Tomasz Tunguz of Theory Ventures on strategically raising a fund in a downturn, Why Firms Need a Business Model, and different views on portfolio construction

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, and on this week's show, we're excited to have Tamash Tungus, founder of the newly formed Theory Ventures. Before starting Theory, Tamash spent nearly 15 years at Redpoint Ventures, and earlier, he closed his made-in-fun at$230 million. For those that have followed Tamash's writing, you'll know that he's incredibly analytical and thoughtful in how he approaches all aspects of business. And this conversation was no different as we went deep into topics such as portfolio construction theory, business models and venture capital, and how to be strategic when raising a VC fund.

0:39I think you'll really enjoy this conversation, so let's get right into it.

0:47Samir Khadji is the CEO and co-founder of Allocate. Allocate and Venture Unlock 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.

1:22Hey, Tom, it's great to see you. Great to see you too. Thanks so much for inviting me to be on the show. Yeah, this is going to be a lot of fun. So I want to go back into kind of the early days. So going back to the inspiration of why you went on the investor side, you were at Google, you know, you spent a few years there. What inspired you to join Redpoint and go on the investing side of the house? I met a venture capitalist. So I'm not from California. And I remember I was at a party and I met a venture capitalist and I couldn't believe it was a job that people had. And I was so I fell in love with it.

1:52And I remember one day I was my wife and I were living in the Embarcadero and we were walking past a restaurant and there was a VC with a founder and they were shaking hands on a deal. And I had this dream. I was like, wow, I'd really like to do that one day. Wouldn't that be amazing? And then I had a wonderful opportunity. I was recruited by Redpoint out of Google, met a couple of other venture capitalists. Actually, when I was at Google, I was a part of this management rotation program. And as part of that, I got exposure to the board. And so I met a bunch of the venture capitalists on the board.

2:19Wow, this is incredible. when the opportunity came to join Redpoint, I jumped at it because it was a dream from that moment. Yeah, it's hard to believe it's been 15 years since you first started at Redpoint. And now kind of looking back, I'm sure you had so many different experiences and learning as an investor, but it also coincided with such a change in the industry. And also from a macroeconomic standpoint, both with the economy going up and to the right, but also the advent of course, mobile and cloud really driving technology to the level it is right now. But maybe you can go back and think about the things that might have informed what you wanted to build when you left Redpoint in 2022 to start Theory.

3:01I had a wonderful education at Redpoint, really an incredible group of people. The industry while I was there changed enormously. We went from as an asset class,$8 billion to$300 billion over the course of about 10 years. I really love reading the history of great financial firms and that evolution paralleled a lot of what happened in the private equity industry. So you had KKR that spun out, Bear Stearns, and there was a massive growth in the asset class as a result of the junk bond market and maybe QE. You could kind of call QE the junk bond equivalent for us in terms of just the access to liquidity and the formalization of the asset class.

3:38When I decided to start Theory, the idea was, well, the environment has changed radically. And for the first time in a very long time, venture capital firms need to think about their business model. The same thing happened with startups. When there's plentiful liquidity, you don't really need to think about your business model. And just to kind of contrast this, when I first started in venture, the very last slide on every pitch deck before the total amount raised was a P &L and a cash flow statement. And at the bottom, what you would do is you would sum up the cumulative burn and that would be roughly what the startup raised.

4:12That's how the financing amount came to be. But after we printed 30 % more dollars than there had been in existence, that changed. I mean, the last time I've seen it, I can't remember the last time I've seen a P &L or a cash flow statement on a pitch deck. And now it's the auction that governs how much money a startup raises, not sort of the fundamentals of the business. And venture capital has been the same thing where as the asset class grew and there was a lot of interest, the business model, we haven't needed to think about the business model of a venture firm in a very long time. But with the correction that we've seen now, I think, I believe we start, we need to think about it again.

4:49And just the way that founders are needing to be more disciplined around how much money they raise and what's the maximum return on invested capital on a per project basis, venture capitalists are going to be forced to do the same thing. And so the idea behind theory was to use math in order to figure out how, and analysis in order to figure out how to build a high multiple fund. How do you construct a very high multiple fund using math and probabilities, which are some of the disciplines from other areas of high finance that I've read about and have been practiced for a while. You talked a little bit about this.

5:22Venture did change a lot and you had this quantum of capital coming into the market and this whole concept of an auction where an entrepreneur would go out and get a number of bids and typically there was always somebody willing to write a check and it was just how much capital could you raise what was the valuation this also happened on the fund side too there was so much liquidity the low interest rate environment you had qe you had lps that were deploying capital and fund sizes were growing pretty significantly and if you look at particularly 2017 to 2021 That was really the peak of when we saw the greatest increases in fund sizes.

6:002020-21, about$300 billion raised by venture funds. And now we're in a different environment. You raised during a correction, which is 2022. Your first fund,$230 million, which is close. Congrats on getting that done. But you also raised at one of the toughest times. So raising as a solo GP in a market that had corrected. What gave you the inspiration, maybe the courage to go out during a very tough time where a lot of people could have just stayed with the existing firm they were with? You can never time markets, but I really believed in this idea that a superior business model could thrive. I think raising in a downturn tests, one, your mettle as a person, but two, tests the quality of your idea.

6:46Because if you can convince people, even when times are tough, then maybe there's something there. whereas if you're in a market where liquidity is sloshing around then there's less diligence to be done and sort of less scrutiny so if i could convince enough people to raise the fund then there's some merit to it right especially the most some of the most sophisticated investors in the asset class and you got the fund raised down fairly quickly so i think your last day at red point and maybe starting the fund was around late Q3, early Q4 of 2022, held a final close sometime Q1, early Q2 of this year.

7:26Talk to us about the fundraise itself. You're very analytical and I've always seen this through your writing. How much did you think about the fundraise in terms of intentionality around what type of LPs to go after? How did those first 30 to 60 days go? who are you really focusing on? Great question. So I really wanted to focus on institutional LPs because I want to build a long-term firm. And Barry Eggers at Lightspeed, actually, he wrote a post about the ideal construct of an LP base. There's a great LinkedIn post and he's been a great help to me along the way. And so, you know, the way that he thought about it, which I agreed with is it's about a third fund of funds, a third endowments and foundations, And then a third, other kinds of LPs and pension funds and so on.

8:15And so that was the mental model going in. The dynamic that I found when I launched the fundraise was that the stock market crash really caused a lot of LPs to have uncertainty around their asset allocation. And so some LPs, they might allocate 1 % to 2 % to venture. Some LPs might allocate 20 % to 25%. Some are as high as 40%. Fund to funds obviously are 100%. But when you are trying to maintain a portfolio and the public market is down 40 % and your private portfolio hasn't been marked to market yet, you might look 2x over allocated to an asset class when in reality, you're probably in line.

8:56And the other dynamic was that a lot of LPs paused new investments altogether just to understand other parts. I mean, I talked to 1LP and they said, we need four months in order to understand our real estate portfolio before we reallocate to venture because they're investing across asset classes. And so that was the market dynamic when I first kicked off the fundraise was people just trying to understand where they were. And even my pitch didn't matter because it was just much more about what our fund flows look like? What are our requirements in order to get cash flows out? What is our portfolio?

9:33We don't know what our portfolio looks like. We can't make new commits. Well, and this was the big thing. I mean, this has happened before where institutional investors are prone to being subject to the denominator effect, right? So your public portfolio and then your private marks haven't marked a market. The other situation I think is as interest rates rise, your opportunity costs for venture is higher because now you could put money in a three-month treasury and get over 5%. Private credit is yielding more. So sometimes it's not just being over allocated, but it's also people looking at rebalancing their portfolios based on where the rate environment is.

10:10You can't really control those things. You can only live with them. So how did you become successful? I mean, in the early days, so you mentioned fund of funds, of course, they're in the business of allocating capital. Many of them are looking at investing in first time funds, especially spin outs. But what really created the momentum? Was it getting one or two of these big institutionals to really drive? And then ultimately, maybe talk to us about the rest of the fundraise. How many LPs did you ultimately talk to? And what did you find from a pattern standpoint, once they got comfortable with investing in the asset category?

10:47There are a lot of parallels between raising a fund and raising a round for a startup. So the first is you have to have a really good story. Ideally, you have metrics and a track record to prove success. At the highest level, an LP is interested in three things, which is what is the strategy? What category are you in? Where do I put you in a box? The second is, have you had success in the past? And the third is, how will you win in the future? At the highest level, that's what they're interested in. I was fortunate enough to have relationships with institutional LPs and was able to close two anchors committed relatively quickly.

11:20And they provided lots of references on my behalf. And for that, I'm eternally grateful. And then the next part was creating a sense of timeline. What I learned in the process is a close date is completely arbitrary. I mean, completely. And the notion of like a first close and only close is also completely, it's sort of a vanity metric for VCs. One friend of mine, he has a very successful fund. He had 11 closes in his last fund. The second somebody decided to commit, he would just close them. And the reality is like, that's probably a really good way of running the process, but there's sort of this emotional construct of, oh, we were single close.

11:59That doesn't make any sense. It makes no sense. The only reason to have a single close is otherwise you're kind of in the ether and every LP will ask you, when are you closing? When are you closing? When are you closing? and you're trying to sort of shepherd this process along. And so you pick some date where you think you have a reasonable sense of confidence that you will hit that date and you drive the product. And so there was this remarkable dynamic when I announced that I was leaving Redpoint and it came to be that people knew that I was starting a firm. The number of other venture capitalists who reached out and helped me, I was bowled over by the support.

12:33And one of them said to me, you have to run it like a sales process where after three days after you've met an LP, you need to follow up and you need to ask them exactly what they need, what their questions are, how's it going internally, what can you supply them? And I took that advice. So I built a CRM and I ran everybody on a schedule. And anytime there was an update and there was a new commitment, I would email people and say, we're at X percent, now we're at Y percent. This is what's going on within the portfolio. This is what's going on with recruitment. And I took some of the strategies from the blog.

13:05The goal with a blog is just to be in people's inbox on a frequent basis so that I'm top of mind and to show a sense of urgency and progression. And so created effectively a content marketing campaign with LPs just to show them this is what's going on. And like any auction, the closer you get to the conclusion and the greater the scarcity that you're able to engender, the more interest there is. So you have this dynamic where it's like linear, linear, linear, linear, and then you're very, very close to the end. And now all of a sudden there's scarcity. There's just a lot more activity there and people start accelerating their processes.

13:41And so once there's this sense of inevitability, which exists, it's just a byproduct, I think, of human nature, then there's a lot more interest and people are willing to be more flexible. Let me ask you. So you did a single close, I think, right? So single close. When you first started, did you already communicate to people you were doing a single close? I mean, was this something that you were going to do a single close no matter what? Or was it a function of like, you got this momentum, momentum, momentum, and you knew it was inevitable and it just made sense to do a single close? Because I always feel like with single close, you say it, but if you don't actually have the momentum, then you're kind of stuck in between a rock and a hard place of, I want to get into business on one hand and just do a close to start investing versus like the scarcity.

14:28yes, a single close does drive a little bit of urgency from LPs who otherwise can just wait. My perception, as a data point of one, my perception is if you're at 75 to 80 % committed, and then you say there is a single close, that will drive urgency. If you're at 10 to 30 to 40 % committed, and you say there's a single close, it has no sting, no catalyzing power. It's meaningless because there's just so much road to hoe or dirt to hoe. When I went out, I would say, I would say something like people would ask, well, when are you closing? And I would say, we will close on this particular date. And ideally it will be a single close.

15:09And here is where I am. I've closed like X percent of the pipe line and the total value of the pipe of interested investors in order to sales qualified leads in the SaaS parlance was this amount of money. And so the goal was just to show with a relatively small conversion rate, I could get to a single close. The question was not whether or not I would get there, but the timing of the investment decisions on the investment committee is not like that. And it speaks to the authenticity of it. You know, we have seen people at 10%, we're gonna do a single close, you need to get in, the day comes, they're still at 10 or 20%.

15:42And then you actually lose a lot of credibility with prospective investors. And it makes the rest of the fundraise incredibly difficult. Speaking of difficult, fundraising always is difficult. You came from a firm where you weren't always just doing the fundraising. You were part of a broader team. Doing it on your own is very different. You are basically doing everything from portfolio, thesis construction, building the model, the business model, which we'll get into in a second, raising capital. And people are making a bet on you at the end of the day. tell us about some of the common objections people had not toward the macro but toward you and i can think of some that i can probably contemplate came up one is solo gp key man risk the second is you were at a big firm does that really carry over maybe talk to us about some of those common objections and how you overcame them there were people who passed out of hand we don't invest in solo GPs will save you the time and the trouble.

16:39Then I was advised by a handful of LPs that there should be very specific provisions within the LPA of if I should become incapacitated for whatever reason, you would need different things. That turned out, I think, to be less of an issue than I initially thought. I think most of the people who don't invest in solo GPs opted out even before. And so the remainder of the funnel was relatively healthy. There's not really a whole lot that you can do about that objection, unless you talk about the firm that you want to build and the processes that you have in place. And I think as long as, so there's some solo GPs who are very successful and it literally is a single person.

17:22And there are some solo GPs where they have a firm or other people that they plan to build. And in the fullness of time, there will be a bigger organization. So in the first case, the solo GP risk or the key person risk is intrinsic and permanent to that particular firm. And there are some where it's a transient risk. And so what I communicated was, in my case, it would be a transient risk in the fullness of time that there would be other people to manage the firm and we would promote and build a firm. So I think that has waged some. Some said, come back when you have a couple more investors involved in the group.

17:58The other major questions, one was around portfolio construction. So the portfolio construction that I've chosen for fund one is different than most other venture firms. And it's much more highly concentrated. Some very small number of LPs did not believe that was a good portfolio construction and they wanted a much broader index in order to hedge the risk. So some people opted out that didn't believe, one, we could get the ownerships that we were looking for that the model would work or they wanted to see some proof points associated with it. I think the last objection with the firm was really around fund size.

18:37So a lot of people said it's quite a lot of money for an individual person to raise on a single fund. And they just asked me why. And I think what they were trying to get at is venture capital as an asset class, the fund sizes have grown meaningfully. And so was this a first time fund that was a rocket booster in order to build a firm or was it sort of a short term money grab effectively, right? When you're a single person, it's very difficult to communicate authentically your ambitions around building a firm and the reason to have a particular fund size or a particular fee structure. And the more that I was able to show that I was recruiting people or that I had thought through the internal culture, the recruitment processes, who the core people were going to be, and sort of the long-term plans of the firm, the more that concern was dissuaged.

19:30You brought something up earlier around the concept of a venture firm has to have a business model. And one thing that a lot of us have heard is that your fund size is your business model. But maybe in the context of what you meant, what does it mean in your eyes when you say a venture firm has to have a business model? You have a certain number of investing slots within a fund. A venture firm needs to model what the failure rate is and what the multiples will be on the exits and what that ultimate multiple implies for the fund. And when I joined venture, I was really lucky to be attached to the hip of Jeff Yang.

20:08And Jeff had grown up in the venture industry, had a very particular view of the world. He was extremely sophisticated when it came to understanding the macro, which is something that we haven't had to understand in venture capital for a very long time because we've had a 12-year bull market. But now I think it matters. We've seen why. He had a very strong view around building a business model around a venture firm that inspired what we're doing in theory. But I think we haven't really done it, I think, as a business. And so one of the LPs, who's a close friend of mine, he sent me an Excel spreadsheet you know i asked him who have you seen that has done this well and he said it's very few but we have a spreadsheet that we fill out ourselves on diligence so when a firm comes in and they tell us they say we want this many seeds of of this much amount and we want this many a's they'll pop it in and then they've got some distribution for exits based on historical there you create a business model and you can say okay well i need one two billion dollar exit i need one one billion dollar exit and then everything else can return capital and i've achieve my target multiple.

21:14It's very much like a startup in that you're kind of putting an idea on paper. The reality may be quite different ultimately, but at least in your mind, you understand if I look at a business opportunity or an investment opportunity, it looks like this, is this within the model or is it without? You know, one of the companies I work with, the founder, she's incredible. She has this principle when she operates, which is she only, she wants 80 % of the bookings to be within the ideal customer profile. So 80 % of the business has to be our model. And I think about it very similarly with a venture firm, which is there's a financial product that we are structured to offer to founders that is right up the middle.

21:51And we want at least 80 to 90 % of the investments within the fund. Because if we do that, then we have the math on our side. We have the probabilities on our side. And there's fund math, which is irrefutable, right? So you have a$230 million fund. And if I'm just doing the rough back in the envelope math, to get to LPs typically would one is a 3x net or higher, which people throw that out. And I think people probably got a little bit spoiled over the last decade, decade and a half that this is easy. It's a really hard thing to get, particularly when you don't have companies that are reaching these billion dollar valuations.

22:26But at 230, let's say you have to have 800 million plus in liquidity flow back to fund, taking into account the carry, right? To get to 3x net to the limited partner. And the bigger the fund size, obviously, we have seen difficulty in getting to those top end returns. Smaller funds tend to have an easier path. How do you think about the 230 fund size in terms of optimizing, both in terms of, yes, you get the ownership that you need to really generate those returns, but also provide a financial product to the entrepreneurs that made sense in the arena that you wanted to play? If you look over the last 10 years, the biggest driving force in venture capital value creation has been multiple expansion, not revenue growth.

23:10So with the creation of 30 % more dollars, something like 60 to 70 % of the value that's created by venture capitalists has been multiple expansion. Historical forward multiples have been around five and a half times. Snowflake peaked in 21 at 57 times, right? So So you cannot, as a venture capitalist in this decade or the next 10 years, you cannot, I don't think you can predicate your business model on seeing additional multiple expansion anywhere near that scale. So if that's the case, then a business that's at 150 to 200 million of revenue is probably worth around one and a half to 2 billion.

23:4524 months ago, companies that were in single digit million ARR were valued at similar rates. With that fundamental change in the valuation environment, your business model has to reflect that. And so the idea behind theory was in order to be able to generate 3x net plus, we would need significant ownership in the companies that we back. And if we have significant ownership, then the total value of the exit does not have to be so great in order to drive the same multiple. And so we structured both the LP base and the portfolio construction to have that model. Obviously, with fewer companies, you do need to get the ownership to make sense.

24:23But how do you think about that from the context of the competitive landscape? Because the more ownership you're taking, the more likely you are competing with other firms. And we've seen so many firms, even some of the crossover firms go earlier and earlier and earlier, and even as early as seed sometimes, but certainly Series A. So when you're looking at, let's say, 10%, 15 % ownership at that Series A level, you're probably competing with some of the other big firms. How do you actually go about winning the type of deals that you want without having to pay a premium? Because if you pay a premium, that comes at the expense of ownership.

24:59The idea is we win with focus. And the reason we're called theory is because we really like to be thesis driven. So we'll spend a lot of time researching a particular space. and our goal is with that depth to understand the domain better sooner and if we can do that we can be half a step ahead the other part is with a relatively small fund the share of total venture capital exit dollars that we need to capture in order to generate a high multiple fund is small so there's a certain number of venture exit dollars each year and if you have and you know like a 50 billion dollar fund that doesn't exist but if you had a 50 billion dollar fund, you would probably need to have something like 30 to 50 % of all venture exit dollars in order to drive that kind of multiple.