Untold Startup Lessons from Dozens of Academic Research Papers with Dan Gray at Equidam

20:37But like primarily you're betting on the category. Yeah.

20:43Turner Novak:You're sure 2022? I feel like that's a little early. Yeah, that could be a bit early. Let's say 2023. 23, yeah. I mean, 23 was, I mean, it was like the entire market was just scorched. And that was like the only thing that was moving. I think like there's, there's just so many incentives where you have to, I talked about with this Dan too, and that, that other episode talking about relevance where you have to like remain relevant as a VC, as an investor. So it's something I kind of struggled with a little bit, especially during like kind of the web three mania. When I, when I did my very first fund for banana capital, I invested in a little bit more consumer stuff than I do now.

21:25Turner Novak:So I'd kind of been going into 2019, 2020 thinking that, you know, liked e-commerce just generally is a trend. And it got stretched pretty far during COVID as I deployed the fund and as I first invested the fund. I think I messed up on not like just rationalizing that. I think it's so hard when you're in those moments to really realize what's sustained. I personally still don't really like going to stores. I personally do a lot of things online. I'd rather order ahead and pick something up. But I had a lot of my LPs that are like, Turner, why are you not a Web3 investor now? We thought you'd be doing Web3.

22:05Turner Novak:Why aren't you in Web3? It's pretty easy today to look back. I bet they're happy about that now. Yeah, I mean, I think that fund will do okay. Like my 2021 fund that was like over allocated to consumer. I don't know how these things are going to benchmark. Like I'm going to make money. I'll give people their money back. I'll get a little bit of carry from it. But at least on like a relative basis to the market, you probably do very well because the market as a whole, I think is going to suffer for that year. Yeah, but that's another thing I think you need to remember in venture is like, there's relative and absolute.

22:46Turner Novak:So like in 2021, I was on a relative basis. I was like, oh, I'm not investing in Web3. I'm not investing in these pre-launch, pre-product, like pre-line of code things at 100 million post money. I'm doing it at 50. That's like half off. That seems so reasonable. But then when you back out and look at it over a full economic cycle or like a 20, 30 year period, that's still a pretty high entry point. Like that's still, you might be 50 % lower than everyone else, but you're still two, three, four X probably higher than you should be. So yeah, they're all 10 X higher than they should be, but you're still, you're, you still fucked up at the end of the day.

23:28Turner Novak:So, and like the point of this is make money. Like you, I think the point of venture, you have to basically outperform every asset class. Like that is a job. That is like the role of venture. People aren't in venture to like, you know, give me like some buffer or like when bonds are down, like I need my venture portfolio to like do X thing. Like it's uncorrelated, but it's uncorrelated because it's like just find people starting things that will be worth a ton in 10 to 20 years. And if your definition of venture is like what we think of as traditionally venture capital. Yeah, traditional early stage.

24:05Yeah.

24:06Turner Novak:It is a good point of like, I think we just need to think of it. We need a new name for kind of later stage venture. Like late stage venture. I don't know. Like I like capital. Capital for ventures is a good one. Capital for ventures is good. Leslie Fienzig calls it consensus capital. Kyle Harrison calls them like the agglomerators. I call them the venture banks. It does need to be recognized as a different strategy, maybe still within the same bucket, but definitely a different strategy because it changes so much about the expectations. I think it's hard too, because if you're any of these data providers, you don't always know what the nature of a round.

24:54Turner Novak:I mean, this is a classic thing in 2021. Someone would say, we raised$100 million for a fintech company, and it was 5 million in equity and 95 million in debt. And so my general, when I see a number of like, oh, you raised X amount of money. If it was around a seed series A, I usually assume seed, you saw about 20 % of the company. If it's a series A, I assumed you probably sold 25. You maybe got diluted about 30 because there's some like options and stuff like that that went in there. So if I see that number, oh, we raised$100 million and it was a series A, you're like, oh wow, 400 million post money.

25:30Turner Novak:what's an appropriate valuation? They must be pretty far along. But it's like, no, they only raised$5 million. They have one customer. Or actually, I guess that's the other side. It's like if you got a debt vehicle that you raised, you probably have a pretty robust business too. Hopefully. You probably passed certain levels of sophistication and maturity and able to prove that. But yeah, I don't know. It'd be hard, I guess, to really actually figure out how to do that. It's almost like it's just easier to just not worry about it and just call it all venture. It's an interesting point, though, about what that does to the perceptions of valuation because you have people making calculations, like you said, where...

26:10Turner Novak:Because it's all comps. I just say, Dan did this. This is public. This is what he did. I'm better than him, or I'm at least as good. So I want to get the exact same amount. And if it's not, then it's not fair. And you have the debt part of that, which complicates it. You also have, obviously, the terms. Like, was it raised for the 2x liquidation preference? Like, what other more investor-friendly terms were attached to make that valuation work? You never really know any of those things. Has a very, like, pro-cyclical effect on pricing. And I have some friends who they have, they strategically release and drip certain information.

26:48Turner Novak:So they will be, you know, they'll say we just crossed 40 million in ARR, but they're actually at 80 or something like that. Like they strategically will put things behind. I don't know if you know that company, Bolt.new. They're like the text to website creation. So I kind of figured it out from talking to him. And we talked about it on the podcast. He's like, yeah, when we announced where we were at, we were actually a little bit ahead of that. Because he was in a case where they were just exploding. And he was like every day waiting for it to taper off. He's like, it just never died. And I was just afraid that if I set a number and the number was no longer there, I was like, okay, let's hedge a little bit.

27:31Turner Novak:So I think that goes into it too. And then there's the other side of where we're like, oh, we're at 100 million ARR, but it's like a creative definition of the word ARR. So again, that stuff is so tricky. Yeah. That's a huge problem. It's kind of interesting to me as well. The extent to which a company hoping for an exit for an IPO knows that eventually one day they're going to have to get to Gap compliant financials. They're going to be audited. So for how long can you keep that kind of mirage going early on, like the creative bookkeeping? It's kind of dangerous. And again, there are incentives on both sides.

28:16Some VCs kind of like it too because it makes it very easy to generate markups on multiples.

28:22Turner Novak:I don't want to miss this question. We talked about it a little bit earlier, but you mentioned that you think basically all of the returns in venture ultimately come from the first check, like true venture capital, the traditional way, how we defined it earlier is like, you're starting a company, extreme amounts of risk and uncertainty. What's the importance of that kind of origination round, that first round, but whatever we want to call it? It is. it's kind of axiomatic a little bit because obviously if you don't have a first check you have no checks you don't exist you need that risk capital the inception stage origination stage yeah exactly and investors that focus on that level the real genuine first check investors and I'm not talking about the ones that need to follow someone else into the round and need traction or whatever, they determine what venture capital is in a way.

29:25They determine what are the exits going to be in 10 years.

29:27Turner Novak:How do they determine that? If it never enters the funnel. Got it. Okay. So they're determining what is allowed to exist. Like what startups are able to have a shot at trying to do something. Exactly. So if they're only funding certain categories. Yeah, the quality of what is in the whole venture fund or venture funding pipeline from origination to all the way to exit at any point is downstream of those investors. So their ability to provide good coverage, to be able to explore every corner of the economy, every category, every industry is super important. Should there be more people doing that?

30:10Turner Novak:More creative? what does the data show? It shows, I mean, there's been a very good study done looking at VC in Europe. And it showed essentially looking at programs like big programs by the EIF, the European Investment Fund, where they put a ton of capital into VC. You get the same uplift in productivity from that investment if you just move the current allocation earlier than if you double the amount of capital. So expanding the early stage origination area of the market has just as good effect as doubling the total pool of capital. So if you're investing$100 million in startups, tech, innovation, whatever Europe's doing, if they instead...

30:59Turner Novak:And then they want it to double their impact, probably the most consensus thing, well, let's just give them twice as much money. They'll have twice as much of an impact. But it actually have doubled the impact if they just went half as earlier or like, how earlier? Do you know how early you have to go? It wasn't too specific, but I think essentially it's ensuring there's enough money at the pre-seed, seed, series A maybe kind of stages. Make sure those companies have a path to really prove the business model and become success stories. So why don't you think more focus is kind of around this origination stage?

31:38And it's interesting because I feel like a lot of people say we're pre-seed investors

31:44Turner Novak:or like we back founders from the earliest stages or whatever they say. Yeah, but like, so like the biggest question there is not necessarily who classifies themselves as an origination investor or a first check investor. It is what is the strategy that they apply to origination? like where are they looking how do they source companies is it through a network of like of like peer analysts or firms or other gps that they know in which case it's already kind of coming through a filter or are they genuinely doing like essentially like the equivalent to a startup of go-to-market are they doing that like do they have a unique defined strategy to go out and find their own deals there's a few examples of of firms that i think do that famously well.

32:37My favorite is always 1517 fund because they invest like$2 ,000 in a college kid with a dream who has nothing. But that kid is like, okay, now I have the money to test this idea a little bit. And if I then start a company, guess who I'm going to call? It's going to be Danielle.

32:54Turner Novak:The one who gave me the 2000 bucks. And it's a grant, right? Like it's free. Yeah, exactly. It's literally just like, at that point, it's a Venmo. yeah the corporate venmo account of 1517 yeah i wonder if that's actually there i should ask and and i think so what do you think about maybe like like a yc is there an example of a good one that's a very good question i'm like i'm kind of torn on that because i've i've written at length about like yc and yc's track record and their performance i've always kind of defended against accusations of YC companies are overpriced because if you look at the historical success rate, they should be priced higher.

33:38They have a higher success rate, higher rate of exits. The question is that involves looking at data from companies that are obviously at least 10 years old. Has YC changed in the last decade? I think is an interesting one to consider. If you look at the breakdown of the cohorts 10 years ago, 15 years ago, how much thematic consistency was there? How many companies were in a very specific category of technology? Essentially, how diversified was it across different ideas compared to today? Where you see people saying there's 20 different windsurfs for X in YC currently.

34:22Turner Novak:I think the interesting thing that YC has too is they kind of have this like built-in price-making mechanism. Like if you think of in an auction market, there's price makers and price takers. And YC basically gets, as valuations keep going up, they have been able to keep this lower price that they come in at. I guess, to your point, the way the market's changed, they've changed where they now do put a bucket, a check in at that higher price, that kind of uncapped safe that they go alongside the first check. So I bet there's like sort of like a weird step. There might be like a step function change.

34:59And like maybe some of the YC

35:01Turner Novak:funds was like an 8x fund. One was a 12x, whatever. But like, I bet you get like a slight bump down by like a full multiple, like that might be a 7x or 11x. But it's probably a bigger pool of capital that you get to work with. So it's probably it's probably okay. Like if I'm an LP, it's like, instead of my LP exposure to YC being like 5 million bucks, I got to put in 20. And I'd actually rather get a 7X on 20 million than an 8X on 5. I don't know. I have no idea if those are YC's numbers. Those are pretty good numbers. I bet they're actually higher than that, honestly, is my guess. But to your point, I think an interesting kind of topic that brings up, though is looking at historical data.

35:48Some of these studies are in completely different market

35:51Turner Novak:structures, completely different market regimes. So there's one end of the spectrum where you could say things are different. You can't rely on this data. All the maybe non-data supported things that the venture industry does is actually correct because all the data is wrong. the other end of the spectrum, that is just a classic thing that you say when everything is about to be over. History doesn't matter. The data we don't follow. It's like the whole, do you want to make spreadsheets or do you want to make money argument? Yeah, I share a lot of old papers. I get a few different forms of pushback to this.

36:35I shared one a couple of weeks ago and a GP replied to me and he was like, this is from 2017. There's no way this is relevant today. Like venture capital, in the traditional sense that we've been talking about, has not really changed that much. It's not changed much at all for 30 years, I would say. There's the bigger end of the market, which has been added, but the traditional part, the risk factors, the decision making process, the portfolio strategies, all of that is the same.

37:06Turner Novak:So it's sort of like venture capital started as this pretty small pool, very beginning stages of the market. And it stayed there, but it's also expanded to become further and further along. And all that expansion is like 10x, 100x bigger than what the first kind of initial inklings of it was. It's still there, but this whole expansion just takes up most of what we think of it today. So it's just like, it's still the same, but it's evolved, I guess. There's new extensions of it. And I think it's evolved in a very expected way in that the larger it's got, returns have commensurately fallen.

37:51And you could almost think of it as a dilution of the strategy. It's literally just more capital, which allows for the scale of returns to be increased, but not the efficiency of returns to be increased.

38:03Turner Novak:What does that mean? Can you explain that? It's like if you're a big sovereign wealth fund and you have to write checks of like a minimum 100 million into funds that you're investing in, you can put that into like a venture bank or A16Z or general catalyst type firm and they can put that to work. And maybe you'll get like a two to three X on that money. You can't really invest it in the early stage of the market because it just doesn't fit. You can't squeeze the check that large into a smaller manager. You'd have to do like 10 or 20 different funds to get that$100 million deployed. Exactly. But if you could break it down like that, maybe you could get a higher total multiple, but it's more work, more risk potentially.

38:48Turner Novak:That's sort of the pitch for a fund of funds then, where it's like, hey, give us$100 million. We have a$500 million fund in the top, whatever, 20, 30, 40, 50 best managers and all their breakouts. It's kind of like hiring a consultant to manage your venture portfolio for you. But they just kind of do it. It's one line item on your portfolio and one headache you have to manage, one update call, one relationship versus 30 or 40 or 50, which that's a lot of time. You need a whole staff to do that. I think if there's one startup idea that I could be tempted by in future, it would be trying to design an algorithmic fund to funds.

39:29Like, so it could be very low fee, very efficient, but identify, like basically index emerging managers to try and manage a lot of the uncertainty involved in that. But to build a process around managing the biases involved in selection, all the uncertainty involved in selecting managers with no track record, it would just make fun, like for that section of the market, which is like the origination layer too, which I obviously care quite a lot about. It would make fundraising so much easier if they had access to that kind of capital.

40:05Turner Novak:I don't know if it's true, but I've kind of had this like maybe hypothesis. Is there some sort of survivorship bias in, I think it's like fairly well known that people say emerging managers outperform, fund ones outperform. And you should just, if you want true venture, if you want the best venture returns invested in fund ones or whatever, emerging managers. But I've always been curious, is there like a survivorship bias of like, let's say you and me boast our funds, you crush it, you're doing really well, I fucking suck. And I just like, drop off and like my data does my data like leave. And so all that they see is you crushed it, I sucked, we offset each other to like equal or maybe we're worse.

40:48Turner Novak:But I dropped off so only your data shows up. Have you seen anything related to this before? That's interesting. Nothing specifically to that. I mean, I will say some of the perception about how emerging managers perform or outperform is based on a lot of charts that the PitchBook have released where they show who have been the top 10 funds in each vintage by size. Is this PitchBook or Cambridge maybe? Could be Cambridge. You might be right about that. And they're biased. I mean, they're trying to sell institutions on new funds. That's true. But they consistently have shown small, like sub 50 million funds, for example, dominating the top 10 each year.

41:34But actually, if you look at the underlying fund data, those small funds are massively overrepresented in the data set. So it's obvious that they're going to take more of those top 10 positions. It doesn't necessarily mean that they're a better bet. Because there are a lot more of those funds that also obviously don't do well.

41:53Turner Novak:That's true. I mean, it's extremely difficult to raise capital for a fund. And especially when you have not done it before, you're first getting it started. So there's probably not very many large early funds. And also, if you're good, you just keep getting bigger. So it's kind of hard to be like a... It's really hard to just stay small. Which is one of the problems with the origination part. If small firms focus on origination, but success naturally inclines them to grow, then they slowly move out of being able to invest in that, like such an early stage. And they start to invest larger checks later rounds.

42:40So that whatever talent they had at origination is kind of washed out. which is a shame because there's already very high churn in the industry. There's already like relatively weak persistence. So, you know, it's a difficult part to make talent stick.

42:57Turner Novak:Can you explain for somebody who may not understand this of like, why do you want to have a bigger fund? Like why do small funds that do well ultimately end up getting bigger? I think there's two, probably two main forces. The first one is the obvious one, which is the financial incentive because you have, as a part of your compensation as a GP, you have your management fees and you have your carry. And the carry is the like, you could consider it like a performance bonus. If your investments do really well, past a certain hurdle, you get to share in that profit, which is if you're a great investor, it's incredible and can be a huge part of your compensation.

43:38Turner Novak:You need to liquidate the asset though. Like it needs, it takes a while. In venture, it's probably like, I don't know, eight to 10 years until you get any of it. Probably longer, honestly. Because you have to first return all the capital to LPs. It's a headache. It's difficult. Whereas much easier is the other part, which is the management fees, which are guaranteed. You get them pretty much no matter what. And that's like 2 % a year, or probably these days more like 2.5, I think a lot of the time. probably over 10 years, but then there's extension periods and caveats around that as well. But if you consider it like 2 % 10 years, it's 20 % of the fund.

44:21Turner Novak:Yeah, you raise$100 million, you get$20 million guaranteed. You think of that like an ACV as a SaaS business? That's an incredible business. You raise a billion dollars, you get$200 million in revenue. It's guaranteed over 10 years. That's an incredible business. and just keep doing it again. And you raise another fund. So then you raise one fund that's a billion. You get your$200 million in revenue. You raise a$2 billion fund because you did well. Now you got$400 million stacked on top of that$200 million. And just like, let's say you started your first fund was a$10 million fund. And you got a 10x return on that fund.

45:05Turner Novak:You took that$10 million and you turned it into$100 million. So you got$90 million in profits. and you got 20 % carry, you got 20 % of that. So you get like 18 million bucks in profit. You probably get it 10 years. So 18 million profit, that is like, if you go back to that billion dollar fund that you raised, you're getting 20 million a year. So it's like, why am I fucking around waiting for all my carry? Like just raise a big fund. It does make sense. But I think the issue then though, you might trade off. And this is something I thought a lot about is like, you have to like build that infrastructure, pay for it, which is usually a team, a lot of people, you have to manage a lot of things.

45:45Turner Novak:You spend a lot of time on that like operational, institutional design. So yeah, you get a lot of management fees, maybe. But depending on the circumstances, it's not quite as lucrative as you might think. But you do get leverage depending on who you bring in. And you may be investing in things that are defensible network builders or brand builders or something like that. So it gives you more capital and power to work with. I think it's useful to look at the extremes. I think consider a small$50 million fund, just a couple of GPs and very little else in the firm. they're spending their management fees on like living travel expenses events you know whatever powers their origination strategy that they they want to do there but it's like basically covering the cost of operations and then they cross their fingers that the carry's great whereas the far other end of the spectrum like an a16z the range of services that they provide for startups like Now they have their own compute that they provide to AI companies that they invest in.

46:57Turner Novak:Oh, so that is a thing. I thought that was a meme. No, no, that's a thing. It's real. Okay. That's a thing. And they have other financial products that they offer. They have the whole platform team. Yeah, they have anything you might want. Any department that your company will have, whether it's recruiting, marketing, capital raising, go to market. you have growth, brand, engineering, like they have consultants that can help you come in. It's everything. It's like any role you might hire for, they have it, they can help you with it. It's an interesting value prop to some companies. And there's also just the brand halo of like A16Z.

47:40Turner Novak:All your friends know A16Z. They've all heard of them. They've seen the podcasts. Your parents probably used the Mosaic browser back in the 90s. why would you not take Mark Andreessen's money versus some random dude with a podcast that no one's heard of? It's an interesting value prop. It is. That's a whole fascinating rabbit hole itself. What is the cost of taking money from these big firms? What do you think it is? There's a great thread by a VC called Rob Go, and he reflects on this as re-risking because essentially their value prop, part of it at least, is that they will be less price sensitive when they invest.

48:26So they will give you much more money on much more friendly terms potentially.

48:31Turner Novak:This is a larger agglomerator of capital type fund. Correct, yeah. Yeah, like an A16Z exactly. Not Rob Go at NextView? Is that an A16 at NextView? Yeah, that's right. That's right. Okay. So the downside of that is the growth that you kind of obligated to deliver as a part of getting that huge check is way higher. The stakes of failure are higher. The risk you're taking on as a company by accepting that much money is much greater. The fragility of your future vision, like how you can adapt if things don't go to plan, like that's much more difficult. So what like essentially, what should happen through a startup's life is as they develop, the risk slowly goes down, you end up raising these huge rounds, and your risk shoots back up to the top again, and then you need to work it down again.

49:29Like it's for some companies in some categories, it's the right move.

49:35Turner Novak:Yeah. Yeah. But for many, it's probably not. How do you decide that? Is it like, how much capital do you need? Is it like a competition? Is it like a certain product type, like capital efficiency or something? Do you know if there's a way to gauge that? To some extent, it's a bit of a competitive force, I think. If all of your peers are in the same category are raising similar amounts of money, to some extent, maybe you feel like you have to as well to compete with them. And that ends up with like an ugly situation where everyone's spending huge amounts of money like bidding their own margins into the ground against each other.

50:18Turner Novak:Yeah, some kind of a paradox. I'm sure there's like a scientific word for this, but like some sort of like losers, prisoners dilemma type paradox or something. Yeah, it's basically venture predation. There's a good paper on that. I'm going to throw Rob's thread and I'll throw this one in the description too. Yeah, that one's looking at like, I think it uses specifically the example of like Uber versus Lyft. So they both absorbed a ton of VC money. And a lot of that money was put to work, basically trying to suffocate the other company, like who can undercut the other company's pricing enough that you steal all their business?

50:57And can you survive long enough doing that before you die yourself?

51:01Turner Novak:Interesting. And it's crazy how I think Uber is like this fascinating example where it's like super profitable now or something, right? Like, they just basically like 3x prices over the past couple of years. And it's like all free cash flow. Like I haven't looked. I don't know the number, but it's like, pretty much they just had a ton of price and power that was kind of hidden. And we're all paying it. And they're making a ton of money now. They also nailed their timeline, I think. The period of time from inception to exit that they had, luckily, was kind of perfect. They could have exited maybe a year or two later.

51:38I think it was 2018, their IPO, something like that. Yeah, 18-19 probably. But if they'd been intending to exit in 2023, and then suddenly they would have hit that speed bump when all the capital dried up, that could have been fatal.

51:55Turner Novak:And they kind of did hit some speed bumps right before the IPO also kind of with the whole management team turnover. Yeah. Yeah, that's another interesting rabbit hole. And you turned me on to this interesting concept. I think it's called startup catering. I think there's like a research paper on this. What is startup catering for people who don't know? Because I think of food. I think of like, you know, getting lunch for the company. But like, what is startup catering? It's probably my favorite paper on VC, which is an incredibly nerdy thing to say, but like whatever, I've said it. Hey, we're in an audience of nerds here.

52:34Turner Novak:We're all on the edge of our seats. It's a safe space. It kind of crosses over like the valuation part, which is obviously what I spend a lot of time doing with the what gets funding question, which I think is really important. So essentially catering, it's a consequence of the fact that investment decisions in venture capital, mostly kind of like relative judgments. So you look at, you know, if you're going to invest in a company and you're trying to understand, is it a good investment? And if so, what price should I come in at? You probably look at peer companies, you look at comps. So like, if you were investing in a B2B SaaS company in 2021, pricing was super easy for you.

53:29There's thousands of them. You probably know a ton. They're at every stage, in every region, in every vertical. So you can find a ton of companies that are very similar to the one you're looking at.

53:42Turner Novak:Yeah, and it's from all stages, like from the inception stage all the way to like mature public markets. Like I have a ton of comps and there's like a history of how these things go. Mm-hmm. Yeah, so in terms of information friction, to understand the company you're looking at through the lens of all these comps, it's super easy. It makes investing very simple. It also means downstream funding is going to be very easy for that company. When they get to the next round, they'll be able to raise very easily as well, probably at pretty good terms. It's just like life is so much easier if you're in one of those categories.

54:21the downside obviously is that it's like a blood red ocean super competitive like maybe overvalued if investors are all piling in there like there's real downsides too from the investor's perspective but the problem from the founder's perspective is if you're trying to do something that is like really unique and innovative you know you're like valor atomics or rainmaker or someone You go talk to VCs and try and explain to them your company and why they should invest. They have no comps. There's no relative judgment to make. There's no other set of peers they can look at to understand your company.

55:08If they want to invest, and probably they should because those companies are often incredible, they really have to understand first principles, foundational value. or fundamental value, and that's much more difficult. So the upside of all of this basically is that founders basically have such a hard time raising money for these really interesting, unique ideas that they tend to cater to VC's preferences. They tend to cater to where there's less information friction. So they're more likely to go and build a SaaS, which I think we both agree is like pretty sad.

55:47Turner Novak:Yeah, I mean, you can solve problems, but the easiest problems to solve are probably the most over catered to, I would think. So then why are the VCs investing in it? Because you just said, I mean, based on the last, I don't know, 53 minutes of our conversation, like, I would lead to believe like, yeah, those returns are probably gonna be pretty low. Why do people do it then? gets into the question of what is the primary motive of VCs today? What do you think it is? Depends. I think there's examples of both. I think by far the most capital is moved by investors seeking markups, seeking like proxy metrics that show their fund is doing well so they can raise another fund and get those management fees.

56:38I think that moves way more money. But ultimately, I think the most returns over time are generated by true investments, which is like you invest because you see this company as a generational outlier and you think the exit is going to be huge. You're focused on the endgame DPI rather than the proxy metrics along the way.

57:04Turner Novak:And is there a good way to do that? if I'm a VC, like if I'm listening to this and I'm like trying to change my ways, like I'm like a markup addict and I'm trying to get clean of the markups and, you know, purifying myself with DPI. Is there anything like you've kind of seen that maybe you can kind of think of or, you know, cling to to get through that? I think there's something said by Michael Dempsey in your podcast with him. Michael Dempsey from Compound. He talked about, if I remember correctly, it was their 2020 fund and they intended to deploy it over four years, but they ended up taking five because they just didn't find the opportunities that they wanted to invest in.

57:55That's such a good attitude. And I think you would find that is relatively rare in VC, whereas most people are just trying to put capital to work, get it out the door, get the next fund. but they said like we're only going to invest in companies that pass a certain bar and if it means we have to wait longer which means we essentially have less income to our firm then we'll wait and i think that's like that's a great attitude they definitely suffered for it in terms of like the versus the income they maybe could have had if they deployed faster but long term it's the right choice to make. And those decisions, I think, are how you build a generational firm and end up being able to charge 3 % management fees if you want to in future.

58:40Turner Novak:I think it will because it's sort of related to this whole raising the mega fund model, big pools of capital. From my perspective, I kind of see it as... It kind of works. It kind of solves this problem in the market. I don't think it's going away. But you mentioned before that you still think it's actually an experiment. So why is it an experiment still? It kind of seems like it works. I don't know. And maybe that's not true, but... That's a good question. I mean, I agree with you that I think it definitely has a place in the market. And I went personally for like two, three years ago, I was very critical about it because I thought like, you know, it's just like basically grifting.

59:27It's just collecting fees. but actually if you look objectively at what the big firms have done it's pull a ton of capital into like tech which has got to be a good thing ultimately the question is how does that strategy work out for their lps and i think we kind of have to see to an extent just how that shakes out over time for example pool, I think AI is kind of the backbone of their strategy at the moment in that it's where they dominate. They have enough money to back the big foundation language model companies. They have the clout, the media presence, the marketing pool to not just promote the portfolio your company is like normal, but to promote the whole category, to build momentum for it, to like push it in Washington even, and certainly to like pull in other investors like to herd in more capital.

1:00:33So to an extent, are they manifesting a wave and then trying to ride that wave by indexing a ton of companies that join onto it? Is that going to work? It could be incredible. It could be 6x, 7x on a huge pool of capital, which would just be amazing results. It could be a failure, ultimately. or it could be something they can't repeat in future. Like that's why it's it kind of seems like an experiment to me. Like is it going to persist beyond the current AI wave?

1:01:10Turner Novak:Yeah, that is a question. It's like do because it feels like we've kind of if you just look at like the history of venture over the past 15 years it's like we keep finding new bigger opportunities. Some people might call them new bubbles like we're riding new bubbles. Like you could look at NVIDIA stock price like NVIDIA at the top of crypto I was like This is crazy. Insanely overpriced. There's no fucking way NVIDIA goes any higher than this. And it's like 20x higher than the top of the crypto bubble because people are using the NVIDIA chips to like mine crypto. And with VC, it was ZERP. It was low interest rates that were just fueling higher asset prices.

1:01:53Turner Novak:We had the COVID to work from home. All the SaaS companies were overvalued. We had the Web3 stuff. It's like everything is going to be on the blockchain. The economy is like$100 trillion. FinTech is a massive market. It's all going to be on chain. And then with AI, it's like labor. like literally the entire economy now is software so we like figured out even though like the web three thing popped and is gone it's like we somehow figured out how to find an even bigger thing the adventure could could eat up and it's like what else is there it's like we're interplanetary now now the number of earths and the number of economies is 10x bigger and they're all software so like we're going to be colonizing mars in the moon or something like the animals start using software so like your dog needs a like a crm or whatever like i don't know obviously i think one way is like biology or something like new new things that have not been impacted by software yet like like healthcare is probably an interesting example where they have not fully utilized the internet or something like that or so i don't know it's again you could say well ai the impacts of it continue to be felt in 20 years probably i mean there's still markets now that are changing from cloud, changing from the internet.

1:03:11It's also kind of a question about LLMs particularly. You could look at it a couple of ways. You could say, using the example of NVIDIA, this doesn't resemble historical bubbles because NVIDIA's revenue has actually gone up so much. Whereas in the past, look at Broadcom and the dot-com boom, the separation of the two is much greater. But then there's other signals which do feel very bubbly, Like the narrative around what an LLM can do has gone from in 2023, it was like, we're on the verge of AGI, it's coming, everyone's going to be out of a job. And now it's like Sam Altman saying like, the biggest risk is that maybe we use too many M dashes in our writing.

1:03:58It's calmed down so much. And why? Has the steam gone out of it that much? Like how much of the capital that's gone into it was predicated on AGI? And is that now not happening?

1:04:09Turner Novak:Yeah, I think it's interesting from like a technological perspective of the cost is coming down and also like the effectiveness is going up. So when you just say like the internet, I don't know. I don't know what you used to pay to access the internet, like AOL dial-up. It was maybe like 40 bucks a month, 60 bucks a month or whatever. It kind of sucked, but it was good at the time. It's gotten better, but it's not like we pay less. Like I was looking, I need to actually go and call Comcast. I paid$230 for my Comcast internet last month for my office, which is way higher than what they, when I initially signed up for.

1:04:51Turner Novak:Totally different tangent. I'm like, fuck, well, I hate how they always increase the price on you. Like, oh, it's 80 bucks for, you know, an intro deal you know about. And they increase the price, but like they keep increasing the prices. Or on the other hand, you think of something like the cloud or whatever. It's like you connect to the cloud, the internet is on, and you didn't get better clouds. Maybe the price came down. They'll add new services where you keep paying higher prices. But you don't get better cloud. It's like a better optimized cloud, maybe marginally. But I think the interesting thing with AI is like, over the past couple years, it's gotten way better.

1:05:31Turner Novak:And the cost to service it has come down magnitudes every, I don't know, nine months or whatever, every couple months. So it's like one of those things that's getting way better. And also the cost is coming way down. I think you can argue that if you want to keep using the bleeding edge models, the pricing is more expensive, but they're still getting way better. And there are cases where you don't have to use the newest model. So it's kind of one of those technologies where it's getting better and also cheaper, which I don't know if it's happened to that extent ever. I mean, maybe if you go back to like the Industrial Revolution or something like that with like, you know, and that's I think some people made that argument of like, if you if you think that LMS are automating like manual software labor, like like computer labor.

1:06:17Turner Novak:The Industrial Revolution was automating physical labor and it was making it cheaper and faster. So that had a pretty profound impact on the world. And so I think that's maybe like an interesting parallel to think about it with AI. I don't know. It's probably not totally correct, but that's one framing I would use. There's like the kind of incremental improvements as like costs come down and it becomes more accessible and more useful, which I think is definitely true. There's also the like productivity shocks. So when AI passes a certain threshold to really do something very well for the first time.

1:06:54So I think the recent MIT paper that looked at adoption in the enterprise showed that the pilots generally weren't working out, like 5 % of pilots were successful. And I think that's essentially a consequence of it's not quite reliable enough yet. Hallucinations are still a problem. On the other hand, if you look at Google's recent image model, Nano Banana, fitting for this podcast, it's so good and so reliable that if you're a fashion company, you can actually use it to do AI photo shoots. If you're a little independent fashion company, you take a picture of the outfit that you've made, you describe a setting and a model, and it gives you a picture that is so close to real, It's actually usable.

1:07:43And that's a fairly small but meaningful productivity shock, like a real jump in value that it creates. The more of those accumulate, like obviously the more important AI becomes. Some of them are going to be huge probably.

1:07:58Turner Novak:Yeah, that's a good point. Thinking about how do you quantify that productivity. Yeah, I guess it's cost replaced essentially. Yeah. One other thing when talking about sort of the mega funds and the way that they fit. It's not like an LP who's putting capital on these things is saying, I'm going to take my origination dollars, stick them in this$5 billion vehicle. It's usually like you're probably taking some public market exposure and saying, I actually think I'm getting higher returns. So I think a common kind of dunk on these funds is like, oh, you're only going to get a 3X. You're only going to get a 4X.

1:08:31Turner Novak:That could actually be higher return. Like it could actually be shifting that shift into that 3 or 4X might actually be higher returns than they were getting in what they shifted it from. Like shifting that allocation might actually improve their overall expected returns. Because you could say that, let's just say like A6 and Z, for example, we're going to invest in automation and software and the internet and AI and factories and physical things. And that might actually be a better investment than like an industrial buyout private equity firm or something. I don't know if that's true, but like you could probably make that argument.

1:09:08Turner Novak:I'm sure there's like a ton of data to support that of like you might get a 2x on that PE bio fund, but you get a 3x on the mega fund software industrial bio thing. I don't know. It's probably like a bad argument, but I'm sure like that's the, that is like the way I'm sure if there's like more data, you could support that. Like if I knew what I was actually talking about, I'm sure, yeah. Not only are you right about that, but I think you kind of make a deeper point, which is that if for all that those dollars are currently allocated in the VC bucket for these LPs, if it's not actually competing with actual capital which should go to VCs traditionally, and actually it's probably displacing PE money, maybe that's because this strategy is really PE and it should be grouped in with PE.

1:09:58you know it's kind of a not something that anyone at a big fund would want to hear that they're like basically private equity but really you know maybe they are yeah

1:10:09Turner Novak:well and it's interesting one of the prior guests of the show actually two guests it's I think one of my only I think actually my only episode with two guests it was the founders of a company called Solugen have you ever come across that one? I don't think so they're basically just making chemicals in a different way they're making chemicals they're all the same compounds that go into like uh petroleum waste and petroleum type products they're creating it from plants essentially and the the chemicals industry i think it's like there's like i think it's like four trillion of just like headline kind of gdp economic activity in the world that is like chemicals so you use chemicals on clothing in health care products in your computer in like cars like everything is like coated with chemicals in some way and the entire industry is is very old and they're it's very asset heavy high bearish entry basically everything the whole industry is revolving around getting like extremely high volumes through on really low margins it's been competed away and super outdated and like there's no real room to like innovate on anything and like change anything.

1:11:23Turner Novak:And it's kind of caused like, you know, you could probably argue, we're literally taking oil that's like on my clothing, it's like touching my skin, like, that's not good, right? I'm not dead because of it. But, you know, if you think about like pouring gasoline on yourself, or like being exposed to nuclear radiation, on like the extreme end, that's not good. And it's kind of interesting, like, they're basically like a venture backed company that's kind of competing in the chemicals industry against these people that have 10 % gross margins and 2 % profit margins that has bad customer service.

1:11:58Turner Novak:It's actually interesting. When I was talking to them, I didn't believe them. They're like, when you order chemicals, they give you a four-week delivery window. Imagine your calendar. Imagine if I sent you a calendar invite for this and it's a four-week window of like, hey, show up at some time in these four weeks and record this podcast with me. You're going to be like, how the fuck do I get anything done. That's so inefficient. But that's how that industry works, where you don't know when this thing is going to show up. And so you could say that using that operational rigor, that technology to say, we'll deliver this thing at this time, and you'll get your product, and it'll be made differently.

1:12:38Turner Novak:Our margins are way higher. We make things in a way that's way faster and more reliable. The customer service is better. You can actually compete with those industrial buyout type, private equity type model, like that form of capital. So I don't know. I think it's net good. To your point, more forms of capital for entrepreneurs is good, generally speaking. For sure. There's a ton of big industries with like high idiot index scores still that are ripe for disruption by that kind of capital. Yeah. So to your point about bringing capital forward, it's like you take, that is like a very late stage capitalism type of capital, like late stage economic activity that you're like shifting the capital into an earlier section of the stack.

1:13:22Turner Novak:It's not origination necessarily, but it's still earlier than what it was before. So you're in theory creating more economic profit of some kind, which I hope is good for the world. Like generally speaking, I think that's generally a good thing. So you commented one time about... A16Z is kind of like a common punching bag of the Megafund model. You actually said their very first fund had a smart, good strategy. What was the strategy in that first fund? I'm kind of familiar with it. But I think people would probably be kind of interested because it's probably different than what you'd think. Yeah, it's interesting.

1:14:02This is kind of the moment when I came across this, when I started to realize I was like, maybe I'm judging them too harshly because I had this sole perception of them as like the mega fund, that archetype. But actually, if you go back to the fund one, they were like a traditional and very well architected VC firm. Like they were targeting like a level of diversification in that fund that was uncommon, is still uncommon, but I think is sensible. and they had like a follow-on strategy for subsequent rounds that was like more sophisticated than many VCs would consider today. So like on the whole, it was like, oh, these guys actually really do understand VC.

1:14:47So whatever they're doing today is like an evolution.

1:14:50Turner Novak:So what was it? Like what was the strategy? If I remember correctly, I think they were targeting something like 60 initial investments in their first fund, whereas the typical today is probably like 2025. Maybe 30. I guess it depends on the stage you're at, yeah. Yeah, for sure. Could be as high as 30, definitely. So they were more diversified on average. Which means they were able to take a bit more risk. They were able to be a bit more idiosyncratic, like choose companies that are like more outliers, less consensus, which I think is good. This is all good stuff. And then they had the strategy for like investing a little bit in the A and then the B maybe being able to double down on winners, which is like kind of has been described.

1:15:39And there's a very good paper by Joe Millam called Process Alpha. And he describes like generating systematic alpha through how you allocate capital. And this is one of the things he talks about a lot, like how you do reserves is actually quite important. And they had a very good grasp of this in like 2009 or 2008, I think maybe. What is the general best practice in around reserves? Because I feel like there's a lot of people that say every end of the spectrum.

1:16:09Turner Novak:What have you kind of seen that you've picked up on? I've seen like most recently, I've seen a few GPs make comments along the lines of they don't do reserves because the subsequent round in that company is so overvalued that they wouldn't want to. It's not worth it for them for the risk, which is a crazy thing to say. Because is that increase in value not reflecting an increase in potential? you know yeah you're saying like my my poor my performance numbers are fake and they're not real exactly like i'll take the markups thank you very much but like i don't want to be involved yeah i'm not selling any secondary either which is maybe then also a question is like what for sure but i think like the the biggest thing and this seems very obvious to say that in any subsequent round of a portfolio company you need to be able to separate yourself off emotionally completely, look at it objectively.

1:17:09Is this a good investment? If I never met the founders before, if I had no track record with the company, if I'd never posted about them, never written a Substack about them, is this a good investment? You have to be able to do that to make good judgments. There was I'm going to keep doing this to you. I can send you links afterwards. There was a very good paper that came out last year.

1:17:32Turner Novak:Do you remember what it was called? I'm taking notes right now, so we're going to throw them all in the description. It is called the sunk cost fallacy in venture capital staging. And it basically describes how VCs grow attached to portfolio companies. And probably they grow more attached to the ones that struggle a bit because they're the ones that need the most help. And they don't want to admit they're wrong in the investment. So ultimately, they pile in capital when they probably shouldn't. And it goes badly. so for all that it seems obvious to say like you should evaluate each investment independently as an objective judgment it doesn't seem to be what is typically the case interesting okay and one one comment i think we i think we had like sort of like a public it was like i think it was a friendly disagreement hopefully on portfolio construction there's been i think there's been some studies that show in theory, optimal portfolio construction and venture is way more diversified probably than most people typically do.

1:18:36Turner Novak:I think my stance on it is the point of venture is getting as high returns as possible. That's the only point of being in this asset class. So that probably means you need a more concentrated portfolio than not. And I think your view on it is a little bit different. What's kind of your view? And I I think this is what the papers show in theory too. Yeah, the question is essentially, like what do your LPs want? Do they want that you get an 8x fund and then your next is a 3x and then your next is like a 1.5 and then your next is a 10x? Or do they want 4x, 4x, 4x, 4x? Like which is preferential? So that is going to depend a bit on the VC.

1:19:21Sorry, on the LP, of course. But I would say, generally, LPs would be happier if the GPs they invested in had good public market beating stable returns. I think that's pretty fair. If you accept that's the case, then more diversification is almost a given because it's how you achieve that slightly narrow band of returns, that slightly narrower band of returns, but still above benchmarks, still good solid VC returns.

1:19:59Turner Novak:Does that beat the public markets, you think, of 4X? I guess it depends on the time to liquidity on that. Yeah, it depends a bit on the era. But even then, it gets very complicated with the maths and the theory. It's not that it makes a 4X more likely, it's that it makes 4x being your minimum more likely, you can still outperform it. Like if you're well diversified and you pick well, you can still do like a 10x fund in theory, or it starts to get difficult, but like you can still get great returns. It's more how it limits the chance of like complete failure. And if you look at the number of VC firms that completely fail, that should seem to be a priority to me.

1:20:47Turner Novak:yeah I think it's a little bit of too high of a number the numbers that completely fail because because I think the thing that I like I kind of honestly I hate about that chart from that study it literally like you cannot get above a 6x like it lived like I don't know where the cutoff is but like there's like zero samples like zero of n that hit anywhere above 6x I'm like that's like 6x is pretty good for venture but like you want a shot at like a 10x 20x 30x and if that's if that that chart should be i think the chart that encapsulates that study should look differently because i think that chart biases my head to be like if there's no chance of getting a 10x i don't think that's a good venture strategy so but your point of like yeah if you're an lp you want a relationship with a manager who will give you a very consistent strategy over a long period of time.

1:21:44Turner Novak:So yeah, there's so much nuance on all this stuff. There's a lot. Yeah, there's a ton. So the chart itself, just to touch on that, that's based on data that looks at what is the typical distribution of returns in VC. So it's looking like an average profile of returns and how do you use strategy to maximize that. So you can, like for sure, like I said, you can definitely outperform that. You can do way better than that. It's just trying to understand based on strategy, like where is the average return likely to be? How does it influence the rate of complete failure versus the rate of success? So it's almost a distraction from the point because it leads people to make a lot of incorrect conclusions.

1:22:39The other two little things I think worth adding on to that is research shows, generally speaking, a more diversified VC is more likely to take or is more comfortable taking more risk on a per investment basis. So they'll go out and back things that might seem crazy to other people more often. And a lot of the time, I think that can help accommodate more like real outliers in the portfolio. The other thing is like research on how like this idea of like, you should have super conviction, you should be concentrated in your winners. And that's how you deliver outlier returns is true in theory. but research shows that overconfidence is more of a negative than a positive, more or less.

1:23:38Like managers tend to have a better perception of their own ability than is realistic. And when they therefore concentrate, they're more likely to do themselves harm than benefit, essentially.

1:23:53Turner Novak:What else do people tend to get wrong about portfolio construction? Is there anything else? because portfolio construction is basically risk management, right? It's like, how do you control? It's like the thing you can't control. You can't control how well a company is going to do ultimately at the end of the day as an investor. It's on the team. It's on the founders. You can have like a 0.1 % impact, but you can control your own portfolio construction and risk management. So what is another thing people tend to get wrong? Probably the two we've covered, I think, are like the biggest ones. One is diversification and the other is reserves and follow-ons.

1:24:32Outside of that, I mean, probably there's something to how VCs think about diversification, not just in number of portfolio companies, but in exposure to particular themes. Because if you're entirely in crypto and then the bottom falls out of crypto, your whole fund is toast. But if you're a generalist and you're like a little bit of crypto, So a little bit of consumer, a little bit of enterprise SaaS.

1:24:59Turner Novak:Got some biotech, whatever, deep tech space. For sure. You're more robust, basically. Have you seen those studies that specialists versus generalists, which outperform? What's the data show on those? I feel like I've seen some data, but I'm wondering what your opinion is. There's been a few studies. Some of them, this is an interesting question that gets into like good data versus bad data, which is I know something we were going to talk about. This question of specialist versus generalist is one of those questions that has like been in VCs for decades and decades. Similar to like the question of persistence, does VC performance last over time?

1:25:46So both of these questions have a ton of data, a ton of studies. I tend to bias towards looking at the more recent data because to the extent that VC has changed a little bit, like it's probably worth looking at the most recent findings and maybe they're the most indicative. So on the question of specialists versus generalists, the most recent research that I know of was PitchBook, I think a year or two ago. And they found basically broadly generalists outperform. for basically the reason we just described, like they can cover a ton of different themes. They're not tied to a particular theme through their LP agreement.

1:26:27So if something really interesting happens in like year two of deployment or year three, they can get into it. The exception is fields where there's like real, like hard science, like life sciences.

1:26:42Turner Novak:Like some kind of expertise that's needed. Yeah, if you need real deep scientific expertise to understand a company in a field at all, then yeah. It's a blood testing startup. It's like, does this blood testing actually work? Yes or no? Well, you say that, but that was like diligenced out by Google Ventures in a simple little test they did. But yeah, it's a good point all the time. I think another lens I've seen on that with, I'm piling on to your, because you just supported my narrative of being more of a generalist investor. But it seems like specialist funds will outperform early in like a sector or like an area of specialization.

1:27:23Turner Novak:And then that kind of gets like competed out. So an example might be like Crypto Web 3. Let's say it was like a crypto fund in 2019, 2020. You're deploying, it's less consensus. But then if you're still doing crypto only in 2022 and all your entry prices are when that is a consensus thing, you kind of match the generalist returns. You no longer get that out of favor return. So I think specialist funds make more sense in a sector or in an area of specialization that are not within the realm of a generalist necessarily. Yeah, it kind of depends on you have to be specialized in an area that has amazing and pretty immediate potential that few other firms have realized.

1:28:12And if you can make those judgments, you're in the right profession.

1:28:15Turner Novak:But then it's like, okay, that gets competed out and you don't have an advantage anymore as a specialist. So you need to have some kind of truly defensible institutional advantage within that area of specialization that continues to give you an attractive entry price and reason to win against maybe the more generalists. So I don't know. I think it can work both ways. I think, to be honest, almost with the exception of the life sciences stuff, just be a generalist. And if you have a thesis on the side, like we're a generalist fund, but at this point in history, we think there's an outsized opportunity in biotech.

1:29:00Then you can just start investing a little bit more in biotech. You don't need to build a whole fund around it. And I think that is... from a kind of basic perspective of understanding outliers and venture capital and recognizing that the greatest companies are generally not from well-understood sectors, like it just kind of makes sense to me that like, that's how you should be.

1:29:24Turner Novak:Yeah, I think my friend Rex Woodbury had an interesting post about this. And it was kind of a chart, you may be seeing this table, it was like years. And then it was like, most valuable company founded in that year. And then it was like hottest sector at the time during that year. Or maybe some of those rows and columns are switched. But it's basically just showing like, and every year, the most valuable company that was started was not in whatever the current thing was. And so I don't think you should just say like, oh, AI is super hot. I am not investing in AI just because of that. But it's like data that shows like, it kind of goes back to that point of like, If you want to actually generate return, you need to make sure entry prices are attractive.

1:30:07Turner Novak:But then it's like velocity of dollars deployed. How much capital could you move? You probably should just invest in the stuff that's moving the fastest, even if it's overvalued. It depends. Are you an investor or a trader? That's the question. Are you chasing ultimate outcomes or the proxy metrics that let you raise another fund? That's the core of all of this, really. Okay, so maybe moving to a slightly different topic, but what do you think is the correct way to value a startup? And you do a lot of it through Equidam. How should I think about valuing a startup? That's a deep question. So going back to what we were talking about towards the beginning, a lot of VC uses relative value as a way to understand how to price a company or how promising an investment is.

1:31:01And it has all those issues we discussed around catering and it channels capital towards areas of consensus, let's say. So the flip side to that, obviously, is if you are in the camp of what I would describe as real VCs doing origination, you have to have a lens on what is the fundamental value of the company. And that means you have to understand essentially what is the future cash generating potential of the company, which is obviously a ridiculously difficult question to ask at pre-seed.

1:31:44Turner Novak:It's one of the things that you can't answer it. You can't say, hey, there's these two people. What's the free cash flow going to look like in year 12? Yeah, it's true. but you also can answer it because it gets really deep into the theory, but essentially you have to understand a few different things as the foundation, one of which is valuation is always based on the future. It's like a hurdle for future performance. It's not a reward for past performance. The other one is it's always an opinion. like there is no calculation in the world that tells you the real value of a company it's always an opinion when you look at public markets it changes every day every stock price changes pretty much every day the price changes of every stock yeah because they're based on like what do people believe basically yeah so then the question becomes like you look at a company at pre-seed you can see the market they're going after you can see the product you can maybe see like what existing solution are they displacing what budgets does that allow this company to tap into you can think about like how much competition is there in the market how much better is this solution than incumbents and that tells you a little bit about what their moats might be which allow them to preserve the margins over time

1:33:11and basically you look at all of this and you can make more or less like a gut judgment of like, does this company, like the way I always put it is like, can it unlock a ton of economic energy? Can it tap into something that like has a huge amount of cash waiting to be deployed into a better solution or like a different way to do things? And is that going to sustain over time? Are they going to be able to keep an edge over the market to let them be the... to create a monopoly, more or less. And I think you can make those judgments at pre-seed. And not only can you, but that's kind of the job. If you care about the ultimate exit and not the incremental metrics to go back to that point again, that's kind of the job, I'd say.

1:34:00Turner Novak:Yeah, that's almost like the role of the founders is to figure out the execution of getting there. And you can help maybe. Most good investors probably help in some capacity, But really just gauging, is this even possible? Is this an opportunity that I want to allocate my capital to, I guess, with my crystal ball in a way? I like that framing of market potential. I think a lot about just customers. Do I think that you can generate a lot of cash flow from these customers? Do I like a company servicing this customer base? I have one that I'm looking at right now. really interesting idea. But I'm just like, I just don't think you can make enough money on this.

1:34:40Turner Novak:I just don't think this is a customer that I want to go after. And it's just tricky because they might be able to actually expand the scope of what it is. But I just don't think they will be able to. I don't know. But I think a lot about customer base. Do I like going after this customer? And do I think you can generate a lot of economic profit serving this customer or serving this market, to your point. And every VC, or let's say maybe like 99 % of VCs, probably 99.9, would say that like a DCF, a discounted cash flow model evaluation, where you model out the future revenue, the future cost, you get to the future free cash flow, and you use that to determine the value today.

1:35:27They would all say that has no place in venture capital. There's way too much uncertainty. It's not practical. You can't do that for a pre-revenue company. It's ridiculous. But actually, what you do when you think about whether or not to invest in a company is basically like a simple mental DCF. The only benefit of putting it out in a spreadsheet, if you need to, is you can pick apart the assumptions like, are you really going to grow at this rate? Is this really going to be your margin? And it's not to get to a precise calculation, but to explore what are the assumptions and the opinion. My general super lazy, just like gut check initially is just you just assume something's

1:36:08Turner Novak:like 10x revenue is like your exit multiple or whatever. Sometimes it's lower than that. Sometimes it's higher. But it's like, okay, if it's like a tech company, like growing at a relatively fast pace, outsized margins, like 10x revenue at exit is probably like semi reasonable. Hopefully, hopefully it's higher. I think you want that uncertainty of like, ooh, 22x revenue multiple, whatever. But I think you start to get in trouble, though, where you go in and you say, let's say you invested at 100x revenue multiple and you're going to exit at 10. You need to grow 10x to then keep your valuation flat at a 10x multiple.

1:36:48Turner Novak:So I like to think, OK, if I'm only investing at a 50x, that cut in half the return expectation. You only have to grow 5x. Or if you come in at a 20x, you only have to double. to hit that same exit valuation. And if you 10x, then you got a 5x increase in valuation at the exit, if all things kind of hold true. So to your point about almost like re-risking the business, I kind of think about that a little bit when I'm just generally thinking about this is like, how high is that hurdle that I'm coming in at that the founders are giving themselves? And then in the context of the full portfolio, like a basket of all of these, how is it going to all culminate when it all gets said and done in 5 to 15 years when some of the stuff really starts to play out.

1:37:32And a big part of that is the multiple drops over time as the growth of the company slows, as it matures, for sure. But also, as you go from pre-seed to a public market company, the quality of your revenue matters a lot more. And if you're investing on an ARR multiple basis, it's kind of the point I made earlier about gap accounting and adjusting to that life. For how long in a company's life can it be valued on ARR and invested on that basis and still be able to do a hard handbrake turn at the end and become a reasonably healthy company in a public market or in an acquisition scenario? because those buyers do care.

1:38:21It obviously created a ton of problems with SaaS companies in 22 because they could not turn around that quick.

1:38:28Turner Novak:Yeah, and one thing I think too, when you look at just generally public market, I feel like you need to use public markets for this because there's not private market data on what drives returns. But I think generally in public markets, you'll see them... I forget the numbers, but the majority of returns are basically driven from multiple expansion and earnings growth. So if you say in venture, you're typically fighting against multiple expansion, like you're probably going to get multiple compression. But like the holy grail is can you actually get multiple expansion on top of earnings growth?

1:39:03Turner Novak:And that's maybe the when you when you look at look at like 100 baggers in the public markets, that typically happens. It's like you bought a company for 4x earnings, and now it trades at 20x earnings. And they grew, they grew 100x and now it's like it's become this like you know compounding durable sustainable growth and the market knows and that's why i trades at 20x earnings but it was trading at 4x before and you bought it at 20 million in earnings so you bought it at like a 100 million market cap and now it's worth 6 billion because you expand your multiple x amount and you also grew earnings by x amount i i kind of talked to like a lot of my public market friends who'd be like, oh, this venture is kind of like, it's like micro cap, penny stock investing almost.

1:39:50Turner Novak:Yeah. If you go look at a public company that's worth$12 million, it's probably worth zero. But you're trying to find that diamond in the rough of like, this is a 300 banker, where this is an$8 billion company that you invested in at 12 million market cap or something like that. And it's like treasure hunting. You're just going through, you're trying to find undercover gems really at the end of the day, finding founders. But it's kind of cool because in venture, they come to you. Like if you're a public market micro cap investor, you're probably not getting these companies emailing you. And if they are, it's probably pretty bad.

1:40:29Turner Novak:But in venture, it's like they're coming to you to seek out capital. So it's kind of like this weird treasure hunting. Well, that again, it kind of depends on your on your strategy, right? The whole origination question, are you relying on an inbound? Like how good is your process for screening inbound? Are you relying on referred deals? Are you going out like hitting college campuses and hackathons? It's a pretty deep question. There's this one study that you brought up that I think you posted about this on Twitter kind of recently, which kind of sounds non-intuitive, but generally speaking, investment firms that are located in popular startup hubs, typically outperform the investment firms that are outside of popular startup hubs, but not necessarily on a company-by-company basis.

1:41:21Turner Novak:Just generally, a company based outside of San Francisco might actually outperform in San Francisco. So how is that even possible? How does that kind of play out? And why is that in the data? Yeah, it is a fascinating bit of research. And the bottom line that I hope VCs take away from that is that they should be looking at opportunities in non-traditional hubs because they're great and they're out there. But essentially, I think it's driven by the friction for a Silicon Valley VC to go and invest in a company in Ohio is very high. So they're only going to make the effort if they think it's really an outstanding opportunity.

1:42:04and also at the same time, because they're a Silicon Valley DC, maybe with like a big name, they can win that deal over any local investor. And also probably they have an easier time raising from LPs than like the Ohio VC does. So they have basically a lower cost of capital. They can invest on more favorable terms. They basically have all the advantages and the ability to pick opportunistically, whereas the local VC is a bit more limited.

1:42:36Turner Novak:Yeah, because I feel like that's generally what I kind of see. It's like if you're the best company in Cincinnati, Ohio, you're going to want to raise money from the best investors. You're going to be seeking out. You want A16C involved. You want their great brand. They will talk about you on podcasts. You'll get the news mentions. You'll get Twitter threads about you. You'll show up in all the reports. People will know that you exist And you're not going to get that from, I don't know, Midwest Ohio Venture Capital Fund. But I don't even know where it's. I think Cincinnati's in the South. Have you ever been to Ohio?

1:43:10Turner Novak:Because you live in Wales, right? Yes, I do. And I've never been to Ohio. Okay. Have you ever been to the US? Yeah, I've been to... I spent about six months living in Miami. And I've visited other parts, mostly kind of West Coast. Oh, interesting. Okay. Because I think in that one paper specifically, it talks about how proximity to portfolio company has no correlation to return to. Maybe there's like a negative correlation. I forgot which one it was, but it's kind of non-intuitive because you'd think like, oh, if you invest in the thing down the street, you can like monitor it and check in and add value way better than if it's, you know, for 20 hour plane ride away.

1:43:50Yeah, I guess the like, whatever that adds in terms of friction is kind of like priced in. Like, so you bet you therefore would only do a deal if it was like really seen as worth it.

1:44:01Turner Novak:Interesting. Okay. And there's another study that shows actually that it's kind of related about founding team and like the sort of like the quality of the founders is not actually a predictor of investment success. It's much more about the actual initial quality of the business. But a lot of times there's kind of like no business, I guess. Like, you know, we were like they're investing in a team. So how do you kind of, what is that study that kind of shows like the actual business quality predicts And then how does that actually play out in sort of this origination stage venture when there's not really a business yet?

1:44:35There's three papers I can think of that have all found basically the same thing. I think that the best of which is called Predictably Bad Investments in Venture Capital. And they basically all look at what are the standard founder attributes that VCs pattern match for. and it's stuff like where they went to school, where they worked before, maybe like socioeconomic background, do they go to the same squash club or something? Like a lot of very weird, like slightly tangential attributes that end up influencing VC behavior and investment decisions, but probably shouldn't in theory. And when you look at the data, like clearly shouldn't, like have quite a negative influence.

1:45:25not only did they lead to bad investments, but they lead to missed good investments, which is a huge problem. There was a second part to your question. I can't remember what it was then.

1:45:37Turner Novak:Well, that actually the quality of the business is what actually predicts the outcome, not the founders. Yeah. Yeah, and how you understand that at a very early stage. But yeah, if you're investing and there's no customers yet, how do you get business quality? Is it like potential business quality or something? There's a quote from Peter Thiel. He was asked a very similar question. Do you focus on founders entirely? What else can you look at at the early stage? And his answer was, it's a complicated package. You have to look at the whole thing. So in order to obviously pre-seed, pre-product, all you can really look at is the founders.

1:46:22but you can understand the quality of the founders and the competence through the lens of how they articulate the idea, how they think about the markets. Do they understand the financial side of things? Do they understand the growth, technical aspects? So it's very easy for a lot of early stage VCs to say, all we care about is the best founders. We don't care about ideas or we don't care about markets. but actually that just means like you're kind of ignoring information that could be useful because even if it's the wrong market even if they end up pivoting the idea the way they talk about it and understand it and articulate it is like still really useful

1:47:05Turner Novak:information yeah and it's sort of like how did you come to your idea what kind of research did you do what was your process like i have i have one portfolio company that when i invested they one idea that I thought was really good well research they ended up pivoting and they the reason I invested was because I thought I bet if they change concepts they'll like they have a good framework for doing this like I trust them with the capital I trust that we'll do something and yeah they just kind of like pinpointed this almost like perfect storm perfect category like it's I mean it's turning out to be a really interesting business still pretty early but it's like one of those things I'm like damn that was like incredible pick how the fuck did they find this like it's also right in front of you kind of a thing so but yeah it was like I feel like that's definitely a good a good way to think about it's just like the founder ideation quality discovery quality understanding of like what it takes to go into you know almost like Porter's five forces or like the seven powers type equation of when you're starting a company, what are the ideas to pursue related to margin structure and dynamics in an industry and how those could change over time based on new technology.

1:48:24Yeah. And you have to reconcile that with the fact that like other research I've shared shows that like high tech startups are actually more likely to succeed after they've had at least one pivot. Or no, after they've had one It goes like down a bit after that, but like one pivot is actually a positive, which is crazy because it means everything you think you know about the business at the first pitch meeting is like probably going to be wrong if it's a good company.

1:48:54Turner Novak:So what is considered a pivot in that time? Is it like we're a consumer social media app and now we're like a B2B AI vertical SaaS thing? Like how do you define like a pivot in that one good pivot thing? It's a good question. I can't remember how the paper described it off the top of my head, but it was like a pretty fundamental shift in the direction of the business. So it was like significant. Yeah, because when I think about all every single, probably like half of my investments I made are just like pre, like pre customer investment, sometimes are pre product, sometimes like, they're working on getting customers or like in the discovery phase or whatever.

1:49:35Turner Novak:But pretty much every single one of those, the thing that was in the pitch deck is the main product that was going to be used to generate the business revenue is not true anymore. There's a lot of cases where generally the customer space or the general idea, but the way they actually solved it, just completely different than the pitch deck. The pitch deck was just kind of wrong. But it's sort of this discovery process of meeting the team and you're almost like sussing out their ability to go execute on this and figure it out really. Because it's kind of an experiment. It's an adventure. You're figuring this all out.

1:50:16And that ties into a few things we've talked about. Also, maybe another paper I would recommend, which is Premature Scaling by Startup Genome. So this It ties together a few of the topics quite nicely. They looked at, basically they were trying to study what are the main causes of failure in startups? And they were surprised by their own finding, which was that I think in 70 % of the failures they looked at, a significant problem of the company was that they'd raised too much money. and essentially what that meant was before the startup had like properly validated what they were working on that they had like product market fit and it was the right direction for the company they raised a ton of money and invested a ton of money in in growth and in hiring and technology and development and then when it was wrong the company just explodes whereas if you go like piecemeal step by step get the very small checks from a nice small friendly originating bc fund And you can work that stuff out as you go and you have a partner to help you through that.

1:51:28So the parallel there on the other side is maybe the mega fun VC who would give you the huge bag of cash in the beginning and then just stand back and maybe you take off and it's amazing, but quite possibly you explode and maybe they're okay with that trade off. Maybe that's built into the math of their model.

1:51:49Turner Novak:Yeah, I would think so. Yeah. Because is it... Does it... The explosion or the failure happen because you set a super high bar of what the company needs to hit in terms of the valuation of metrics to reach that valuation. And you're just unable to raise more capital and you run out of money. Is that generally why the explosion or the implosion happens? Yeah. Yeah. Basically, you have a very fragile future. The thing that you pitch them on, that they invested a ton of money in, it has to work and it has to scale quickly. And if it doesn't, you're done because the hurdle for that next round is now so high, you just can't clear it.

1:52:32Turner Novak:Interesting. Yeah, and if you just think about a$10 million fund that writes a 100K check, that's 1 % of their fund. A$100 million fund that writes a million dollar check, 1 % of their fund. A billion dollar fund that writes a$10 million check is also 1 % of their fund. So in all those cases, if I invest$10 million fund, 100K, if it doesn't work, it doesn't work. That can drive my return. If I was like, hey, that's okay. You guys tried. There's a reason I have a fund. Let's say I wrote 100 checks of 100K each. It's fine. For a fund that's$1 billion, wrote$10 million check, didn't work. like, yeah, that's fine.

1:53:21Turner Novak:We tried to get to the Series A that we wanted to put 3 % of the fund into. Didn't work, whatever. It's not a big deal. So I think as a founder, if you're trying to play that game, I would say, you've got to find more funds that you can find that very small percentage of the fund option check. They're there. We see it. I have portfolio companies that have done that, that have been like$10 million kind of option check from a big pool of capital to keep it going. Sometimes it works, sometimes it doesn't work. So, but it's an option there for founders. The question that it kind of leaves me with is the mega funds, when they start doing origination themselves, like how well set up are they for that?

1:54:07Or like, do they even have like slightly different incentives? Like if they're doing this strategy of like trying to ride the waves and trying to produce essentially venture beta rather than alpha? Do they necessarily care about finding the crazy little outliers? Perhaps that's not how they're oriented. And that kind of shows in the data where they actually seem to be increasingly concentrated in San Francisco software companies rather than branching out as they get bigger. So yeah, I have lingering questions about that and their involvement at the very early stages. Yeah. I mean, ultimately their business model is put a bunch of capital into only a couple companies.

1:54:51Turner Novak:And you can't put a bunch of capital at the origination stage. You need them to get further along. Like you're probably on a cost weighted basis. Like let's say one of these mega funds fully plays out. And you just look at like, we're talking in 2040. We're looking at what they were doing in 2025. I've, I mean, their average, average entry point on dollars is probably like a series B, or maybe even a series C, because it's like 5 million at the C, 10 million at the A, 20, 50, they might put 100 million in right before an IPO. So like your average cost basis was like, almost at the IPO really at the end of the day.

1:55:27Turner Novak:But you basically use that origination check is a right to get there to get into that company. So and actually you you want it to like whittle down like you want to start with whatever they're doing like a hundred seed checks a year and you want that to be like two companies by the end to concentrate all the rest of the money into yeah because you want to do as you want to make as much money as possible while doing as little work as possible as an investor right like you want to give someone you want to give them cash a year later they give you a hundred x of it back and you did nothing. That is probably, for an investor, that is the most ideal.

1:56:06Turner Novak:No one will admit that publicly, but I mean, that's ultimately what every investor is going for. And so we first connected on Twitter a couple years ago. I don't know. I just feel like I've been reading your stuff for a while. We've kind of talked back and forth. How did you kind of first get started with writing? So my blog, which has the very unusual name of creditstick.com, which is a Shadowrun reference. unfortunately a misspelled Shadowrun reference. Shadowrun? Is that a game? Yeah, it's originally a tabletop RPG that became video games later on. Yeah, did you play the video game? Yes. So this is the one where it was a gun game, it was shooting, but there was magic?

1:56:48Kind of, yeah. It was like an isometric turn-based kind of setup. But basically, it's a connection to science fiction, which is what I originally intended to start writing about, the intersection of science fiction and technology today. That led into writing about Web3, Metaverse, because I was super interested in that. I'm a big fan of books like Otherland by Tad Williams, Permutation City by Greg Eisen, Neuromancer, of course. They all have connections to this. And then Web3 turned up and I was like, oh, this is amazing. So I started writing about it and I quickly realized the people investing in Web3 didn't have any familiarity with the science fiction, the literature about it, with existing virtual worlds.

1:57:43They didn't know about Second Life. They didn't understand World of Warcraft. I needed the research on these topics. So much interesting stuff was out there to be a very useful resource. that wasn't being applied to this wave of Metaverse and Web3 companies. And that's when my writing took a pretty hard turn into being like, hey, venture capital is kind of broken.

1:58:05Turner Novak:Okay. What were the name of those three books? I'm going to throw a link into the show notes for people. The first is a series of four books by Tad Williams called The Otherland Books, The Otherland Tetralogy. The second was Permutation City by Greg Eisen. And the third was Neuromancer by William Gibson. And there's also, there's a ton of others you could mention in that same kind of genre, but like, those are the three I think about the most when I'm like, it's like near future sci-fi that is still relatable. So if you're a VC and you're thinking like, what's the world going to be like in 10, 15 years?

1:58:47I think those are good books to read and think about.

1:58:50Turner Novak:What are the general takeaways in terms of what's the world going to look like? Is it not Web3, everything's tokenized? Is it more of like virtual economy? What's a way to think about it? I'd say like Neuromance is interesting because it's kind of like, it's cyberpunk, so it's dystopian. It's like, what would happen if the FTC didn't exist and corporations were allowed to do whatever they want? No, that's basically today, right? Kind of. You can see the direction of travel a little bit. Did you see? We'll throw the picture up on the screen. I think Trump posted a picture. It was like an AI generated picture of him looking at a computer that just said, Intel,$30.

1:59:33Turner Novak:Buy Intel stock or something. Did you see this? I didn't. I didn't. I missed that. Oh, man. I'll send it to you right after this. But it's so funny. It's like, what are we doing? Why are we allowed to do this? This should not be allowed. It's crazy. It's like, you know, Neuromancer kind of gives you a lens of like, what the worst end state of that would be. Also with some fun stuff like human augmentation, biohacking, sprinkled in. Otherland is like, like really quite literally like what the metaverse should or could be like. And this is like with, like, brain interfaces. like AR, VR, like all this, like future visions of like current technologies, which is really interesting.

2:00:26And it like, it's not set too far into the future. So it's like quite attainable relatively. And then permutation city, I think is more like what science could look like in the near future, like biology particularly as well.

2:00:40Turner Novak:Interesting. Yeah, I'll throw links to all those in the show notes if people want to check them out. I should start like a VC sci-fi book club because I could talk about that endlessly. Yeah, you should. I feel like people appreciate that kind of stuff. Any advice for someone who is kind of starting to think about writing online? I'm assuming you probably did a lot of not online writing before this. Is there like a transition that you kind of went through or made or like a change in mindset? It's maybe tricky. There's a leap you have to make. When you go from just posting on X and being in the timeline with hot takes on topics, to when you start being like, okay, I'm going to have a blog or a sub stack.

2:01:26And the transition is like, what I write is no longer really ephemeral. I'm carving it somewhere. So you have to be comfortable being like, this piece of writing is kind of like a part of me or a representation of me, my view on the world in a certain way. You have to be willing to be wrong or to look dumb, to have people like send you comments or DMs and be like, here's 500 words about why you couldn't have a more idiotic take on this topic. And maybe they're right, maybe they're wrong. Maybe it changes your opinion or, you know, you end up rewriting something. But that's like has to be part of the process.

2:02:07because the alternative is you do what most VCs do, unfortunately, which is rewrite the same perspective on the market that everybody else is saying that adds zero insight.

2:02:18Turner Novak:Valuations are too high. Mega funds are bad. Whatever, whatever. AI is going to change the world. Yeah. Why whatever my portfolio is mostly invested in is the best opportunity right now. Yeah, exactly. That's good. You should write about that if you're a VC. Go for it. I'm not going to stop you. What was the most bold, cold email you've ever written? That would be by quite a wide margin. A few years ago, I was working at a media company in Berlin. We were focused on data science, machine learning, more or less what you would call AI today, but people didn't back then. and I was trying it's a media company it's a grind it's horrible you're trying to do anything you can to get page views and I saw like Mark Cuban had this new app so I just sent Mark Cuban an email and I was like hey Mark can I interview you about this app launch and he replied like 30 minutes later and said sure I had 0.1 % chance in my head that he would even see the email, but it was pretty amazing.

2:03:31It taught me like from then on, you got to take those shots because there's no cost. There's no downside. You might as well. And it can have big payoff.

2:03:40Turner Novak:I actually, dude, I've heard Mark Cuban response to a lot of stuff. Like I've heard so many people say they've emailed me to respond. He actually, he once retweeted a couple months ago, he retweeted a clip from the podcast on the Twitter account. And I was like, oh, was not expecting Mark Cuban to see this and retweet it. So I DM'd him. He's like, hey, want to come on the podcast sometime so we're trying to figure it out i gotta like i gotta like i have to fly to dallas and do with him in person or maybe i can get him to do it virtually he actually has a surprising amount of podcasts and it's hilarious if you look at his background it's like the messiest office with just shit everywhere just youtube mark cuban and just scroll and look at look at his youtube thumbnails on on youtube you could tell he does not care quite often with like NBA trophies, if I remember correctly.

2:04:26Turner Novak:There's just random stuff. You can tell that it's just a guy's office. It's a 55-year-old dude's or 60-year-old dude's office who's like, he's just got stuff going on. There's stacks of papers. There's snowboards or football basketballs and trophies. Massive stacks of papers and binders. Anyways. Well, it was a lot of fun. Thanks for coming on the show. I really enjoyed it. I would do this. you know, any any time all the time, you'd have a hard time getting me to shut up. But you know, I really enjoyed it. Actually, before before we sign off, what's a good way for people to follow you? Twitter seems to be probably your main channel.

2:05:04Turner Novak:You got a blog to where you write sometimes. What are those? Yeah, pretty much everything on Twitter, to be honest. It's like, my goal with all my writing is to put it in the most accessible place. So that for the time being, seems like Twitter. Yeah. Okay, cool. Yeah, we'll throw links to those in the show notes, some people can find them. Well, cool. This is a lot of fun. Thanks again for doing it. Thank you for having me. It was great. And thank you for listening. And thanks to Ramp and Harmonic for supporting this episode. Head to ramp.com slash the peel for$250 on your first set of cards and harmonic.ai slash Turner to check out their AI startup scouting tools.

2:05:38Turner Novak:If you like this conversation, check out the back catalog of over 100 episodes, including last week's with Dan Fader, who runs private market investing at the University of Michigan's$8 billion portfolio. If you want to help me out, please like comment subscribe and name your next venture capital research paper after me and if you don't want to miss a future episode subscribe to our newsletter the split linked in the description to get each episode plus the transcript emailed directly to your inbox every week thanks again for listening see you next time