The Brutal Truth about Building a VC Fund I Christian Nagel, Co-Founder Earlybird

0:00When we left, he said, well guys, and don't forget, become a good VC, you have to lose 50 million. Otherwise, you're not going to become a VC. Looking from today's perspective, like something works. What do you think was it at the early beginning that set you apart? In the US, we were co-investing with good names, the Sequoias, the Mayfields, the Kleiner Perkins and so on. But we didn't realize that they were happy to find some dumb money from Germany, basically to put in the bad deals and didn't let us into the good deals. It's exactly this one funder is missing in the history of early bird. But again, it was impossible to raise back then.

0:32We supported our investments, the good ones we had back then with investing our own money in the end, our management fees. We didn't get any salary for years. So there was a pure entrepreneurship in the end. Our first fund was one of the best funds in Europe back then and delivered the 4.5x. The most craziest time I've seen in basically all history of early birth was back then. I would say we were almost there again. With regard to AI companies, it's already, the craziness is back. Ladies and gentlemen, by way of introduction. Christian, what is your personal mission you are on? What is your goal and what is your personal big dream?

1:10If I start with Olibert, it's clear. I mean, we produce good returns for our investors. That's the ultimate goal in the end. By doing disruptive things, basically, by investing into disrupting technologies and founders who want to change the world and basically build something which disrupts old things. That actually has been our mission since the start. So since the early days, obviously, very different technologies, very different setups, very different concepts and so on. So what had always been the idea of doing exactly that and with this creating value in the end. So that's something what's behind because obviously we are here to invest other people's money and deliver good returns.

1:51And by doing so, we think we can do this better maybe than with other concepts. So that's been driving also me personally here. And how does this align with your personal goals? Because what I always think is that there are certain personal goals and then you find a tool to execute on it, which in your case is venture capital and proved to be quite successful. So how does the goal with Early Bird that you just described align with your personal ambitions? Well, personal ambitions have always been also basically to change something, to change things to the better, to be basically, to be on the forefront of innovation, to learn about innovation.

2:30So that's something that would always entreat me. And obviously you can do this in different dimensions. I have been doing this in sailing, you know, I've become very successful in sailing. So you can do this in some dimensions, you know, I'm a so passionate skier, you know. We bring it to the edge and use data to make changes. And so that's something what combines a little bit also the thing. And also VC is something which you basically have to do, I would say 24 hours, you know, 24-7, something like this. As you always have phases where things are happening and where you have to be available, where you have to be accessible.

3:06So it's hard to do a kind of a nine-to-five thing. It always surrounds. And you always have to take care of founders, of issues, and especially the portfolio. There's always something going on. Some companies are developing well, and suddenly something happens, and we have to be there. And so there can be different companies. Companies, yeah, developing there for a certain period of time and then suddenly something changes. Yeah. I like that it seems to be rather an approach to life than anything else if you're also like kind of questioning or trying to disrupt other industries in your like skiing and sailing that you mentioned.

3:42And if we go back to the very start of Early Bird, how did it begin? Like how did you start Early Bird? And for this, could you give some context about the state of technology, venture capital and entrepreneurship at that time? Yeah, no, happy to dig into this. The story is, I basically, after having finished studies, I was with McKinsey a couple of years, did the first project for McKinsey in Eastern Germany. It got me so excited, basically, that I have to leave McKinsey and do something on my own to become an entrepreneur. And this is what we did with colleagues. Basically, we bought companies from the state holding.

4:16There was a state holding called Treuhandanstalt. It was called back then, basically, which owned the assets of East Germany because obviously it was a socialistic and a communistic state. And so it was all owned by the state. And then they built this kind of super holding from which they sold all the assets. And this is what we did back then. And what we applied there is a principle which has been working very well. And those companies were kind of pretty run down, difficult cases. Most of them were machine building, machine construction companies. So oily, greasy and kind of stuff, which is special, I would say.

4:56Nothing to do with venture. So that just makes special. And what we did is basically we took those and took those sometimes pretty big companies with a couple of thousand employees, which have already been reduced when we took them over. But anyways, the structure were there, the machines were there, the space was there, everything was there. And what we did is basically we separated, we built many small units along the value chain. So basically, we started with drill machines. We say we're drill machines, we build a company out of drill machines. And the next step was basically the assembly. We built a company which does the assembly.

5:32And we had the next company which does all the testing and the measurement. We built a company out of this testing measurement. And then we had a company which did basically the installations on the site. And we also built a company around the installation part of it. So across the value chain, basically, just a couple of examples, we built companies. We had identified very early then the people who could run this. We said we incentivized them, gave them some sharers, incentivized and said, well, you pick from what is there what you need to run this small company. and they picked the machines they need, they picked the people they need and they picked the space they need.

6:08And then they got off. And with this, and we in the holding kind of, where the whole structure, which basically was implemented in the first few weeks, really, we did this basically. We put all the people also in those companies, which were defined then by the leaders of those companies and the managing directors of the companies. And this worked quite well. We in the holding basically kept all the rest, which nobody wanted to take. And that included indeed also employees, including space, machines, and everything. So we took care of all that. And these small units, we told them, go out, not just live from within, not just basically make offers to your quality companies here, go outside and basically offer your service to other companies, meaning dual services, meaning measuring services, meaning installation services, and so on.

6:57And that worked quite well. So these small units became profitable pretty quickly. So some after a few months, some after half a year, they already were profitable because they only had what they needed to run the business, not more. We took care of the rest. So this worked quite well. And this worked so well that the state holding said, OK, we have another difficult case. Can you also take over that one? And this went on. It went on, at least for me, it went on three times. And then they said, OK, we don't do these deals anymore. We stopped doing this. And that was also the time where the internet came, where the Neumarkt came, basically, so companies could go public.

7:34The first time in Germany ever, basically, that companies without financial numbers, just concept, could go public, which was crazy back then. And we said, well, this is much more interesting to invest into something which is more towards the future in terms of really more to disrupt something. it was obviously the internet. And then in Germany, it very quickly picked up. In 2000, we started in 97. We had a first fund in 98. In 2000, I think there were more than 100 venture funds in Germany. So very quickly picked up. Many of them might just say there were corporate venture funds. So because all corporates felt back then they had to do something.

8:16And so it picked up quite quickly. And as quickly as it picked up, it also went down because in the beginning of 2000, in March or April 2000, it was the bubble burst and the stock market started to crash. And that was obviously the end of the party. There was the internet crash then, which happened, which happened not just in Germany, it happened everywhere, also in the US. With the big difference that back then in the US, they were used to these cycles in terms of they had been living through this. All the industry, all the venture companies and so on, have lived through this. Whereas in Europe, especially in Germany, nobody had experienced that before.

8:56And people may remember the telecom stock, basically, which was celebrated back then as the hottest thing on earth, which sent dramatically down. And everybody was affected by that because everybody was active in the stock market, basically, the telecom share in the portfolio and was obviously not very happy with that. And so the recovery took much longer than in the US and the US started to cover it very early. So for us, it was kind of, we call it back then nuclear winter. So it took four years basically where nothing happened. And we were lucky in that respect that we could live from our second fund generation, which we raised back then, which we could live off.

9:37So which was raised in the beginning of 2000. So really before the bubble burst. So we had the last basically investors coming in in the course up until middle of 2000. So that basically helped us surviving this phase and then making still investments and so on. But then it took really four years where it was hard to exit anything, where it was hard, where fundraising was impossible. We also basically missed one fund generation. The next fund we could only raise is back on first exits we had in 2005, 2006. Only 2007, we were able to raise the next fund on the back of the successes of the first fund, we were able to raise the next fund.

10:20It's exactly this one funder is missing in the history of early bird, which could have been a 2003-2004 generation. But again, it was impossible to raise back then. It's also the outcome of the Neumarkt was also remarkable. I think 330-something companies went public. I'm not sure if you would recall one name of them. You wouldn't at least... For me, it's hard to identify any name of the companies, whereas in the US, those times the Amazon were created, the Googles were created. So companies which are global leading companies, most valuable companies globally, nothing of that happened back then in Germany.

11:01And on this very last point, what was the hypothesis that you started out with? I'm asking this question because a couple of weeks ago, I spoke to André Bartosz from Credo Ventures. And he said when they raised their first fund in the early 2000s, that they told the LPs that this is an experiment and that they might not even see their money again. So what was your hypothesis that you started out with and how did you operate on it? Yeah, well, my hypothesis was that you could earn a lot of money with this. have because back then the times were crazy because obviously everybody was thinking and seeing on the neue mark how it can work how he can become a millionaire billionaire whatever in just a few months so that was kind of it was crazy the most craziest time i've seen in basically in all history of early but was back then also with regard to fundraising so it was it was a meeting and we we got a got a commitment of 50 million for for a fund so which was quite a lot back back then so um now it takes years you know to build the relationship and and basically nurture this get to know each other and so on so so all that in that respect was was kind of crazy that's why we also thought okay well it's it's an easy thing you know we will easily do four or five times um the fund and um which we actually delivered back then so we would fund the fund fund our first one was was among the best funds in europe back then and delivered the 4.5x so that that's really something what what happened but um and so we were um sure we were very optimistic back then and basically in late 2000 2000 was still okay but late 2000 really everybody realized okay well this is really going going south ways um and that's not not it will take some time also yeah and looking from today's perspective like something obviously works like how you started out so what do you think was it at the early beginning that set you apart also from the other venture funds and that kept you going?

12:53Well, I did previously, previously before starting early, but it was always that we had the idea of separating risks. So the concept I mentioned at the beginning in terms of separating all and building some small units, typically it was something between around 10 plus minus units we basically created very early on. The idea was not so basically to have small units basically develop faster then, but it also was a risk separation. That was also the idea basically because with this, we could separate these risks And if one of these smaller companies would have not worked, then it would not have harmed the entire, you can call it fund almost.

13:29And that's something we then applied. So it was not new to us in the end that we would have to apply this in a fund, obviously. So you also have to do proper portfolio management. But also sure we did everything wrong back then. So we over-invested, we over-committed. So all these things we did wrong back then. But at least we kept this kind of principle that we need to have a portfolio. We also should basically invest in different sectors, not just allocate the money in just one sector. So that was important. So that, I think, led us to also the success then of the first fund. And the second fund generation, we committed all mistakes with regard to US expansion.

14:15So we learned our lessons there. We had a different team there. and tired too fast without basically building relationships. We had a different strategy in the US. We were co-investing, co-investing with good names. So the Sequoias, the Mayfields, the Kleine Perkins and so on. So we did co-investments with them, but we didn't realize that they were happy to find some dumb money from Germany basically to put into their bad deals and didn't let us into their good deals. So that was something we didn't realize back then. Well, we realized then, but only, but it wasn't most too late already. And so there was a lesson learned in the US.

14:55We closed down the US, said, okay, well, we have to focus. We have to follow our strategy. And the strategy was always given our operational experience that we have to be in the lead. We have to be close to the entrepreneurs. We have to help the entrepreneurs. We need to form kind of partnership things so that we really support the entrepreneurs on their way and share the experience we've made. So there was this you can only do if you're a lead investor. If you're not, basically, you can't do this in the US. That was a mistake. We weren't more than that. And in the first time, we thought, okay, well, we would be better than the average in terms of, well, we can do better than just 10 % real winners in a fund.

15:29No, we weren't. We have these 10%. And this is, we couldn't beat that so far. But at least we have that. And every fund, every fund, we had them. And also the principle that you should not over-allocate. You need to need a certain balance in the end. And you also, something we find now only in later funds, that since in the beginning, you don't know which companies would be the winners, you have to basically, first of all, have to have the same bar in terms of entry bar for everyone. So they have the same, every company we invest in could have had the same potential because you don't know which one is going to be.

16:07And you should also play the first seven principles in terms of applying the same terms, meaning also ownership terms in terms of exit terms and so on. So they should all be on the same level and you should not basically compromise on that because in the end you don't know which one will it be. And if you end up then in a very successful company where you just own 1%, it's not meaningful enough to pay back fund or create some returns. That principle is also very important. So kind of also a disciplined portfolio investment and not just invest on the gold. I think once I heard you say that the education of a VC costs 50 million, right?

16:47Yes, actually, we learned when we started, we actually did a tour then to Silicon Valley and really met the top funds that were also around now, the Sequoia and Kleiner and so on, and among others, NEA, and the central role was pretty easy because you couldn't just drive from one block to the other and could meet all them. They were very friendly and happy to meet us. And then I got these old sayings then, okay, well, we're never going to invest in Europe. It's too far away. We are so happy to invest basically in driving distances. All these kind of talks we have then basically realized life, so to say.

17:28And there was also, then when we left indeed, and it was Dick Kremlick, basically the founder of NEA who died recently, by the way, but he was already pretty aged back then And when we met him, he was already in the late 60s when we met him. And he said, I'm on a deal diet, so kind of with the mid-60s. And then he said, when we left, he said, well, guys, don't forget, to become a good VC, you have to lose 50 million. Otherwise, you're not going to be becoming a VC. And we said, it's crazy. How can we lose 50 million? Our first fund was 50 million, five zero. How can we basically lose 50 million?

18:03Each partner. He wasn't saying the company, each partner. now with hindsight looking back it we we are we reach that you know in terms of um money we we lost with investments made who basically did not pay back or we had to write off or write down or whatever and we are we are there so we we we um we reach that you recovered your 50 million so yeah and not just me my colleagues as well so it's kind of no it's it's whole to you you learn really by by doing this that's why that's why portfolio is important that's why partnership is important also to have them some checks and balances around so that's that's that makes it makes it that makes the model successful in the end you know and what was the first investment where you thought um that this whole thing could actually work out i mean like i can give you an example like for me it was not so long ago when i started with the podcast and because I literally did not know what venture capital was at the time and I reached out to a bunch of people like among others Saul Klein and invited him to my non-existent podcast at this time and he replied and he was happy to join me so this was for me kind of the moment where I thought okay this might be actually working and yeah I'm curious what was this for you this moment?

19:22Well the interesting thing we had companies where we thought they would be working that did not work out in any way anyways because of different reasons it was it was on we we've seen everything we have seen founders split up we have seen founders disappearing we have seen kind of thing so most of the things which did not work out and that's why also basically we we changed we changed most the most over the course of the time is basically how we how can we make sure that we get a better feeling a better judgment on the people we're investing into. I think that was back then, because if you look back, if we do this post-mortem analysis, which we did obviously now, since there has been quite a good number now of companies, which we lost over the time, it was 80, 90 percent.

20:10It was the team. So that's why we have much more emphasis on how to find out whether it can work and what is needed basically to make it work and how to get a good feeling before we decide if it can work out or not. So that's something we are much more focusing on than in the beginning. So that's why in the beginning, we think every investment is going to work out and yield big time. And in the first fund, it was mainly Interhipp, so the mortgage marketplace in Germany and and tip 24 were basically, so bringing basically lotteries online, you know, kind of old-fashioned system made online. And that worked out quite well.

20:58So those two companies have, there were two other good ones, but those contributed mainly to the performance of the first fund. And did we know from the first day on? No, we did not because other companies have also had a good start. We had a company called Avax back then, which was almost about the vertical public. You know, they had very good numbers. They're the best numbers of all companies in our portfolio. They then didn't make it and they were just disrupted by other companies in the course of that. I mean, it was good that we did not bring them public because they probably also tanked then pretty early.

21:32They were due for filing in April 2000. So this kind of thing. And then they withdrew and then it's okay. Well, let's go after summer. And after summer, it was even worse. And then it was over. The party was over then. but but you have sometimes you have these cases that you have companies which have a very good start and and look really fantastic they are not the ones who make make the make it then at the end and you mentioned that uh now you're putting even more emphasis on the people and the analysis also of the team so i'm curious like how does it how does this look like in practice like how do you like what are your steps to really get to know the people behind the product and the startup?

22:16Yeah, well, first we try to basically establish a relationship to work together. And what we don't like too much is basically being forced and handing out an LOI within a week. And so we don't like the situation that followers come to us. Are you interested? Next week, we were expecting first LOI. So that's something we don't like too much. On the other hand, we are in a much better situation today and that because we have way more repeat entrepreneurs we have way more possibilities also technically to to look for and seek references so that's much much better possible than than back then so it was many people just came from university they have not had no experience so it was kind of very very different in that respect so in this respect we are in a much better situation now that's why we also have developed our own software, which helps us getting to know disruptive concepts, disruptive good entrepreneurs out there very early, even if it's too early for us to invest.

23:16We can invest early and we do invest early, but even we like to get to know them as early as possible. So then establish a relationship, help them with all the investing and with this building a relationship and then see how things evolve. But then also be around at the right point in time when it's about the first investment. So that's the way we try to build, which is not just good for us, it's also good for the entrepreneurs because the entrepreneurs also should find the right partner. And so it goes both ways in the end. So for the entrepreneurs, it also makes sense to build a good relationship and try to find partners.

23:52and have so many examples out now, recently also with companies who have issues in the cap table, you know, because you have different interests and who have raised maybe in 21 very high valuations, but nobody cared back then in terms of it doesn't matter who it is. That obviously can haunt you then. So that's why it's also important for the entrepreneur to look for the right partners. We also basically always involve our head of people and she's involved very early on and then she's basically then also giving giving assessment of of the founders team um so that's the way we try to um yeah get it to a holistic view have everybody also involved in the discussions we also try to basically involve many people on our end to get to know the team to work together with the team even interns and so and afterwards we also like to hear opinion from everyone so not just the investment committee but also everyone being involved.

24:52It's a marriage, you know, it's seven years more, more than seven years. Typically, I think the average duration of marriage is seven years. So it's longer in all cases. And you mentioned the importance of the team. I'm curious, like you have grown early bird now also over the years into a larger team. So how do you design a company culture and how do you then implement it? Well, it has to be defined. It has to be lived also. That's why we also have a team basically of HR who supports our portfolio company. This is in all details, you know, it's how the company is welcoming you, how the CI is looking, how basically you clean your office.

25:37So kind of all these things, you know, they all should basically pay and cater to your values. Those things and those little details you can much better observe, obviously, if you They have meetings on site if you see how they live, how they introduce their colleagues, you know, how the office looks and so on. So all these small, small little things give you give you some hints whether whether these cultural suspects are taken care of and how they lived. And for you personally, because you're also in the position of a leader, so how did it change for you what it means to be a good leader from when you started out and how you would see it now, also based on the experience you made that you just mentioned?

26:20In the end, it's about sharing the same and living up for the same goals. And we have also had on the partner side also our churn, I would say. So it took some time also with an early bird to establish the second generation after the founders. It took some time. Why did it not work out earlier? Because obviously there were no shared value. They were just different divisions. Sometimes it's you share the same, then you realize, well, they're not really the same. It's also a different direction possible. And then in those situations, you rather should react and basically not try to make it happen.

27:00I think entrepreneurship and especially also venture capital are in general very polarizing ways of living your life. Because sometimes things can go exceptionally well, but which is like as part of the venture asset class, most of the investments are not successful. So what skills or qualities do you need as a person to excel in that very specific environment? I think it's important to be very honest with your investments. Be honest also of the expected directional outcome. We tend to be much more upfront now as in the beginning in terms of giving clear feedback with regard to the next funding.

27:42So if things are working not so well, we try to realize or basically communicate that we may be not happy and maybe also not up for the next round. People realize, okay, well, it's hard to find. We try to find a solution in terms of can we sell the company? Is there a buyer, a natural buyer? Basically, can we do something for the company? So we try to be supportive in that direction. It doesn't work out. Always. No, it does not. But at least we try to be very, very front and open in that regard so that founders do not expect, basically, they will be funding forever and do one funding after the other.

28:22We could, basically, even the fund has the reserves, but it's not an automatic thing that the reserves will be released to the next round. Because in the end, we have to, we are fund managers. We have a portfolio and the best companies should get just the attention, but also the money to be supported. And the weaker companies, you have to find solutions. And whereas in the past, basically, we had also more write-offs in the past in the end because we weren't early enough communicating that. Because if you do so, founders, you come up with new ideas, you just create options in the course. And the option can be, not necessarily can be bad.