The Craft of Venture Capital with David Sacks

0:00Welcome back to another episode of Venture Unlocked, the podcast that takes you behind the scenes of the business of venture capital. I'm your host, Samir Kaji. On this week's episode, we have a conversation with David Sachs, founder and partner of Kraft Ventures. Based in San Francisco, Kraft was founded in 2017 and currently has over$3 billion in assets under management. Across the last three decades, David has been incredibly influential as an investor, entrepreneur, and public thought leader. When starting Kraft, he was able to draw from his deep operating background, having worked as an early leader at PayPal, and then later founding Yammer, which he sold to Microsoft for$1.2 billion.

0:35He is also one of the hosts of the All In Podcast, one of the most listened podcasts in the world. We had a wide-ranging dialogue that took us through the evolution of Kraft Ventures from its initial days to today, the strategic decision-making behind scaling fund sizes and team growth, and his overall views on the current outlook of venture capital. I really hope you enjoy it, so let's get right into the show. If you're a venture investor, then I'm sure you already know about Sidecar, the go-to platform for emerging VCs to manage their SPVs and funds. Sidecar is on a mission to make private markets more accessible, transparent, and liquid by standardizing how investment vehicles are created and executed.

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1:47To learn more, visit sidecar.io forward slash venture unlocked. Samir Khadji is the CEO and co-founder of Allocate. Allocate and Venture Unlocked are independent of each other. Any statements or references made by Samir or his guests regarding third parties, investments, or securities are solely their views and opinions and are not intended as investment advice or an endorsement of such parties or securities by Samir, his guests, or Allocate. Allocate or its clients may maintain relationships with or investment positions in guests, third parties, or securities mentioned in this podcast. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions.

2:28David, thanks so much for being on the show. An area that I think it makes sense to start with is really the inception of Kraft. And I know it's been seven years. And before that, you had a ton of experience at PayPal in the late 90s, early 2000s, and then starting Yammer during the beginning of the GFC. Curious about the white space you saw that inspired you to start Kraft and go full-time and investing in 2017. Samir, thanks for having me on the show. So I had been investing in startups for 20-something years, basically throughout the whole time that I was operating and founding companies. And you're right that around 2017, I decided that I didn't really want to operate companies as a day-to-day job anymore.

3:10And so that gave me capacity to basically take on capital partners. So that was sort of the first thing is just to kind of wrap some structure around what I was already doing from an investing standpoint. In terms of building craft, our philosophy has been to build the kind of firm that we wanted to partner with when we were founding companies and operating companies. And the thing that we've done is really focus on the area that I know best, the area that I was a founder in with Yammer, which is SaaS, and specifically product-led growth models or bottom-up SaaS models. So we've assembled a team that understands SaaS really well on both the investing side and then also on the operating partner side.

3:53We built a pretty robust platform team that helped provide services to assess startups. And the goal is not to do the work for them, but rather to have an expert in every area that can help them get jump started. A lot of our Series A investments are startups that are building on a sales team for the first time. I mean, they may be founders who did the initial sales themselves. We'll help them find the right VP of sales. We have a pretty large recruiting team. We'll partner with them on that. We'll show them kind of how to set up and structure their sales team, their go-to-market team, and so on.

4:27You know, we have kind of experts in a bunch of areas like that. That's basically what we've tried to build is, again, just the VC firm that is the kind of firm that we wish we had as a partner when we were kind of going through this as founders. I think it's a good segue to go through the evolution and the scale of craft. And during these seven years, you've done that fairly significantly, both on fund sizes and team. I think fund one was$350 million. Now you're managing just under$3.5 billion in assets. And I get the question a lot from both GPs and LPs on how do you think about scale? When is the right time to scale fund size, team?

5:05And would love to hear your perspective on how you thought about scaling fund size and the reasons behind it. Sure. Well, I think our first fund was, like I mentioned, an extension of the angel investing that I'd been doing for two decades. And I already had a backlog of companies that I was already involved in and was very optimistic about. And so our first fund was really optionistic. It was kind of multi-stage, multi-strategy. We didn't necessarily focus on just one vertical. We sort of made, I guess you could say, continuation investments in companies I was already involved in. So that was really the first fund.

5:45And then starting with fund two, we started to get serious about having a focus. And the venture capital landscape is obviously very crowded. There's a lot of competition. And so I think it is important to have a strategy and a focus. And we decided to focus on the areas where we ourselves had been founders. So obviously, with SaaS, and specifically bottom-up SaaS is what I had done as a founder, creating one of the kind of pioneering bottom-up SaaS companies with Yammer, which we sold to Microsoft back in 2012. And then the other GP at Kraft, Jeff Flohr, had been the founder of StubHub, and he was an expert in marketplaces.

6:20We decided to really focus on SaaS and marketplaces. And that's what we've basically done at Kraft since then. In terms of your question about fund strategy, there's an old saying that fund size is fund strategy. Because if you take a typical fund size, the first thing you have to do is you kind of have to separate out, okay, there's some percentage for fees and expenses. There's going to be some percentage for reserves that leaves the amount of capital you can have for first checks. And then you might want to divide by a number that you think that gives you an appropriate portfolio size, maybe 20.

6:58So when you do that math, you figure out like, what is the typical check size that you can write? And that's really going to dictate what stage you can play at. I I mean, obviously, if you have$100 million fund, by necessity, that's going to be a seed stage. On the other hand, if you have, say, a$600 million fund, that is going to be much more likely to be a classic Series A, Series B venture fund. Likewise, if you've got a multi-billion dollar fund, you're going to be doing a lot of late-stage investments. So you want to have an alignment between the size of your fund and the stage that you're pursuing.

7:33And then I think, like I said, you want to have a focus for the fund where you think you have a competitive advantage. There is an area there I want to double click on. And you're right. You know, you focused on a certain category, which is what you've done in the past with bottom up SaaS and really SaaS, understanding how to scale SaaS businesses. the area that you know i'm curious about is thinking about as you scaled the fund sizes and knowing that fund two was really this non-extension of just the angel track record but creating sort of this profile around sass and marketplaces how did you think about portfolio construction because as you look at a seed fund versus an early stage fund a lot of seed funds maybe 70 80 percent initial check and seed.

8:18They fall in in a small percentage of those companies and may reserve 20 to 30%. With the bigger funds, oftentimes you have the reverse where 30 to 40 % might be initial in the rest of reserves. How do you think about maximizing ownership at the initial check versus keeping enough in reserves for some of the breakouts? Yeah, it's a good question. I guess if I do anything over again, we probably would have reserved more. We probably didn't reserve enough. We invested more in, you could say, first checks. And we ended up having a lot of markups in fund two. We ended up not having the capacity to take those.

8:56Or later, we raised our first growth fund, and then the growth fund was able to take those allocations. So yeah, we probably should have reserved more than we did. I think the classic rule of thumb is you probably want to reserve about 30 % of the fund for follow-ons. And then fees and expenses, maybe it's roughly 15%. So when you add those things together, you're only investing about half the fund or maybe 60 % of the fund roughly in first checks in companies. And so you do have to take that into account when you pencil out your portfolio construction. And this comes back to the point of overall return profiles.

9:36And one of the things that I know you've talked about and others have talked about is not only has venture potentially gone mainstream, but it has also increased in AM. And if you look at some of the bigger firms, most of the AUM built was over the last five years. Funds were raising more. They were raising at faster cadences. It was 18 months versus the traditional three to four years. Within a fund structure, during the ZERP period, of course, we saw multiples expand. SaaS multiples were, in some cases, depending on the stage of company, 2050x. Public multiples now are at 6x. What is the overall mental model now in terms of returns?

10:19Because ultimately, most venture investors or LPs want to get to a 3x net pretty consistently. Knowing that you're not investing the entire fund because you have fees and expenses that you have to account for, how do you approach a deal today knowing that the multiple compression that we've seen and really the return to normalization is something that's probably the new normal. First, we may want to discuss what happened in 2020 and especially 2021. We basically had an asset super bubble in not just venture, but across capital markets in the United States and really broadly across the world. I mean, starting in 2020 with COVID, you had the Fed and also fiscal policy in Washington to start airdropping money into the economy.

11:08And in combination with lower interest rates or basically zero interest rate policy or ZERP, you saw a huge speculative bubble form in pretty much all risk assets. So it wasn't just venture-backed companies. It was also crypto. There was even real estate. pretty much across the board, the more oriented towards growth or risk the asset was, the bigger the bubble got. And so you saw in venture markets in 2021, 100 times ARR became the rule of thumb for valuation. And that has corrected massively since the correction really started in 2022, but it's kind of continued now. And I think it started stabilizing around Q3, Q4, of last year.

11:58But we basically went through a bubble in 2021. And I think that has huge ramifications for everyone in the ecosystem. I mean, it has huge ramifications for startups that some of them were lucky enough to raise at that peak. But a lot of them, you know, had burn rates that were way out of whack because they assumed they'd always be able to raise money at those valuations forever. And there's had to be a huge reckoning among startups to in terms of right-sizing. I think there's been a huge reckoning at venture funds in terms of pace of capital deployment and valuation. So I think everybody is living through this hangover now to the bubble that happened in 2021.

12:41And we're all kind of adjusting because of that. The interesting thing about the ZERP period was the length of it, which depending on how you counted 11, 12 years, And we had an entire generation of entrepreneurs and investors who had been in the industry for 10 years that had never seen anything but up and to the right. And for companies, the fundamental metrics that people were judged on was top line revenue growth. It was how much capital can you raise to help at least temporarily outmaneuver competitors? And I'm curious, given that you've been through the operating side in really tough times, both with PayPal and then certainly Yammer, how did you help companies and entrepreneurs navigate something that they had never been through before?

13:26Well, the message to entrepreneurs has been really, we started doing portfolio reviews, or rather, we started doing meetings with all of our portfolio company CEOs in February of 2022. And we did another one, I think, in May of 2022. I think we've done three or four of these. We actually ended up posting all of these on YouTube, so you can go find them. But what we started telling our portfolio companies in February of 2022 is there's been a regime change in the capital markets. Capital used to be abundant. It was easy to raise. Valuations were high. We're now seeing a huge change because of interest rate policy.

14:06And with interest rates going up, I mean, in fact, they spiked up from, call it roughly 0 % to 5 % in one year, as the fastest rate tightening cycle we've ever had. Capital availability just really dried up. And what we advise founders is you should really make the capital that you raised last year, if you were lucky enough to raise at the peak, you need to make that last much longer than you thought. This is not an environment in which you're going to be raising capital every 12 to 18 months. This is a kind of situation where you may not raise capital for three or four years. I mean, you should effectively consider that last round that you raised to be two rounds.

14:45We also stress the importance of metrics. Fortunately, Kraft as a firm has always been very metrics focused. And we've published a lot of blogs on the SaaS metrics that matter. We've invented some metrics that we think are a good way to benchmark SaaS startups, metrics like burn multiple. And so we've always been, even during that frothy period in 2020 and 2021, we did not invest in startups that didn't have good metrics. There were a lot of VCs, I think, started investing in companies with no ARR. You'd see deals get done and valuations and the hundreds of millions. And that just always seemed crazy to us.

15:23You know, when we did invest, I mean, one of the things that we do believe is that as a VC, you're largely a price taker. I mean, your job is to find the right companies, is to pick the right companies, but valuations are set as a result of a market process between VCs and founders. And so you have to, the most important thing to decide is which companies you want to be in. And then you're somewhat beholden to where market prices are. And there's no question that entry prices in hindsight were way too high in 2021. But we feel like at least we got into the companies we wanted to be in. So in any event, the advice we started giving founders in 22 is just, it was all about the regime change.

16:06And we talked a lot about this on the All In Pod as this was happening. There's a lot of nuance and some things that I think that are a little bit difficult for people to always understand, which is I think most people overpaid, if not all, in 2021. That was essentially the game on the field. And as you mentioned, almost every investor was a price taker. And it was how do you have a market clearing price in the very best companies that make sense where there's still significant upside? Now, some of those companies will continue to do well. They will raise capital, but there's probably a long tail of companies that raised gobs of capital during that time that might have had some tailwinds.

16:48And we've seen things like Hoppin, of course, that was benefiting from the tailwind of COVID. There's other companies that didn't have those strong fundamentals. How do you see this playing out? We have seen markdowns during 2023. I don't know that they're as ubiquitous across every single firm. And as you know, valuation policies across funds are very different in how they mark down and mark up. But what do you anticipate seeing in 2024 with this logjam of companies that may not be able to be spoon-fed in inside rounds and are going to have to test the capital markets? I think you're going to see in 2024, the, I guess, final piece of the reset that really started in 2022.

17:28And it just takes a long time because startups were able to raise so much money under such good conditions in 2021 that a lot of them haven't needed to go out. And I would say that most founders did listen to the advice that we were giving and obviously was by no means us alone. I think most VCs and certainly all the responsible ones were letting their portfolio companies know how things had changed and were advising them to reduce burn rates. So most founders, I think, listened and reduced their burn in 2022 and 2023. We saw a lot of rifts, you know, headcount reductions at startups. It was pretty much the norm.

18:08And as a result of that, I think a lot of companies have had the runway to not raise for three years. In 2024, we're getting to the end of that runway. And I think most startups that haven't raised in three plus years are probably going to need to. I mean, even if they don't hit the wall and run out of money, they might get to the point where they're six months away or a year away. It's going to be uncomfortable for them not to run a process and raise. So logjam is a pretty good word. There's going to be a clearing through the system of these companies that haven't raised in a long time. And we'll get to ground truth on where their valuation should be.

18:48What is the impact, I guess, then to the venture market itself? Of course, we talked about this earlier in the conversation about the run-up in new firms raising, mega funds getting bigger and bigger. Of course, we've seen some of those funds maybe stabilize their fund sizes, even go a little bit lower. We saw Founders Fund, for example, split their fund from a billionaire to two separate funds. How do you see this playing out? and maybe going into detail, both in the small side of the market with all the seed funds that were raised, but also the potential impact with many of these large funds that have raised, in some cases,$3,$4,$5 billion.

19:27Well, I think the impact has been greatest at the late stages. And the reason for that is because you have to write bigger checks at the late stages and you have to raise bigger funds. And so it's been more impacted. Also, a lot of the liquidity that flooded into the venture markets came from crossover funds. VC firms might derisively call them tourist investors, people from outside the traditional venture industry who came in looking for an arbitrage. If you look at venture capital deployment as an industry, it was about 2010s that decade, call it. it was around 50, 60 billion a year was the amount of venture capital that got invested.

20:09And around 2020 and 2021, it went all the way up to about 200 billion. So again, during this bubble, you had a roughly tripling of the industry. And a lot of that money came from crossover investors, these absolute mega funds that came in. And their logic was as follows. They were looking at the public markets. And they were seeing that public SaaS companies were trading for 35 times ARR. And so they looked at the private markets and they saw, well, wait a second, we can get in to a private SaaS company that's, let's call it roughly tripling year over year, at 100 times ARR. So if we invest at 100 times ARR in one year, then this private company will catch up to the sort of public comp.

20:55And then from there, we'll be compounding and we'll be able to make a lot of money. This is basically just an arbitrage. That whole methodology kind of fell apart when public SaaS companies corrected from, say, this is a high growth multiple corrected from 35 times to eight or nine times. And then the other thing that happened, I think that was very damaging to that formula was that the growth rates also slowed way down. So if you look back in In 2022, the thing that happened in the first half of the year was multiple compression. The thing that started happening in the second half of the year is that virtually every public and private SaaS company started forecasting down.

21:38And we just saw the buying environment for software got much tougher. Buyers just got more discriminating. They started consolidating vendors. They started pushing off purchases. The deal cycles got tougher. Remember, layoffs were happening in a lot of these companies. we really had what I call a full-blown SaaS recession or B2B recession. The overall economy may not have had a recession because the consumer held up. But if you look at what was happening in the B2B world, it was very much a recession. And public SaaS companies were slashing their growth forecasts by about half on average. It just got much tougher to sell.

22:14And I saw that in all of my board meetings is that private SaaS companies were having a much harder time and they started forecasting down to more realistic sales targets. So the growth rates slowed way down. And so you had this double whammy where the multiples were coming down and the growth rates were coming down. And I think that created a crisis for these crossover funds who came in. They were really acting like term sheet generators. You could send them one page of metrics and get a term sheet back the next day at these valuation multiples that in hindsight were completely crazy. But again, they were basing their methodology off an arbitrage to a public exit comp.

22:55So that whole model kind of collapsed. And what you saw, I think, over the past year, two years, is that all of these kind of crossover investors have left the market. And that has created a huge contraction in the availability of growth capital. It's only gone back to the way it used to be. But basically, that bubble got corrected. So that's what's been happening at the growth stage. Now, what's happened at the earlier stage is because you never needed very large fund sizes to have a seed fund, for example, the availability of capital is not reduced as much. I think smart investors are being a little bit pickier and more discriminating about valuations because they know that if there's less growth capital, then growth rounds have been priced much lower.

23:39That means, so if the series C, if the average series C has gone from$500, $600 million valuation to a$200 to$300 million valuation, the series B can't be at$200 anymore. It needs to be at like$80 to$100. And that means the average series A needs to be at$40 to$50, not at$100. And typical seed needs to come down to somewhere in the$10,$15 range. There has been a trickle-down effect and a right-sizing all the way down, but the trickle kind of hits the seed stage last. And we'll talk about it at the seed stage, but going back to the growth stage, and when you mentioned crossover investors, it's the Tigers, the D1s, the Dragoneers, which were coming in and providing massive amounts of capital.

24:18And the product was very different. Tiger's product was, we say out of your way, we'll write you a check. We're not going to sit on the board. And for a lot of founders, that was a really attractive way to get financed with large dollar amounts and valuations that ultimately were fairly non-dilutive to them relative to what we've seen in the past. As those people have vacated, and I'd probably throw in the third whammy, which is the absence of a liquidity market that we saw in 2021, of course, it was SPACs, it was public markets are very friendly to new entrants. But as we got past that, the public markets were looking at a different set of variables outside of just growth.

24:58And so it just became tougher for those companies to even test the public markets. Arguably, many of them should be public companies, and we'll have to figure out what the market clearing price is. But one of the questions that came up, and I think you guys have talked about this before, and I want to dig in a little bit deeper, is the dynamics at the board level for some of these later stage companies. Because as a later stage investor, you may not even have ratchets if the company goes public where you get more shares. And so in some ways, you may not be as incented to take the company public.

25:29You know, you have your preferences versus an early stage investor, the common shareholders being the employees who are sitting behind all these preferences that may want a public offering where you can get liquid or everything converts to common. What are you seeing, I guess, at the board level? You know, I haven't seen a ton of that. I'm, you know, I'm familiar with the problem that you're describing, but I haven't seen a ton of it. I mean, I guess my attitude is that, you know, what I've been preaching since February of 2022 is just that there has been a regime change in the markets. Capital is much scarcer.

26:01Founders need to recognize that. They also need to recognize that the metrics that investors care about have also changed. One of the ways I frame it is that when you're in a boom market, the only three metrics that investors care about are growth, growth, and growth. When you're in a bear market, the three metrics that investors care about are growth, burn, and margins. So it's not that growth stops being important. Growth is always important and attractive to a VC. I mean, ultimately, we're investing in little startups that we want to become big companies. And that can't happen unless they're growing extraordinarily fast.