E441 | Alex Konoplyasty, Flashpoint Venture Growth: The current exit landscape and the rise of venture debt

27:26This is something that has not happened before. Can you describe a bit or comment on this discrepancy between what's been happening in the public markets and what's been happening in the venture markets? Yes, absolutely. Thank you. I think, you know, indeed, I mean, NASDAQ from the lows of 2022 is up like 70-80%, right? So it's like the valuations are all-time high in a way now with all the elections and geopolitical turbulence have come down a little bit. But in general, VC is a very particular asset class for a number of reasons. Number one is that investors are coming in into basically preferred shares that are liquidation preference driven.

28:12So for example, imagine you invested$10 million dollars into a company, you value the company, let's say at a hundred million dollars, you got roughly 10 % stake in that company. The company was worth, after your investment, 110 million, right? So you invested in this company at the 30 times revenue multiple. So the company had 3 million revenue, you invested at 30 times revenue multiple. So here's the deal, right? And then everything collapses and the company, okay, it's growing somehow, you know, like whatever, It gets to five, six, seven, 10 million, right? And then basically what usually happens is that for you as an investor, because you're in liquidation preference priority, for you, the company is not worth 110.

28:51For you, the company is worth 10. Because if you sell the company for 10, you're the first to get the money. You will be getting this first distribution. That's like the inherent discrepancy of the VC asset class, which A, creates this unhealthy evaluation environment on one side, but on the other side, in times of downturn, like right now, it creates conflict of interest because the founder does not want to sell at$10 million, because you will get the money, but then all the angel investors, all the common shares, all the management, they lose everything. They spent already 10, 15 years where we're building this thing, and now they're going to lose everything.

29:32So there is a big conflict that arises out of this whole liquidation preference waterfall. And then number two is that VCs, because they have long dated funds, right? They can wait. There is no pressure to sell, right? So for a VC to sell now is to record the loss. If you don't sell now, like nothing happens, right? You can still wait for five years. Yes, you don't make distributions, but then you don't mark a loss. And that's what's been happening, I think. This whole big disconnect between the, on one side, high valuation market environment. On the other side, I think for certain companies, for certain, you know, segments, the valuations have remained high.

30:16For example, you know, we've been actually, last year, we sold companies at like 10 times revenue to private equity. But for certain segments, the valuations have collapsed. If you're in HR tech or if you're marketplace or in e-commerce, you know, the valuations have totally tanked, right? And that's been a disaster. And also, private equities and growth funds are like the nature of buyers right now. They're pressurizing you. Despite Nasdaq trading like all-time high, you know, for certain segments, the valuations are like 10, 15 times revenue. Private equities are trying to buy things at like five times, six times revenue, right?

30:50So you as an investor, you invested at 30 times and now you need to sell at five. So this is a huge disconnect that is happening between public markets and private markets and also the structural, you know, sort of problem with the asset class because of the tiered structure of the gap table. So I think, unfortunately, it's something that, you know, cannot be solved only through time. And if the company can, if the companies can, what we're seeing is that companies are just taking time to grow into valuations where founders are not willing to lose money. Founders are just trying to win time one way or the other, take on debt, cut the cost, do whatever, be the founder, right?

31:32Be like the real entrepreneur. Kudos to those. I think there are a lot of big fighters. And in our portfolio, we've seen like a lot of fighters. Unfortunately, some people had to go through COVID, you know, just four years ago, five years ago. Now they're going again through the turmoil. A lot of like resistance needs to be shown, but there are big fighters who are like fighting and working through, and they just need to grow into the valuation, right? And then, okay, it's easier to sell. And I think slowly this will, this whole problem will devolve, like start devolving. But right now it's like a very stressful environment.

32:04You are investing primarily at Series A, and then of course you follow on in the later rounds. When you're looking at the use of liquidation preferences, How do you think about it yourself at the CSA stage? And how do you think about it in the stages that follow? And what are tactics, strategies for you to use that are effective? It's like a standard market practice. We also come in as a preferred shareholder. I think the way to manage this whole disconnect, I think, is still around the company. right? So, you know, our preference is always to, and what we're telling founders is that, listen, your valuation today at Series A is not a real valuation, right?

32:51It's just some watermark, because two things will happen. You need to be thinking about how much dilution you will, you know, in general experience in the next five, seven years. You know, people rarely think, how much capital do I need to raise in total to get to, let's say,$100 million of revenue? Nobody thinks like that. Everybody's like, okay, I need to raise 10 million now. You know, that's it, right? So how much money do you need to raise in total? What's the business that you can build? Because dilution actually impacts things a lot. So A, valuation in that sense today is theoretical. Number two, nobody's selling, right?

33:26So I'm not buying the founder out today. I'm putting money into the company. So in that sense, valuation is also in a way theoretical. And then for the founders, from our experience, And we have some companies that, you know, took from 2 million, 3 million of revenue to like 200 million of revenue or like hundreds of millions. We have companies like Guesty, you know, Preply, Chess.com, you know, et cetera, Printify that went, you know, all the way and we saw them like grow big. It's all like very different journeys. But what happens usually is that founders and the management team through ESOP, over time, they can compensate this dilution, right?

34:03Why is this entry valuation, series A valuation important? Because when, you know, 50 % of cases are successful, but then 50 % of cases could be not successful. When it's not successful, if you overhiked this valuation, it becomes a problem. Because then you come into all of this discussion, okay, my last round valuation was whatever, 100. I cannot sell for 30 or 40, right? But, you know, and that becomes a conflict because like then for me, you know, for the last investor, then they're losing money. I think that people should like try to be less greedy in a way, like in the good sense. Okay, if you have a deal and somebody gives you money at 100 million valuation, it's great.

34:44But sometimes I feel like it's not the right advice of earlier investors who are pushing the founders to start marketing deals that are more capital than the company needs. And also high valuation that is reasonable, right? It's like early investors who are pressurizing, go, go, go. You can do it five times money. Let's do it. I think it should be more thoughtful in a way and not disconnected from the reality, to be honest. Because the other problem that we're seeing, why valuations are high at Series A also, is that founders take much more capital than they need. They take money for, let's say, their budget for next year to burn$3 million.

35:23They raise$15 million. Why do you need$15 million? Why? You're going to burn$3 million. Why do you need 15? Tell me. Like, honestly, you don't need so much money. Like, I mean, we had a lot of these discussions in 21, in 20, when it was like overinflated environment. But in my mind, because then it destroys discipline within the company, because then you have so much money. You start hiring more people than you can manage. You're growing too fast. You create, you know, inefficiency, A. B, if you're raising 15, that's how the valuation ends up being 45 instead of 20, right? because you're being diluted much more.

35:59So you as a founder, you don't want to be so much diluted. That's why the valuation goes up. It doesn't go up because the business is worth 45. It goes up because you take 15, right? It's like, you know, a very weird logic. So, and that's why we like founders originating from Eastern Europe, to be honest, because they're more efficient just because by nature, the R &D costs much less than in Germany, UK, or Boston, Massachusetts, right? So these founders need less capital. All of our companies took a fraction of capital required to get to$100 million of revenue versus some other peers who went there.

36:37And that's why I really enjoy our thesis because then there is a lot more efficiency. And that's what we are pursuing ourselves. And in general, I think founders need to be thinking about this efficiency already they want. how do you, when you talk to founders at the CSA stage and you're considering coming in, how do you bring this perspective to founders? And oftentimes there'll be competition in the round. So you'll have colleagues in the business that would might have a different perspective than yours or might have that pumping up mentality. And for that reason, are offering different terms than yours.

37:14What are the arguments that you find making sense, both in terms of putting the full syndicate together with co-investors or maybe approaching to an existing potential co-lead and saying, we'd love to come in, but could we maybe talk about how we're structuring this round? And same thing with founders when they approach you and they have a different perspective on what the ideal price of the company would be in the size of the round. Yeah, that's a great question. When we usually come in, most of the time we're like the first in a way institutionalized investor because before us they're usually like angels and early seed investors who are not maybe as equipped they don't have such big teams and they're not as equipped at looking at the underlying business sort of economics and the assumptions we sometimes come across companies who come to us and say listen we have two million of revenue and then you start looking at the revenue it turns out that's not revenue because they include into revenue cash collections, contracted revenue, it could be like a mixed bag of things, right?

38:16And they think it's revenue, so there is no like proper reporting, no proper thinking about it. When we invest, what is important is that to build a company, it's actually a very specific like formula, right, in a way, because, you know, there is a process times people times execution, right? And there is capital that comes into that equation. When we invest, for us, it's very important to agree upon the budget, right? So when we invest, there should be a budget, which is quite specific plan, how the company is going to execute, right? So how many people are they going to have? What sales and marketing channels we're going into?

38:52How do we think about the costs? How do we think about the economics, right? You can't just take money because you need money and like just have money in your bank account, right? You need to be very, very specific and granular. And I think the best founders are the founders who think about this nitty gritty detail and then are capable to hire people and build the processes. Because then, you know, we come usually into companies that have like one founder who is the person responsible for the product and also the person responsible for the sales, right? So there's like no real organization. And then founder needs to start building a C-level, start building processes, right?

39:31How do these various functions work by themselves together? How does it become a company in a way? So this is a difficult bit. Not everybody is actually capable to perform this and to execute on this budget. So for us, that's how we think about it. And then that determines how much capital is required. So we think about the budget because this is a specific plan that we're going to execute. and then it creates like the round and the structure around it. When we invest, we want to provide enough capital for the company, let's say for the next 18 months. I'm not a big fan of overfunding companies, but I also hate to underfund companies because then, you know, you cannot like manage the budget, you cannot hire enough people and then you can fall into a trap that, you know, you're on a plan, you have an investment plan and product.

40:24and because we like invest a lot of times in enterprise software, which takes time to develop, products that take time to develop and also the sales cycle is quite long. Could be 12 to 18 month sales cycles. So you need to allow the company to like go through this thoughtfully because the problem is that you don't see results for a long period of time. That's why discipline is super important. You cannot like defocus, run into too many directions and then you basically fail, but you spent a lot of money and you failed. So this is what we are super cautious about. That's where we spend a lot of time talking to founders, talking to early investors and trying to find, okay, what is the right connection?

41:05And then usually the way the round is structured is that we are quite flexible and loyal. Obviously, we have our own targets in terms of the stake we want to be getting. But then for us, if existing investors want to participate, the founder has preference for some angels joining who could be value additive or some other funds would be value additive, we are very open to that. And thus, on the back of all this work, and I was about to call it financial engineering, but that's not the word, but all this work, looking at the finances, looking at the quality of the real revenue and so on, on that basis, you tend to be able to reset the conversation around valuation and round size.

41:46Am I correct? Well, valuation, I think it's always a discussion. Because I think the way we are trying to think about valuation, as an investor, I want to make money on growth, right? I don't want to arbitrage the founder. In an ideal world, you know, if you sell at 10 times revenue, if you enter at 10 times revenue, that's a fair deal, right? Nobody's like, it's not unfair to anybody. And you just made money on the growth in the meantime, as you were an investor, right? So that's how I think about it. sometimes, you know, you might not sell at 10, you might sell at five, but if you enter at 30, that creates a huge gap, huge disconnect in terms of fairness.

42:28A, B, if the company raised money, let's say six months ago, and then they're asking for like a three times markup versus, you know, that investment round, I just think it's unfair. Well, of course, depending on the performance, you know, performance, like we could, like, we could be flexible. I mean, of course, if the company has grown five times, you know, or whatever, it's a different discussion. But we are looking because we're looking at a lot of companies. Last year, we spoke to about 5 ,000 companies. Andres, we spoke to a lot of companies, right? And then we've closed about six investments.

43:01So we are having a lot of these discussions with founders. Valuation is not the determining factor for us to invest. For us, the determining factor is the quality of the team, the quality of the product, the quality of economics, the quality of the market. So a valuation is a conclusion in a way, right? So if all of these things stack up, then comes the valuation and we need to decide, okay, how much money are we putting in? Do we get enough stake? Because for us, stake is important because we're going to be very involved with the founder. We view it as a partnership. We're going to be spending a lot of time helping him build the company.

43:34I have a curveball for you. And that curveball is you guys are investing in Sirius A. In the US, you oftentimes, like the holy grail of venture was Sirius A, is Sirius A. And then if you do venture, you assume it's, well, okay, you're probably doing Sirius A. And then if you're a seed fund, you'd call yourself a seed fund. In Europe, we tend to say we're a venture fund. And that, in other words, most of the time, you're a seed fund or a pre-seed fund i'd love to ask you any reflections on why this is yeah i think uh to be honest i'll be i'll be very uh like honest with you i'm super confused with all of this like terminology and tax because now they have like this european series a they have like u.s series you know it's like for me like i can tell for ourselves what we're doing because it's like very, like I know, very straightforward.

44:33So we are investing, I don't know if it's series A or post seed or what is it, or series B maybe even because what we're doing is like in the US could be even series B already. So we're investing in particular, into a particular stage of the company itself. So it's less driven by the amount of money the company raises or devaluation because they tell you, listen, if you're below 20, you're a seed value, like if you're more than 20 million, than series A. I don't know. For me, what is important is that stages of risk depending on the company's development. So for me, there are several things you need to prove.

45:11First thing that you need to prove is the founder market fit. And that could be like pre-seed, seed stage where the founder needs to prove to the investors and to himself that he actually fits the market with his product thinking and execution capability. And he needs to build the product. The next stage is the founder product market fit, right? So when the product fits the market that is targeting, and that's when I come in. For me, what is super important is that after this point in time, inflection point, there'll be no pivot of the product. So in the in the founder market fit, he can be pivoting the product.

45:55He keeps iterating, iterating with the product. He keeps iterating. He's trying to find, you know, the founder market fit. And then once he found it, there is this like nutshell. There is a product that starts building. And then for me, it's super important that the product is not going to be pivoted after I came in because that is a disaster. If you need to change the product, it's a disaster because I'm not the right guy. I'm just not the right guy. I'm not the product guy. What I'm good at is to help with the growth, hiring people, thinking about economics. How do you add sales and marketing channels?

46:28How do you think about growth? How do you raise the next round? So we are like, how do you grow a company from 50 people to 60 people? That's where we come in. If you need to stay at 15 people and keep iterating the product, we're just the wrong people. I don't know if it's called Series A or what is it called? Like, I don't know. And to be honest, I don't very much care. In different segments, if it's more enterprise-ish, it could happen like when the revenue gets to three like we just invested in a company that had four million of revenue right so for them i felt like before four million you would because they had one customer or like two customers for like you know half a million dollars each right it's super hard to understand okay when you have two customers like is it the company even like or is it just two customers right now they have like more customers it's easier if you're more as in like smb uh if you have like a thousand customers and they have like a, I don't know, a thousand to two thousand dollars annual contract value, then you need more customers to prove because there is churn, there is net dollar retention.

47:27So we need to look at all of these numbers to understand, okay, how does it stick, you know, product usage. We calibrate depending on the sector, depending on the, you know, this profiling, is it the right point in time? I want to ask you something, it's a completely different topic, but I want to make sure we get to cover it and that's co-investments. It's one that we always hear everyone being interested in on the LP side, but it's oftentimes hard for them to execute. Of course, they like it because they get a direct exposure and reduce the feed drag. That's like the things they see and they think, ah, this is going to be amazing, but it's not always such a great win-win for people.

48:04I'd love to ask you, first and foremost, LP co-invests, what is your take? I totally agree with you that LP is really like coinvest exactly for the reasons you mentioned. They think that they invested in the fund, it's too expensive, we have the fees. And then if they invest directly, become part of the cap table, they control their destiny. And it's a great job. It's very hard to execute for two reasons. And there are two types of coinvestments. There is a type of coinvestment when there is a round, let's say there is like a Series C, Series D, it's happening, it's taking a while and then LPs are aware about this deal and then they want to co-invest like and they're proactively monitoring this these situations themselves amazing we're definitely supportive of that if our LP wants to come into CEC directly I'm happy to introduce him to the founder or he by coming to our investor days he knows the founders he sees the reporting on a quarterly basis if they want to co-invest we're super happy about that we'll introduce them there There'll be zero fees actually, because we don't do the work.

49:11They come in directly into the round. But what is important in this type of co-investing, they should do the work. So the SLP coming into this co-investment, they need to do the work. Because Dragon fee, if I do the work, then all work needs to be paid. I mean, why the work should be free, right? It's a very strange concept to save on the payment of work. Is it also a relationship management solution hack in terms of making sure that if they choose to invest, it's definitely on their own work? It's not based on our recommendation. Because that is what some people oftentimes find that LPs, if it goes well, they're happy.

49:57If it goes bad, they're super angry. And if it goes well, they think it's because they picked the asset and it can be very hard to end up with a win as a GP. You're guilty anyway, even if you didn't do the work, because then you should have advised them not to invest that you didn't. So you're anyway, right? In my mind, the niche that we found ourselves is that we are a very active follow-on investor. And a lot of the follow-ons that we're doing is around cleaning up kept tables or adding some intermediate capital to the companies before next rounds. So we actually have quite a bit of this type of co-investing happening.

50:36And there, we do all the heavy lifting. Like right now, I have a deal where we have been working on a very complex situation. issue. It's a big company already, and there has been some participating league preference structure, which we're restructuring right now. So it took us nine months, Andreas, nine months to re-agree with other shareholders, with the founder, like what we're doing, because it's a drag on the cap table, having a participating league prep. We let it happen in the past because it was bad market environment. We took participating league prep in the company. Things actually turned out to be working very well.

51:10The company has grown like five times since then, it's a performing company, but it cannot take more money because it has a participating leap prep in the cap table. So we need to restructure it. And it was like, and I'm actually, we are like the ones that are saying, listen guys, we need to restructure it. We want future for the company, let's do it. So, but it's a nine months transaction and we need capital to facilitate this restructuring. So that's where our investment comes in, right? And obviously, because we've spent nine months doing this work, like, you know, it's a proprietary deal. So there will be fees, of course.

51:47But our investors appreciate that because they understand that we've done the work. They're doing co-investment with us not because they want to save on the fees or because there is another element to it. If you're a family office, if you end up directly on the camp table yourself, then you probably will end up with a small stake, which means that you have zero information rights. You will not be getting, you will not be part of the board. You will not be getting information, right? And B, you probably would end up like stuck being some, maybe even share classes that don't have privileges of right to first refusal, tag, or, you know, any preemption, right?

52:24So if there is an exit happening, it might be more difficult for you to get out even, right? And manage this position in general. And that's where a lot of family offices do get stuck. They get stuck in these, you know, sort of, I call them lazy SPVs where nobody manages them. People just created SPVs to pump in capital and they just let it sit there. Nobody manages that. So our approach is different. We usually, like, we join these core investments together with our main position. And there we manage it from, like, exit perspective and rights. People get the same rights. People get the same information as I do because I manage the position.

53:04Do you see an increased appetite right now in the co-investment market or do you see that it's actually still quite subdued because of general appetite towards risk in the early stage markets? Yeah, last year we closed, Andres, we closed six co-investments last year. So maybe not a huge volume in dollars, but we've closed a number of co-investments. For this year, we have a plan of like 10 co-investments. And the way we operate is that we basically, ahead of the year, we know the situations which are performing, where we run out of capital and where we would need more money. And we would go to our LPs and tell them, listen, here are the situations, they're evolving, they might be needed capital.

53:50So please take a look, keep them in mind. And let's think, you know, which ones do you like better or not? So it's about education and telling people in advance, because in a lot of these co-investments, we just don't have enough time. You need to wire money in like a month. And if people are not, you know, privy to the situation, if they have not been involved, it's super difficult to wire$5 million in like a month if you have never heard about the company, right? That's the challenge I have, but you're absolutely right. I feel like, you know, there is still a level of appetite for these risky situations is lower on one side.

54:24On the other side, we see other like family offices that have actually ridden the wave of the public market. And they made money in the fixed income and inequities. Last year for some of our family offices, people are telling me that they made in public fixed income, like 20 % net IRR, right? So people are significantly in the money and they want to reinvest that, understanding that the interest rate market environment is stabilizing. It's a good time to be investing in equity section. And I think that was the most beautiful sentence to close on. It's a good time to invest in equity. Yes, thank you so much for doing so, Alex.

55:06Alex, I look forward to hearing from David that the two of you met at the 0100 conference. And I hope they will be doing many things together in the future. Perfect. Andres, it was a great pleasure. Thank you so much. Here's a few words from our beloved sponsor. If you're looking to meet key players in Central Eastern Europe's private markets, this is the conference you don't want to miss. Join us for the 14th edition of the premier networking event for Emerging Europe. You'll meet investors from firms like Antenna Digital Ventures, EBRD, EIB, Ersk Group, IFC, Tybus Ventures and many more. Join 0100 Emerging Europe from May the 15th to the 16th in Budapest.

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