E56: Upfront Ventures' Mark Suster on Fund Management and the Exit Landscape

28:07I mean, you could theoretically, but that's called luck. So it's our job to invest in something that we believe is going to happen in five years and being correct. If it's going to happen in a year, you probably missed the trend. And there's probably 10 other VCs that were investing four years ago. And if you invest in something that's going to be big in 10 years, you probably are going to run out of capital at that startup before it succeeds. So there's an old saying, which is being too early is the same as being wrong. And I'd say often we as investors are too early. We often know a lot of the right trends and we're just too early.

28:46So market timing is incredibly important. So often what we're talking about is not what the market talks about. And therefore, we come across looking strange. So seven and a half years ago, when we met Michael Spiegelmacher from BioNaut, and we had a belief that two belief sets. One is that we felt there was going to be a merger between technology and health care in a way that you could get mass devices created more cheaply and more accessible in ways that hadn't been used in procedures before. So we started looking at examples of that. And then also looking at places where IT itself could play a bigger role in healthcare companies.

29:33And we have two very big companies now doing that. Not a lot of people were talking about healthcare seven, eight years ago because it was seen that healthcare is a regulated industry that moves too slowly, that has complicated set of buyers, that is not a big adopter of technology, or at least at scale in a uniform way. There's too much custom that's done. And so I think we had a good category to ourselves. We started doing ag tech, agriculture technology. That's become a lot more common in the last three or four years. We started in 2014. We had LPs saying it was strange. So you asked me a very specific question is what are we looking at now?

30:15The things that interest us the most now, space. because Falcon 9 by SpaceX has reduced the cost per kilogram by 90 percent to launching payload into space. There's a lot of opportunities opening up in space and they're not rocket propulsion. We're not funding businesses to compete with SpaceX. That ship has sailed, so to speak. But there's a lot of interesting stuff happening in space. We just announced that we were investors in Apex, which is a satellite bus company. And it's reducing the cost of a satellite from about$30 million to about$6 million per satellite. And they will continue to drive the cost down.

30:59And they're increasing the frequency and cadence of how quickly they can create buses by standardizing. And there's never been a standard bus for satellites. And then we're doing a lot more national defense. That can cross into cybersecurity. It can cross into computer vision inspection. It can cross into actual physical hardware devices. And then last is we're looking a lot more at ships and shipbuilding and the shipping industry. It's something that, again, not a lot of VCs are talking about. But when you look at where all the dollars are going to go five to 10 years from now, we believe in the following.

31:43Number one, we believe in declining demographics. So smaller populations to get productivity out of smaller populations, you've got to be investing in robotics and AI to improve productivity. And so we're doing that, but we're just doing it in sectors that we know better and that we think we can have an influence over our investment decisions. So that's one trend. The second trend is deglobalization, because deglobalization is causing people to think about how do I create more ships? How do I create more cybersecurity? How do I create my own sustainable food production? We think a lot about climate.

32:30And we're not necessarily investing in reducing carbon from the atmosphere. But what impact does climate have on fire? And what investments can we do to help with fire? What markets will emerge? Even things like insurance markets, we invested in a company to help insurance for floodwaters, as an example. And then shipbuilding plays into that, both because you have the deglobalization conflict. So, you know, the Hutus are shooting boats that are coming through the Gulf of Aden and up through the Red Sea, causing more ships to go around the Cape of Good Hope, which adds a million dollars per shipload and about two to three weeks of extra delivery, which means you need more ships.

33:20And then you're going to need ability to protect ships where there's more conflict between countries. So as we sit here in June of 2024, there's an increasing conflict between China and the Philippines. And there's a lot more conflict that you'll see. I know one of the things you wanted to ask me was about books. And if you read any of Peter Zeihand's books, he talks a lot about this in Disunited Nations. Actually, it was in The Absinthe Superpower. He wrote a book called The Absinthe Superpower. He started talking about something called the tanker wars. And I'm like, what the fuck is the tanker wars?

34:03I don't even understand what you're talking about. And so he showed the movement of oil around the planet. So China, Japan, Korea, and Taiwan are highly, highly dependent on oil imports. The United States is not. So we don't have the same problem that they have. So almost all of their oil comes from the Middle East. It goes up and around through India and it arrives at Singapore. It goes through a place called the Straits of Malacca, which is a 200 mile long channel that if someone shut down the Straits of Malacca, they'd shut down the world economy. So that's one thing that you need to protect in terms of shipping.

34:47And then they dump it at oil repositories in Singapore. And then it gets picked up by a tanker in Singapore from their oil repository and brought up around through Asia. Now, if you're, I don't know, Japan and China blocks that oil from being imported or blocks the ships from getting through, what do you do? So he was basically saying there's going to be increase in tension between all the major nations who need access to that oil to survive. So anyway, so we think a lot more about national defense and shipbuilding and things like that. I challenge you on that a little bit, Mark. Those are categories that are traditionally capital intensive.

35:32I listened to your episode on Apex and I thought that was great. I thought you provided a really good example. and reasoning behind why you're still doing it and how you debunk these misconceptions. So I'd love to hear more about maybe it's specifically with Apex and space, but what are the main misconceptions about these categories that are now being unraveled? So if you assume that you're operating a hardware business that requires CapEx, that let's say it's a 50 % profit margin, just to pick a random number. and let's say your product is$10 million. So it's$5 million for you to actually produce it, 5 million in gross margin.

36:16If that 5 million, so your sales price is 10 million. If I get 20 % down from a customer, if I'm producing something they really need that they can't get from other places and they put 20 % down, I'm covering two out of five. So I'm covering 40 % of my CapEx with the down payment before I start even buying materials. Then you can do stage gate payments. So you have milestones. And when I hit the milestones, you have to make another 10%, another 10%. So you can find yourself in a world in which you've shipped a product that has very limited capex risk, not zero, but limited capex risk, as long as you're meeting the deliveries that you set forth for yourself.

37:03In the case of some hardware products that I'm seeing, you have to invest 10, 15,$20 million in setting up manufacturing in the first place. That's a large capital outlay. But the size contracts that they're talking about are 100 plus million dollars. So in what category selling t-shirts and socks are you going to get to$100 million in orders in a year or two. So it's at a different scale. And you can actually use scale to an advantage because there aren't going to be that many people that can make those kind of investments to yield the kind of contracts that people can yield if you're successful.

37:45So you look recently at Anduril, probably the most important company in the private markets behind SpaceX. Incredibly large CapEx to get into the game. But once you're into the game, you're able to win massive contracts. And most people won't succeed. But I don't think CapEx itself is a limiter to being involved in industries. And as I always tell people, so many people are afraid of hardware. If I tried to sell you a product on your iPhone, download it and pay$20 a month. It's so hard to get someone to pay$20 a month for anything on their iPhone. If I sell you a$200 piece of hardware, but then you need a$20 a month subscription, it's very easy to get someone to pay for the subscription.

38:34For whatever reason, cognitively, once we're willing to pay for hardware, the subscription we're willing to pay. So Aura Ring, Whoop, 8Sleep, Peloton, you name it. Now, I'm not saying all those companies are They're going to succeed. But I always challenge people to say like Apple, one of the most successful companies in the world, maybe second or third most successful in the world right now, at least by market cap. Largely drives its profit through having hardware. Their profit itself doesn't come from the hardware. I mean, they get a lot of profit from the hardware, but the lock in that they've created, the app stores delivering 90 plus percent gross margin, incredibly profitable business from the app store.

39:16If you look at Google, you know, Google also produces hardware products to protect their leadership. If you look at Amazon, Amazon produces or buys hardware products like the Ring camera, which, you know, we were an investor in to protect their the markets that they're in. But even look at NVIDIA, like the world's most valuable business right now is a hardware business. So I think VCs just got a little too comfortable that every investment they were going to do was software only. And I just don't think that's realistic for the future. From the investment standpoint and the investor seat being in the glimmer of really sky high software valuation multiples is also a draw.

40:01in hard tech? Are the multiples that large? What are you seeing? What are markets? Well, let's at least demystify software. People were paying in 2021 25 times next 12-month revenue. Over the last 10 years, they were paying just under 10 times. Let's say it's just under 10 times. That is building in an assumption that you are going to continue to have nonlinear growth, that maybe you're growing 80 % year over year. And if you're growing 80 % year over year, it doesn't matter if someone pays 10x because you're going to grow into your profits. But the 20-year average is 6x. And right now, if you're growing at 20%, you're probably trading at 4x.

40:55Okay, so it's not as crazy valuable as people thought. Now, why people are so interested in SaaS is as long as you add high net dollar retention, if you went out and got 100 million in revenue or 50 million in revenue, and you had really high recurring revenue, then you could count on cash flows that would last for a series of years. Now, we went through about a 10-year period where everyone was trading client server for SaaS. And as they traded client server for SaaS, every category in SaaS grew. I'm not sure we're in that world going forward. I think you're going to see a lot more consolidation of platforms for the enterprise buyers.

41:40And, of course, the software companies are going to use AI to improve their margins, their operating margins, and that's going to help with some of the companies. But again, I just think it was unique to the last 10 or 15 years, and it may or may not apply to the next 10 or 15. On the exit standpoint, I know that you've talked about this a couple of times, but the window to IPO and exit has elongated a lot. And now we're getting to a PE-ification. Very hard. I don't know why I just said that, but of the market. And so there's a lot of restructuring that are happening or they're just being private longer or going away.

42:18So what are you seeing in terms of exit opportunities for companies? Well, first of all, what I would say is that IPO is what everybody used to want. And it was like when I was younger as a CEO, your dream was to IPO. But the structure of the market was very different back then. You had a whole industry. You had investment bank analysts that would cover small cap companies. They would do analysis on small cap companies. You could be in the market and have coverage and have investor base that cared about you. But over the last 20 years, you have more automated trading. You have more mass dollars moving to the biggest investments, building index funds.

43:14And the investment banks that used to cover small caps don't exist anymore. So you have almost no analyst coverage. It's just not cost effective for them to do so. So if you go public and you have no analyst coverage and you don't have institutional investors looking to pile into your company, how does someone discover that your shitty little company exists from a stock perspective? Unless you just happen to keep growing really strongly. And even if you read the analyst reports, like go look at any tiny little company that does its quarterly filings and you go read the analyst reports and they're just AI bots writing stupid articles that say nothing because no one's covering it.

44:00So going public, if you don't have coverage and you don't have an institutional base that wants to invest in you, like is worse than being private. Because you now have a fixed market cap that doesn't go up. You don't really have liquidity. Like I look at some of these stocks, they trade$50 ,000 a day. So imagine you own$80 million of a stock that trades$50 ,000 a day. And if you try to trade$200 ,000 in a single day, you drive the price down 20%.

44:32So you really have to be enormously successful, I believe, to take a company public in 2024. Maybe that'll change over time. I'm not so sure. I know other people believe it will, but I'm not so sure. I hope it does, but I haven't seen evidence of it yet. The second category is selling to strategic buyers. And of course, that's a great outcome if Google, Facebook, Amazon, NVIDIA, whoever can buy your company. Awesome. The problem is that at least in the current administration, the FTC has not been looking too kindly on these mega deals. And so I think the mega deals just aren't going to happen for a period of time.

45:15I don't know what will happen post-November, but even either administration, I'm not convinced they're suddenly going to open the floodgates for M &A. So what I think will happen is there's a ton of companies that can acquire businesses for 100 to 500 million dollars. There's not so many who can acquire it for 2 billion or 5 billion. So if you're disciplined as an investor, if you're disciplined as a founder and you're funding things at a 10 million, 20 million, 40 million, 60 million dollar valuation over time and not trying to pile all your money in at a 2 billion dollar valuation, your universe of buyer outcomes is much bigger.

45:56And then the third category of exit, of course, is private equity firms. Right now, there definitely are private equity firms buying startups. They typically want to buy things that are at scale. So that's hard. Like if you're at 15 million in revenue and next year you're going to do 22 and the year after you're going to do 40, they just don't care. You're not big enough. So you have to be big enough to matter. You might have to do M &A to consolidate yourself unless you can grow organically to get there. And right now, they have, on a relative basis, more attractive opportunities in the public markets.

46:34Why? Because the private companies that raised a ton of money in 2021 and 2022, the valuations haven't been reset and the expectations of founders haven't been reset. So they're going in to talk to someone that they think they should buy at four times sales who still believes they're worth 16 times sales. And so the spread is too big. But I suspect in two to three years, they'll get a lot more aggressive about buying startups. Yeah, yeah, that's valuable. So I know we're running up on time and we'll close it out with some fun things. Okay. I've noticed throughout this conversation, you've changed your name like five times.

47:14I don't know if that's like a purpose. first it was mark runs the world then it was mark the shark now it's mark in the dark what do we got next i'm just having a bit of fun with what is this riverside is that what you yeah yeah this is riverside just it's you know i have adhd so like i can't talk and not type at the same time it's great it's great uh i just i want to know what each one of these personas is oh okay how about if i stick with that one mark with adhd okay let's go um so okay so you only had like half answered this question earlier but i wanted to get a book recommendation from you you're like you're a really big book reader carrie's a big book reader everyone there is very uh studious and into literature we we read very different things though.

48:08She considers everything I read too boring and I consider everything she reads too literary. So here's some book recommendations. The book I'm currently reading is called Freedom Forge. Okay. Okay. And it won't really focus. It's called Freedom Forge, How American Business Produced Victory in World War II. So we tell ourselves all sorts of myths about the tech sector. One myth we tell ourselves is we never get government support and we never sell to military. Anyone who knows anything about Silicon Valley knows that it was really financed by the DOD and that most technology, starting back with chips, were serving dual use, serving government, and then that led to a commercial industry.

48:55And it was large government contracts. So what this book is it's the story of the people who built the infrastructure that made America successful from about 1900 to about 1940. So it profiles a guy named Bill Knudsen. And Bill was working for Henry Ford and helped Henry Ford improve his production of the Model T. And they had a big And then he went and joined a failing company called General Motors. And General Motors was a shit show. And there was a gentleman named Alfred Sloan, who was brought in to turn it around. Alfred hired him to revitalize General Motors. And he launched a brand new car called the Chevy, the Chevrolet.

49:44It never existed before. He launched it in, I can't remember, like the early 1920s. Maybe it was even the late night. It was the late 1920s. And over a period of like five or six years, it became the best selling car in America, overtook Ford and GM became a bigger company than Ford. So you have this guy and then the second guy that they profile is I can't remember his first name, but I know his last name is Kaiser. and he's the guy who figured out how to build the road system in the United States. He says, we had more car production, you needed more roads, and there weren't a lot of people skilled at doing that.

50:26So it talks about how he built roads across Oregon, Washington, California, eventually built the Hoover Dam. So these became the great titans of infrastructure that created competitiveness for America. And then World War II happened. And FDR tapped these titans of industry to step in and help the United States figure out how to ramp up its war production. So Freedom Forge, how American business produced victory in World War II, which is something people often don't say, which is your ability to manufacture, your ability to produce products can determine success or failure of countries. And I would argue that's why companies like Anderil are so important, because the future battleground are going to require a new type of weapon, a new type of defense system that if we don't develop it, the Russians will, the Chinese will, the Koreans will.

51:23And I'm just really grateful that both people and companies like that exist. I think entrepreneurs in 2024 are way more patriotic than they've ever been. And then, you know, there's sort of a pride in helping America and capitalism. So that's great. That's a book. The second book related to that is called Chip Wars. And Chip Wars tells the history of the chip industry and it tells some of the stories that I was talking about. But the origins of chips in the Vietnam War, we dropped a bunch of bombs on Vietnam that were dumb and they were just like killing civilians and blowing up needless stuff and not hitting their target.

52:01And a group of people in Silicon Valley figured out that using a chip, you could create a precision guided munition and actually strike the bridge that you were trying to strike and not people. And by developing precision guided munitions, we were able to save lives, meet our strategic objectives. But it really changed the balance of power between us and Russia. And it talks a lot about capitalism and risk taking and why capitalism and risk taking always produces a better outcome than command and control economies. So for anyone who's despondent that thinks China is going to take over the world, I just encourage you to read books like that because I think I'm incredibly long America.

52:44And then the third book is called The End of the World. The End of the World is it's about it's about deglobalization. It's not about the world actually ending. It's about declobalization. It's written by Peter Zeihan. He's written four books, The Accidental Superpower, The Absent Superpower, Disunited Nations, and The End of the World. And they all talk about geopolitics and demographics and how that is deterministic about how the world itself is organized. So anytime you start to think you understand how the world works, unless you understand demographics, geography, natural resources, how people defend themselves, you don't really have a sophisticated understanding or model of how the world will evolve.

53:35And he's very good at breaking that down with data. So those are some books you might enjoy. Those are fascinating. I read the last one already and I remember the first chapter of that book. I was like, oh my gosh, I woke up early on a Sunday morning. I was like, I'll just, you know, I'll read this. It'll be nice and light. And it was definitely not light. It's not a Sunday morning read. No. Oh, I do have one more book recommendation. I wanted to make sure that I also covered this. I highly recommend this book. I just want to make sure I get the title right. I'm pretty sure I will. Yes, it's really simple.

54:14It's just called Israel. Okay. And it's written by Noah Tishby. Noah is a left wing Israeli. Okay, not a right wing Israeli, a left wing Israeli who moved to the United States. she was a film producer and she's a media entertainment executive. And she started to realize just how much bias there was in understanding what actually happened in the land of Israel. So if you're anyone who's not Jewish, who doesn't naturally know this, and if you consider yourself an unbiased person, of course, anyone who writes history writes from their own perspective. But if you want to read someone who writes a wonderful account of what it was like growing up in Israel from parents who got away from the pilgrims and Jews being killed in Europe and helped settle Israel, and what was it like when they settled it?

55:10How many Arabs were there? Did they have good relations or bad relations? What happened in 1948? How and why did the country separate? How has it been managed since? She spent time in the West Bank. She spent time with Arab populations. And she tells a very human story with a lot of facts on what's it like on the ground in Israel. And I just highly recommend it to everyone. Because if you're getting your news from TikTok and you've never spent time in Israel, and you're being influenced from Twitter, from people talking about things like genocide, which of course isn't happening, if you're talking about, you know, I always say people who throw out terms like apartheid, okay?

55:50So of the almost 10 million people that live in Israel, 2.1 million are Arab Muslims who are citizens, not the West Bank. That's separate. In Israel, they are Arab Israelis. Those 2.1 billion, 2.1 million. I'm not saying that it every day feels as good, like, because you don't control the country. You're a minority. And anytime you're a minority, You're fighting to get your fair share of the voice. But they are elected to government. They can serve. They can run hospitals, be doctors. They're citizens with equal rights. And so people throw out terms without knowing what they're talking about, things like apartheid.

56:31And then they talk about mass movement of people. So there were, I think at the time, I might be off by a little bit, but approximately 800 ,000 Arabs living in Judea and Samaria. Judea and Samaria, Jews have lived there for 3 ,500 years. So to put it into perspective, that's 1 ,500 years before Christ. And I'm sure you know Christ was Jewish. He was Jewish because he lived in Nazareth, which was part of Judea and Samaria. And Islam was created in the 7th century. So you're talking about people who were tied to this land for 2 ,000 years before other people were there. They were, of course, many of them forced out.

57:20Some stayed, but they were forced out by people like the Romans who came in and killed Jews and spread them to the diaspora. There were 13 tribes of Israelis that left. And Zionism is simply a belief in the legal right for Jews to buy land in the land of their heritage and return home. So around the time of 1948, when the United Nations recognized the state of Israel and a separate right for Palestinians to have their own land, there was a war. And something like 700 ,000 Arabs left. I think 154-ish thousand stayed. that 154 ,000 became 2.1 million. So if you want to call something a genocide, the Jews are pretty bad at genocide, if that's the case.

58:09Meantime, the Jews were driven out of Tunisia, Algeria, Iran, Iraq, Morocco, like Jews don't live in any of the Arab countries anymore. And I mean, there's like 40 or 100 people, not even in the thousands. And it's just, you know, people have to have context and this book will set that context. So I'm sorry to go on and on, but you asked me short questions and I give you long answers. No, it's fascinating. And I love the theme of history throughout all your book recommendations and learning from the past to understand future structures and have empathy for the world around us. I appreciate it.

58:47Well, Mark, it was a pleasure having you on and I can't wait to see you next when I'm in LA. Please come see me. All right. Bye. All right. Take care. Thank you.