E229: Inside Industry Ventures: The $8 Billion Firm Backing 650 Venture Funds

0:00The customer is the ground truth. You have to be willing to bet against those people who've done the almost impossible at the earliest stages and then say, yes, but these other questions aren't being answered in the way I'd want them to be. I think a lot of investors don't go to the customers as ground truth and don't see that as the leading indicator in whether the business will be successful. It shocks me how few people really do the customer calls and do it in a thoughtful way. To me, the question is, if you define integrity as, are they being honest with us? I think I would like to say 100%.

0:31It's very close to that. But there is a question of being honest with yourself. And there, I think, is where some of them fail to test. N of one is special. N of one is obviously rare. And you can't get too caught up on valuation. Don't miss companies you really believe are N of one are really special. I think a lot of VCs make the mistake of passing on great opportunities because they see it as expensive relative to comparables that aren't really comparables because the comparables aren't the end of one. So give me a sense for where Industry Ventures is today from an AUM standpoint and also in terms of number of fund investments.

1:05Yeah. So we just celebrated our 25th anniversary, been around since 2000. We now have AUM of a little over$8 billion and it's divided more or less equally between secondary, which is what we're originally known for, and co-investment, as well as a small fund-to-fund component and a tech buyout component. Tell me a story of how Industry Ventures got into co-investments in late 2010. So Industry Ventures started as a secondary firm in 2000. In 2007, with the introduction of Roland Reynolds, who I think you've talked to before, we introduced a pure fund-to-fund with this thesis that seed-stage dedicated managers would outperform the larger bulge bracket cross-sector funds.

1:47And what happened is by luck with Chris Saka being the sole institutional LP in that fund one, we stumbled into the realization that all of these smaller fund managers are going to share a common problem, which is their capital constraint by the time their companies get to the series A, if certainly by the series B. And Chris, through his own generosity and opportunity view, introduced us to great companies like Stripe and Uber, which we, not through genius, but through luck and faith in Chris, we had the luck of investing in. And then we expanded that opportunity across all of our managers. So he came to you with opportunities, you saw the entire market, and then you're like, this could be a thing.

2:29This could be its own standalone business. Exactly. Exactly. And so that we started to do that, as you said, 2010, and then we built out a dedicated co-investment fund for LPs who wanted just that component. So these co-investments in your context are called direct investments. So tell me what it means to be doing direct investing within a platform like Industry Ventures. That's a great question. We started off as a secondary firm, as I told you, and the mindset of secondary is quite a bit different than the mindset of direct, right? Where you are investing in great assets, but they're really de-risked.

3:06They're much later stage assets. So to be on a direct investing team that is focused at an earlier stage is culturally different. We are taking a lot more risk there. And it works out, I think, at industry ventures because we have the humility to listen to each other and recognize that we're looking at things through a different lens. But it's been really rewarding to introduce the mid-stage and earlier stage part of venture to a firm that's been historically later stage. So you have a co-investment opportunity come to you. Is that exclusively from the 650 funds? And tell me about the life cycle of that.

3:49How does an opportunity come to you and what's the first steps? Quickly on the 650, 250 of that is our primary checks in seed stage focused venture managers, seed series A stage focused venture funds. And the other 400 or so are through our secondary team buying LP stakes. So of those 250 seed stage focus, series A stage focus managers, 100 % of our deal flow is coming on the co-investment side. So you get a co-investment. I'm sure every manager comes in and says, we like this. This is the best company. This is next Uber. This is the next Stripe. what's the next step and how do you corroborate the opportunity and the information around the opportunity it's an awesome question i think the challenge that we have when we get a deal is assessing right the the manager's ability to evaluate a company at that stage so typically we're looking at a company at the series a b or c stages even where the manager's sweet spot has been the pre-seed seed, maybe to some extent early A, I think that there's a different set of questions that they're asking than the questions that we're asking.

5:00And the questions they should be, and sometimes are asking when they're handing us that deal at that more evolved stage, right? Their stage, their original investment entry check stage, they're really just asking two questions to simplify it. It's, is this a great team who can build a product that customers will want. So great team, can they do what they say they're going to do? Part A, part B is, will customers want this thing? And when we look at a company at the series A, B, C stages, we now have metrics around that. And we have to evaluate the metrics and ask a different question, which is, is this a great business?

5:38Not as a great team who can build something people want, but is it a great business? And we go back to the Warren Buffett quote around, it's really important to distinguish something that can be huge from something that can make a lot of money what do you mean by that so i i would take the airline business as a good example where warren buffett's famous for saying hey look if you invest in every single airline company you would have lost an enormous amount of money but it's an it's an enormous it's an enormous market um there's tons of customers for it and it's not going away um so if you were a seed stage investor you'd probably have been very excited about the Wright brothers and what was to come for good reason, lots of demand.

6:16But as an investor at the growth stage of it, you have to ask the question, can I make money in this thing? And I think the answer in airlines is generally no. Just to double click on that distinction. So in seed, it's highly power law driven. You could argue all of venture is power law driven, but the seed extremely so. So if you get the team right and the customer demand, the expected value of the investment is astronomical versus at the late stage, you can't have 50 % of your investments go to zero unless you really have an open AI or you get extremely lucky. But if you're focused on building the right portfolio, you need to make sure that every one of those investments is also good business.

6:53I think you could have a 50 % strikeout rate at the series B and still do very, very well. But definitely you want to have a lower strikeout rate than you're obviously in 650 funds secondary and primary are there really funds that have a 50 loss ratio at the series b that returning three four five x net funds i'd have to push that to our secondary team to ask i evaluate those 250 managers more at the seed stage and those loss ratios are you'd say between 50 and 85 and it's not unusual to have a manager on the high end of that loss ratio range outperforming the basket. So we last chatted about your portfolio of 250 primary funds, 400 secondary funds.

7:37And one of the lenses that you look through that is whether the party bringing you the opportunity is credible. Break that down to me. What does it mean to be credible bringing you a co-invest opportunity? Ray Dalio, you mentioned, and I think you're going to be interviewing us. I'm excited to watch that. I think he's been written some awesome stuff. I can't remember his term for this. Believability. Believability. Thank you. I think of that in two components. One is, do they have a proven track record? I think this is how Ray Dalio would say it, probably be more articulate about it, but a proven track record.

8:12But also on top of that track record, a process which is repeatable. So when we get a deal from a manager, we are going to want to know that they have a good track record around introducing us to companies at this stage, this series, let's call it late A, B, C stage. And sometimes we'll pass until we get to see the, Hey, we should have done a bunch of these. So we want to see their ability to invest well at, at that stage. So you're not only, you start tracking them just like an LP would and you essentially come back. It's not fun too, but it's a, it's a basket of co-investments two years later and you're tracking how did the first vintage do, which is the first couple investments.

8:55So you're, yeah, it's not to say we wouldn't do the first one they showed us. But if we miss it, it's very useful for us to track. And of course we'll track it. By doing that, you're avoiding your own bias towards maybe the manager was overconfident. Maybe they banged the table really hard, but that has nothing to do with returns. You're actually taking all that out, taking your own egotistical views on, and you're like, what does the spreadsheet say? Are they good or not? Yes. Yes. And again, it's not to say we wouldn't take risk with them before we have the spreadsheet data, but that spreadsheet data is really valuable to us.

9:24The second piece of this believability from redaglio is okay do they have a process here which is repeatable or were they lucky on the two or three pieces of data that we have here and one really valuable way for us to assess that is to run diligence alongside them to see how they think are they talking to customers are they hearing you know are they interpreting it correctly i think one of the biggest risks with a seed stage manager investing at the mid-stage of the market is that they're really excited about this asset, genuinely. I don't think it's a lack of integrity to hand us stuff. I think they're genuinely excited about it.

9:57And sometimes that's drinking the Kool-Aid can happen. And you can be obscured from the facts from the data set. And we want to see them run the diligence process, which is really mindful of the actual data. Double click on that. So you're literally on the diligence calls with them. You're in their data room. How are you assessing their process? Break that down. Are they talking to customers? Do they understand the difference between a pilot, whether it's called a pilot or not, and something that that customer is truly locked in and excited about? are they looking at you know things like gross retention versusnd net dollar retention to really understand is this super sticky and are they asking questions about scalability profitability margin protection over time so it might have a really attractive gross margin but do they understand what's happening in the competitive environment have they talked to the to the customers using the competitor product things like that so what a typical series a b and investor would do, are they essentially doing that kind of diligence, not the seed diligence?

11:04A lot of people think it's absurd. The best investors have pre-seed to do things like figure out the market size or those things at Mike Maples. And he looked back at his entire portfolio and he found that the companies that actually did the very best were creating new industries, were more movements than companies. If you took that lens to Series B, Series C, you might have an issue. Yeah. I mean, I think Facebook's a really good example of this. If I understand where you're going, where we definitely would have missed it, right? There was no market. It's not in the spreadsheet. There's no revenue.

11:35Yeah, exactly. And I think great seed investors can see around the corner. I think at the mid-stage, I think by the time, I'm guessing here, but I would imagine by the time Facebook got to the series A or B, there was just enormous user demand, right? And there was something to trade on there. But as a mid-stage investor, person focused at the mid-stage, I'm pretty certain I would not have done Facebook at the pre-stage. I would have missed that. there's no data to support that when we last chatted you said that you find 20 to 25 percent of your managers at a later stage are highly credible which is another way of saying 70 to 70 to uh which is another way of saying 75 to 80 or not but it's not an integrity thing that's only one side now there's a lot of money at stake so i'm sure there is a non-zero integrity factor on those 650 managers you don't have to nod your head but on top of that we talked about this do Are you able to assess the good investment at the Series A, Series B?

12:31I would argue very different skill set than on the seed level. That's probably the main component. Is there anything else that you're looking for in the managers outside of, do they have high integrity? Are they able to assess? Is there a third thing? In terms of like, would we do a co-investment with them at the mid-stage? Yeah, I guess like if you think about the investment as two components, the actual investment and the manager's believability, is there anything else that would fit in that manager's believability bucket? I think you summed it up. I like that believability quote from Ray Dalio there.

13:04I just correct you on the 25%. In large part, it's small because we haven't done co-investments with the rest. So there's only 25 % that have gone through the process that get the stamp of approval. They know how to do later stage. There's 75 % that have not yet gotten the stamp of approval. Yeah, exactly. We haven't done a lot of co-investment with them or if we have, it hasn't worked out that well. I have to ask, what percentage have integrity issues when they send you SVVs? Is that a real thing? And if not, why not? Because the dollars at stake are real. This is life-changing money. It's essentially the lottery tickets, the Series A.

13:39Any one investment could buy your second home in Florida. So there are real stakes at the table, if we're honest. What percentage of your managers don't have that integrity layer? Or may not even be aware that they don't have the integrity layer. But yeah, I would say, you know, I haven't seen any managers send us a deal that they don't believe in. To me, the question is, if you define integrity as are they being honest with us, I think I would like to say 100%. It's very close to that. But there is a question of being honest with yourself. And there, I think, is where some of them failed the test.

14:14And I think that's not a bad thing. If you're a seed investor, you know, you have to see the glasses half full. You believe in this team and you might be well be right. The team is great and the product market fit may be there, but that those set of questions don't necessarily make it a great investment for us. Said another way, it would be very difficult to be a highly cynical pre-season buster. I think so. Yeah, exactly. I think that's a really good way to put it. You're generally positive. You're generally leaning in and you have to make a mind shift, which is, I think, really hard for people to do between the questions you're asking at that seat and the questions you're asking later.

14:51You're going from a qualitative assessment for the most part, right? Is this a great team? And will the dog want to eat the dog food? Sometimes in a market doesn't really even exist yet to a more quantitative approach. And if they did part those answers, those first two questions, that's pretty amazing. That's great. And it's hard to to then say no, right? It's hard to... It's a high cognitive dissonance to be extremely interested in something at the pre-seed and not interested at the Series A. Yeah, I think it's really hard. Especially as they keep on raising and bringing in more capital. That's a hard, conflicting kind of dichotomy.

15:26And some of them are amazing at it. I mean, I think Founders Fund is a great example of a firm. Krosla has done this well too. Keith Raboy has done it as an individual investor in both firms. There are people, I think, put benchmark in this category sequoia has done it really well who will invest at the seed and the mid-state and are those firms or people are there i think a little bit of both like at andreason i think it's more people like right because you'll have a earlier stage team and then they have to make a handoff yeah right so they might be a different person but i think at firms like cosla and i'm not sure about sequoia but i believe it's sequoia too it's the same manager making those early set bets who's able to go and be honest what makes them able to do these seemingly contradictory investments?

16:08I think it's really, you have to be willing to bet against those people who've done the almost impossible at the earliest stages by being a great team who can build this thing that's really hard to build and get some product market fit and then say, yes, but these other questions aren't being answered in the way I'd want them to be. And I think the least sexiest thing in capital markets and investment is process. And yet it is one of the most sustainable points of alpha. There's many different processes and even due diligence itself, the length of your due diligence, the way you reference all these things are extremely correlated with good investment and good investing and extremely correlated with good sustainable returns.

16:58Yeah. So not all co-investments are equal in your mind when you see them. What are the two best, most low-hanging fruit? When a manager comes to you, you get excited. This could be something we want to do. It has to answer the question of what's special about this deal. What's special about the deal for us? We have to believe we have some asymmetric information. We have to believe that the board member who gave it to us, typically our managers, are board members or they're deeply engaged. And that's important because then the quality of the information. Exactly. So the way that I put it is that investing has an art aspect, but it's over-relied upon.

17:36So let's say you have investment, two processes. One does three references and one does 20. The person that did three references is just handicapping their return. It's not because they're an artist. It's not because they have intuition. All these things are a misuse of investing and a destruction of returns. I agree with that. I think the way we think about it is we have to triangulate on that board information we got by talking to other board members, right? And we also have to get customer information. So by getting all that information from customers or prospective customers and from other people very close to that management team across – and maybe it's not 20 data points, but quite a few, the more the better.

18:16That's good. So we can kind of – it's not that the – back to your integrity thing. It's not the managers intentionally. They may not have all the data. You know what a great gauge of managers' believability is? It's what is your GP commit? I found that as a way to create integrity in myself, which is I'm super excited about this investment. Great. How much am I putting? 1%. Why? Why aren't you putting 10? Right. Oh, that's a good question. Let me think about that. Why? Maybe I'm not as excited. Maybe I'm hyping myself up. Yeah, yeah. So it's a great way to be honest with yourself, the GP commit, and asking yourself questions.

18:52Why? And why not? and that you know that's that's obviously and i do think there are people unfortunately that do see these as see relationships as short-term see these as lottery tickets and i i would argue that some don't have integrity in my maybe you guys weed that out in the diligence process before you invest but there's certainly there's high stakes at play and there's certainly people that are pushing investments that they don't believe in i'm sure that i'm sure that that's true yeah so So I think your process is really fascinating. Again, not the sexiest thing, but I think it's really cool.

19:25So a seed manager comes to you. Let's say it's a series B investment. You're on the call, but you're also starting to essentially like an FBI informant. You're starting to triangulate information about the company. Tell me about that. Yeah. How we triangulate it. Yeah. How do you get to what I would call ground truth, which I want to talk to about what that even means. But how do you get to your version of summer's here, which for me means occasionally trying to escape New York City on the weekend. When I get time off, the last thing I want to do is worry about keeping my personal finances organized and my budget and balance.

19:59With a little advanced planning and powerful software tools, I can enjoy the summer knowing my money is taken care of. Monarch is the personal finance app that tracks everything, accounts, investments, saving goals, and spending. Get your first year of Monarch Core for half off, just$50 with promo code invest. What I like about Monarch is that it takes the mental load of managing your finances off of your plate. Instead of checking multiple accounts and spreadsheets, you could see everything in one place. The AI Weekly Recap is especially useful because it flags spending spikes and upcoming expenses before they become surprises.

20:29I also like Monarch's AI Assistant. You can ask questions like, how much did I spend on travel last summer? Or how many subscriptions am I paying for? And get answers instantly. Use code invest at monarch.com to get your first year off Monarch Core half off at just$50. That's 50 % off your first year at monarch.com with code invest. ground truth? It's an awesome question. And I think it's an asymptote. I don't think you can get the ground. There's always going to be a lack of information at the end of the day. So we have to be comfortable with that, right? To get as close as we can, we will triangulate with other managers because it's typical that we'll have overlap in a deal.

21:09So we can talk to multiple managers, multiple people. 650 managers is a significant market share in the entire ecosystem. Yeah, we're going to find multiple points of information around the quality of the team in a company. We're going to talk to customers or prospective customers, depending on their stage, and try to understand, right, will the dog really eat the dog food? And who else are they talking to? And if these customers are really valuable to us, if they ran, which is interesting with customers, if you just ask the CEO to give you a list of the customers, obviously they can give you the best ones.

21:42You've got to get your own customer base. you want to talk to customers who ran a great process looked at all the competitors all their options and really did their homework and you can assess that on a call with a customer well who would you talk to what was your process um did you talk to companies b c d and e or is it just a because they're your buddy you got it you got to sort through all that um and when you get because that's not scalable you could only have so many buddies that yeah yeah but we do see that all the time by the way there's a bunch and it's a completely legitimate zero to one strategy it's just not going to turn into a$10 billion company.

22:14Exactly. So we want to know that you have customers who ran the process. They believe that you have a sustainable advantage over the current nature of the competitive landscape, and you are sticky in some way. And we can assess that relatively easily. There is now the question of what are you hearing on these calls, which we found really interesting. I found really interesting. You might be on the same call with somebody else on our team and come to a different conclusion from that customer or other board member. So that's next level. So not only do you have multiple points of information on the customers, in this case, you're on the same exact call.

22:58Two people at industry, two highly educated people on the call, highly experienced as well, and they hear a different thing on the call. Yeah. A, what does that even mean? And B, what do you do? Why is that customer really excited or there's, there's this conflict of interest when you're on with a customer for the most part, they want to make sure this company gets funded because they're a customer. They want to make sure this startup doesn't run out of cash. So there's, there's some, some subtlety sometimes to the way the question is asked and to what they're giving you. And you might come up with, you know, if you're, if you're just on a phone call and you're not getting the body language from it, that can be tricky.

23:37but you can be on a call with a customer and believe that you know they're super excited and but the other person not not pick that up um so that's tricky and i think the best answer to that is have more calls um right so you keep adding more data points to it but that that will happen of course it's like references oftentimes it's what they're not saying then the follow-up question though is well okay i happen to know you know you have these other five managers i name the names now force rank them for me because otherwise you're they're all going to be the best i love that and also it allows you to maintain confidentiality because you're not isolating the manager isolating the opportunity at the risk of saying something extremely obvious your version when i asked you about ground truth you went to the customers the customer is the ground truth will the customer buy the product is a leading indicator event i realize that's extremely obvious but i think it's important because i think a lot of investors don't go to the customers as ground truth and don't see that as the leading indicator in whether the business will be successful.

24:37Totally agree with you. It shocks me. It shocks me how few people do the really do the customer calls and do it in a thoughtful way. You can't just take the basket of customers the CEO gave you for all the reasons I've mentioned before. You've got to go and find your own customer base. Then there's a great third party services, Gerson Lehman Group and Tagus and all these others that will do that for you. There's many. Um, so you've, you've got to do that hard work and you have to make sure they ran a quality process. Cause at the end of the day, I think the customer is gonna speak, right? That's the, that's the best.

25:11What do they say on a reference? A seven is like a two and eight is like a four. So you need a nine or 10, I think basically for it to, for it to be a good reference, uh, from a customer. Yeah. Customer, anybody, any reference and eight is a very low signal and a very negative signal. Yeah, and I always sort of take it to, well, how much money are you going to spend with them? What's between now and actually making the decision to write that check? What has to happen? Get very specific with them, with that customer. What remains on the product roadmap before you write that check? What will get you to not re-engage with that customer, to drop that customer?

25:46Which other competitors are you talking to? If they offered you A, B, and C and start getting in, rather than have them do a 1 to 10, they're usually going to give you a 9 or a 10. get into what has to happen to sign up what has to happen to resign what has to happen to drop and get as specific as you can and there are some obvious investments that you make i'll use that term i don't know if you would but super oversubscribed pro rata where you know the lead let's just call it sequoia founders fund in their right strike zone how much diligence do you do there on or off the record yeah yeah and just tell me about those opportunities and how do you what lens do you go through those opportunities?