E281:The Tsunami of Pain Facing Venture Capital

0:00Before we go into the tsunami of pain, as you told me last time, that's facing the venture market. I want to go back to when you were in Etherius, which is a company and it was acquired. You put your earn out. You invested it all in Tesla. This was back in 2014. What gave you the conviction to invest so much of your capital in one stock? I truly felt like I was watching a generational entrepreneur. And a lot of people were saying, you know, this is a car company. But if you were reading what he was doing, if you read the master plans, if you listen to how he was approaching the problem, he was going after something much, much larger.

0:40On one hand, him being a great entrepreneur is one thing, but that doesn't make it a compelling investment, right? Because if everyone agrees with you, the value is already baked in. What made it special was I had strong conviction, but the market didn't, right? If you read the news articles, it was short positions. It was, this is a car company that doesn't make money. And so to me, the best bets are something that you truly believe, but the market doesn't. A 14 is when he announced the Gigafactory. And that to me was the line in the sand moment of, you think I'm building a car company, let's go, right?

1:16And build a multi-billion dollar battery factory. Last time we chatted, you showed me a graph about how revenues diverge in software and hardware companies. Tell me about that. In what ways are these two different types of businesses fundamentally different? The first element that comes to people's mind when you bring up hardware and software is they say, hardware is so capital intensive. That's the initial gut reaction. It really isn't true. And it might be surprising, but if you start to look at the data, if you look at exits over$250 million, deep tech fundraising, it's about 13 % of the exit value.

1:58If you look at more traditional technology investments, it's around 11 % of exit value. And so the capital intensity of these business models is more similar than people believe. But David, what you pointed on is really where I view the differences. It's speed to revenue and what the revenue ramps look like. So let's take software. Let's start with software. If you have a successful venture-backed software business and you look at the revenue curve, two things are going to jump out. Number one is they can get to revenue very, very fast, right? And I think people know why, but the infrastructure and the tool set for software right now is amazing.

2:39I mean, you could build a product from scratch, start making revenue in six months, very realistically. And then beyond that, another great feature of software is if you start to look at the revenue curves further out, you end up with pretty smooth curves. And the reason for that is instant global distribution, right? So it's a great, really beautiful looking revenue curve. Now, I operate in the physical world, and I'll be the first one to tell you that the revenue curves aren't as pretty. They just aren't. So that quick revenue, pretty much non-existent. It's very typical that a hardware business could have no revenue for five or six years.

3:18I mean, look at Tesla, no revenue for five years. Why is that? Well, if you're building something complex, think a car or a robot or a drone, it takes time. There's no way around it. once you start to get revenue inflecting for a hardware business, it's also not as pretty. As opposed to a smooth revenue curve, you're going to get more of a step function. And the reason is you usually have to build up some sort of manufacturings or facility supply chain, some capabilities to meet that demand. Once that demand is met, you don't just flip a switch, right? If you want to go to the next level, you're talking about greater manufacturing capabilities, maybe new facilities.

4:00And so in the early days, you kind of see it going in steps. Walk me through the death valley that predictably hits most hard tech startups. We go back to the example that we just talked through. You're building some amazing technology for six years. In the very beginning, there's a lot of excitement. There's a lot of hype around it. Now, as time goes on, you are forced to continue to stay focused, stay leaned in on what you're building, right? Maybe you're getting some customer feedback, but you're not getting revenue because it's not complete. And so while maybe the entrepreneurs and the investors look internally at the company and they say, wow, this is incredible.

4:41What does the outside world see, right? Because right around this time, you're raising a Series B and these Series B investors look at you and they say, all right, this is really cool, but you spent six years building it. You've burned$40 million and you have no revenue. So I'll wait, right? Well, what happens if everyone waits? Well, these companies have no revenue, so they can't get profitable. So inherently, if they don't get a new funding, they will die. So what it comes down to is you reach this critical moment, right? Within Death Valley. And it's kind of the sink or swim moment. You're either going to raise a big round, and be worth$100,$200,$300 million, or you won't and you go to zero.

5:27Nobody in the company knows when you reach that critical moment, if you're going to get it done. None of the investors know. Nobody in the market knows. And so it's just a very scary moment where everyone's kind of holding onto their seats thinking, is this thing going to the moon or is it going to zero next month? So a portion of the companies might be raising those hundreds of millions of dollars, and then there's the rest. Some are just bad companies and some are just companies that haven't raised the necessary funding. How do you differentiate between those two? What we try to do is put them in buckets.

5:58The first bucket, and this sounds blunt, said with love to all you entrepreneurs out there, it's no chance, right? And it quite literally means these companies have no chance of survival. Why? Well, if you're building something complex and you can't get the technology to work, you're going to fail. right? If the team hates each other, you're going to fail. Maybe you're building this amazing thing and all of a sudden the unit economics weren't what you thought they were going to be, right? You fail. And so ultimately that is part of venture, but a certain number of companies will just simply lack the elements to continue.

6:33The next bucket, and I think these are the most interesting, are the, we call them the unmet potential or kind of the unsurers. So what are those. Those are companies that have the fundamentals, right? They have de-risk technology, they have strong teams, they have great unit economics and large markets that they're tackling, but they don't have that extra X factor. They just have the fundamentals. And so you're not sure, right? Is the market going to see the vision of the founder and fund them a little bit longer or not? You don't know. David, what you mentioned though, the best ones, the ones that really fly through Death Valley are the ones that have the fundamentals and something extra, right?

7:14So what is that extra thing? Well, it could be pre-orders, right? If you have 10 ,000 pre-orders for what you're building, that's a pretty good indication. Maybe you have a deal with Amazon. That's a great indicator. Maybe the Department of Energy is giving you$200 million to build a facility, right? These companies have the fundamentals and they have something extra that gives visibility to the market that says, yeah, they have a pretty clear path to scaling, right? And so those are how we generally try to bucket those companies. And last time we tried, you said there's a tsunami headed towards venture.

7:51And a lot of people are predicting this, but you said you have the data to prove this. Tell me about the data and what does the data say about the future of venture? Let's be honest. Subscriptions out of fast. streaming services, apps, memberships you forgot you even signed up for, and canceling them is usually a pain. That's where Experian subscription cancellation comes in. Experian can take the pain out of canceling subscriptions by handling it for you. You just keep the ones you want and put money back in your pocket. Over 200 subscriptions are cancelable. You can also save money by letting Experian negotiate the rates on your bills.

8:29They'll keep an eye out for new deals and saving opportunities and negotiate directly with your provider on your behalf. And the best part, you keep 100 % of your savings. Get started with Experian app today. Results will vary. Not all bills or subscriptions are eligible. Savings not guaranteed. Paid memberships with a connected payment account required. See Experian.com for details. Let me take a step back, because if we're talking about the future venture, venture's always been driven by outliers. That's where the returns come from. Historically, that's where they'll always be. Those aren't going anywhere.

9:05I think the issue that's arising is once you go one step below there, there was some good value. Right now, it appears that there's going to be value destruction for those that aren't on that elite level, right? And there are three pieces of data that I would point to that indicate this. The first one is we were looking at some Carta data and Carta tracked about 1 ,700 companies that had raised the Series A between 19 and 21 and since raised an extension. So think convertible note, price extension, those things. Well, we're now in 2025. 80 % of those businesses haven't raised the Series B. 80%.

9:50So if you start to look at this, you see, all right, the cap tables from 2019 probably weren't planning on keeping these companies afloat for six years, right? The companies probably aren't profitable. Why? That was never the intent of these businesses. That was never the business plan. They can't raise new money. So what's going to happen to them? And that brings us to numbers, like larger numbers. So that was 1 ,700 companies. There were 10 ,000 companies that raised the Series A from 2019 to 2021. And the reason I know no one's coming to save them is data piece number two. Look at the amount of capital that venture firms have raised, right?

10:33If you look at 2019 and 2020, it was pretty good. You look at 21 and 22, it doubled, right? We're talking about$188 billion-ish per year in those years, right? So a lot of money flows in. In 23, it dropped to half. In 24, it's down again. In 25, it's even lower. There is not enough money. There really isn't enough money to keep servicing these businesses. It just doesn't exist. That brings me to the third data point, which is graduation rates. You're going to notice everything keeps pointing to this gravity moment. You can't escape it. So the third piece of data would be graduation rates from series A to series B, right?

11:16The percentage of companies that raised the series A that then two years later raised the series B. And so if you look at the 2020 cohort, so look at a company that raised in Q1 2020. You go out two years, 42.6 % of them raised the series B. That's an amazing number, right? And it makes sense though. So 2020 fundraising was all right. Then it shoots up. You would expect graduation rates to go up, right? But then think about the companies that raised the series A in 22 or 23. If you start to look at those cohorts, the two-year graduation rate to series B is sub-15%. Sub-15%. Said differently, six out of seven companies that try to raise a series B can't, right?

12:02And it's the same problem. Where are they going to go? Well, a lot of them are going to go bankrupt. And so the tsunami that I see coming is kind of the hangover effect. It's the catch up from the big venture funding downturn that we saw post 2022. It inherently is going to catch up with the companies that were founded before then. You started a fund to buy these assets that won't make it. Tell me about that fund. Yeah, the strategy is incredibly simple, right? If you look at graduations going rates going from 42 % to 15%, right? And maybe let's say the historic leverage is 30%. You have 15 % of companies that historically would have raised the Series B.

12:50What is a Series B company, right? Anyone can raise a pre-seed round. Seed rounds are a little harder. You get to a series A, you're getting into institutional money. By the time you get to a series B, you're talking about companies that are underwritten to be worth hundreds of millions, if not billions of dollars at a pretty high success rate. And so the fact that 15 % of those companies that would have received funding otherwise aren't, I mean, it's just a dramatic failure. And so what we're going to do is we're going to find the companies that have a significant amount of R &D, right? that have real customers, proven products, defensible IP, and we're going to acquire those businesses for a fraction of historical R &D spend.

13:34And then once we've acquired them, you then can't rely on the venture market, as we've talked about. And so what we're going to do is we're going to take the single best use case of that business, we're going to narrow the focus, and we're going to push those companies to profitability in 24 months or less. How do you structure these types of investments? So we've actually done this twice. The first business had raised$49 million or rather had$49 million of R &D. We invested$2 million. And for that$2 million, we received 53 % ownership in the company in the first$44 million out. Well, the first calendar year after we made the investment, the company was profitable.

14:14We're on the doorstep of the largest contract in the history of the company. And in two years, we're up 17x, right? And I think people would say, that's a great story. Can you do it again? Well, the next year we did. So we took a company that had$100 million of R &D. We invested$2 million. And for that, we received 45 % ownership and the first$20 million out. Same path. I'm looking at all the numbers and the financials. 2026 will be profitable. And so you can start to see just this fundamental mismatch of how venture is funding these businesses in the market conditions with what's actually the reality of the companies.

14:54And you're oftentimes keeping the exact same management teams in place. How does that work? That's a core element of the thesis. We don't believe these companies are rotten fruit. What we believe is they're late bloomers. And so for us, we just think that these management teams need more time, right? And the way you get infinite time is profitability. And so what we're really doing is we're going to the management teams and saying, hey, maybe the burn money, go for a billion dollars approach isn't appropriate right now. Let's lean down. Let's get to profitability. And then you're going to have unlimited time to prove your market advantage with your product.

15:36Does it require an about face from the management to go from wanting to build a unicorn, a deck of unicorn to building a profitable business? and how do they adjust to the new reality of their business? A lot of that realization has already happened, right? They've been trying to fundraise. They can't. But at the same time, the companies that we're targeting deeply, deeply believe in what they're building, right? And so they're faced with an issue. And this is a big issue is you've raised a bunch of money. It's almost definitionally because they've spent half a decade, six, seven years building a business with low revenue.

16:15What's upstream of that? You have to really have passion for what you're building or else you just get off the bandwagon and join another startup. So it's almost an intrinsic part of the startup universe you're going after. And it's actually the easiest off-ramp of all time, right? If a company and the founders have been thrown through the ringer and you say, hey, we've got a chance to let you go at this a few more years. If you don't believe in it, that's the time to quit. And people will. What we found talking with founders, I mean, you should look at some of the quotes. It's my team are warriors.

16:47I'm stronger than I've ever been. Like I'm bulletproof right now. We have hardened teams. It's not the first year of a startup. Everything's going to be going great. You've been in it for six years. And if you don't want, if you're not truly believing in where you're going, you're not going to sign up for the journey, right? You just won't. how do those conversations go with their existing investors they're essentially underwriting it down to zero what does that look like so what we believe and what we've seen actually in practice is this is a win-win-win so from the outside you might say hey your ownership's going from x down to you know a lower number but put yourself in the shoes of that venture investor i mean that's what i do i try to think if someone gave me this deal what would i I say, right?

17:38So option one is the standard, which is, hey, you're an investor in this company. You tried to fundraise. It didn't work. It's going to zero in the next three months, right? You're getting wiped clean no matter what. But you get an actual, you get a special bonus on top of it. You're on the board. So you get the role of firing everybody, right? You get all the liability. You got to take this thing through a bankruptcy or through a shutdown. So not only do you get a zero, but you also get a huge pain along the way. We come in and we say this, hey, as opposed to a zero, you will get some upside, right?

18:15I hope no. You will get a chance. You know, if the company goes to a billion, which was probably unlikely, they'll actually make a fair amount of money, but you have a decent chance to recoup your investment. That's great. But also, we're going to relinquish you of the board because we're going to restructure the board so it's focused on the industry, not on financial investors. We're going to take you off the board. And so what you get back is freedom, right? You don't have to spend your next three months going through this hellish process, to be frank. You can go spend time with your winners, which is where most venture investors want to be anyways, because that's where the economics are usually made in your winners.

18:51And so if you structure and you communicate it that way, the output is pretty obvious. And we've seen it in practice, right? In the two companies where we perform this on, we have venture investors asking to invest in the fund, sending us deals, right? The value to them is clear. What does success look like for Roke over the next decade? What are you trying to build? If we succeed in our vision, we look like Constellation Software in 10 years. There was a venture capitalist named Mark Leonard in 1995 that started to look at software businesses that didn't really fit that venture curve. And stop me if this starts to sound familiar, David, but he felt there was value there.

19:36So he started acquiring these businesses, usually for less than$5 million. He would then use the profit of those businesses to acquire new businesses. So that group, Constellation Software, went public in 2006. I think about 250 million. I looked at their market cap last night, 70 billion. And so they have proven without a doubt that there is value in Unlook places. For us though, we want to be Constellation Software. We want to be Bending Spoon, but we want to be doing it in the physical world. Where Mark Leonard was able to ride the wave of software from 1995 on, we think we're early to the physical world transforming and we want to ride that wave.

20:18And ultimately, that's the vision. That's it for today's episode of How to Invest. If this conversation gave you new insights or ideas, do me a quick favor, share with one person in your network who'd find it valuable or leave a short review wherever you listen. This helps more investors discover the show and keeps us bringing you these conversations week after week. Thank you for your continued support.