Talk Your Book: The State of Venture Capital

0:28Welcome to Animal Spirits with Michael and Ben. in the conversation we have with Samir. There's a lot of companies that have done fairly well bringing alternative investments to advisors, private credit, real estate, et cetera. The venture industry is different. It really is about relationships and access. And it's not easy to get access to the best of the best. And so Samir and his team have been doing that for a long time. They're great people, great relationships. As he said, relationships are it pretty much in venture capital. Yeah. That's the thing. Yeah, money's not the thing. It's about relationships.

1:02So on today's show, we discuss, we spent the bulk of the conversation talking about the state of venture, where we are in relationship. Obviously, this is a much more sober market to say the least compared to 2021, where we saw some wild shit flying. And we are now definitely on the other side of that. So here is our conversation with Samir from Allocate. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnick and Ben Carlson as they talk about what they're reading, writing, and watching. All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of Ritholtz Wealth Management.

1:43This podcast is for informational purposes only and should not be relied upon for any investment decisions. Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

1:57We're joined today by Samir Kaji. Samir is the founder and CEO of Allocate. Samir, welcome back to the show. Thanks for having me, guys. All right. So we're going to be spending the next 30 minutes or so talking about venture capital, where you fit in the ecosystem. But before we get into the state of the industry, we tend, as investors, tend to think about venture capital through the lens of investing. but we don't often discuss why venture capital as an idea is so important and all of the benefits that everyone in society gets to take advantage of, whether or not you're an investor. Can we just maybe talk about the good that, and I don't want to overstate it, but seriously, venture capital has provided wonderful benefits with the companies that they've invested into the services and products that they provide to Americans and people all over the world.

2:59Just talk about that idea for a second. Well, I think that maps back to what venture invests in, which are technology companies that have kind of reshaped our entire lives, the way we work. Of course, right now we're on Riverside, which is a venture-backed company. But going back 30, 40, 50 years to the early days of venture, it was the only type of equity source that was willing to invest in companies that were at the very inception phase of their lives. Companies like Google, Amazon were all companies that were venture funded. At a time where the first check in those companies were done at a time where there was a pitch deck, maybe there was an idea on a napkin.

3:40Absent the venture capital funding source, these companies would never have been able to go on to build and scale to what they have now. And so as you've thought about venture over the last, let's say, 40 years, it's always behind creating these massive super cycles of technology innovation. So going back from mainframe computing to personal computing to the internet to mobile cloud, now AI, these are all things that were enabled by the venture capital industry. And of course, over the last 25 years, we've seen the number of public companies in the US decreased by roughly, it's cut in half. And these companies not only stay private longer, but the necessity for a funding source that can help those companies get to a point where the public markets will take them is just much more important.

4:31I saw a tweet today that Uber was either founded on this day 13 years ago, or they got their first money or whatever it was. And it was, I think they were raising at a$5 million valuation. The company now has a$90 billion market cap. So obviously the venture capitalists in there have had a hell of a run and venture capital has had a hell of a run. I mean, let's be real. This was like certainly in the aughts and the teens and I guess culminating with like the fever pitch of everybody doing venture capital in the early twenties. But we are on the other side of that euphoric mania in all markets, but certainly in venture as well.

5:15There's an index, Refinitiv Venture Capital Index. I don't know how this is. I don't know what's in here. Maybe you do, but I'm looking at this chart and it's down 50 % from the peak, which feels, I don't know if light is the right word. It feels right. It feels right. How does it feel to you? I mean, look, there's going to be a lot of pain that continues to happen. We just exited a long-term ZERP period where everything was up and to the right. There was so much capital sloshing around that in the private markets, you had a complete divorce from reality. And the public markets face this too, right?

5:53So we saw 2021 being one of the most frothy markets we've ever seen for gross stocks. That filtered into the private markets. And a lot of these companies were fundamentally financed on the basis that the public markets and the multiple expansion that had happened would continue. And of course, now that's not happened, you have a lot of companies that are sitting there in the private markets that just simply have to be marked down. Now, those aren't death nails to these companies. In fact, you think about Facebook. Facebook actually had a down round in the private markets. I think a lot of people overreact by seeing down rounds when you realize that the public markets have down rounds every single day.

6:33And we sometimes forget the fact that companies go through journeys and they go through ups and downs. And in 2020 and 2021, companies were just funded at valuations that actually anticipated something very different than what we've seen over the last 19 months. So it feels right. And you talked about Uber. Uber actually was started in late 2008, early 2009, during one of the toughest periods. Airbnb did the same thing. And what you have is a resetting of everything, resetting of expectation, resetting of values. You have what we would consider the grifters leaving and the tourists leaving, and people that are actually building things for the long run that now are staying in it because capital constraints are so difficult to navigate.

7:22And so I like times of sobriety. I started my career at the peak of the dot-com bubble in the late 90s and then went through the dot-com collapse two years later. And so times like this are just a natural cyclical overlay to what venture capital is. I'm so glad you mentioned that. So Bennett, we've spoken over the years a million times about, did the zero interest era change how a pension fund will allocate? In other words, are they really going to take money out of bonds and put them into stocks and take money out of stocks, put them into venture capital? And I think some of that obviously happened to the extent that it did.

8:05Some of it might've been overstated. I'm sure it varies by company. But what is hard to argue is the distortion that zero interest rates created for how loosey-goosey investors were with the money that their companies were doing, right? It was just build product market fit, get market shared. We could subsidize it. It doesn't matter. I remember in 2016 or 17, well, it was probably, it was a podcast pitch. So it must've been 2018 or so where Ben and I were talking to somebody and it was a neat idea. And I can't remember if it was free. And we were like, well, how do you make money? And they were like, oh, we're not worried about that.

8:44And we were like, sort of laughing. And I think we said like, oh, thank you, venture capitalists. But that era that we, that we, you know, it was, it was a good run. It was a decade, right. Of Uber losing money on every ride of just everything that the consumer imagine was heavily subsidized and everything was artificially cheap. That era is obviously over. And then that culminated with just this boom of crazy valuations, crazy multiples, crazy rounds, crazy speed with which the rounds got done. That's done. Are you seeing any remnants of that or is that just completely buried at this point? I think it's largely buried.

9:26And we could put AI maybe in this separate bucket, because I do think AI still exhibits some of the craziness that we saw pre-2022. What happened during the period that you just described, let's call it 2011 to 2021, was not only the amount of capital, but the incentives that were in play. If you think about venture as an assembly line, a company raises a seed round, then they have to raise a Series A, Series B, Series C. there's always a downstream buyer. And what companies and investors realized was that there were downstream buyers that were willing to pay a higher price, usually based on one fundamental metric, which is top-line revenue and revenue growth.

10:09No different than what we saw in the late 90s when it was eyeballs. And so companies were manufacturing growth only to understand that they could just get to the next round at a higher valuation, secondaries. But if you look at under the hood and look at the quality of those revenues, we call them dirty revenues because ultimately if I pay$2 to make$1, probably not a good long-term business model. But that's what it was. It was buying Facebook ads. But the market was buying it. Even the public markets were buying it, right? So you saw the SPAC explosion of 2020 and 2021. So from an incentive standpoint, you were incented to put a lot of money to work, have somebody else market up.

10:47you can raise the next fund and raise much more capital, get more management fees. And it was a rinse and repeat. And a lot of people won't necessarily admit that that was what was happening. And you'd always look to justify when you're in the moment that the markets change. We're in a new paradigm. But effectively, gravity has now come back in. And outside of AI, which still remains frothy, everything else has course corrected to what the actual reality in the public markets are. and the fact that people have more options to where they invest their capital. Taking the speculation piece off the table, because obviously that was a big part of it with the 0 % rates, financially, couldn't you make the argument, if we're doing a private versus private comparison, that venture capital is in a much better space than private equity because there's not as much reliance on debt, right?

11:34So the higher interest rates, I think, eventually are going to make such a higher hurdle rate for private equity and adding leverage that obviously you need the funding to still come in for venture funds or venture firms or startup firms, but since there's not as much debt, financially, it's not as big of a burden there. So yeah, I mean, we've seen the downside of interest rates in the world of mortgages right now. The mortgage rates are over 8%. Private equity, as you mentioned, does heavily use leverage when it comes to acquisitions. Venture doesn't. It's an equity play. So yes, From the standpoint of returns, actually, I would make the case that venture, just what I've seen historically, is going to outperform, and it actually has outperformed private equity.

12:20The knock against venture is it's a longer-term illiquid asset category, slightly more risky depending on where you invest and how you invest in venture. During times like this, people tend to not be return-focused but risk-oriented. And so that's why we have so much capital flowing into things like private credit, secondaries, and private equity versus early-stage venture, which logically would make sense when valuations are down. And founders today have to exhibit better behavior in terms of building companies. But to your point, yes, interest rates do matter in the private equity world. I'm also curious about doubling down in venture.

12:59because the market cap or the index and everything is down and valuations are down. Is there more doubling down on companies? Obviously, people wish that they could take back a lot of those investments and valuations from 2021 or whatever. But is there more doubling down or are a lot of venture capital firms just saying, you know what, we overpaid, let's not double down on that mistake and let's fund something new or just fund these other handful of firms. How much of that is going on now where you've seen this big repricing? It's a tough thing to answer in a blank of ways. So I think it really depends on company by company.

13:36And what you're describing is, do you put good money after bad, right? So you invest in this company. It hasn't really scaled. Yet the company needs some level of capital to sustain. What I'm seeing in those cases is, and what we've seen over the last 12 months, is a lot of those companies are getting spoon-fed by their existing investors. at different terms. Maybe it's a convertible note financing to see if the company can cross over the spectrum and sustain during this really tough time. There's other companies like Hopin that were a product of the pandemic that soared to this massive valuation and then ultimately sold for $15 million.

14:16I think from a VC standpoint, the question really is around this dynamic at the board level of what is going to produce the best return for that existing fund that might be compromised because of the high price I paid. And it really is company by company. I do think there's some good companies out there that are getting absolutely obliterated in the valuation market where the venture investors are doubling down. And there's others where it's just very clear that there's no product market fit. There's no chance that this company is going to drive anything but a 1x return. And in those cases, those companies are either going away quietly or getting acquired essentially for parts, hopefully at an amount enough to take care of the preferred shareholders, which are the venture investors.

15:04I want to go through some charts from CB Insights. Every quarter, they do a state of venture, global trends. And And in the most recent quarter, there was 6 ,100 deals, give or take. That's down from a peak of, damn, my eyes suck. 12 ,000? 12 ,000? Okay. So cut in half, basically. So cut in half the number of deals. The amount of funding also more than cut in half from the peak. But up from Q2, around flat from Q1. So it seems to be stabilizing. but it's still a lot of money,$64 billion that was invested into these companies. Around half of that came from the United States. $64 billion is a lot higher than zero.

15:53Stuff is still happening. Yeah, stuff is still happening. And there's areas that are a little bit more insulated than others, like the seed and early stage tend to still have investments because at the seed level, whether it's an$8 million valuation or 10, companies are still being founded during this time. The growth stage markets are where we've seen the biggest reversion. And it's partly because people need to understand, how do you price something in a market that is uncertain on a go-forward basis? It's also the fact that many of these companies really don't deserve that quantum of capital that they received.

16:28I saw a stat recently that the average unicorn, which there's about 1 ,200 unicorns right now, have raised a median amount of$350 million, which makes absolutely no sense in terms of why do you need that much capital? You had companies like Viva and WhatsApp that were these massive scale companies that, you know, I think Viva raised like$4 million. WhatsApp was, you know, roughly$50 million or less. And so a lot of these companies are just in this, you know, kind of death zone. But I think that the biggest thing that we've seen is the crossover funds start to depart, right? So during the peak times, the Tigers, the CO2s, the D1s, firms like that were the ones writing massive checks in debt.

17:11So for example, you look at some of the big firms, Insight and Tiger. Collectively, they raised$33 billion between the two of them and two funds. These are just two funds. And Tiger was writing checks at a pace of$1 billion a month. So when you extract that level of capital, you're going to have the late stage market, which was the vast majority of the capital deployed, completely atrophy to what it is right now. How have you noticed the changing dynamic between VCs and founders? Because obviously for a while there, the founders had complete upper hand and Michael and I were hearing things like, listen, here's the valuation.

17:50You have 48 hours to decide off of basically a pitch deck and a 10 minute call or something. And now I'm sure it's flipped, but how quickly did that dynamic change? It took a while. I think during 2022, we were still in the world where there wasn't full capitulation to the new reality. And remember, a lot of founders were raised in a period where they had only seen one thing up into the right. I mean, 2009 could have been a lifetime ago. That was 14 years. So you had people that were in their 20s and 30s that had never seen the downturn. So the beginning of 2022, is this just a blip that we'll get through and everything's transient, interest rates will go down, everything will be back to normal, the party's back on.

18:35Obviously, that didn't happen. Now, what we've seen is kind of this, I always look at the 90-10, right? So, you know, in markets like this, you have 10 % of the founders that can dictate those type of terms, say, hey, this is my valuation, this is what I'm going to raise, this is how quickly are you in or not. During the hot period of 2019, 20, and 21, it was a reverse. And it felt like 90 % of the founders we would meet were like, I'm closing on Monday. Here's my valuation. We're oversubscribed. And so I don't know that we're quite at the 1090 now in terms of founders, but I think we're getting pretty close.

19:12I had a small Roth IRA that I had rolled over to AngelList to have fun and write some small checks and in 2000, I guess, probably 21. And I remember there was a bunch of like deals that just were completely filled in like 20 minutes. It was crazy. Like legitimately, like the email went out and these SPVs were all accounted for like literally in 20 minutes or less. and and that um what your experience was exactly what was happening all over the place and in these and many of these companies were like the third derivative of something that had already been created too and it was based on hype and everyone is moving very quickly there was a lot of dispensable capital and disposable capital and if you remember you know during that time there was another asset class that was bringing people a lot of wealth which was crypto we had the meme stock.

20:13So people had this ultimate risk taking mentality where they actually lost the notion of what risk wise. And so, yeah, it's it's going to make it. And remember, you know, I think it was on Twitter, this, you know, the saying for crypto people of have have fun staying poor. It was just this, you got to take as much risk as possible. And that's what happened. And now, of course, we've seen the seeing the painful unwinding of it. Do you see any benefits or positives? Because like a lot of the dot com boom, a lot of people said like, well, that totally built out the telecommunications that set the stage for the next level of the internet.

20:48So is there anything good that got overfunded here that we might look back on and say, you know what, not a lot of these companies made it, but there was so much money invested that we laid the groundwork for the future. Is there any spots that you can think of that that happened to this time around? Yeah, I mean, I do think AI is, you know, is this incredible sort of platform. And I do think it's part of this new super cycle. Yes, there's going to be a lot of companies that are overfunded. But the companies that do make it are going to have a disproportionate impact in terms of our lives on a go-forward basis.

21:19But in venture, it's always that, right? So if you think about venture from a return standpoint, it's the ultimate Pareto principle of 80 % of the returns come from 20%. And if you miniaturize that even further, that 20 % of companies that are driving those 80%, it's actually maybe 20 % of that 80 % of returns, maybe 20 % of those returns are actually getting, actually, let me start over. Let me do the math again. So that 80-20, that kind of says that if you go down one layer deeper, of that 80 % of the returns, it's probably 4 % of the companies that it returned 64 % of total returns. And 20 % of the 4%, which is 0.8%, returns about 50 % of returns.

22:10So you have such a right-skewed power law business that investing in venture, you just have to accept that there are going to be overfunding when things are very hot. But ultimately, there's going to be those companies that fit not a linear curve, but an exponential curve, which is just hard for us as human beings to get our arms around typically. Samir, you just became the actual manifestation of the Zach Alphanakis gif where he's pointing with all the math and the numbers. Yeah, yeah, I did, I did. There was a saying that I heard that might still be true, but it just is wildly like emblematic of the times, the boom times.

22:51Like venture investing is not about what you say no to, it's about what you say yes to. In other words, like maximize your surface area because it is about the outliers And I don't know if that's exactly how like true venture capitalists would describe their philosophy, but whatever. Okay. There's a great chart showing the breakdown in terms of who's investing in these companies. And so there's VCs, which account for 30 % of it. There's incubators and accelerators. There's private equity. There's CVC. I don't know what that stands for. What does that stand for? The corporate venture capital. Okay.

23:24Okay. Got it. Yeah. Like Coinbase was a huge crypto investor. All right. there's corporations, there's angels, and then there's other. And other is big. Other's 22%. What do you think is baked into the other slice? I don't know. I don't know what the - That individuals or endowments maybe? I don't know. It could be family offices. Could be family offices. Could be government. Could be sovereign wealth. It's hard to actually know what that other 22%, but that 22 % is actually pretty significant in terms of the entire pie. Yeah, that's why I was sort of thrown off. All right, Just in terms of the average and median deal size, this goes back to your point earlier that these growth companies were effectively publicly traded companies that just happened to be private.

24:06Just in terms of size, I'm just going to assume that there's not a gigantic gap between, say, a firm and Klarna, except for one's shares traded every day in a stock exchange and the others didn't. And so a firm was down 90%. Well, guess what? Klarna's down 90%. I mean, in real life, And then they took a huge write down. So the average deal size year to date is 13 million, all from a high of 23 and a half million in 2021. But the median deal size is pretty much unchanged because the early stage companies, it doesn't really, really matter what's happening in public markets today because these are ideas.

24:44These are companies that, assuming a normal trajectory, would not even begin to potentially sniff public markets, the one in a million company, until 2030 or whatever, right? So they should be less impacted. Now, of course, there's impacts because appetite for risk and all that sort of stuff. But in terms of where seed companies get valued, that just is what it is. I think that's right. I mean, we're basically buying out of the call, I'm sorry, out of the money call options, right? That are long dated. So if you think about a seed stage company, in all likelihood for a breakout company to exit its 7 to 10 years.

25:22So the only thing that you're really thinking about at that time is when you fund that seed company, is the company going to have enough runway to be able to hit those milestones, to be able to get downstream financing, which we know is much more constrained than before. So that's Series A, that's Series B. In fact, one of the things that we chart and a lot of investors chart at the seed stage is graduation rates, right? So what percentage of your companies that you invest in at the Series A then go on to raise the next round of capital or seed to Series A. And during the heyday of 2019-21, it's hard to call it the heyday.

26:00It was just recent. But ultimately, we were seeing funds at the seed level that 70 % to 80 % of their companies were getting Series A financing. And what's normal? 30%. Wow. And a lot of those seed to Series A were probably happening pretty quick too, right? Oftentimes within six months. And so think about the IR bump. If I invest in a company at a$20 million valuation, six months later, the company doesn't even need to have a lot of traction. Somebody else at the Series A who has a big fund comes in and invests at a$100 million post-money valuation at the next round. I have this nice, shiny markup on my books.

26:41I can go back to my LPs and say, look how great I'm doing, and then raise the next fund. And so that is the one thing that investors have to think about at the seed level is, is this company going to get downstream financing? And what are the real milestones they now need to have? Because even Series A investors, they're not investing in companies that lack complete product market fit. Now, there's a couple of maybe exceptions if it's deep tech or bio. It's just, you know, those are long gestation businesses. But your average SaaS or consumer company is not getting this huge round six months after the seed round.

27:15and therefore that's the risk that you have to underwrite to at the seed. I saw a crazy stat a couple of years ago, and I'm making this number up, but it's directionally right, Samir, you might know it, that even like 60 % or whatever of companies that end up raising like a Series D or maybe even an E fail to have an exit. It's really, really, really hard. Yeah. And well, there's two ways to look at it. So I've seen that stat too, and sometimes it gets a little bit mistaken. Just because a company gets a Series D does not mean it's going to have a successful exit. Now, it may still have an exit, but that exit could be a fire sale of certain assets where nobody makes money.