E361: Why Venture Capital is Not an Asset Class

0:00Graycroft today is$4.6 billion. You're both managing partner, but you also founded the firm. And last time you told me something interesting, venture capital is not an asset class. That's right. What do you mean by that? So I think it's manager selection masquerading as an asset class. So let's say you do what everybody tells you to do. You go out, you're an LP. You go out, you evaluate the universe of managers out there. You say, hey, I've got my emerging managers to my experienced platform managers. I've got my specialist to my generalist. I go pick firms across those buckets, you are almost certain to underperform.

0:35Because the asset class itself has a mean and median return that not only underperform the NASDAQ, but they're negative in most vintages. So diversification makes your returns worse. And that's just a statistic of the asset class. In general, you have to pick not only top quartile managers, but really top decile managers in every vintage in order to outperform. Just to push back on that, the median for venture is horrendous. It's like 68%. It'd be the worst asset class in the world. So if you picked the average, the median fund, but the mean is actually quite good. It's in the high teens. It's a difficulty because it's so fat-tailed.

1:12It is very difficult to get the mean. Let's look at statistics for a minute. So we all know that this is a power law industry where there's a few companies that drive the vast majority of the entire industry's returns. I think about that as roughly 20 companies a year that really matter. And there's a few firms that have access to those 20 companies in a meaningful way. So those firms themselves drive the vast majority of the entire industry's returns year after year. There's quite a lot of persistence in that group of firms. So it's a universe of thousands and thousands of managers. But when you distill it down, there's only a couple people on the margin who are really generating outperformance.

1:50And I think about outperformance a little bit differently, like, you know, five, six, seven percent. That's not interesting to me, nor should it be interesting to any LP that's listening to this podcast. They're thinking about I have to sell the S &P 500 every single time I make a venture investment. Right. The S &P 500 today, like the 500 best companies ever built. These companies have experience management. They're all audited. They're profitable. They're growing. They have huge moats. I've got to sell that group and invest in a manager that is going to build a portfolio of 10 or 20 startup companies.

2:21How hard is that to do? Well, only a few people can do it, every single vintage. And that's why this industry is so skewed. So what does an LP do in that case? Well, they have to evaluate managers based upon criteria, and they have to bet with conviction, the same thing that venture managers do. I think there are really two businesses inside of venture today. And ventures changed a lot over the past 25 years since I started in the business, but today there's two. I'll call one business the access business, which is basically taking the Russell 2000 and converting that into the private market. And these are companies that are$1,$2,$3 billion and up valuation businesses.

3:00They're really hard to get access to those companies, particularly the best ones that are growing at 100 % a year, because they're going to end up in the S &P 500 someday. That's one business. It is scalable. It's super interesting. It's relatively new. And then there's the craft business of venture, which is the QSBS seed business. It is unsexy. It is very hard. And it's actually what I want to talk to you about today because I think it's the most interesting part of the entire venture business. So let's talk about that. So the seed business, what you call the craft business, although some people now have half a billion, billion dollar seed funds.

3:34But regardless, talk to me about the art of seed investing. And presumably, that's also not an asset class. It's not because it's not scalable, right? So I think to be an asset class, you have to be able to deploy billions of dollars a year against something. And that business is just tens of billions a year, hundreds of billions a year. It just doesn't absorb that much capital. What's interesting about the seed business, and I'll think about seed as kind of within the confines of QSBS, which for your audience, you know, companies with$75 million or less of assets post-investment, right? First off, you've got structural alpha in that business.

4:12It's triple tax-free. No state, no Fed, no local, except for California, which has its own special issues. And New York is trying to tax. Trying, but it got thrown out, thankfully. So you already start with this massive tax advantage. Second, if you can pick well and you can provide value to those founders, you can make money on these investments. But it's really hard to do. I've been doing it for 25 years. I didn't even know if I was good at it for at least a decade because you have to have so many shots on goal. You've got to live with these founders. You've got to go through cycles. You're investing in companies today that you won't exit like until 2036 and how much the world's going to change in the next two years.

4:49Think about how much can change the next 10 years. So when you, when you make these bets, you got to kind of figure out where the market's going to be, what your freedom to operate is. It's just a very tricky and challenging and I think really interesting place to play. I'm going to go back to 25 years ago when you first started Graycroft in 2001. First of all, talk about timing. But what was venture like back in the 2000s? So I started Graycroft in 06. In 01, I had graduated from MIT and I got my first venture job at a firm called Boston Millennia Partners up in Boston through on-campus recruiting.

5:21In 2001, the party was over, but people didn't know it yet. So I recall the winter of 01 up in Boston, we went to this huge holiday party. I'm trying to remember what the venue was, but it reminded me in hindsight of like the scene out of Hogwarts where they all descend upon the Great Hall and have dinner. And there were banners and venture firms were flying their flag and you had all-you-can-eat sushi. And that was like the last of the great holiday parties in Boston because the market, of course, tanked. That was the first thing that went away. Yeah, the first thing that goes away is the multi-million dollar holiday party.

5:56So what happened in 01 was, A couple things. The venture world thrives on large companies buying software from small companies, right? It's an ecosystem. If you can't get, you know, your first 10 customers, you can't get your next 10 customers. And you never get fired for buying IBM back then, at least. And so what happened were the big companies stopped buying from small companies because they were worried that the small companies were going to go out of business. And then that just accelerated the rate at which the small companies went. It became self-fulfilling. It did. And two, all of the public companies of that era, they all traded way down.

6:31So all of these firms that had unrealized gains and weren't able to sell yet in the public market, their fund performance went way down. Most people allocated way too fast. And as a result, you know, fundraising dried up. Firms persisted on for some time. Most were not able to raise a follow-on fund. I went to business school. That's the short story there. But after 36 months, it was brutal. I mean, we would take all of these meetings with founders, and most of these companies just couldn't raise capital. And you came back from business school, and you decided to double down? Go back to venture again.

7:05Why? I went to business school to start a company. And Columbia had this thing called the Lang Fund, which was attached to a greenhouse program. And I started this business, Strong Data, which was an encryption business. And I came out of school fundraising for that business. I said, I'm not going to go work somewhere. I want to be a founder. And when I was out fundraising, I met a venture capitalist named Alan Patrikov. And Alan is unbelievable. He was unbelievable then. He's unbelievable today. But he was, I think, 72 when I met him. He had built a firm called APAX, A-P-A-X, which stands for Alan Patrikov Associates Cross Border.

7:48And he retired. And then he decided to get back into venture again. and I had an opportunity to learn from Alan. I said, well, this is like a once-in-a-lifetime thing. Alan's contemporaries are the founders of Sequoia, the founders of Greylock, the founders of Kleiner Perkins, the legendary venture firms. And he grew up with these people. He was on the board of Apple. He was on the board of AOL. So on my second day of work, he called Steve Jobs because his iPod wasn't working. Yeah, he's like an unbelievable person to learn from. Do you think the skill set of venture capital, is it a skill set or is it something like a founder that gets reinvented every five to 10 years?

8:38So I think all VCs live in a paradigm where there's a builder persona and an investor persona. And if we were more builder, we would be running a startup company. and if we were more investor, we would be running a hedge fund. But we're all somewhere in between. And where you sit in that paradigm ultimately determines what stage of investing you will gravitate towards. So if you want to do late stage pre-IPO investing, you are far more of an investor persona. If you want to do pre-seed and seed, you're far more of a builder persona. And I think if you're in that builder persona, you do have to reinvent yourself every three to five years.

9:21Because the stuff that you're interested in and focused on today is not going to be investable 36 months from now. It's going to be too old. The qualities that make somebody a good, let's say you're 80 % builder, 20 % investor, for the sake of argument, to be in that kind of very early stage bucket, I think you just have to be motivated because you're naturally curious about the way the world works. And I think that characteristic shines in the best people who are very early stage investors. And today you have AI native founders. Everybody's waiting for this one person unicorn. There's been reportedly several companies that accomplish that.

9:57Are founders looking for something fundamentally different today than they were even two years ago? Or is it still the same mentor and partner that has capital? founders are becoming far more educated about what they get and i think that's a good thing one of my friends runs a big brand consultancy and she said to me look ian uh if you think of the world as a two by two matrix everything that's known and unknown good and bad the internet's so good at taking the bad unknown and making it known and so if you're a founder today and you want to learn a lot about Ian Siglo, you can go learn a lot about Ian Siglo.

10:35You can listen to this podcast, but you can go out and research me. That was not available to people 10 years ago. Information asymmetry. Yeah. And I actually encourage everybody I work with, you should reference me, because this is a harder relationship to get out of than a marriage. Once you pick me and I pick you and we decide to work together. So I think that information asymmetry is significantly narrowing and may even advantage the founders today versus the VCs. And I think that's a good thing. And I think the best founders really do their homework. You operate in a market. You don't operate in a vacuum.

11:13You're competing against some of the top firms in the world, the Sequoias, the Andreessen's, the Benchmarks. How do you compete with them, given that sometimes you're writing$10 million checks? At the end of the day, you know, when founders make a decision to work with a firm. They are making a decision to work with first a partner and then a firm. The way we compete is we go head to head with those firms on a partner by partner basis. You want to work with me, you want to work with my partner Dana, you want to work with my partner Marcy, Dylan, Pete, Mark. Sometimes you want to work with a principal because they've figured out a way to create a great bond with that CEO.

11:50Then the firm comes behind and you leverage the teamwork and the culture and the resources of the firm, but it is really a personal bond between the lead investor on one side and the founder on the other. We're in a talent business. The startups we invest in are in a talent business. And those founders have to have that sort of relationship with their lead investor. It is particularly important the earlier you go. So if you start at Seed, they really look at you like, hey, this person is going to be my partner for the next 10 years, almost like a co-founder. If it's pre-IPO, they're probably linking more about credentialing, maybe some additional resources you can bring to bear on helping them draft the S1.

12:33But that doesn't get you pricing power at the pre-IPO round. At the seed round, you can get certain pricing power. That may be the case with the founder. They want the best thought partner, but they also have to think about how do you recruit? How do you get the early customers? We talked about the first 10 customers. And how do you compete against a Sequoia where every engineer in the world wants to work for a Sequoia-backed company? Our approach to this is highly customized for every company. There are three things that all companies need help with. One is recruiting. I generally don't recruit rank and file staff engineers.

13:10That's not where I spend my time. but if you're building kind of your first 10 person team or 20 person team you should be able to count on your venture partner to help you recruit the VP and C level executives that are going to help you build that business and the best VCs are expert at this and that's the highest leverage very high leverage because those people recruit your staff engineers to the extent you even need them in the age of AI anyway which is a second question the second is you need design partners proof of concept partners we help you do that. So we will walk you into the C-suite at Fortune 500 companies all the time.

13:50And that enables you to close those pilot deals and it gets you your first customers, which of course gets you your first couple million of revenue, which gets you your next financing. And then the third thing, and the third thing is a little bit flexible, but we help you think about strategy. Like how do you position the company? What's coming around the corner? How do you price this? What should be in the product? And that is the creative part. And I think the best early stage investors are expert at that. And tell me about your latest fund and what is your strategy? So the last funds we closed were Partners 4 and Graycroft 7, an early stage fund and a growth fund.

14:27We raised a billion dollars, final close in 2023. That strategy spans the very first check, the couple million dollar pre-seed, all the way up to the pre-IPO strategy. As I mentioned in the beginning, I think venture is this craft business and this access business. And I think that in order to compete in 2026 as well as 2023, you need to do both of those things really well. Because the access business credentials the firm and the craft business, we credential the startup. And there's a flywheel that exists around those two things. It's kind of like an arbitrage. kind of like an arbitrage, but you want to have a well-branded firm and a well-branded firm helps you get access to great companies and it helps great companies.

15:16I guess it makes it such that great companies want to approach you for their funding. To your point, you mentioned Sequoia Unprompted. They're a well-branded firm. They've been around for decades. We started the firm 20 years ago and to get from far left field into the infield was a real exercise in how to build a great venture brand. And venture brands, no matter what I say, a venture brand is created by what other people say about you. So you've got to go out. That's what people say behind your back. Exactly, when you're not in the room. So that you only get through repetition and through a lot of cultural work.

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17:38What's the process for evolving your firm, evolving your brand? And how do you make sure that you know exactly what people are saying behind your back? I don't think anybody knows exactly what people are saying behind their back. We go out every day and we do our very best and we hire people with a specific ethos. And that's where you start when you build a company. Because you think about every employee as doing their day job, but also being a brand manager for the firm. This is something I learned over decades. But you have to be actively building the culture of your company. It's not something that just happens in a vacuum, right?

18:14So if people aren't a good cultural fit, we have to fire those people. We have to find new people. And you have to move quickly on those things. Perhaps a dumb question, but how do you build your culture? First off, every company should have a set of values. And these have to have inherent trade-offs. Of course. I'll give you one example. One of those values isn't make the best investments. That sounds good. That's an outcome. Yeah. That's an outcome. Raise the most money. Make the best. These are outcomes. Find power loss. Exactly. Compound a little every single day and get incrementally better times a thousand.

18:48You know, like that sort of thing. But I'll give you an example. One of our values is teamwork. okay and um you can go very fast alone but you can go very far together and they say also if you have children you go neither fast nor far but that's a side note but you know as you think about going far together there are definite trade-offs because some people want to operate as like a solo gp right so they wouldn't be a good fit for our culture because our culture we have to share everything you're working on, what you're thinking about, because we believe that the collective kind of hive mind of Graycroft leads to better decision making and a whole bunch of other good things.

19:30What's your philosophy around making decisions by consensus versus individual? I think conviction trumps consensus. So if one person is really keen on making investment, the governance allows for that? Absolutely. If that person is a partner. You're known for incubating companies. How does that work within the structure of a large fund? And what have you learned from this process? We really started this activity maybe 15 years ago. And incubated is a strong word. They didn't work in my office. So it was like we were the first capital. Sometimes we brought the team together. Sometimes it's our idea.

20:09Sometimes it's somebody else's idea. Often we are the only money. And that was the case for a company like Hidden Road, also the case for public.com. It was the case for branch insurance, handful of other businesses. Some work, some didn't work. The way we approach this, first off is you have to structure these like a normal seed round. So we don't look to get super economics. I want the things that were germinating at Graycroft to be and look like independent startup companies in the future. Other people have to come into those companies later and provide follow-on capital. Second is you need real founder CEOs.

20:52So not people that we go hire to do that job. These are people who you would feel fortunate to work for. And when you find those people, you're really betting on them to breathe life into this idea. So because ideas at the end of the day are free and cheap. It's the execution of that idea that really creates the value. When does it go from just a good idea to something that has tangible value? There's a moment where things start working in a company. And it's kind of like a magical moment. It can take a long time. It can take a short time. But, you know, we'll have a really good board meeting.

21:30And the CEO will be bouncing. One of my CEOs called me. She was like over the moon, excited about three things that happened in short succession. and you get this feeling like this is now an independent business. They don't need my help anymore. They'll get it, but they don't need my help because the flywheel is turning. They figured out how to package and sell a product to a company that's going to pay them a whole lot of money and if they continue to execute, they will build a winner-take-all business in a category. And you can see kind of like the dominoes start moving. And it's fun to watch because there's like a point where you know a secret that no one else in the whole world knows except for the CEO of this company.

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