E58: Roger Ehrenberg on Mastering Seed Investing

0:06Welcome back to Turpentine VC, the podcast where we discuss the art and science of building successful venture firms, VC to VC. Today, we revisit one of the best turpentine VC conversations, an interview with Roger Ehrenberg, founding partner of eBerg Capital and IA Ventures. Roger is widely considered the best seed investor in the business, with renowned investors Mike Maples Jr. of Floodgate and Chad Byers of Sousa, both citing him as the gold standard. In the conversation ahead, Roger shares the secrets of his seed strategy that's netted him 10x returns. He offers valuable insights on how seed funds should operate in today's market landscape and provides his contrarian perspective on various investment approaches.

0:46Please enjoy the episode.

0:51Welcome to Turpentine VC. Thanks so much for joining. Thank you, Eric. Great to be here. So I just had Mike Maples on before you, and he unwittingly said that you're the investor he perhaps most admires because you were very specific about what you were doing, what you were not doing, what you stood for, what you didn't stand for, and you didn't waver. And you've had phenomenal results to show for it, I believe, 10x funds. Why don't you talk about what that firm strategy was exactly? Sure. So I had this deeply held view that running a concentrated portfolio at Seed and being ownership sensitive was ultimately the way to give yourself the best chance at outside success.

1:38And my goal was never to try and stamp out 3x funds. It was to try and create discontinuity, kind of maximum convexity in the portfolio. And rather than having a series of smaller option bets, It was really much more a function of both acknowledging that the most valuable resource that myself and my partners, Brad and Jesse, had was time, really not money. And that we specifically focused on companies that sat at the intersection of what we perceived to be not well understood. and yet if their hypotheses were correct that there was a massive market opportunity that sat that was there for them but at the same time where we felt our greatest value was in helping those founders design the experiments to determine product market fit so we always would invest pre-product market fit we're not providing scaling capital we're providing can this actually be a real business capital and can just then warrant additional money to peel back the layers of the onion to see, can you actually create a category defining company?

3:03And so in 2023, do you think that strategy would still take hold? We've seen seed change a lot, right? Multi-stage firms have gotten into seed. There's a lot more capital. Sam Lesson recently wrote a, where he thinks it's the end of seed, but he particularly thinks end of seed in terms of club deals. He thinks you can only do seed in the way you did it, which is contrarian and right. How do you think about seed today with the rise of super angels, et cetera? Do you think that strategy holds up? I do. And I think very few firms do it. And why? Because it's hard. And it's putting your eggs in a relatively narrow basket.

3:47And I think that makes most managers, especially first-time fund managers, very uncomfortable. That what feels safe when one gets in a business is to tag along with demonstrably successful investors, or perhaps even more truthfully, investors with bigger names and brands forgetting about success in the way that high quality LPs measure success, notably DPI. And I think it's, it feels comfortable to be with the crowd because if you're wrong, everyone's wrong. And if everyone's right, you're right. So it's kind of a seemingly less risky strategy when one is trying to get in business and not screw up too big so you don't get a chance to even have a second fund.

4:43But the reality is, to me, the risk is almost the exact inverse. The real risk, especially if you have LPs with any sophistication, is that if you're not taking true pre-seed and seed stage risk, which means not just the companies, it means the ownership, the check size, and the conviction where you're going to actually allocate your scarce time. and the way that we talked about it at IA was really bending the curve. That if we didn't feel that we could bend the curve for a company in that pre-seed to seed stage as they're going through this kind of experimentation process and sprinting towards product market fit, then unclear whether or not we were really the right investors for that company.

5:30And I would say today in my own investing, I still follow a similar strategy. So, which is all to say, I think that the data bears this out. One of the features of our favorite LPs was their willingness to share data with us on their historical experience with managers across decades. And there is something about concentrated seed that occupies this unusual place in the two by two because you are taking the biggest risk, but you are generally getting compensated for it. Whereas at the series A and often at the series B, you're paying much higher prices without a similar amount of de-risking. And I think that's really the key.

6:19is that many larger multi-stage funds will invest in A's and B's without really pricing the risk reduction from seed as you think about that valuation versus the seed valuation. So we always lived in that very early, very risky, miasma, teams forming, ideas gelling, plans codifying. But boy, if you hit it, then you can really hit it. Right. And yeah, it's interesting because there was a ton of capital that flooded in over the past few years. One of the things that we did at our firm was we were seeing that follow on rounds were happening increasingly earlier ahead of any de-risking for these companies.

7:12And so it actually made more sense to allocate the follow on dollars to new companies so we can get more shots on goal. And just because these follow on prices didn't make sense. I'm curious if you would have advised against that or how you think about that for you if you were starting IA today, given sort of how much capital has flooded into the ecosystem. I think your adaptation makes sense. I think it depends on how horizontal your portfolio is. I think what IA did was severely cut velocity to almost zero and then would just be wildly selective about even that first check in a market where even those first checks are getting priced at largely irrational levels.

7:57And I think the current market is kind of bearing that out now that we're in the midst of this correction, or one might say rationalization. What I think an adaptive strategy in this environment is for a manager that runs a concentrated portfolio and has skill in helping to assist leadership teams with hard, hard questions of resource allocation? Do you narrow your scope in an environment of scarcity and go deeper? Or do you try and go more horizontal and to build brand that way and to kind of believe that your best position for the next phase of abundance because you've created a broader footprint?

8:50Those are really hard questions, but I think the best opportunities in this current phase aren't necessarily net new companies, but investing dollars in existing companies at depressed prices when the businesses themselves are simply taking longer to gestate because they might be platform type businesses, which as you know, if you're actually building a platform business, I mean, it could take five years to actually create the critical mass. Or if you're, you know, building something that is around, you know, open source or developer tools, and you need that community evangelism, and you need a large enough user base to get that flywheel going, like these things just take time.

9:38But in a market like this, it's very painful to give companies like that the appropriate resources and the time necessary to achieve their potential. So that's when tremendous opportunities exist, when it's almost like dislocation in the opposite direction, where the potential of these companies relative to the price is massively skewed in your favor instead of the converse when you're reaching to invest in companies when valuation is moving away from it. I see you as a true craftsman investor. You have an idea of what it means to be a good investor, an idea of what it means on how to win, and you've won.

10:17And so that's only been confirmed. And it works in rational markets better than crazy markets, but it works in all markets. Whereas there are other, I'll give YC and Andreessen as other examples, where it's almost like they're playing a different sport. YC in particular is obviously playing a hugely horizontal or, you know, high volume game. They have special economics. They don't invest in the way that you invest. But they really focus on sort of the product to entrepreneurs and this heavy services approach and Andreessen at the later stage and they're playing this massive AUM game. And is your analysis, hey, different, like it's a different sport, but they, you know, you can have multiple kinds of winners.

10:59I've wondered if the future of venture is going to look more like the craftsman approach that has won for so long or more like the sort of product or platform approach that is a bit newer, but is, you know, creating a, getting a lot of dollars and has some, you know, flashy wins. What do you think about that? Eric, that is a fantastic question. This is one of the times when my being old and having been through so many cycles and been in so many corners of the financial markets, I think I've actually got pretty reasonable perspective on this. The answer is there is no one prevailing regime. It's cyclical.

11:36It's based upon interest rates, investment alternatives, PR, and a host of other factors. But certainly the most notable is kind of interest rates and macroeconomic environment that drives interest in these long duration, less liquid asset classes. So I would posit that the venture world is no different than the public equities world when it comes to its shape and how things move up and down and firm types and preferences shift. But if you look at some truly great generational firms that have literally done the same thing from inception, like take Baupost Group in deep value long short. Okay, so Baupost has been doing their thing for I think 40 years now, let's say.

12:38And their relatives' returns would go up and down cycles and go down and up cycles. But net, net, if you look at the rate at which capital compounds, and again, I'm not an LP, I just know from being in the hedge fund business, like Baupost was always just unwavering in their strategy. I view us in the way, in venture, in the way that I view Baupost in the hedge fund arena, which is they stayed relatively small. They've generated tremendous returns over long periods of time. They've obviously built a culture of success where they could continue to elevate young talent and to continue to be great stock pickers in all markets.

13:27That is what I set out to have IAB. I think Brad and Jesse are carrying that along brilliantly. Um, but I think there will always be the YC types in the world. You know, you could argue Vanguard, right? Kicked off that incredibly horizontal approach to investment management, right? And then you've got these very narrow specialty managers. So I think it's all part and parcel of the same thing, which is there, there can be these multiple strategies that are also servicing different types of investors. Like, let's face it, if you're a certain scale of LP, you can't really invest in IA because we're just too small and the check size that you would want to write, we simply won't accept.

14:20So then Andreessen, with their infrastructure and their, I mean, they're a corporation, right? It's like, But they are institutionally investable with enormous dollars. And if they can put up good returns, they don't even need to be great returns. Good returns in this multi-product array that they now have, then that's great for what many institutions want. YC is much more geared towards not the investor, but the founder. And they've created this ecosystem. And if I look at what I would consider their unfair advantage to be at this point is cohort after cohort that have extraordinary individuals that have built some really tremendous companies that then feed back into the ecosystem.

15:21And they've done a brilliant job. I mean, think what different people think different things. That's something I respect very highly is that they really have built an ecosystem that is unrivaled in gunship. Hey, we'll continue our interview in a moment after a word from our sponsor. How deep do you go to seek out an answer to a question? Maybe you've spent hours clicking the source links on an obscure Wikipedia page. Or maybe you're even the type of person who checked out the entire shelf on the topic at your library. If you're nodding along, then check out GiveWell, an organization that researches questions about global health and philanthropy, even if a satisfying answer might require years of reviewing studies, talking to experts, and over 300 footnotes.

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16:38If you've never used GiveWell to donate, you can have your donation matched up to$100 before the end of the year, or as long as matching funds last. To claim your match, go to givewell.org and pick podcast and enter econ102 with Noah Smith and Eric Torenberg at checkout. Make sure they know that you heard about GiveWell from econ102 with Noah Smith and Eric Torenberg to get your donation matched. Again, that's givewell.org to donate or find out more. Now, most venture capitalists are not macro thinkers or don't have the type of experience that you do, but you are a macro thinker. And so when you think about the next few years, and obviously no one's a predictor, but you're a student, how do you expect what's going to happen in macro is going to, what kind of ripples is it going to send through the venture ecosystem in terms of what kinds of players it's going to favor, maybe what kinds is going to hurt, or what mental model of macro should VCs have as they look at the next few years of venture capital?

17:36definitely a defensive posture um i think that again so much is driven by rates and global sentiment long-dated rates not that policy and look i mean if uh if so for was six and the 30 year was three i would feel very differently um but with SOFR at five and change in the 30 year, well above four and mortgage rates over seven for the first time in 40 years, like that's a tough environment, right? Because we are, as a general matter, in a more risk-off culture when it comes to illiquid assets. You know, in liquids, you know, we've seen, you know, the equity markets, the, you know, large mega cap techs had a bid for a while.

18:37It's softening now, but you know, in general, I mean, it's been pretty, pretty good, but long duration assets have generally looked like crap. And that's the intersection of poor liquidity and uncertain prospects. So not really knowing how macro is going to affect growth rate, which of course, The two biggest things with a long-duration equity like a venture-backed company is growth rate and interest rates. Those are really the two salient financial factors. So what I had alluded to earlier about the best place to deploy dollars right now is probably in your best companies and to be extremely careful with met new companies to the extent that they're capital intensive.

19:29If you back teams that are unbelievably scrappy and can really build a lot for very little, and you feel like you've got very strict parameters around which you're willing to write an additional check to continue to fund that development, again, in an environment of scarcity, then I think probably the best risk reward is fortifying your high potential companies that you've already gotten to know over years and years and years. Fascinating. And give my audience a little bit of a, you know, mini macro lesson in terms of close the loop or flesh out more about how higher interest rates or lower growth rates, like how that affects the venture ecosystem.

20:19exactly kind of tie that thread together. Sure. So they both ultimately get to the same concept with, which is terminal value. And what is the multiple that an investor is willing to put on future cash flows? And when you have attractive, low risk investment alternatives that are yielding a high rate, and in our case, the highest rate that we've seen again in decades, then cash feels pretty good in a scary world. And that's going to mean that the risk premium that you're going to charge on long duration equities is going to be much, much higher. So then we get to growth rate. Well, so that means that you need extraordinary growth rate like the 10 % month on month, not from C to A or A to B, but from B to N.

21:21So something that really has tremendous nonlinear growth, which again, is very, very hard to find. I mean, there have been companies like Snowflake or something like that that have exhibited these unbelievable, or even for a period of data dog, right? That just crazy, crazy growth, even at scale for an extended period of time, those are companies that they will not trade anywhere near what they would have in a lower rate environment, but they will still trade at premium multiples. But unless you're one of those companies, then growth rate and interest rates are going to drag down that terminal multiple, which is going to drag down the present value to future cash flows.

22:04That's a helpful overview. And do you think that interest rates have been artificially low these past few decades? My economist friend, Scott Sumner, thinks that maybe perhaps they weren't low. Maybe perhaps thanks to demographics or productivity or other factors, maybe we just have lower rates from now on. I would say yes and no. Now, look, your friend is a trained economist. I'm not a trained economist, but I would say it can't be either or. certainly the you know global growth rate is slowing down so global gdp is slowing down as the population explosion slows down and now we're even saying in the company that had the greatest growth in history china they are you know their growth is waning and they're in deep trouble because they've had this massive demographic shift against a wave of overinvestment that's going to have ripples across the globe, as we're already seeing today.

23:09So that's certainly part of it, but it can't be disputed that in just talking about US policy, that the US very intentionally and Western Europe very intentionally ran loose money policies in order to keep interest rates towards zero, especially coming out of the global financial crisis. They had been low before then, but they were not crazy low. But we had more than a decade of that bubble inflating of literally zero interest rates that made investing in long-duration equities and other risk assets so compelling. um so you get what exactly what you what you have today which is the bubble coming out of the balloon incredible pain i mean i i remember i was sitting on a panel with fred wilson i think this is probably in 2010 coming out of the gfc and you know what is venture investment going to normalize that on an annual basis.

24:23And we were like, yeah, maybe like 10 billion. 10 billion? I mean, I was 10x off that one. I mean, by the way, if I had known what Fed policy would be, I would not have said 10 billion. Maybe I would have said 30 or 40 billion. I would not have said 10. I would not have thought it could be 100. so i was like orders of magnitude off because i could not have foreseen that the fed would keep rates at zero for almost 15 years if you let's say you have to make a prediction now about where they will where they will normalize knowing what you what you know now about you know how the fed has acted and and what played out what prediction would you make i mean so i don't again i just haven't looked at the statistics lately so i mean obviously i mean i know that venture investment in 22 and 23 has fallen tremendously.

25:19I don't know what it is now. If you tell me what it is now and what it was at its peak, I could tell you, I think it's going, it's going to be significantly lower. I mean, I, I just do not think that there's going to be a ton of net new, uh, investors coming into venture right now. I think it, and you can see it, you know, where, where is some of the biggest money going right now? It's going into real assets. It's going into things like sports or it's going into, um, intellectual property like media rights. And I think there's, there are other mega trends now, clearly AI occupies this unusual place in the universe right now, where it has largely been immune to the cyclicality and volatility of venture investment.

26:13But there aren't too many sectors like that. And there's always one, right? Whether it was clean tech, machine learning, big data, whatever, and now it's AI. So I do think that the biggest pockets of capital right now are not really focused on venture. Right. Because even with AI, it's unclear how many amazing startup opportunities that will be as opposed to just going to the incumbents. I agree with you. I like right now, you know, the, I don't know how much true white space is left in the Venn diagram with, you know, 200 new circles having been created over the last 18 months. And so if the, if, if your prediction is correct, what does that mean for these, the A16Zs, the YC, these massive kind of AUM platforms, do they, do they struggle or do they they have to reset their strategy a bit.

27:06So I think with, with folks like that, that already have an embedded LP base and they're just cranking out new fund products, I think they'll be fine because again, they are institutionally investable. I, my hypothesis is that these LPs are underwriting these firms for a generation. They are not, um, tourist VC investors. And as such, those are not the firms that are going to be hurt. I think net new fund creation is going to be hurt. And if I'm totally honest, Eric, and I actually, I said this five years ago, there are too many firms. And when you have taxi drivers and Uber drivers talking about their venture investing in the same way that, you know, when they talked about, you know, crypto with Bitcoin at 60 ,000.

27:58And again, this is not a new movie. We've seen this movie a thousand times before. You don't, in the same way that you don't need as many banks in the country as we have, you don't need as many seed stage venture funds. You just don't need them. Totally. It's, you know, I'm going to make a joke of an analogy only because you said you're old. I remember this video around this kind of veteran or very old man who who looks at the state of America today. And he he's very sad. He says, you know, we didn't go to Vietnam for this. It's kind of this this meant to be this moving video. And I'm sort of imagining you looking last five years of venture or, you know, or maybe about a decade saying, oh, yeah, I can't believe it went like this.

28:43It wasn't supposed to be like this. you make me sound like one of those old guys in that i can't believe the industry's unfolded this way yeah okay well you're right that is exactly what i would say yeah all these players who've made all this money maybe in the wrong way or i don't know just uh yeah is that kind of your like a wow i mean that's the thing man it's just i just i have such a hard time with it now look Again, Andreessen is very particular. They are a multi-strategy, multi-product, institutional investment management firm. They are not a venture firm as far as I'm concerned. So forget about them.

29:25But then if you look at the rest of the industry and you look at what I believe is the lack of LP discipline in just signing up for fund 3, 4, 5, 6, 7, 12, 15 of name your venerable venture firm. And you look at the returns with a few notable exceptions, they're not good. And to me, I never understood that. I've never been an institutional LP marshalling dollars of that magnitude. but somehow the GPs were able to create this illusion that, and it can't be true that all of these funds are so special and all of this capacity was so valuable that, well, if you don't jump, if you, if you don't re up, well, then we're going to give it to X and you'll never get to invest with us ever again.

30:24The GPs were masterful at that. You're talking about, hundreds of billions of dollars over the last 20 years in these kinds of funds. You know, which again, I feel so grateful for the LP relationships that we established and cultivated at IA because we were extremely focused on getting a set of partners, firstly, who we viewed as true partners, where we wanted them so they could mentor us in ways that we needed help and support. And believe me, we needed a lot and we still learn a ton from our LPs, but where they, even as large institutions viewed a 20, 30, 40,$50 million allocation to IA as being incredibly valuable.

31:19And yes, it's not a$200 million allocation to a billion dollar fund, but that was, it's huge to us. And look, if we can generate what we've generated so far, then that's a lot of absolute returns for these causes that we believe very passionately in. So I just think the whole market was so distorted on both the GP and the LP side. And now that reckoning is it's happening. And even though it's it's painful, I think it's ultimately a really healthy thing. Yeah. And others like Bill Gurley have been talking about it for needing to happen for a while. And so you're encouraged by this forced discipline that is going to have to come back.

32:08You mentioned crypto. I believe that you guys got into crypto as well. You mentioned sports. You guys are focused on sports now. And obviously, it's both to make money, but also a passion project with you and your family. Any reflections on getting involved in crypto a bit or what you learned about it from a meta perspective? And also, then let's talk about sports. I view it in kind of three buckets. There's crypto, NFTs, and Web3. So crypto, just Bitcoin, Ethereum, whatever, I traded some of that pretty well. Cool. But that was purely a short window in time where I felt like I had a deeply held view about the way things would go.

32:56Took my gains and stopped. right for me it's not it's not a religion it was an asset that had an observable value it had a trend in the sentiment and i traded against that and made some decent money and then said okay i'm at so that's that's crypto then there's nfts and projects my sons um andreith and i spent some time looking at different projects and and invested in some and i would say that we did a relatively shitty job um pricing those projects rationally i think we got caught up in some of the hype and the shifts in sentiment and it was a great learning experience that was that for it and then web three more like um core infrastructure we've got some investments there that are good and that's more like venture uh but it's something that you know was this this sphere was kind of the initial engagement with my sons and working together.