another business like that. And so I think about it as a small fund manager, it's very comforting for me to believe what Patty's saying, which is like, hey, like this has gotten out of control. But I'd argue if you're a fund manager who can turn 5 billion into 15 billion, your limited partners will continue to give you 5 billion every time and you will stay in business. And maybe if you turn five billion into seven and a half billion, those funds I think are solving for a bunch of different problems and they're also frankly able to fund ideas that require 10, 50, $100 million to get scale. And small funds cannot do that. You know, there aren't many blocks I've seen in America where you have a McDonald's on the same block as a Michelin star restaurant. And most Cities have more McDonald's than they have or McDonald's like restaurants than they have Michelin star restaurants. And my question is like, well, what happens to our industry if LP dollars and AUM continue to flow to the big funds? What opportunities still make sense for small funds? And I'm still working through that myself. And it's a question I ask myself every day. But I do recognize it's very self serving for me to say like the thing I do is like the true venture capital. And of course I do believe this. I do believe that small artisanal funds have an important role. But I, I talk to my friends at big funds and I have a lot of respect for the challenges they face. Because you know, if you're running a $5 billion fund owning 20% of a billion dollar company returns 4% of your fund. Just, I wouldn't say it doesn't matter, doesn't help you solve your existential math problem. I'm just picking 5 billion out of. That's the wrong number. We raised 5 billion and we want to send 10 to 15 back. We can't do that $200 million at a time. So I think we will either learn there's a very small segment of our industry that's capable of raising multi billion dollar funds and generating returns that are sufficient to keep LPs interested and excited. Second, those firms will morph to be something that looks less like a traditional venture firm and more like a multi product asset management firm. And they will generate returns that make sense with that structure. Or it will turn out that you can't actually make good returns on a $5 billion venture fund. And we've overshot. I have no idea what the right answer is going to be.

One thing that I did also like what Patti said, was drawing on your comment of respecting the larger funds that have massive amounts of AUM and the different challenges. You can have a McDonald's and you can have a Michelin star restaurant at the same time to expect the same results and what they're doing to be the same. That's what's actually a fallacy if you think about it.

If you're a gigantic pension, you're like, I have $250 million. It's more important to me that I get $250 million back than I get 750 million dol million back. So I am willing to take a more compressed return. But I don't want the downside scenario where I give you 250 and I get 125 back. And I think we talk a lot about the outperformance of small funds. The left end of that tail is really bad. The probability that you'll get nothing back from a big fund is fairly low. But the chances you'll get a 10x fund are also lower. So I do think there's two different products serving two different objectives for oftentimes two different limited partner sets. I think the thing that makes me kind of sad is it used to feel like like all venture capitalists with the same scale of outcome was good for all of us. And now I'd say for most sub $100 million funds, a $1 or $2 billion company, it's a good outcome for you and it just wouldn't matter to the biggest of big funds. That's a, that's a new thing.

More to come there. Hopefully we'll see in the next 10 to 15 years. We are all out of time. Thank you Charles and thank you to our listeners and viewers. Please like subscribe and share with your friends and we will talk with you all next week. Thank you.