The End of the ZIRP Era, and why recruiting is SO PAINFUL | E2164

Key Concepts

• Secondary Market: Buying and selling existing ownership stakes in private companies or venture funds.
• Fund of Funds (FOF): Investment fund that invests in other investment funds (venture capital funds in this case).
• GP (General Partner): Manager of a venture capital fund.
• LP (Limited Partner): Investor in a venture capital fund.
• DPI (Distributed to Paid-In Capital): A metric that measures the amount of capital returned to investors relative to the capital they invested.
• TVPI (Total Value to Paid-In Capital): A metric that measures the total value of a fund's investments relative to the capital invested.
• Preference Stack: The order in which investors are repaid in the event of a liquidation or sale of a company.
• Continuity Fund: A new fund created to hold the remaining assets of an older fund, often to provide liquidity to LPs.
• Rule of 40: A metric used to evaluate software companies, calculated as revenue growth rate plus profit margin.
• Default Alive: A state where a company's revenue covers its expenses, allowing it to survive without raising additional capital.
• SPV (Special Purpose Vehicle): A subsidiary created to isolate financial risk.
• AI-First: A strategy where artificial intelligence is prioritized and integrated into all aspects of a business.
• PLG (Product-Led Growth): A growth strategy where product usage drives customer acquisition, retention, and expansion.

Practical VC and Secondary Funds (Dave McClure)

• Focus: Practical VC focuses on secondary transactions, both at the company and fund level.
• Origin: Stemmed from Dave McClure's experience selling a piece of his carry in 500 Startups funds, finding the terms unfavorable to the seller.
• Target Transactions: Primarily sub $5 million LP secondary transactions and direct secondary in Series C or later stage companies with $50-$100 million in revenue.
• Investment Strategy: Avoids top 10-20 names due to high demand and premium pricing, seeking value in less sought-after companies at a discount. Aims to be the sole or one of the few buyers in most transactions.
• Fund-Level Transactions: Buys secondary from LPs, often a strip of the fund. GP transactions can involve single assets, fund strips, or carry pieces.

NVNG and Fund of Funds (Grady Buchanan)

• Investment Focus: NVNG invests in smaller, deeper tech, Midwest-driven funds, predominantly sub $200 million managers.
• Fund Size: Fund one is just north of $50 million.
• Secondary Transactions: Primarily sees secondary opportunities from newer fund managers, not existing portfolio.
• LP Base: Predominantly Wisconsin corporations.
• Investment Strategy: Focuses on institutional quality, trusting other LPs and conducting thorough diligence. Avoids overvalued AI application layers.

Emerging Trends and Extended Fund Lifecycles (Tomas Tonguz)

• Shift in Private Equity: The venture capital industry is mirroring trends in private equity, with an increasing number of private companies and longer holding periods.
• 15-Year Funds: Some funds are now structured with 15-year terms and potential extensions, requiring clear disclosure and expectation management with LPs.
• Continuity Funds: A strategy for managing older funds involves creating a new vehicle (continuity fund) to hold promising assets, offering LPs the option to roll over or receive liquidity.
• Valuation Challenges: VC marks are a significant issue, with many unicorns potentially overvalued.
• DPI Importance: Showing DPI (Distributed to Paid-In Capital) becomes crucial by fund three or four for fundraising.
• M&A Revival: Startups are increasingly buying startups, potentially driven by a desire to wrap up old funds.
• IPO Hurdles: Companies need substantial revenue ($400M+ trailing) to justify the costs and requirements of going public. Large asset managers need to deploy significant check sizes at IPO.
• Rule of 40: Many unicorns are not achieving high growth rates, indicating a backlog of companies needing resolution.

Managing Portfolio Companies and Providing Support

• Three-Bucket Evaluation: Dave McClure uses a three-bucket method: unicorns (IPO potential), centaurs (acquisition potential), and horses (unlikely to exit).
• Pod System: Jason Calacanis's fund uses "pods" of investment team members to manage portfolio companies, categorizing them into breakouts, figuring-it-out, and winding-down groups.
• High-Impact Support: Tomas Tonguz provides hands-on support, such as embedding sales leaders, to accelerate company growth.
• Voice of Reality: Fund managers need to be realistic with founders, especially those struggling, and help them consider alternative paths.
• Capital Efficiency: AI tools are enabling startups to achieve more with less capital, potentially changing term sheet expectations.

Secondary Market Dynamics and Liquidity

• Evolving Views on Secondaries: Attitudes towards secondary sales have shifted from being seen as disloyal to a necessary tool for managing portfolios and providing liquidity.
• GP-Led Secondaries: Selling positions to a continuity fund or SPV can push DPI into the primary fund and allow new investors to take on risk.
• Non-Traditional Liquidity: Grady Buchanan emphasizes the importance of demonstrating the ability to produce non-traditional liquidity.
• LP/GP Secondaries: Dave McClure notes that the secondary market is not yet 50/50 LP/GP, but there is a growing need for GP-led secondary transactions.
• Tiered Market: Dave McClure identifies three categories in the secondary market: top 10-20 names (overvalued), next 50-200 names (good companies at a discount), and 800 names (avoid at any price).

The Impact of AI and Capital Efficiency

• AI-Driven Efficiency: AI tools are making startups more efficient, potentially reducing the need for large teams and capital.
• Term Sheet Changes: The ability to generate substantial revenue and profit with less capital may lead to changes in term sheet expectations.
• Cash Flow Sharing: Investors may seek a share of cash flows, similar to private equity, especially in companies that choose to remain private.
• Go-to-Market Strategies: Tomas Tonguz differentiates between consumer/product-led growth (PLG) companies, where AI can significantly increase efficiency, and enterprise software companies, where human capital costs may remain high.
• Breadth of Offering: The breadth of integrations and features is becoming a key competitive differentiator, requiring significant R&D investment.

Notable Quotes

• Dave McClure: "I'm not going to make my equity investors whole, but I might be able to make my debt investors money."
• Jason Calacanis: "Winners keep winning, losers keep losing, and tweeners keep tweening."
• Tomas Tonguz: "You play the way that you practice and you always want the practice to be harder."
• Dave McClure: "Growth at all costs became profitability at all costs."

Conclusion

The venture capital landscape is undergoing significant changes, driven by factors such as extended fund lifecycles, the rise of the secondary market, and the impact of AI. Fund managers need to adapt their strategies to address these challenges, including actively managing portfolios, providing liquidity to LPs, and embracing new technologies. The ability to generate DPI, demonstrate non-traditional liquidity, and navigate the complexities of the secondary market are becoming increasingly important for success. Startups, in turn, are becoming more capital-efficient thanks to AI, potentially altering the dynamics of fundraising and investor expectations. The conversation highlights the need for a more nuanced and proactive approach to venture capital investing in the years to come.