I’ve spent the last 12 years looking up to a lot of the best VC firms founded before ours. And it’s sent me into a bit of an identity crisis.
Since my freshman year in college I knew I wanted to be a venture capitalist. I viewed venture as the best combination of getting to context switch from company to company, feeling like I was making an impact by helping work with early-stage companies when the capital was most meaningful, and getting to work with and learn from some of the most talented people in the world. Founders are inherently “interesting” (and/or crazy) people. Both work for me. And I knew I looked up to firms like First Round, Benchmark, Sequoia, and many others. I also knew that I kinda wanted the firm I worked with to look like theirs.
It took me 10 years (and job offers from a bunch of those traditional firms) to realize I would never be good at what a lot of those firms do. And it took me about that same amount of time to realize inspiration and imitation are different things.
In my latest board meeting (yes, even though we’re an investment firm, we have a board of directors) I was asking some of our directors about the founding stories and histories of the firms they had founded or run. My lead investor, who formerly ran a $100B+ AUM firm, responded with another question: “Why are you asking? You’re not going to make money the same way we did. You may end up having success (or not having success) but either way, trying to imitate what someone else built in a different time wouldn’t be the right answer.”
The advice was hard to take because it was the moment I realized I had to give up the dream of being like my heroes. But the advice was so dead on.
And now, as we think about building Crossbeam, it’s caused us to pause and think: “What has changed about the world? And what does a VC firm need to look like now, in a new environment?” Firms like First Round responded to a shift in the amount of capital software companies would need to launch. And so they helped build and invent seed investing as an asset class. In order to build an impactful firm, we too would need to build a firm that was right for the current environment. Not right for whatever the past used to look like.
Some observations of the now:
VC-backed companies are beginning to look more alike than ever. And investors are intoxicated with pattern recognition. We believe that too many VCs are copy and pasting a specific formula that has worked for them or their colleagues in former vintages. And they’re letting pattern recognition guide their models with too heavy a hand. This started with B2B SaaS – once a few great funds figured out the SaaS playbook they commoditized it. While each investment they backed was in a new (or slightly new) vertical, they looked for cookie-cutter characteristics – the same churn profiles, the same sales efficiency profiles, and often founders that even acted (and worse, looked) the same.
“Venture” implies taking risk. Our industry is defined by risk yet we find that many of our peers continually drift further away into safety. This would be fine if they weren’t paying too high a price for it. But today, investors are willing to pay an undue premium for that “safety.” A good company funded at too high a price is no longer a “safe” bet. The company’s execution may have less risk, but the investment becomes riskier at the wrong price. A company with a big outcome can still be a bad investment at the wrong entry point.
We believe there are a few trends that are causing us to re-think what kind of companies we invest in, and at what price.
Valuations are higher now – and they should be. So we’re not against paying “some” premium:
- The Internet is bigger now than it used to be. So the Total Addressable Market (“TAM”) is bigger. Venture capital was built on the idea that the Internet might be worth $1T one day, and now Amazon is worth over $1.5T. Whereas a one-billion-dollar company used to be the far goal post, $10B is today’s equivalent.
- The founders who are starting software companies are more experienced than before. Today, it’s much more common to back repeat founders or individuals who were “early employees” at large tech companies that went on to sell or go public. This is simply because the market has matured, there have been more exits, and those executives have recycled into new companies. This means there is less founder risk, founders are rolling up well-known playbooks, and they move faster than first time founders often do (this isn’t always true! but in general).
- Growth channels also have greater scale. Social media has dramatically improved the ROI of ad-spend, and has allowed companies to market their brands so quickly that 200% YoY growth is the new 100% YoY growth. Social media companies allow targeting and reach in a way billboards and newspaper ads never did. Whether or not acquisition costs have gotten too high, and will stay too high due to new privacy concerns is its own debate. But I’ve never seen companies growing as quickly as we see them growing today. SaaS companies can also sell their software faster than ever before. Buyers are more comfortable buying tools in shorter time frames – and the tools they are buying are easier to use. Plus founders know how to build out sales playbooks in a more sophisticated way than ever before. They know how to manage their SDRs, inside sales teams, account managers, drive up-sells, etc.
- The business models are better understood. It used to be that companies experimented with new business models that had a lot of risk. Some models worked, some didn’t. For example: there was only room for a few ad-supported businesses (in media). Selling commoditized data saw compressed margins (in ad-tech). Flash-sales couldn’t drive enough repeat business to justify themselves, and aggregators of products (like Fab.com) just couldn’t earn the contribution margins needed to survive. But a lot of models survived.
The old adage of “no one gets fired for buying IBM” is no longer the case – even large corporations are eschewing buying from the giants old and are instead going with the new gold standard of Snowflake, Gusto, and Stripe. In fact, “still buying from IBM” is becoming more likely to get you fired in a young, fast-moving environment.
Marketplaces, direct to consumer, SaaS, and other enduring models have dominated the venture-backed companies we see today. And now that these business models are so well understood, they’re easy to value, the markets have become more efficient, and the multiples applied to them are higher because they’re viewed as less risky and growth seems inevitable. Investors are willing to apply high multiples to SaaS because they view the revenues as annuities, and they are willing to bet on companies that rely on ad-spend to grow because they believe the compelling CAC:LTV stories.
However, in today’s environment, valuations for “easy to understand businesses” are too high even despite these tailwinds – and this is why we try to avoid “checklist companies.” I’ll define “checklist companies” in a moment.
Rounds happen more quickly, and more fluidly:
It used to be that a company would raise a “friends and family round” (a term I’ve always hated since most people don’t have rich families), then a seed round, then a Series A, and then a Series B. Now, the rounds all kind of blend together. Founders raise pre-seed rounds, then seed rounds, then post-seed rounds, then pre-Series A rounds, and whatever else they raise. I joke that it’s kinda like holding a teenage athlete back one year in high school so that they look better to college coaches during the recruiting cycle.
On top of that, because companies are raising rounds more fluidly, VCs know that they are more open-minded to pre-empted rounds than before.
The combination of this willingness, and the crazy high valuations of “marketed rounds” has led to most later-stage VCs building their current funds off the back of pre-empted rounds as opposed to rounds that come at the reaction of a full “process.” I spoke to a $1.5B fund recently who’s instructed its team to not participate in “shopped rounds.” And that the only rounds they’d participate in would be ones that we’re pre-empted and proprietary.
We’ve also found that as valuations move so much, there is a lot of price discovery that’s happening. For most of our companies – when they raise they immediately get an offer from another firm for more money at a 1.25-1.5x higher price. We call these “double rounds,” and they’ve become the norm.
The big tech platforms are acting differently
There are two general themes most VCs would agree with:
- The platforms capture most of the value, and it’s hard to build big companies on these platforms
- Network effects are incredibly powerful
But our point of view varies somewhat from the consensus. We think that platforms have actually become better places to build big companies, and we think network effects matter less than they used to. The latter is related to the former.
Platforms realize that they need to avoid being monopolies and that they need to be highways of small business (not the killers of small business). That’s part of why The Amazon FBA ecosystem has turned hundreds of thousands of Americans into millionaires. It’s why YouTube has focused so heavily on making sure its content creators “actually make money.” Instagram will have to figure out how to make this happen, or Instagram will just stay a platform for influencers to share funny memes (the reason Memes dominate Instagram is because they’re cheap to make, and unlike YouTubers, influencers on Instagram don’t make enough money off their content to re-invest it into high quality production). Plus, new link-in-bio companies are making it easier than ever for creators to help direct users to their favorite channels, further reducing the power of platforms.
Platforms are also losing leverage on the people in their ecosystems. Why? Because social media companies are no longer social. YouTube is no better for any of you whether your friends are on it or not, because you’re not watching your friends’ content anymore. You’re watching content made by professionals. SNAP, IG, etc are all going in that same direction. That loosening of network effects is shifting the value from the platform to the creator. And it’s not just happening in social media, it’s happening across every other major platform.
Many Good Companies Have Become “Checklist Companies.” And because they’re too easy to understand, they get funded at too high of prices:
All SaaS companies have “good” business models. SaaS companies have predictable revenues, high margins, switching costs and reasonably predictable CAC:LTV cycles and payback periods. On top of that: financiers like ClearCo, Pipe, CapChase etc are all able to shorten payback periods and increase tolerance for increasing CAC for high value and low churn customers.
The problem is that these views are fairly consensus. And so all investors love these companies. If a VC has a great brand (like Bessemer) they can invest in a company at a “fair” or “less high” valuation. But if the VC fund has a bad brand or no brand, the valuations are untenable.
Marketplaces, D2C companies, etc are similar.
So what are we doing about it?
(1) We are trying to avoid “checklist companies”. One of the reasons we like fintech so much is that most companies within fintech are “bad companies” [I always love this point].
They sell commodities (cash), they have expensive customer acquisition costs, they rarely find repeat customers, and often their temporary advantages (unique data, a good algorithm, a better process) have short half-lives. So most VCs are bad at actually picking which fintech companies or lending businesses are actually good “businesses.” This lets us be more discerning, pick and choose with more fidelity, and actually become “investor, investors” instead of “checklist investors.”
(2) We try to be thesis-driven: we never know which theses we’re going to pick a few years into the future – but we know the theses we’re pursuing now very well. That way, by the time we see a company we like we can short-circuit the due diligence. Rounds happen too quickly to spend lots of time on DD post-pitch meeting. That either means a firm has to do too little diligence (which many firms do) or that they need to be prepared and knowledgeable about the market in advance. We try to do the latter – and when we see a company in a space we don’t know we pass quickly. If we see a lot of companies in the same space, and we don’t know it well, that space often becomes our next thesis and we begin to dig in during our off time or weekends so that we’re prepared the next time a good company in that market comes back around.
(3) We try to internally litigate why we might think a company’s valuation is too high. Is ie because: (i) it’s actually too high, or (ii) because of our anchoring bias.
The biggest mistake we made last year was not leading a follow on round of one of our best-performing companies. We invested in April of 2020 pre-launch, and by March of 2021 they were already doing over $100m of revenues and had become profitable. The round got done at 20x our initial investment, and so we took only a little more than our pro-rata, thinking we had already “won.” It turned out that it was one of the cheapest rounds we had seen and we should have leaned in harder, but didn’t because we thought the fact that it had 20x’d that quickly made it over-valued. As humans, we’re really bad at mental, non-linear math. It’s not intuitive to us. And so it’s really hard to justify paying a crazy high revenue multiple on a software company without the foresight that the business will grow into its valuation faster than expected. We’ve almost completely eliminated talking about “revenue multiples” internally because they leave out the most important parts of an analysis: how fast is the company growing, how high quality is the growth, what are the margins, and where will the business be 1-2 years from now when we need to decide if we’re financing them again? What will they have proven by then, that they haven’t proven by now? That clarity in how we evaluate the high or low nature of a company has also helped us avoid the companies where valuations are out of control.
(4) We’re leaning more heavily into early rounds, and investing less heavily in growth rounds. Generally – buying as much as we can early on when we have a unique conviction, and trying to buy less by the time a business has become consensus and properly valued has let us blend in at lower valuations than we’d other have to endure. When we lean into growth rounds, it’s because we’ve spotted some “product optionality” or “market optionality” not being priced into the current round (H/T to Jesse Beyroutey at IA Ventures for helping me crystalize that line of thinking).
(5) We are investing in a lot of companies that other investors don’t think are “venture businesses.” For example: we have invested in many AMZN TPS rollup companies - these are businesses that purchase third-party sellers on Amazon. Most VCs don’t like the space because: (i) it’s not software-based, (ii) the companies won’t sell at crazy high revenue multiples someday in the future, and (iii) the fact that they are rollups seem like they’d take a lot of capital to finance. But they are wonderful businesses because they can use very little equity, and lots of debt to finance the purchases (because the purchases are at 3-4x EBITDA, keeping debt to income covenants in check despite high LTVs), making them capital-efficient and allowing these companies to grow very quickly/earning VC-like returns. On top of that, the seller accounts they purchase come with embedded barriers to entry due to their comment/review moats. This is an example of the type of business we like to back because: the model feels less obvious to the market, may not even sound like a “VC-bet,” and because of that lack of consensus we are able to avoid paying valuations that are “too high.”
(6) We are investing in platform economies. Whereas most of the VC world is trying to avoid investing in companies that live within the ecosystem of another business, or that take platform risk – we have a higher tolerance for these points. We think these platforms are big enough, and certain platforms have become more benevolent to their actors (partially driven by anti-trust fears). We think avoiding the AMZN or YouTube ecosystems would be like avoiding the iOS app store just because it sits within Apple (it’s not a perfect analogy, but it helps land the point). Investing in other people’s ecosystems is not a new concept. Investors have made tons of money investing within the McDonalds franchise ecosystem. We see that as an interesting analog that can exist within the tech-enabled world.
We still call ourselves venture capitalists – but I’m starting to wonder if that’s even the right term anymore. The venture market has changed – in some ways for the better and in others, less so. But we’ve decided we’re not in the business of trying to be like everyone else. We’re in the business of making money for our investors and helping support the new wave of incredible entrepreneurs.
I was watching a short documentary on Chess, where the narrator explained the “dark ages” of Chess. It was a period where all the grandmasters tried to win “beautifully” using techniques that were thought of as elegant.
In Venture Capital, there is a way to “win beautifully.” Build a great brand, back technical founders, invest in capital-efficient businesses, lead rounds, take lots of ownership, avoid any structure and ensure companies raise money from high-quality follow-on investors. There is a mystique about the cultures of partnerships, how certain investors act, behave and what is “proper.”
A lot of these “beautiful strategies” are based on good logic. We aren’t trying to purposefully avoid any of these features. It turns out buying a higher percentage of a winning company is better than buying less. And keeping cap tables and cap structures clean avoid compounding complexity. We just don’t cling to these features as if they were religious.
We’re sorta tired of trying to “win beautifully.” We’re just trying to win. No matter how good, or ugly it looks while we do it.
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