Things We Think We Think: Q3

November 5th, 2024

FirstLook Partners is a hybrid venture capital firm, investing in US-based, <$50M thesis-driven emerging managers and breakout companies. Every quarter, we send our investors thoughts on the broader market and our portfolio. Below is a preview of our letter.

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Before we begin, we’re beyond excited to introduce the newest member of the FirstLook family, Kobi Porter, who joined the firm last week as a Junior Analyst and is already rolling up his sleeves and adding value:?

Mom is doing great, Kobi is excited to get home and meet his big brother, and dad’s heart is overflowing with joy.

Dad is also cognizant of the fact that his family has just experienced what we in the business call a platform shift.?

(Sorry, we had to).

Nothing gets venture capitalists more giddy than arguing about politics on Twitter platform shifts.

And that’s with good reason. Platform shifts create the conditions for widespread disruption across broad strokes of the economy.

Platform shifts don’t become obvious to the average consumer until companies that are built in the application layer become ubiquitous.

If you’re anything like Kobi on his second week, you’re probably wondering what the ‘application layer’ is. Hang tight.

The first time you signed on to AOL or got picked up in an Uber, it was pretty clear that the world had changed dramatically. You could feel it.

In retrospect, the advent of the internet protocol or the iPhone, and then the app store, were all layers of platform shifts that seemed obvious once you got mail or Uber became a verb. The saturation of mobile smartphones in everyone’s pocket enabled companies to build applications on this novel technology that had never before been possible. Once the average consumer, or business professional starts using these applications, platform shifts become recognizable. They’re sort of like the 1964 Supreme Court case Jacobellis v Ohio regarding..ahem, adult films. Justice Potter Stewart famously said, “I know it when I see it.”

The only problem with investing in platform shifts is that they’re not easy to spot when they begin. And there have been plenty of headfakes over the years.

It was just two years ago that Bessemer, one of the most well-respected venture capital firms in the business, posed the question, “Is AI generation the next platform shift?”

Last month, Google CEO Sundar Pichai gave an hour-long speech at Carnegie Mellon titled, “The AI Platform Shift and the Opportunity Ahead.”

So it feels like at some point in the last 24 months we may have undergone a platform shift with the advent of AI. But why is this so hard to define?

For starters, it’s because there are layers to platform shifts.

Our friends at Epical Group define these layers in this current platform shift graphically as follows:?

What further complicates this is the platform vs distribution shift question, best summarized by Casey Winters:

“What separates a major platform shift from a minor platform shift is a platform shift that enables both a technological shift (new ways of making things possible) paired with a distribution shift (new ways of reaching people with it). The internet and mobile both created new technological and distribution shifts that enabled lots of new multi-billion dollar businesses to be created, wheras “cloud” as an example made new things possible without any new distribution (favors B2B innovation) and crypto arguably enabled new forms of distribution (tokens), but didn’t fundamentally make many new things possible with technology...Other things VCs have hyped in the past as potential platform shifts have largely neither made interesting new things possible nor driven new distribution opportunities (NFC, VR, Internet of Things, et al.)”

We can have an honest discussion about whether AI is a major or minor platform shift, but it seems like – unlike the most recent platform shift hype-cycle, crypto – this platform shift has application layer legs. There are applications for this new technology across almost every sector we can think of, which just hasn’t happened with crypto outside of payments. Sorry, but how are your NFTs doing?

So how do you express this view as an investor?

Sequoia recently published a fascinating piece titled, “Generative AI’s Act o1.” In it, they opine that, “The cloud transition was software-as-a-service. Software companies became cloud service providers. This was a $350B opportunity. Thanks to agentic reasoning, the AI transition is service-as-a-software. Software companies turn labor into software. That means the addressable market is not the software market, but the services market measured in the trillions of dollars.”

Further, they note: “Cloud companies targeted the software profit pool. AI companies target the services profit pool. Cloud companies sold software ($/seat). AI companies sell work ($/outcome).”

They conclude that the most interesting place for venture capital to play is the application layer. “~20 application layer companies with $1B in revenue were created during the cloud transition, another ~20 were created during the mobile transition, and we suspect the same will be true here.”

During LA Tech Week a few weeks ago, we attended a panel about AI-Native Vertical SaaS. Trevor Neff, a Partner at Headline Growth, pointed out a number that stuck with us:

He said, “software spend is 1% of GDP. Labor spend on repetitive tasks is 13% of GDP. That’s the opportunity for AI.”

This is already underway. Some of the most talented entrepreneurs in the world are building applications on top of foundational models that will completely change the world. These companies are not yet household names. Much of the ‘mainstream’ (what are we calling this? legacy? traditional?) media on the topic of AI has focused on OpenAI and what likely may have been an overly exaggerated fear of the unknown as it relates to the capabilities of artificial intelligence.

In Bessemer’s most recent note on vertical AI, they write: “In the past 12 months, new models have emerged that demonstrate significant advancements in terms of their ability to understand context and reduce hallucinations, as well as their overall reasoning capabilities. The performance we’re seeing across speech recognition, image processing, and voice generation in certain models is approaching (or, in some cases, surpassing) human capabilities, unlocking many new use cases for AI.”

There are transformational, potentially category-defining vertical AI companies being built and scaled as you read this:

• Abridge transforms patient-clinician conversations into structured clinical notes in real time
• Writer enables enterprises to deploy custom AI apps for a wide range of use-cases, including digital assistants, content generation, summarization, and data analysis
• Harvey helps lawyers get answers to complex research questions across multiple domains in legal, regulatory, and tax
• Modelcode, a FirstLook portfolio company (shameless plug alert), enables enterprise software developers to focus on building the future, rather than fixing bugs in legacy codebase

Since launching FirstLook a year and a half ago, one of the more common pushbacks we get to investing in this asset class in the current market environment (elevated rates, stocks on a run, venture taking a beating) is that – even if I’m bullish on AI, why not just invest in Nvidia, or a basket of the Mag7 (Apple, Microsoft, Google, Amazon, Nvidia, Meta, and Tesla) and have the luxury of liquidity while still having beta to the AI platform shift?

First, the alpha to be captured in the application layer will happen in private markets, not public stocks, over the next few years. The same was true in the last platform shift.

And second – and this is important – remember, liquidity works both ways.

Yes, you can usually buy and sell public stocks easily without much slippage. But the illiquidity in private markets is a feature, not a bug.

AirBnB jumped from a $70M valuation at their Series A to a $1.3 BILLION valuation at their Series B in EIGHT MONTHS. If the stock was public, and you held it during that run, and you can honestly say that you wouldn’t have sold any of it after a run up like that, then you should submit your resume to Berkshire Hathaway because they may have an open position.

AirBnB was notorious for not allowing stock transfers, even for employees. Again, that’s a feature, not a bug.

So yes, you can buy Nvidia, or the Mag7 right now and avoid venture capital. But if that basket is up 10x in a few years, will you hold on to it? That’s the place venture capital and private equity hold in a well-balanced portfolio.

Now, back to platform shifts.

We took a look at Cabridge Associates data on DPI (or Distribution to Paid in Capital, net to LPs or – as we’ve said frequently in these writings – the only metric that matters) dating back to 1998. To smooth the data and try to eliminate as much noise as possible, we looked at 4-year rolling averages of Top 5% funds in each vintage. The top 4Y rolling average vintage was 2013 at 5.8x DPI; meaning a basket of the top 5% of venture funds between 2010 – 2013 returned almost 6x cash to LPs after all fees.

The iPhone launched in 2007, and the App Store opened in July 2008. Entrepreneurs started building the application layer of the mobile platform shift shortly thereafter. And it's no surprise that those vintages that followed produced the best venture capital returns of the last 25 years.?

Venture capital is a power law business. Our job, put simply, is to find outliers – for both fund managers and founders.

While investors appreciate the power law within a venture portfolio, a recent?study?from Stepstone shows venture vintages themselves have the power law dynamic within them. The analysis “shows that 80% of venture capital returns have consistently been driven by 22–30% of vintages over each of the measured time periods. Put diffently, of the 23 vintage years assessed, 80% of returns come from just five to seven separate vintage years over the short, medium, and long term. Furthermore, 95% of returns come from six to ten of the 23 vintages measured over each time frame. These statistics speak to the degree of impact that the strongest vintages have on industry-level performance and underscore the difficulty of trying to “market time” the asset class.” Investors are well served by investing capital each vintage year in the asset class (or even better, getting exposure to multiple vintages through one vehicle so they don’t miss the power law vintage years).

If we’re now transitioning to the application layer of the AI platform shift, the next few years look very promising.

History doesn’t repeat itself, but it often rhymes, as they say.

Market?

It’s our view that the negative headlines will continue for another 8 – 12 quarters as the glut of the asset bubble of 2020/21 works its way through the system. There are just too many companies that raised (or were force-fed, there’s plenty of blame to go around folks) too much capital and will likely run out of runway before they can grow into those lofty peak bubble valuations. Some will get recapped, many will fail. Not a whole lot will go public or have an exit that makes for venture-like returns for investors. This will look like a slow-moving train wreck.

We want to highlight what we believe are the three most salient trends in the last quarter from the?Q3 PitchBook/NVCA Venture Monitor (as Dan Primack calls it, the gold standard for data on US venture deals):?

• Distributions, or the lack thereof, continue to be the most important component in the current venture environment. Initial public offerings (IPOs) and large M&A remain particularly absent from the market – just 14 companies went through a public listing in Q3, and the final exit value for the quarter reached just $10.4 billion. The market continues to be flush with headwinds despite the 50-basis-point rate cut from the Federal Reserve (the Fed) in September, which will continue to pressure the exit market for the near term.
• Outsized deals elevate total deal value. This year’s deal value is on track to reach $175.2B, surpassing 2020 but still a long way from zero-interest-rate-policy (ZIRP)-era highs.
• The closed IPO window has forced venture investors to take whatever liquidity they can get. The share of exits in which VCs made back less than their initial investment is at the highest level since at least the global financial crisis of 2007-09.?Since 2022, 70% of VC-backed exits were valued at less than the capital investors put in. That figure was 58% for the period between 2009 and 2014, according to PitchBook’s Q3 2024 Quantitative Perspectives report.

But, there are some green shoots. (And no, we don’t think Stripe’s acquisition of Bridge at 90x revenue is really a repeatable green shoot).

This is anecdotal – which is sometimes all we have because it’s really hard (if not impossible) to find trustworthy, real-time data in the asset class – but we’re finding that early-stage founders are being more capital efficient and doing ‘more with less’ vis-à-vis founders who raised their first round of institutional funding from 2020 – 2022.

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We surveyed our six Core Managers about this and received the following:

• “Most companies have 24+ months of runway at the time of funding today versus 12-18 months of runway when raising 2-4 years ago.”
• “More ‘spend-heavy’ mentality in founders in 2021.”
• “Round sizes today are smaller, and the runway is slightly longer, so the gross burn is definitionally less.”
• “The average burn for companies we've funded this year is between $100 - $150k/mo. We want companies to have 24 months of runway, which gives them more time to prove the market and show early lift. In 2021, we were fine doing a smaller round even if the runway was 12 months or less (if the team was strong) mainly because we knew a good team could easily go out and raise the next round, so it felt like there was much less financing risk.”
• “We have had a couple seed companies who are looking at possibly being profitable before Series A – that never happened from 2020-2022.”
• “In hard tech, we’re not seeing the hypothesis play out.?

• It's fairly similar vs. a few years ago where companies raise for 18-30 months of runway. I think companies are being more prudent with their cash, of course, versus a few years ago, but it's resulting in more pre-seed deals where they aim to do a lot with a little ahead of a larger seed raise.”

You can see this playing out in recent data from Carta, which shows a very clear upward sloping trendline from Q1 2022 to today in the time between financing rounds at every stage?

The data suggests that founders in this market are wise to assume they’ll need more runway to get downstream funding. As the chart below suggests, companies that raised a Series A between Q1 2020 and Q2 2021 (when private markets started to crack), went on to raise a Series B 30% - 40% of the time 2 years later. Companies that raised A rounds after that have seen a dramatically more challenging environment to raise a Series B – only 8% - 9% in the Q2/Q3 2022 cohort. The goal posts have moved, and the best founders can see that and are making adjustments to how they allocate resources.?

Lastly, we believe one of two things need to happen for the venture market to right itself. We always keep an eye on the public markets – particularly publicly traded, enterprise SaaS businesses and where they trade as a multiple of ARR. Their current and long-term valuations are the best barometer for where mid-stage enterprise SaaS businesses should trade, and we note that this is only a directional proxy since growth rates can be vastly different. But directionally, the valuations should be in the same ballpark. If you look at the basket of publicly traded, enterprise SaaS businesses below, you’ll see that they have $500M - $1B of ARR, are growing 15-25%/year, and generate positive free cash flow – all impressive metrics of a healthy business. However, they trade at an implied ARR multiple of 7x, while private enterprise SaaS companies raised mid-stage rounds (Series C-E) sometimes at 50-100x ARR from 2020-2022. So, in our view, one of two things need to happen for the enterprise SaaS market to right itself – either the private companies need to quickly grow into a 7x ARR multiple before they can raise a subsequent round or exit, OR this basket of publicly traded businesses need to re-rate to 12-15x ARR.?We think the multiples will eventually begin to converge, but some of the higher quality names below will re-rate first (and we’d probably be buyers, but this isn’t investment advice, do your own work, yada yada). And in this process of convergence, the lower-quality businesses that were funded at high multiples in the ZIRP era will be washed out along the way.

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?Finally, a few things?we think we think, in the current news cycle:

• If?Goldman’s prediction?of 3% annual returns for the S&P 500 over the next 10 years is right and rates continue to decline, then we think we’ll see more inflows to private markets and specifically our asset class.
• We think emerging managers raising a Fund I in this?environment?are built different – you have to be extremely passionate, confident in your strategy, have a true sourcing edge, and resilience to power through this slog.
• There will be an uptick of LA-born babies this month named Freddie.
• We think we won’t know the election results on Election Night. Or for quite a few nights.