Ok the title here is a bit dramatic, but certainly seed investing is in an odd place in 2024.  Public valuations are still at a fraction of their 2021 peaks, but seed rounds are more expensive than ever.

Is it sustainable?

Harry and Jason did a deep dive on this and so much more here:

Intro (00:00:00)

  • Seed investing is broken due to limited founders capable of triple-digit growth.
  • The best investments grow from $1 million to $10 million in 5 quarters or less.
  • To IPO, companies need to triple their market share in their core market and have a churn rate of less than 3-4% per month.
  • The market is flooded with capital, leading to higher valuations and unrealistic expectations.
  • Founders are raising larger seed rounds, which can be detrimental to their companies.
  • High valuations make it difficult for companies to achieve profitability.
  • The current funding environment is unsustainable and will eventually lead to a correction.
  • There is more capital available to startups than ever before.
  • This is due to several factors, including low-interest rates, the rise of venture capital, and the increasing popularity of angel investing.
  • The influx of capital has made it easier for startups to raise money, but it has also led to higher valuations and more competition.

The Science & Art of Successful Deals (00:01:27)

  • Jason Lemkin discusses his best deals by cash and by NAV.
  • His best deals by cash are:
  • Sales Loft: $2.5 billion cash, $100 million ARR.
  • Pipe Drive: $1.5 billion cash.
  • Harry’s: $300 million cash.
  • His best deals by NAV are different from his best deals by cash.
  • He didn’t predict that Sales Loft, Pipe Drive, and Harry’s would be his top three cash returners.
  • He learned that even though VCs say you have to go long, you don’t always know how companies will perform later in life.
  • He also learned that some founders just can’t lose, like Kyle from Sales Loft.
  • He was surprised that both Sales Loft and Outreach were able to survive and win significant market share.
  • Jason Lemkin discusses why pricing is worse than ever for startups.
  • He says that there are three main reasons for this:
  • The cost of customer acquisition has gone up.
  • The competition is more intense.
  • Customers are more demanding.
  • He also says that there is more funding available for startups than ever before.
  • This is because:
  • There are more venture capital firms.
  • Venture capitalists are investing more money.
  • Startups are staying private longer.
  • The combination of these factors is making it more difficult for startups to succeed.

Lessons from the Best & Worst Deals (00:05:03)

  • To succeed in today’s rapidly changing business landscape, startups need an ultra-committed binary team, especially two co-founders with an insane level of commitment.
  • Investors should immediately engage with the CTO to assess their technical capabilities and potential, as great CTOs can demonstrate their exceptional skills quickly.
  • The best way to understand a product is to ask the CTO about their favorite features and frustrations, as great CTOs are hyper-transparent and will openly discuss their challenges.
  • In the early stages, the CEO is often better than the CTO, but a 10x feature can help a startup succeed up to a million or two million in revenue before the competition catches up.
  • In today’s venture capital landscape, seed funds face significant dilution, potentially reducing their share of a company’s value from 12% to 6% by the time of an IPO, but venture funds can still be profitable with multiple billion-dollar exits.
  • When evaluating early-stage startups, it’s crucial to assess the CTO and CEO, rather than the entire management team, as companies with 10 or fewer employees may not have a fully developed management structure.

The Qualities of Great CTOs (00:15:54)

  • To identify great CTOs, it may take interviewing 20 candidates.
  • Look for candidates who can demonstrate their work and explain their thought process.
  • Ask open-ended questions and pay attention to their answers.
  • Observe their passion and excitement for their work.
  • Don’t lower your standards when interviewing for a functional area you’re not familiar with.
  • The best CTOs have built great software, even at early stages.
  • Look for signs of “crappiness” or shortcuts in their work.
  • Slow or buggy software at a million in revenue is unlikely to improve as the company grows.

Investing in Competitive Markets (00:19:28)

  • Jason Lemkin believes that passing on great founders and CEOs solely because they’re in a competitive space can lead to missing out on significant deals.
  • He emphasizes the importance of hyper-agile teams with exceptional engineering and product capabilities, as they can pull away from competitors over time.
  • Lemkin cautions against investing in startups that compete with established players without the potential for exponential growth and innovation.
  • The timing of investments and founder departures can significantly impact a company’s success, with founder departures leading to decreased agility and innovation.
  • Lemkin expresses skepticism about private equity firms’ ability to make money on certain investments due to cannibalization and decay rates.
  • Timing is crucial for exits, as seen with Slack’s sale at $27 billion with $1 billion in revenue, potentially being worth $12 billion at $2 billion in revenue today.
  • Distribution is key to success, as seen with HubSpot’s Pipe Drive competitor reaching $700 million quickly due to effective distribution.
  • Founder-led companies should be wary of expanding into different categories, as it may not always be successful.

Founder-Led Companies & Product Expansion (00:31:13)

  • Founders often want to expand product lines and move away from core focus, but investors usually advise against it and emphasize the importance of nailing the core market first.
  • The right time to expand product depends on the specific situation, but a good rule of thumb is to start considering expansion when the company reaches 10% market share in its core market.
  • At 10% market share, growth starts to slow down, and it’s important to have a second act or plan in place to maintain growth.
  • The second act doesn’t always have to be a second product; it could also involve expanding the target market, going more enterprise, or entering a new country.
  • Many investors create narratives in their minds to simplify investments and may not listen carefully to the founders’ vision for the company.
  • It’s important to listen to the founders’ goals and understand their specific aspirations for the company before making investment decisions.

Investing Mistakes (00:34:43)

  • Jason Lemkin discusses two significant investment losses: a company sold for $100 million during the lockdown but could have sold for much more and another where he lost $5 million due to a dishonest CEO and poor hiring decisions.
  • Thorough due diligence is crucial, especially for follow-on checks, as investors often overlook details beyond the top line during these checks.
  • Founders should be transparent about their company’s financials to maintain credibility with investors.
  • Manipulated metrics and fraudulent practices can cause long-term problems for companies and investors.
  • Customer references should be used to confirm an investor’s positive impression of a company, not to change their mind about an investment.
  • The best investments still grow from $1 million to $10 million in revenue in 5 quarters or less.
  • To IPO, a company needs to triple, triple, double, double its revenue.
  • Despite founders’ complaints, the IPO markets only care about efficient revenue trajectory, not past fundraising rounds.
  • Insiders are flooding fast-growing startups with capital, which can be negative as it leads to less work and a different bar for success.
  • Companies are getting overfunded at inflated valuations by insiders, resulting in unrealistic market caps.
  • Some companies use structured or flat rounds to conceal financial struggles.
  • Zombie public companies with low growth and unexciting roadmaps are potential targets for private equity firms due to their high operating margins and potential as cash engines.
  • The current funding environment is challenging, with pricing becoming more difficult, but there’s still potential for good deals if market conditions improve.
  • Examples like HubSpot and LinkedIn show the importance of making the right bets and capitalizing on market upturns.
  • Churn rate is a key metric, and understanding acceptable levels in different market conditions is crucial.

Acceptable Churn Rates for SMB & Enterprise Companies (00:52:28)

  • A net retention rate (NRR) below 110% at $1 million in revenue indicates a fundamental problem for Enterprise companies.
  • A monthly churn rate of 3-4% is common for small businesses (SMB) due to factors like credit card expirations and business changes.
  • True Software-as-a-Service (SaaS) companies should aim for 100% NRR, even if it means tolerating a 3-4% monthly churn rate for a few years in the SMB segment.

  • Highly volatile churn rates pose a significant risk and make it challenging to make accurate projections.
  • The last-four-months (L4M) model provides valuable insights and predictive power for startups and investors by averaging key metrics like growth and churn.
  • Pricing is more challenging than ever, and venture capital funding is more readily available.
  • The traditional sales-led model is unsustainable for SMBs with a high churn rate.
  • Venture capital can obscure churn by providing capital, making it harder to identify unsustainable businesses.
  • SMB software has a lower margin for error compared to enterprise software and needs to be self-serve and product-led to succeed.

Assessing Burn Rates & Revenue Projections (00:59:00)

  • Burn rate is a crucial metric in assessing a company’s financial health, especially if revenue is insufficient to sustain growth.
  • The burn ratio, popularized by David Sacks, is useful but has limitations, as companies with lower margins or longer customer acquisition periods may require a higher ratio.
  • Putting Enterprise or mid-market people into SMB models can be a mistake due to differences in skill sets, hiring practices, marketing strategies, and customer metrics.
  • Founders should be ambitious with revenue projections, but investors should challenge modest projections.
  • Distinguishing between experimental and sustainable budgets in the AI sector can be challenging, and investing in rapidly growing areas without overanalyzing is acceptable.
  • Very high burn rates can be risky, especially without sufficient revenue to sustain growth.
  • The current funding landscape involves massive burn rates and high valuations, making it difficult to assess startups’ true potential.
  • Low ownership stakes due to high valuations and small fund sizes pose challenges for VCs in securing meaningful returns.
  • YC’s batch funding model prioritizes quick funding for most startups rather than focusing on individual deals or accommodating specific VC fund structures.
  • RevenueCat’s initial misunderstanding by investors led to a riskier investment, but its strong founder commitment and market dominance make it promising.
  • Backing founders with a long-term vision and deep industry knowledge is crucial for successful investments.
  • Poor decisions by founders, such as firing the entire sales and marketing team, can lead to investment losses.
  • Pursuing seemingly good deals may not always result in great investments.
  • End-of-fund investments should be treated similarly to start-of-fund investments, and extra investments may not always yield significant returns.
  • Recycling capital from successful exits early in the fund’s lifecycle can significantly impact overall performance.
  • The speaker aims to invest more rapidly in the future to avoid missing out on opportunities.
  • While existing investments are expected to achieve goals, the speaker plans to invest in two more funds to increase successful investments.

Quick-Fire Round (01:13:04)

  • Klaviyo, an undervalued SasS company, has achieved remarkable success and is poised to surpass major competitors in terms of revenue despite recent price increases.
  • The success of Klaviyo has led to an overvaluation of many other SAS companies in the venture market, creating a market where almost everything is undervalued.
  • Companies like Atlassian and Anaplan are facing challenges and uncertainties, raising questions about their long-term prospects and ability to sustain growth in the teens to reach the rule of 40.
  • Upstart companies with consistent growth and reasonable margins can yield significant returns over time, despite criticism.
  • Finding a few LPs who genuinely believe in your investment strategy and delivering results consistently can lead to a supportive and beneficial relationship.
  • The venture capital landscape is changing, with some successful managers becoming less active or leaving the industry, making it challenging for LPs to identify consistently high-performing funds.
  • It’s essential to look beyond past performance and carefully evaluate the current state and trajectory of venture funds before making investment decisions.
  • Venture capitalists are increasingly getting smaller ownership stakes in startups, which makes it harder to return the fund.
  • Some venture capitalists, like the partners at Emergence, have been able to sustain their success by holding onto their investments for a long time.

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