20VC NEW FORMAT Mega Funds Will Come Back, Why Markups Have Corrupted VC, Why RIFs Should Always Be An Embarrassment To SaaS Founders and Why Pitching is BS and Fake with Jason Lemkin and Rick Zullo

In a dynamic conversation, Jason Lemkin, Rick Zulo, and host Harry Stebbings dissect the future of venture capital, focusing on the anticipated resurgence of mega funds in 2024-2025 and the evolution of unicorn investing. Lemkin predicts a rebound in large fund investments despite current fundraising challenges, emphasizing the significance of $10 billion outcomes to sustain big funds. The trio also debates the efficiency of SaaS companies, with Lemkin asserting that good CEOs should avoid layoffs through strategic financial management. Zulo suggests the venture industry may shift towards an asset management model, with specialized strategies for different funds. Additionally, the discussion touches on the risks of overfunding and the importance of founders maintaining control over cash flow, as well as the potential impact of AI investment trends in the coming years.

• Predictions about the resurgence of mega funds in late 2024 and 2025.
• Observations on the current difficulties of raising a fund and LPs cutting back.
• The belief that these challenges are temporary and that when times improve, money will flow back into mega funds.
• Discussion on two methods of building a unicorn: stair-stepping or swinging for the fences.
• The importance of confidence in valuation growth for the next funding round.

"I think there will be a resurgence of mega funds in late 2024 and 2025. There's so many stories of how hard it is to raise a fund and how LPs are cutting back. It doesn't last. It can't last. Right? When times are good, money will reflow into this."

The quote explains the speaker's belief that despite current challenges in raising funds and LPs cutting back, the situation is not permanent, and investment will eventually pick up as economic conditions improve.

• The evolution of unicorn investing expectations from targeting billion-dollar outcomes to aiming for $10 billion outcomes.
• The impact of achieving a $10 billion outcome on the sustainability of large funds.
• A billion-dollar outcome's insignificance in the context of a billion-dollar fund.
• The challenge for early-stage funds to predict which startups will reach decacorn versus unicorn status.

"We were chatting before about things I learned when I started investing I didn't get. But when I started investing, I remember one of my LPs Limited Partners came back and this is probably nine years ago from Founders Fund LP meeting, right? And this is a decade ago. And they came back and they told their LPs, who were stunned, that they're aiming for at least 100 billion dollar outcome per fund."

The quote reflects the speaker's past experience learning about the ambitious goals set by a prominent venture capital fund, highlighting the shift in expectations for investment returns over time.

• The potential transformation of venture capital into a more traditional asset management business.
• The emergence of core funds and splinter strategies within large VC firms.
• The need for rational math to return funds that fit specific strategies.

"I think one thing that we could see is the maturation of this truly going from venture capital to an asset management business."

The quote suggests that the venture capital industry may evolve to resemble traditional asset management firms, with diversified strategies and professional management.

• The recurring issue of startups running out of money and the responsibility of founders to prevent this.
• Criticism of founders who fail to manage their finances and run out of money.
• The importance of planning and managing growth sustainably.

"Your job as a founder, if you got 8 million instead of 2 million, is not to spend it all. Why are they spending it all? As a founder, your job is not to run out of money."

The quote emphasizes the responsibility of founders to manage their finances wisely, especially when they have received more funding than anticipated, and to avoid running out of money.

• The shared blame between VCs and founders for startups running out of money.
• The need for founders to anticipate business declines and adjust accordingly.
• The expectation that founders should be proactive and not rely on investors to prevent financial mismanagement.

"We did. And I blame the VCs at least as much as the founders. Right. 51%, 49. But the founders, it's your life. I don't get why they drive the car off the cliff."

The quote assigns responsibility to both VCs and founders for the financial missteps that lead startups to run out of money, with a slight majority of the blame placed on VCs.

• The debate over the necessity and impact of layoffs (RIFs) in startups.
• The view that good SaaS CEOs should never need to conduct layoffs due to the nature of recurring revenue.
• The acknowledgment that investors have a larger dataset and should provide guidance to founders on best practices.

"If you're a great SaaS CEO, you should never have a riff. It's called recurring revenue."

The quote argues that SaaS companies with recurring revenue should not need to resort to layoffs, and that doing so is a failure on the part of the CEO.

• The need for honest and direct communication between investors and founders.
• The challenge of providing constructive criticism without damaging the relationship.
• The potential for a more productive relationship if investors can offer critical feedback based on broader industry insights.

"The reality is people are paying a lot for that right now."

The quote acknowledges the consequences of the recent trend where investors and founders did not maintain an open and honest dialogue, leading to poor decision-making and costly outcomes.

• The conversation starts with a discussion on investor influence and control in startups, specifically in the context of high burn rates and the changing dynamics of board meetings.
• Jason Lemkin shares a personal story to illustrate the disconnect between investors and the operational realities of startups.
• Rick Zulo points out that the influence of board members has decreased over the years, and that founders' willingness to engage and board votes are key factors in determining investor say.
• Lemkin emphasizes that despite legal and contractual rights, the practical influence of investors is diminishing, except perhaps when a company is close to running out of cash.
• Harry Stebbings raises the point about the potential increase in bridge rounds for companies that are not performing exceptionally well or are not in vogue.
• Zulo agrees with Stebbings, suggesting that there will be more business closures than down rounds or bridge rounds, and that mega funds have less incentive to engage in tough conversations with struggling companies.

"The cap table can only add up to 100%. You sell slots, right? So let's imagine you've sold half your company in two and a half rounds, right? Does that mean the VCs get 50% say in how you run the company?"

This quote highlights the issue of investor control relative to their share of the company's equity, questioning the actual influence they have on operations.

"For better or worse, if a board controls a company, the founder is probably going to have to listen a little bit more than if the board does not control the company."

Zulo is emphasizing the impact of board control on a founder's decision-making process, suggesting that founders are more likely to heed the board's advice if the board has significant control.

"I just don't see the world working that way today anymore. I think they may listen more to the board members the week before they run out of cash, but I don't see that awareness of that dynamic."

Lemkin expresses skepticism about the practical influence of VCs and boards on startups, especially when the companies are not in immediate financial distress.

• The discussion shifts to the market's impact on startups, particularly how the high burn rates of 2021 are no longer sustainable in the current economic climate.
• Lemkin discusses the need for startups to become efficient, citing examples from SaaS companies that have successfully improved their profitability in a short time.
• Rick Zulo stresses the importance of financial acumen and business model quality over chasing revenue multiples, suggesting a return to fundamentals in investing.
• Harry Stebbings expresses concern for founders who have made their companies leaner and more efficient but are now facing slowed growth.
• Lemkin believes that the market has given founders a temporary pass on growth expectations, but warns that this leniency is ending and that sustained growth or a pivot is necessary.

"And it's been a year and no one wants to talk about the issues."

Lemkin points out the reluctance within the startup ecosystem to address the unsustainable burn rates leftover from 2021.

"I think founders should pay attention. I think founders are out of the loop. What's happened in the public markets, and founders are out of the loop about efficiency."

Lemkin advises founders to be aware of market trends towards efficiency and profitability, implying that ignorance of these trends could be detrimental.

"I feel sorry for founders, though, because I have many in the portfolio who have absolutely learned those lessons."

Stebbings empathizes with founders who have adjusted their businesses to be more efficient, yet are struggling with reduced growth.

• The conversation concludes with a discussion on the valuation of startups and the impact on venture capital funds and their limited partners (LPs).
• Lemkin and Zulo discuss the challenges of assessing the value of venture portfolios in a fluctuating market, with Lemkin suggesting a discount on valuations above certain revenue multiples.
• Stebbings questions the accuracy of current valuations, pointing out that many companies are priced too high relative to their revenue.
• Lemkin and Stebbings debate the appropriateness of markdowns in valuations, with Lemkin advocating for adjustments based on market conditions and Stebbings expressing concern about the severity of such markdowns.

"I have two thoughts, and I'll tell you what I've done myself. Right. Once the market turned right, first, I basically decided anything north of 15 x ARR had a suspect valuation."

Lemkin shares his approach to evaluating startup valuations, setting a threshold for suspect valuations based on revenue multiples.

"If you were advising an LP today on how much they should discount the value of their books, what would you tell them?"

Stebbings is asking for advice on how LPs should adjust their expectations of portfolio value in the current market.

"The market goes up and down, too. Why shouldn't our funds go up and down?"

Lemkin argues that fluctuations in fund valuations are natural and should reflect market dynamics, similar to other financial markets.

• Mark to market has led to corrupted behavior in venture capital.
• It incentivizes overfunding companies during favorable market conditions.
• LPs (Limited Partners) at larger institutions are also compensated based on paper markups, driving a cycle of inflated valuations.
• The desire for high IRR (Internal Rate of Return) and successful funds can lead to too many funding rounds at excessive valuations.

"It's created an incentive to overfund companies when times are good." This quote explains the negative impact of mark to market on funding behavior, leading to potential overfunding when the market is thriving.

"Even less discussed is that a lot of lps at the bigger lps, they're compensated based on paper markups, too." This quote reveals a lesser-known fact that LP compensation can be tied to paper markups, contributing to a cycle of increased valuations and funding.

"Everyone wants it. Everyone says they don't. I think is lying." The quote reflects the widespread but often unacknowledged desire for high-return funds and successful investment outcomes in the venture capital industry.

• LPs desire high-return funds but also value trust in their investment managers.
• Emerging managers feel pressured to demonstrate a strong portfolio through markups.
• Trust between LPs and fund managers is crucial, especially for smaller funds where relationships are more personal and less transactional.
• The dynamics between LPs and GPs (General Partners) are complex, with concerns about overstating involvement or achievements.

"LPs Trust. When you're big, it's different, but most funds that aren't huge have a few core anchors, and typically those relationships are trust driven." This quote emphasizes the importance of trust in the relationships between LPs and smaller funds, where personal connections are more significant.

"It's a complicated relationship, and I'll tell you my learning." The quote acknowledges the intricate nature of the LP-GP relationship, highlighting the various factors that can influence investment decisions and partnerships.

• There has been an increased focus on salesmanship in the venture capital ecosystem.
• The ability to pitch effectively is important, but it can overshadow the actual substance of a company or fund.
• Founders and fund managers should focus on substance and understanding the business rather than just perfecting their pitch.
• Salesmanship is necessary, especially in B2B, but it should not come at the expense of building a solid company or fund.

"I think if we all did 10% less sales and actually 10% more substance, everyone would be a lot better off." This quote suggests that the venture capital industry would benefit from a shift in focus from salesmanship to the actual substance of business operations and investment strategies.

"You have to pitch, and you have to be fucking good at pitching, because you have to sell customers, you have to sell investors, and you have to sell employees." The quote acknowledges that despite the need for substance, pitching skills are essential for founders to attract customers, investors, and employees.

• Pitching is an art form that has been embraced in Silicon Valley, but it can lead to an overemphasis on fundraising skills rather than business-building skills.
• The ability to raise money at the seed stage does not always correlate with the ability to build a successful business.
• Fund managers and founders should be able to articulate their vision and challenges clearly, demonstrating strategic thinking and self-awareness.

"I review your deck. I actually know the four or five key questions to get me to conviction." This quote from a fund manager describes a focus on understanding the core aspects of a business rather than being swayed by a polished pitch.

"The question is, do you want to put in the energy to cut them the slack?" The speaker is questioning whether investors are willing to invest time and energy into understanding founders and businesses that may not present well initially but have potential.

• Investors often underestimate the potential size of successful companies.
• A focus on identifying companies with "decacorn potential" or exceptional founders can lead to missing out on great investments.
• The venture capital industry relies on identifying and investing in companies with the potential for significant returns, but this process is not always straightforward.

"Does this have the chance to be such a fu big outcome that it's going to completely return our fun 510 times?" The quote highlights the high-return expectations that fund managers have when evaluating potential investments.

"We all underestimated the size of the outcome." This quote acknowledges a common experience among investors where the eventual success of a company far exceeds initial expectations.

• Venture capitalists (VCs) often gauge potential investments based on future valuation multiples.
• An initial investment strategy may focus on whether a company can achieve a 3x return in the next funding round.
• Valuation sensitivity is crucial, particularly during market peaks when discipline may wane.
• "Stairstepping" is a method of incrementally increasing valuations and is contrasted with "swinging for the fences" from the start.
• Founders are encouraged to be confident in tripling the value before raising funds.

"But I was confident for a variety of reasons they would be worth three x the price."

This quote reflects the speaker's past investment strategy, which was based on a confidence in achieving at least a 3x return on investment.

"I've done better stairstepping than whiteboarding."

The speaker suggests that a methodical, step-by-step approach to investment has yielded better results than starting with high ambitions.

• Identifying massive companies at the seed stage is difficult, and European seed stage VCs face significant challenges.
• The pressure to find unicorns can lead to irrational paths and wasted money.
• Venture capital has inherent risks, including the possibility of focusing too much on potential decacorns (companies valued over $10 billion).

"The scary thing about venture is when you really cut yourself off, that if you're a european seed stage vc, and the only way you can win is if you have Spotify, that is a really, really tough position to be in."

This quote highlights the difficulty for European seed stage VCs who may feel the need to discover a company as successful as Spotify to achieve significant returns.

• There are two approaches to building unicorns: stairstepping and swinging for the fences.
• Stairstepping requires more valuation discipline and may lead to more consistent outcomes.
• Founders should consider the certainty of achieving a 3x return before accepting investment.
• Even if every investment does not result in a unicorn, achieving consistent 3x returns can be sufficient for the success of the fund and stakeholders.

"And so stairstep your life. And I do think you can build unicorns and large funds stairstepping."

The speaker advocates for a gradual approach to building companies and funds, emphasizing the potential to achieve significant outcomes through consistent growth.

• Seed deals are expensive, and Series A valuations have decreased, which may lead to adverse selection.
• Investing in European founders was initially seen as adverse selection but led to successful investments.
• Adverse selection can be a narrow focus on a specific type of founder or company, potentially missing out on undiscovered gems.

"When I started investing in european founders, some folks I invested in said, don't even tell the lps that you're doing that because it shows you can't get any Americans to invest."

This quote reveals a bias that existed against European founders and how the speaker overcame it to make successful investments.

• Early-stage VCs must focus on getting enough high-quality opportunities and supporting companies to scale.
• It's essential to manage the portfolio effectively, aiming for multiple returns on some investments, even if they don't become decacorns.
• Sequoia's playbook may not be suitable for all VCs, and each should strive to execute their unique strategy.

"But you got to also be really draconian with the portfolio and say, okay, can I get a couple of turns on my fund on some of these other ones that aren't going to ascend to a decacore type outcome, but you've kept it alive and got enough ownership and done the hard things."

This quote emphasizes the need for rigorous portfolio management to ensure returns even from companies that do not reach decacorn status.

• The most common reason companies fail to scale from seed to success is having good but not great growth.
• Sustaining high growth rates is crucial for staying on the venture track.
• The difference between good and great growth is subtle but significant for venture success.

"The line between good and great is subtle, but it's painful. But it's so real."

This quote underscores the fine line between growth rates that keep a company on track for venture success and those that do not.

• Being overly thesis-driven can lead to missing out on great investment opportunities.
• Personal connections with founders and flexibility in investment theses can be valuable.
• Learning from investment mistakes involves being more open to opportunities outside of one's strict investment criteria.

"Honestly, I'm incredibly thesis driven and I've missed a lot of amazing companies because that around investing in the guys from veterinary and then they started a public company in our office and we didn't invest."

The speaker reflects on a missed opportunity due to a strict adherence to an investment thesis, suggesting a need for more openness.

• There is debate about the future of venture capital spending, especially in AI.
• Some believe AI investment will double, while others expect a decrease due to fatigue.
• The trend of thematic investing and the need for big money to find opportunities suggest continued investment in AI.

"Everyone's a thematic investor and I think this has just started and I think big money needs somewhere to go."

This quote suggests that thematic investing trends, like AI, will continue to attract significant investment due to the need for large funds to deploy capital.