Jordan Stein from Cresset Partners on VC dynamics, evaluating emerging managers, & more! | E1901

27:24We're really, you know, cognizant of that. It's one of the wonderful things. Just, you know, during this holiday week, a lot of people are off. I've been given some thought to this. My lord, it's incredible how functional our ecosystem is. The seed investors are making these crazy bets, pairing their positions. But then there are these later stage investors who want those shares. And then there's a public market after that. And then there's co-invest. And, you know, in some ways, it's so vibrant. and the transactions are happening at different stages with different goals. I'm not saying it perfectly.

28:00But you know, now that I've been doing it and going into my second decade, you start to see the chessboard a little bit more. And it's beautiful. It's just a beautiful symphony of risk taking, you know, like, unbelievable, insane risk taking, which is what I love about it. The fact that we can tell people with a straight face, we're going to invest in 100 companies, two of them, based on the power law, are going to be 95 % of the returns. And they're like, which two? And I'm like, I mean, I could tell you what I think. But if I if I'm being candid, historically, when I look back on my track record, you know, the idea that a taxi cab company, and a stock trading company where you don't pay to trade stocks, and a meditation outcome would be three of our biggest returns, I would be like, kind of lying, you know, we thought they were really great teams, don't get me wrong, we was clear they were going to be winners, but it wasn't clear the extent of the win.

28:55And how do you think about the power law? Because you're investing in so many different funds, you're actually in some ways trying to capture, you know, the average, maybe and then some, you know, because you're managing entire portfolios, how do you think about that and risk, generally speaking? We, you know, the power law definitely exists. I think there's no doubt about it. And it's hard to find evidence to the contrary. And I echo what you have found within your own portfolio. Like I have yet to meet very many managers who at a pre-seed, seed stage can predict with significant accuracy the winners.

29:31It's very, very difficult to do. And so the way we think about it is in the context of a complete portfolio, right? And so we have kind of a barbell, if you will, where, you know, funds like injuries and Horowitz or founders fund or light speed, they're a little bit bigger. And so they're not going to benefit quite as much from the power law. I think they're going to generate fantastic returns for us. And I think they're absolutely brilliant. Do they have a shot at the, you know, 50x? I think that's a lot harder. The math is a lot harder to get there. To take a billion dollar fund to 50 billion is really just it's not going to happen, folks.

30:06You're investing at much later stage companies when, you know, it's pretty clear they're a winner, you know, to a certain extent. And even if you're really leaning in, I mean, if you've got a billion dollar fund to 50 exit, to take that extreme example, generating 50 billion, you know, if you own, say, 10 % at exit, you're creating$500 billion of enterprise value that is like really, really difficult to do in terms of IPOs. And so, yeah, it's just not going to happen. Just to explain that to folks, to go from one to 50 billion is not the total value of the companies you invest in. in the best case scenario as you're correctly pointing out here you might own 10 on average of the companies so that 50 billion if you were theoretically able to get it would be 10x in market capitalization 500 billion in market capitalization it's that would be like hitting apple tesla uber and google like it's just you know it has happened at the seed stage you know instagram which was actually kind of a smaller uh you know outcome at a billion but instagram and uber and twitter which was the larger one were all in chris saka's eight million dollar fund and you know you do get those 200x funds from time to time 100x fund but they generally happen at seed is what you're saying yes uh and and the counter i guess is unless you can generate a ridiculous amount of concentration and ownership and i've only seen a few do that really well i will tell you you know orin zev is a solo gp on the west coast that i have like the most respect for uh we're an lp in his fund and he has the most incredible returns and he is not necessarily invested in you know hundreds of companies um but when he does he has super high conviction and doubles down and triples down and that has worked really really well and you start to get into those upper echelon numbers so he's able to or and watch the seed investments he makes and then determine they're a definitive or likely winner in some way and get that second and third bet in the series a and the series b right right and uh and but it's really you know there aren't that many out there who do it well and i frankly haven't seen anyone have done it as well as the founder's fund's actually very very good at this too um but but we just had brian singerman on for the same series and he was talking about i don't know if you saw the episode but he was talking about uh airbnb SpaceX, Andro.

32:29I don't know if Andro was in that short list yet. I think that's his future list. He believes that will become one. I think that's pretty good logic there. But I think it was, no, it was Palantir, Airbnb, and SpaceX, where they backed up the Brink truck, 15 % of the fund, 20 % of the fund into one of those names, which is bold. Yeah, but when it works, it works really, really well. And I think the folks at Founders Fund are some of the smartest out there. I mean, they've really built an incredible program. and there is something to, again, there's not many, but they definitely have a little bit more predictive ability, I think, than others.

33:01So that is one side of the portfolio. And then you layer on the emerging managers who are going to be, in some cases,$500 million funds. In some cases, we're an investor in a$60 million fund and everything in between. And you have a little less volatility with the Andreessons and the founders and the Lightspeeds of the world at their size, with their coverage, with their expertise, they're not going to lose money. They're going to generate two, three, four, something that's very solid. And then you can layer on these emerging managers, or what we call established a little bit more under the radar managers, and define that as more under the radar for our client base, who's not intimately familiar with venture.

33:43Oren would be an example of that. But everyone in venture knows Oren, or Ray Tonsing, a caffeinated capital. There's a number of examples there. And so that type of portfolio construction, we believe can create this really strong risk return profile where you've got a little bit more vol, but increased potential for that 10x, 20x, whatever x fund on the one side, buttressed with the more established managers who are a little bit bigger and are going to generate more stable returns. right now startups have to do more with less we all know that it's rough out there folks so if you need great tech talent but you don't have the time to interview dozens and dozens of candidates you need to check out lemon.io lemon.io has thousands of on-demand developers to choose from and these devs are vetted experience result oriented and they charge competitive rates great developers can be incredibly hard to find and when you do find them it can be hard to integrate them into your team lemon.io handles all of that for you startups choose lemon.io because they only offer handpicked developers with three or more years of experience and strong portfolios.

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35:21And how do you define emerging managers? So maybe for the audience, we can start with how you define what an emerging manager is. And then since it's emerging, you don't have 20 year track records, you don't have 10 funds to look at how do you determine where to place a bet? Yeah. So it's definitely tricky. And the way to start with the definition here, and it changes a little bit, we've, again, bifurcated into established, but under the radar, and then emerging. And we view emerging managers as you're on fund one, two, three, maybe four, kind of depends your size and your network and your brand.

35:55And for us, we have generally been looking for groups that have spun out of institutional players. And so I mentioned, you know, West Chan at FPV, who spun out of Felicis, before that Google Ventures, before that Google. It does give us a track record and attribution can be a tricky thing. But we can get comfortable that, OK, this is someone who's been doing this for a long time and we think can continue to generate these types of returns. You know, Tomas Tungus, firm called Theory, spun out of Redpoint. We're an investor in his new fund, same type of idea, right? We can get comfortable. These are not people who - So that's easy.

36:28They had a track record. They were at a great firm. You can kind of look back into what they had their fingerprints on. And then there's folks who, and I have a little bit of that to a certain extent because I had Sequoia, a scouts portfolio that people could look at. So what do you do for somebody who's, hey, I'm just, this is my first fund. This is my second fund. Just get to know them and we'll talk to you on your third fund. Not necessarily. Not necessarily. So I think, you know, we think about answering a few basic questions, right? So is this individual or fund? And usually it's individual.

37:00I feel like ventures become very individualized in terms of there's been a movement that I've observed. I'm curious if you agree with this, where people, founders are often interested in working with specific investors, right? Within brands or otherwise versus like, I just want, you know, FundX. Sequoia, whatever. You want Alfred Lynn at Sequoia. You want Stephanie. you want rule off on your board. Yes, that is the thing. Yes, people start to identify the individual and their traits and their reputation and their network. So that first question is, okay, are you someone that's going to see the best opportunities and the best ideas, right?

37:37Are you getting that kind of coverage? And then the second layer is, can you win investments into those businesses? Because that is equally important. You could have the most crazy CRM system in the world, then you could get in front of every great founder before they even launch. But if that founder doesn't want your capital, then it doesn't really matter. So are you actually able to get into these really eye-popping opportunities? And then how do you demonstrate that? And that third piece is the most difficult. So the way that we will go about underwriting for a new fund manager who we don't really have full track record for is, you know, we certainly aren't going to invest in someone if they've never made an angel investment or an early stage investment, like that's, that's kind of a non starter.

38:21But we think network is probably the most powerful thing in venture capital. And at the core of that is trust. And so we will go talk to and we'll do this really for any fund we talk to, but it's weighted higher, if you will, for these types of managers, other GPs, we'll go ask Andreessen Horowitz or Founders Fund or any of the groups I've mentioned, right? Hopefully, someone who shares a board with this individual and say, Hey, what's your view of them? How's it been working with them? Are they really sharp? Does the founder respect them, etc? We will go to the LP community, talk to other institutional investors, or family offices who have broken through and say, Hey, you know, what are your views on this LP?

38:59You're an investor, what made you get excited about this? And then, arguably, one of those critical pieces is we'll talk to founders. And we'll say, okay, tell us in a demonstrable way, what has so-and-so done in their relationship with you starting from the beginning? How did they find you? Why did you pick them? And what have they done since? And then you're really looking for the core question, which is, if you've got a founder friend, would you recommend them? And would you recommend them over one of the other folks that you've mentioned and that we've talked about? And if we can't get comfortable that GPs think this person is rock solid, I would bring them into any deal that I have and be happy about it.

39:37LPs are able to say, okay, because we could do 10 references and another LPs can do another 10, another 10, and you start to benefit from that scale. and then the founders, right? If we can get comfortable across all three of those lenses and it makes sense from a portfolio construction perspective because we're looking at stage, we're looking at size, we're looking at sector, then great. That's how we would get comfortable. But it's not as straightforward as looking at one of these great firms that's been doing it for a while. Yeah, I'm in 20 funds that are not my own, 24 including my own. and yeah i i i'm almost exactly parallel to yours do they have some unique deal flow right and then can they compete for a deal now i tend to do seed stage deals seed stage funds and i do pre-seed and seed the the great thing about that is by the time people get to series a there's between 30 and 50 names so the the competition is not as dogged as people perceive it to be because they're used to series A and series B competition, most LPs don't understand at the seed stage, because there's no, you know, evidence here, or the evidence is not as clear as a series A or series B investment.

40:49You don't have one person backing up the truck. You have people going, huh, I would like to put 250 or 500k into this$1 million round. And they're like, the founders like just to take the whole million. And they're like, yeah, maybe I pass the hat here and spread the risk a little little bit um and then i'll put more money into the next round so it's it is definitely competing for deals then i think this doubling down strategy your decision making strategy is super important and some people have great decision making some people don't um and i think you know your doubling down strategy is critical as we talked about earlier and that's the one i am obsessed with right now yes because we do precede and seed we just get people to send us monthly reports quarterly reports, roll them up, and that we have some secret sauce.

41:35Some of it should be obvious, like revenue, or, you know, what's the level of the investor who's interested in the next round and which investors are inbound to them or which ones respond to our introductions. You know, Sequoia and Kraft and, you know, whoever benchmark are really interested in meeting with the firm, man, that's pretty good for us. Like, yeah, maybe we need to, if a top tier fund is going to give them a term sheet at series A, maybe we need to take that option to put another 500k in so i i have really gotten obsessed i have a framework now i guess i could share it if you're interested yeah um well i like to vet them and i like doing it publicly because i don't feel i'm in competition with anybody we we have the second largest amount of inbound of any firm you know it's like yc and then us 45 000 applications and we get 20 so with all these applications coming in like we don't really feel like if we lose a deal it's our fault not that we didn't get to the company you know um so i've now defined likely winner and definitive winner coming out of the seed stage so these are my criteria likely winner definitive winner now that doesn't mean definitive dpi ipo parade you know pop the champagne but coming out of seed to series a likely they tend to have a party round going on and there's you know two or three leads so multiple leads putting in money when it's a definitive winner it's usually a known vc firm okay so you can compare those co-lead multiple co-leads one person a convertible note in the likely winners a price round in the winners definitive winners so just the legal instrument because somebody's putting in three million five million whatever they're doing in the definitive winners they're just like i want to price these shares.

43:23And because there's three people leading this one and a couple of angels or whatever doing their prorata, they just do a convertible note. Okay, so you got two criteria there. And then on the on the third criteria, governance. In the first one, the likely winners, there may not be a governance change, they might not have started the board meetings, nobody wants to take the board seat. Then when you get to the definitive winners, somebody specifically wants support scene. So that's how I've now parsed the world. And when I see a likely winner, I tell my team, which bucket does this feel like more and they tend to have the same growth, could be two or three, four x growth year over year, they had 100k in year one, year two, they have 500k, or they went from 200 to 600.

44:07But it's that it's how seriously, you know, the round is the next round is coming together and is the organization becoming properly governed you know with the right investors now it's not perfect but it definitely signals it and they just say tell me if it's a likely or a definitive and it's so rare that you see the definitive set as i've outlined it it's rare but you do see a lot more i would say it's 10 to 1 we'll see a note come together for 3 million bucks and then the definitive you know five million bucks comes down from craft or whoever gets greedy and wants the whole round and they want to be on the board and they want to you know i use greed as like the good type of greed yeah like i want to see this succeed you know the passion come in i don't know what do you think of that i like it i think it makes sense the one yeah if anything yeah i mean so yeah this is a working theory i'm still working on it i'm about 70 % of the way they are with this theory.

45:07That's pretty good. That's pretty good. I think there's a few things. One thing that's interesting is you'll hear a lot from VCs that in order to make the highest returns, you need to be contrarian. And so interesting within that context of, and I think it fits well, actually, if you have one strong lead, and you don't have others at the table who are trying to co-invest, you kind of could have that contrarian view. Yes. So that's really interesting. I think that fits well and makes a ton of sense. I think the one piece, there's some firms out there, Goodwater, for example, or an investor in Goodwater, I think they're really, really smart.

45:45They are more data-driven. And one of the things that they are trying to identify is, other than the obvious, that sort of Stanford computer science graduate who has already built a billion-dollar company and is starting his next one or her next one. how do you figure out the opportunities that other people will miss? And so actually, I think that fits into your framework well, too. But the interesting question is, I don't know that the founders, funds, the Andreessen's, those folks of the world, maybe they do, are willing to take as big of a risk on someone like that who may create a different category and maybe, you know, a dentist who may be, you know, someone who doesn't fit the traditional bill.

46:28um now i'm talking myself into a circle here back to actually thinking if you've got one lead that's actually a huge uh a good positive signal yeah it's conviction right so it could be contrarian i was thinking conviction but i like your punch up there that it's conviction and also contrarian like it's not like there's four people five people everybody's group thinking okay this is some ai startup yeah we all gotta put 500k into it everybody talks themselves into it everybody's taking a little bit of risk not a lot of risk so it's like when you have whatever size fund you know the 500k check you can get a little frisky but the five million dollar check gotta think it through people are gonna notice that bet 100 how do you think about uh you know that's kind of pure signal from who's investing uh the other side of the coin might be you know to say product market fit, right?

47:20And so one of the interesting concepts I've heard from one of our fund managers is, you know, I'm really looking, I get excited when I see extreme product market fit, right, huge growth with no marketing. And so I wonder for that. Yeah, it's market pull is what Andy Ratcliffe from one of the benchmark founders called has called it and market pull is you know it when you see it it's like the stuff is flying off the shelves faster you can then you can do it and your issues become customer support you know your issues become customer success sales people just yeah you know the number of requests coming in servers it's just the whole nature of the startup changes like the problem set moves from you know okay let's come up with a great hamburger and a great you know way to present it to oh my god we're out of napkins you know like there's just too many there's too many people online we're gonna run out of iced tea you know it's it's that kind of thing if you thought about it like a hamburger stand it's kind of like what are shake shack's problem shake shack's problem is the line's too long you know when you go to madison park it's like that line's too damn long okay let's put a camera up so people can see when the line's shorter and they can time it or you know whatever yeah we'll we'll tweet out when the line goes under 30 minutes or something that's a different problem so we do look at that yeah absolutely and you know at the seed stage you have to you have to start talking to customers that was the thing i found very disturbing in the zerp environment that last three or four years to see people not want to join the board and own a higher percentage than we did so we might own when we own over five percent we want to be a board observer or have a board seat we think that's reasonable yeah um and we really don't care if it's an observer or a full board seat in most cases because in my experience i've never seen in a startup like the board vote be some dramatic television hbo movie where like oh my god the future of this startup is based on that it's very very rare happened with uber it has not happened a second time in 400 it almost happened with open AI, right to a certain degree.

49:30Yeah, so that the reason these are notable is because they're rare. Yeah. And really, what you want to know when you're on the board is when's the next round? When is the next round happening? So you don't get left out of it. And are they going to sell the company or not? Right? And they just having that early signal like, hey, they're thinking of selling the company. Or are there secondaries occurring just like there are major financial transactions occurring. And if you're a VC firm who owns over 5%, you own 8%, 12%, 6%, whatever it is, that could be a very meaningful moment for you to expand your position, to clear some of your position, to take your pro rata to not and if you know about it early, you can really make a more thoughtful decision.

50:09So that's always been very troublesome to me people not calling customers, and no governance. Those are my two huge red flags. And man, I saw that happen. It was one vertical where it happened more than others. It was crypto. Yeah, I was just thinking that I mean, this FDX in a nutshell. I mean, it was so weird to see these companies come in and I'd say, who's your customer? And they'd be like you and I'm like, No, no, I'm an investor. I say, Yeah, no, we want you to invest in the token. I'm like, Yeah, but what does the token do? Oh, you know, it helps you render, there was like a render coin, it's actually done pretty well helps render videos, whatever.

50:40Like, okay, it's really novel concept in the world. I appreciate on a technical basis. But we're the customers, we'll find out. But your value in the company at$1 billion. And we'll find out like, how about we find out lean startup style ask a customer get them to use the product and then see if they'll give us their credit card after the trial or take their credit card and say on day 31 it's going to get charged like there are some founders who do that you can use it for 30 days but i need your credit card day 31 if you don't cancel by day 31 it's going to charge it and you can cancel after that but you know you're at least going to get that one month out of you some founders are afraid to do that it's interesting i mean you can do there's this concept of you know painted door tests too right where like even before you launch uh you know you could say okay we want to see if this is product that's going to resonate with the market and so we're going to create a website we're going to create basically like the minimum amount of stuff we need to do to have it be there and then let's see if we get pre-orders let's see if we get website visits so we can drive traffic i never heard it as the pre or the painted door test is a really good name to door test evocative name yeah that was you know a lot of steve blank and And Eric Reese, you know, started this lean startup movement over 10 years ago and the science of it.

51:50And yeah, just put up a landing page with the name of your product, sign up for$49, ask people to put their credit card in and then say, yeah, we'll charge your card when the product comes out. We've put you on the mailing list. We're going to send you 30 days. And then they wouldn't even start it. But you at least see if people have any inclination. That was the thing I liked about Kickstarter. It's too bad hardware sucks as a category. Yeah. It's a lot harder. i mean have have we seen any hardware consumer hardware company have a great venture outcome in the last 10 years name your top three i i mean it's it's tricky because yeah okay okay i was i was gonna just dodge your question there but i'll think about it for a second bought by google for nest whatever that was drop cam became nest i guess that was 500 million i mean i i've been down this road so many times it's really hard to find consumer hardware that works well i think it goes to the exception proves the rule back to the earlier point um it's tough i mean and it starts with you know margins to a certain degree right and growth to a certain degree and then you got to sell for distribution you got to sell for manufacturing you got to sell for like so many more things defensibility yeah defensibility tesla would be the one.

53:04Tesla would be the one. If you consider it like it is a hardware product. All of those have huge software components, right? So it's maybe less a little bit GoPro, but even there. Yeah. Alright, man. This has been amazing. You know, the one thing I wanted to talk to you about was just the democratization of VC. You work with a lot of family offices and we actually did our arrays 506C and I just published the deal memo at launch.co slash memo and hundreds of people ask for an allocation. Now we have a limit on the number we can give to accredited investors, and we can't accept non-accredited. So we can really only accept qualified purchasers at scale.

53:40But we did get a lot of accredited investors and accept a lot of them with 50k, 250k checks, which was great. You see a lot of demand in the long tail or the medium tail for this space. And how do you think about capturing that? I love that you're doing that. And as a personal note, like it's one it's something i'm passionate about i think that certain regulatory agencies make it way harder than not to invest in top tier venture firms by basically incentivizing structural changes such that they only take qualified purchasers or even accredited investors uh and if you think about like i could go buy name your coin you know tomorrow but i can't invest in a top tier VC fund, it makes literally no sense.

54:24And so I hope that we see greater democratization in the space. I think you're leading the way and I applaud you for it. I think that there is trillions of dollars in value, right, that right now has no home in that market segment. And I think to the extent that they, you know, educationally understand the power of venture capital, and to be fair, have the ability to allocate to a space that's not going to return capital for quite some time. That is something that would be fantastic to see more of. So I do think it's, I'd love to say it's inevitable. I don't know based on the things that have to move in order to create more people doing it.

55:06They have a mandate to create an accreditation test. And I really think that would be helpful. And I think taking the accreditation limit off, like accredited investors who pass a test should be able to invest in whatever they want. if you take a five hour test, or let's just say a test that takes five hours of studying, the test itself could take half an hour. But you know, like, imagine you had to sit through five hours of courseware on diversification, on interest, on private companies, how long they take to go public, how many fail. And you just showed people the statistics for venture capital and the IRR, private equity, real estate, and then you made them take a test that proved they understand you know the failure rate of these and and what did the top quartile venture from firms do and the average one do and they just had a general idea of like the risk they were taking or you know a very concrete idea of the risk they were taking you know they don't do that in vegas they don't do it on you know i don't know all this fantasy sports stuff people are betting on and people can gamble the heck out of the super lottery take a state lottery i mean it's unbelievable and you look at how that disproportionately affects lower income people yeah right i mean it's like okay you're gonna let them do that i think the chance of winning the lottery and take the mpv of it do whatever you want with it and compare it to like low like bottom quartile venture and it's not as good that would be actually correct somebody make a chart of that i'm gonna that's a really good blog post i should do but like if you took scratch off tickets and you took the bottom quartile of venture capital better off putting in venture capital so So maybe they should have scratch off tickets and you scratch it off and you get a certain amount put into a venture.

56:45I love it. Yeah. It's funny which one. That'd be fantastic. I'm in. Scratch it off. You got, oh, I got three sequoias. I need one more sequoia to get in there. All right, Jordan, you've been a great guest. I'd love to have you on again and we'll see you all next time on this week in startups and the angel podcast and whatever this is. Okay. Bye-bye. Thanks, Jason.