Capitulation?
Are VC's Abandoning Hope?
A reminder for new readers.?That Was The Week?collects the best writing on critical issues in tech, startups, and venture capital. I selected the articles because they are of interest. The selections often include things I entirely disagree with. But they express common opinions, or they provoke me to think. The articles are only snippets. Click on the headline to go to the original. I express my point of view in the editorial and the weekly video below.
This Week’s Video and Podcast:
Editorial: Capitulation?
Charles Hudson and Manu Kumar are two of the best early-stage investors in the world. This week, they both penned meaningful essays declaring that the fundamentals of early-stage investing have changed, possibly permanently.
Charles states:
For the past 18 months, the Series A market has been very quiet. Outside of AI-related investments, it feels like deal volume is off 75%. The Series A investors I know don’t feel any pressure to make investments and don’t really seem that excited or interested in much these days. Unfortunately for seed-stage companies, the Series A market can remain on strike longer than most seed-stage companies can remain solvent.
He predicts a significant dip in the number of seed-stage companies doing a Series A, a drop in Series As, and fewer extensions or bridge rounds.
Manu Kumar of K9 Capital extends the theme and suggests only companies building real businesses with real customers and revenue will survive. He implores companies to understand the following:
Early stage venture, particularly Pre-Seed and Seed stage venture, is a different game today than it used to be 10 years ago. LPs and GPs should be aware of this dynamic as they make investment decisions.
This follows from Sam Lessin’s theme a couple of weeks ago, declaring that the era of larger checks coming in at later rounds is now over.
At Signalrank, we have always distinguished between organic unicorns, built over many years from the seed stage, and artificial unicorns created by a single large check in an early round. Organic is always best and can survive downturns.
In this week’s video of the week, Jaimie Rhode doubles down on the theme, explaining that in venture capital, only power-law companies matter. Those companies grow to valuations, enabling an entire fund to be returned or more. The venture capital industry relies on the few power law winners returning invested capital.
In the heady days of 2019-2022, it was possible for a power-law company to emerge fast due to a single round of financing. And then quickly go on to do two or three more rounds within a year or two. Charles and Manu correctly point out that this is unlikely, except perhaps in AI. A power law winner will have to be built organically.
The implication is that early-stage investing will need to become once again deliberate and patient. I use the word capitulation (with a question mark) in the title, but this is just a recognition of reality. Capitulation to reality is a good thing. So, no, it is not a capitulation.
But it begs the question, can venture capital support wealth creation if it is really a lottery for a power law winner? Is there a way to benefit from the growth in venture-backed companies without needing to play the lottery of picking individual companies?
Then I read Howard Marks, the CEO at Oaktree, in Fewer Losers, or More Winners?
I feel strongly that attempting to achieve a superior long-term record by stringing together a run of top-decile years is unlikely to succeed. Rather, striving to do a little better than average every year – and through discipline to have highly superior relative results in bad times – is:
Marks is a long-term believer in consistent average returns. Usually, this requires indexing, where investors can invest across an asset class and enjoy returns at or close to the market norms. If, on top of that, you can avoid losers, then you will beat the market.
SignalRank does exactly that but in the venture capital market. Marks writes only about public markets, bonds, credit, and debt. If it is possible to deliver better-than-average returns from venture investments by de-risking them, then that would be a revelation. Series B rounds return about 3x over 5 years if it were possible to invest in all of them. Here are all venture-backed Series B companies for 2012 onwards, with performance (scroll right in the table to see all fields).
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It is possible to remove likely losers (SignalRank only selects 2800 out of 20,000 B rounds since 2012). By doing so, the group averages over 5x return in five years and picks close to 30% unicorns compared to 10% in the market.
Avoiding losers produces a higher proportion of winners. Howard Marks is right. This has never before been possible with private venture-backed companies, but it now is. We can now make smart indexes in the venture capital asset class.
So, the capitulation implied in Sam Lessin, Manu Kumar, and Charles Hudson’s pieces is understandable. And correct. if you play the normal venture game then finding a power law winner is the meaning of success. Until then, dry powder should remain dry.
But if you can play the Howard Marks version of venture capital, then continuing to invest makes sense, across a broad range of likely winners and eliminating likely losers. Building an index-like portfolio of likely high performers produces predictable and excellent rewards.
Content this week from @kteare, @ajkeen, @MikeNayna, @HowardMarksBook, @Noahpinion, @readmaxread, @krishnanrohit, @Alex_Lazarow, @chudson, @ManuKumar, @gruber, @Jessicalessin, @KateClarkTweets, @ttunguz, @mslopatto, @waxeditorial, @VinodJason, @julipuli, @vkhosla
Contents
Editorial:? Capitulation?