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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Jason Lemkin, Khareem Sudlow
