20VC Why Valuation Is A Stupid Concept, VC Is Ripe For Disruption & Not All LPs Are Made Equal with Michael Skok, Founding Partner @ Underscore VC

In this episode of the 20 minutes VC, host Harry Stebbings interviews Michael Scott, founding partner at Underscore VC, discussing his transition from a software entrepreneur to a venture investor, his teaching experience at Harvard, and the inception of Startup Secrets. Michael shares insights from his listening tour with entrepreneurs, emphasizing that capital is a commodity, but entrepreneurs' time is invaluable. He highlights the importance of talent and community in building a company and underscores the need for alignment between entrepreneurs, VCs, and LPs. Michael explains Underscore VC's disruptive model, which involves sharing carried interest with their community of Core members who contribute to portfolio companies. The conversation also touches on the firm's approach to early-stage investing, portfolio construction, and long-term support for entrepreneurs, aiming to transform the traditional VC model into a more transparent and collaborative partnership.

• Michael Scott is a founding partner at Underscore VC.
• Before founding Underscore VC, Michael started his first software business as a teenager.
• He has 21 years of entrepreneurial experience, founding teams and attracting over $100 million in private equity.
• Michael transitioned to venture investing for over 14 years.
• He mentored and taught at Harvard Business School as an EiR (Entrepreneur in Residence) for four years.
• Michael conducted a year-long listening tour interviewing entrepreneurs.
• He created the Startup Secrets educational series in collaboration with Harvard i-lab.

Now Michael is a founding partner at Underscore VC. But prior to underscore, Michael started his first software business as a teenager. He then spent 21 years as an entrepreneur where he founded and recruited teams that attracted over a hundred million dollars in private equity for investments in multiple software companies.

This quote provides a background on Michael Scott's extensive experience as an entrepreneur and his transition to venture capital, illustrating his depth of knowledge in the field.

• Michael believes in the importance of developing listening skills.
• The listening tour aimed to understand what entrepreneurs seek from their journey and from venture capitalists.
• Key insights from the listening tour:
  • Capital is a commodity, but entrepreneurs' lives are not.
  • Time is the scarcest resource for entrepreneurs.
  • Talent is the most valuable asset in business.
  • Building a great company requires a community over many years.
  • There's a lack of alignment between entrepreneurs, VCs, and their LPs.

And I heard a few very basic things, the headline of which is that capital is clearly a commodity and entrepreneurs lives clearly aren't.

This quote highlights a fundamental insight from Michael's listening tour: while capital is essential, it is the entrepreneurs' unique commitment and time investment that are truly invaluable.

• Alignment is crucial for the relationship between founders and venture capitalists.
• Traditional VC models are seen as outdated and ripe for disruption.
• Underscore VC aims to create a community accessible to entrepreneurs at every stage.
• Different stages of business development require different skills and expertise.
• Traditional VC models often fail to reward community members who contribute to a business's success.

And it turns out there was one other very big theme that needed to be addressed, and that's alignment. There isn't good alignment, whether people like it or not, between the entrepreneur, their VC and the VC and their GPS, sorry. And their lps in many instances.

This quote emphasizes the issue of misalignment in traditional VC models and the need for better alignment between entrepreneurs and their financial backers.

• Underscore VC disrupts the traditional VC model to address changes in the industry.
• The firm focuses on building a community to support entrepreneurs throughout the business lifecycle.
• Different stages of business growth require different community members with relevant skills.
• Underscore VC has a unique compensation model for community members who contribute time or investment to businesses.
• Community members, known as "Cores," can earn carry from the fund similar to partners.
• Cores receive the same investment terms as Underscore VC and are rewarded on a company-by-company basis.

We said, look, first of all, we're going to take a chunk of our carry and we're going to make it accessible to what we call our community, which is the cause.

This quote describes Underscore VC's approach to creating alignment by sharing the fund's carry with community members who actively contribute to the success of portfolio companies, thereby incentivizing their involvement and aligning interests.## Venture Capital Fund Structure and Incentivization

• The venture capital fund model discussed allows for new core members to join at each funding series.
• Entrepreneurs have the option to choose who these new members will be.
• This model is designed to be mutually beneficial and allows for long-term partnerships over many years.
• The fund is structured to reward contributions throughout the investment period.

Then at each stage, each time we write a check, for example, at every series, there's a new opportunity for new core members to contribute and for the entrepreneur to choose who those are.

This quote explains the flexibility of the fund structure, which allows for new contributors to join and be chosen by the entrepreneur at each funding round, enabling the adaptation of the team as the company evolves.

• Introducing innovative fund models to Limited Partners (LPs) can be challenging and may lead to a selective group of investors.
• Establishing the model required significant legal work and a new approach to financial modeling.
• The fund sought LPs who were innovators and aligned with the fund's vision, leading to a filter that weeded out traditionalist investors.
• The fund was oversubscribed, indicating strong interest from selected LPs who understood the model's potential benefits.

That's a great question, Harry. It's so funny. We have ended up with a very select group of lps because a lot of lps just said, no way, not going to do that.

Michael Scott highlights the selectivity in LP recruitment, where traditional LPs were skeptical of the new model, leading to a group of LPs that were more innovative and aligned with the fund's approach.

• The fund's LPs include educational institutions, children's hospitals, and foundations, chosen for their innovative mindset and societal impact.
• The fund's General Partners (GPs) personally invested significantly more capital than traditional models, demonstrating commitment to the fund's success.
• LPs were selected for their potential to co-invest, support the fund's agenda, and make a difference in the world.
• The fund emphasizes the importance of long-term relationships with LPs, preferring entities with the patience for decade-long investments.

So we not only selected them for their innovation, we also selected them from their causes.

Michael Scott explains that LPs were selected not only for their willingness to embrace an innovative model but also for their philanthropic and societal contributions, aligning financial objectives with broader impacts.

• Not all LPs are seen as potential contributors to portfolio company strategy, as they usually trust the fund managers' expertise.
• Some LPs, however, have mandates to co-invest and can provide significant follow-on capital for portfolio companies.
• The fund carefully selects LPs that can offer strategic value, whether through co-investment, support, or alignment with social causes.
• The fund aims to build a diverse LP base that can support portfolio companies in various ways, ensuring a robust backing for long-term success.

I don't think many of them think that way, because most of them obviously look at us as the professional portfolio managers and say, look, the reason we're giving you money is because we don't have time to do that.

Michael Scott notes that most LPs do not actively engage in portfolio strategy, instead relying on the expertise of the fund managers, but some LPs are chosen specifically for their ability to provide strategic value through co-investment or other means.

• The fund focuses on early-stage companies, providing support when entrepreneurs are tackling challenging problems.
• Entrepreneurs often struggle to find support at the idea stage, and the fund aims to fill this gap by taking risks alongside them.
• The fund uses "vector funding" to commit to an entrepreneur's journey from seed to Series A, providing clarity and confidence in the available capital.
• This approach has led to significant early successes for portfolio companies, as they can focus on growth without worrying about immediate fundraising.

We want to be there when the entrepreneur is first thinking through those challenging problem sets and needs somebody who understands how to do this, who's done it before and is willing to take the risk with them.

Michael Scott emphasizes the fund's commitment to supporting entrepreneurs from the earliest stages, recognizing the need for experienced investors who are willing to take risks on big ideas that require substantial time and capital to develop.## Long-Term Investment Mindset

• Michael Scott emphasizes the importance of thinking long-term when funding startups, advocating for a "vector funding" approach.
• The vector funding strategy involves considering the entire trajectory of a business, from ideation to various funding rounds.
• Michael teaches a course that includes this concept and has additional resources on startupsecrets.com.

"What I love about Jeff's thinking is it's really a ten year game. So actually, how I think about it is even longer than that."

This quote underlines the idea that successful venture capital investment requires a long-term perspective, often spanning a decade or more.

"We think about the entire vector of building a business...you can at least create the vector and start to look at all the milestones it's going to take to fund them."

Michael's quote explains the concept of "vector funding," which is a holistic approach to funding that considers the full development process of a startup.

• Michael introduces the concept of a "minimum viable segment" (MVS) as a crucial step beyond creating a minimum viable product (MVP).
• MVS focuses on identifying a specific market segment that a startup can dominate based on unique customer needs.
• Timeframes to achieve MVS can vary widely, from 6 to 18 months, depending on product complexity and market.

"You actually need to break it down. Another step into what I call a minimum viable segment, and you have to pick off your first segment that you can really dominate uniquely well, where customers have the same set of needs."

Michael discusses the importance of focusing on a specific market segment where the startup can excel, which is a strategic move to gain a strong market foothold.

• Michael uses the "black and white framework" to analyze market needs, with the acronym BLACK standing for blatant, latent, aspirational, and critical.
• The framework helps to identify where a product fits within the market, ranging from latent aspirational needs to blatant critical ones.
• Understanding the market position helps in assessing the potential for market creation and guiding product development.

"So if you think of a two by two, where at the bottom left is latent and aspirational needs... At the top right is blatant and critical."

Michael's quote describes his framework for categorizing market needs and assessing the potential for market creation based on these categories.

• Michael criticizes the concept of valuation at early stages, focusing instead on partnership with entrepreneurs.
• The key is to ensure founders and talent have enough ownership, with valuation being a secondary consideration that emerges from funding strategies.
• Michael anticipates a shift away from transactional relationships towards more partnership-based venture capital.

"Valuation is just a stunningly stupid concept. Who on earth can value a person?"

This quote highlights Michael's belief that early-stage valuation is not a precise science and should not be the primary focus in venture capital.

"What you've got to do is as an entrepreneur, form a partnership with your funding partner."

Michael emphasizes the importance of a strong partnership between entrepreneurs and venture capitalists, rather than a mere financial transaction.

• Michael predicts a shift in the venture capital industry towards more transparent and partnership-oriented relationships.
• He advocates for the democratization of the VC process, with investors participating in a cloud-based investing program.
• The goal is to eliminate the "VC black box" and empower entrepreneurs and future investors with a clear understanding of the investment process.

"We intend to blow up the VC black box."

Michael's quote reflects his ambition to transform the traditional opaque venture capital process into a more open and collaborative system.

"Our core members, when they're investing with us, get to watch us and participate in a whole cloud based investing program."

This quote explains the innovative approach Michael's firm takes, involving investors in the process and providing transparency through cloud-based tools.## The Role of VCs and Entrepreneurs

• Michael Scott discusses the importance of VCs contributing to the next generation of entrepreneurs.
• He expresses a desire to share his knowledge and hopes others in the industry will also benefit from it.

"That's going to take a decade or so, but if I have my choice before I die, I will have at least tried to share that openly and hope that other VCs and entrepreneurs benefit from it."

This quote emphasizes Michael's long-term commitment to nurturing future venture capitalists and entrepreneurs, highlighting the importance of knowledge sharing within the industry.

• Michael's current favorite book is "Demon," which explores the potential future of VR and AR integration into society.
• He values books that are visionary and provoke thought about future possibilities.

"Right now I'm reading a fun book called Demon, which is all about the future and how, for example, VR and AR might merge into our world."

Michael explains his interest in books that challenge traditional thinking and offer a creative outlook on the future, particularly in technology.

• Michael views everything as a learning process.
• He believes there are no failures, only learning opportunities, which is a crucial perspective for entrepreneurs.

"Everything's a learning process. So for me, one of the most important things here is that there are no answers and there is also no failure. There's only learning."

The quote highlights Michael's philosophy on the importance of continuous learning and reframing setbacks as educational experiences.

• Michael has had mentors throughout his life and considers everyone a potential mentor.
• He emphasizes the collective learning experience in entrepreneurship, as it involves creating an unknown future.

"But I think every day I have mentors. My peers are my mentors, my entrepreneurs are my mentors."

This quote conveys the idea that mentorship is not limited to formal relationships but can be found in daily interactions with peers and colleagues.

• The biggest challenge for Michael in establishing Underscore VC was unlearning previous successes and approaches.
• He focused on listening and rethinking strategies from the ground up.

"Far the biggest challenge was to unlearn, because what I didn't want to do was bring any of the legacy of VC or even of my success to date."

Michael discusses the importance of starting fresh and not relying solely on past achievements when building a new venture.

• Michael prefers interactive dialogue and workshops over reading blogs and newsletters.
• He encourages entrepreneurs to blog as a form of therapy and to attract potential support.

"I'm a big believer, as you've heard, in listening rather than reading."

The quote reflects Michael's preference for active engagement and dialogue over passive consumption of written materials.

• Michael does not listen to many podcasts due to time constraints.
• He utilizes podcasts that help him connect with entrepreneurs who need support.

"I don't listen to many podcasts. Admittedly, funnily enough, I have very little time for them."

The quote reveals Michael's selective approach to podcast listening, prioritizing those that align with his goal of aiding entrepreneurs.

• Michael's recent investment was in Mortech, an open-source marketing automation company.
• The decision to invest was based on the engagement and support from his team and the potential impact of the business.

"This could be game changing. And eleven of them wrote personal checks alongside us which made it very easy for us to write our check and commit to the thing."

This quote explains the collective confidence in Mortech's potential, leading to a group investment decision.

• Harry Stebings started podcasting due to his love for the venture capital industry since a young age.
• He was inspired by the film "The Social Network" and Peter Thiel's investment in Facebook.
• Harry's podcasting journey began with the intention to learn and potentially secure a job after law school.

"I do it because I've loved the industry since I was strangely 13."

Harry shares his long-standing passion for the venture capital industry, which drives his commitment to podcasting and sharing knowledge.

• The podcast mentions Cooley, a law firm specializing in startups and venture capital.
• Eve, a direct-to-consumer mattress company, is highlighted for its importance in ensuring good sleep for high-performing individuals.

"Funds would be nothing without the operational support behind them."

The quote underscores the necessity of having a strong operational foundation, such as legal support, for venture funds to succeed.