What a lackluster IPO market means for the venture ecosystem + insights on the changing VC landscape

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October 20, 2023

DESCRIPTION

In this week’s pod, I am joined by Mike Rogers, our VC Partner, to chat about the state of the market, especially in relation to technology companies and the venture capital space. We discuss the disappointment in recent tech IPOs, which have not performed as well as expected. Our conversation touches on the importance of strong IPOs for the entire venture ecosystem, as they drive liquidity events for investors and unlock talent for new ventures.

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Our conversation dives into the changing landscape of venture capital, including the shift from traditional seed rounds to larger pre-seed rounds and the high expectations for Series A rounds. We emphasize that building real businesses with solid fundamentals is more important than inflated valuations.

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Thanks Mike for joining me this week, always a good time.

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Links:

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TRANSCRIPT

‍MPD: Welcome everybody, Mark Peter Davis, Managing Partner of Interplay. I'm on a mission to help entrepreneurs advance society, and this podcast is definitively part of that effort. All right, we got a session with Mike today. We are going to do a deep dive wrap on the venture ecosystem.

Everything from what's going on in the IPO markets, which have been lackluster not all of the outcomes we were hoping for, to how the VC ecosystem from a financing perspective has restructured. This is one of the more conversational threads we've had in a while. If you're in and around the game, LP VC entrepreneur, I think you're probably going to find some nuggets in here.

I hope you enjoy.

Mike: So where'd you get

MPD: the glasses? Hold on a sec. I've got it. Caddis. Yup. Check it out. If you're a geezer McGee's like myself, Caddis makes designer reading glasses. Oh, and so you can get aviators and other types of extremely stylish frames for old people. And all of their models are probably 50 plus, but as cool looking as possible.

And so you can go in and get some fresh gear. No, they're not sponsoring us, but they should be now because that was the plug of all plugs. So when I found out about him, I was like, okay, I need reading glasses because I'm old and I went in and nothing fits me. Don't love style usually and was in and out of the cata store in 25 minutes.

With new shades or new reading glasses, I would

Mike: bet you that a lot of old people would find it offensive that at 42 years old, you think you're old,

MPD: Maybe everyone thinks, actually, it's weird. I was just talking to a a friend who is in politics and the senior political folks who are in their seventies are calling him a young man.

Yeah. And he's pre 50. Okay. Yeah. I don't know when you're like late 40s, pre 50, I think you're I don't know if you're like middle age. Let's be honest, you're not old.

Mike: Yeah, but we're going to work on this mindset. Okay, hold on a second. I'm the

MPD: gray hair guy and I'm one of the gray hair guys now in startup community, right?

Cause like the average age and startup plan is waiting twenties, thirties, you tip 40 and you actually have real gray hair in your face. Everyone's whoa, he's still walking without a, without a

Mike: walker. Yeah, I don't think that's really true anymore. If you look at like the, the guys and women who have been adventure for a long time, look at the Peter Teals or Keith or boys or Bill Gurley's of the world.

They're older than you. They probably would think you're middle aged anyway. Anyway. Yeah.

MPD: Old is relative. It's a state of mind. Yes. We're gonna work on your state of mind. There's advantages to feeling old though.

Mike: Interesting. It's a tactic

MPD: for you. I think it's self deprecating in a world of young people constantly around you.

You

Mike: could talk with your therapist to figure out like why you call yourself old.

MPD: Mike, aren't you my therapist? Isn't that what this is? You'll pay me enough to be

Mike: that's a whole another JD dude. All right. All right, cool. Let's talk about starter markets.

MPD: What's going on in the startup

Mike: markets? Yeah, I'll kick it off. I think, everyone was super hyped for some. Big tech names, IPO, Klaviyo, Instacart are probably the two that were most relevant.

It got very quiet after that. Those IPOs have not traded so well. I think they fit in the bucket of not good, not terrible, somewhere between medium and bad, both trading down, I think something, you 15 percent from the IPO price. I'm sure not what the company is looking for that I was looking for.

Although there is a strong case study here. And I think a lot, a little bit to dissect on why they want public and how there is a roadmap for a lot of other companies like them to do the same thing. But generally speaking, not what we wanted to see to open the floodgates for IPOs.

MPD: This was a dagger in my heart moment. Yeah. Having these companies repriced, From private market highs, AKA insanity to public market, viable pricing. And then to go into market and get a dip was just sad. And reason why it was not just for those companies and all the people who have worked their ass off to get those companies to where they are.

We were hoping they were first companies through the gate in this new cycle and gonna blow everything open and make way for the next folks. Yeah. It's less clear now. I agree. It's like a medium outcome, a medium negative. Not a not an awesome. Yeah. And so I think for founders and board members that have optionality about when to take the company public.

Let's say they're operating profitably or they have the option to tap into some more capital resources. There's a moment where you say, Hey, I'll wait another 6 to 12 months maybe two years to pull the trigger. And that's a big deal because it's not just about those companies. The whole ecosystem is bottlenecked.

Yeah. With all this value locked up in these big late stage companies. And once they liquidate and bring money back to institutional investors, VCs, the system starts cycling again. We need what we call in VC land DPI, which in English is money back to the investors and funds so they can redeploy it.

And the circulatory system gets thriving again. Totally.

Mike: I think that's an underlooked part of how the venture ecosystem works. Big IPOs drive. Big liquidity events for VCs, which means big liquidity events for LPs. And also what it does is it unlocks talent at these companies to go start their next thing.

Totally. Because if you're a senior executive at something like Instacart, for example, you can't, you don't want to leave until the IPO happens. And when that does happen, then, you get liquid, you get some cash, maybe you go start your next thing, or you join an early stage company to help them go from zero to one again.

But you really need these moments and you need them to go decently wealthy people to go do that. And yeah, I think it was a bit of a shame. That we couldn't have this kind of catalyst in a moment that we wanted.

MPD: And there's even another social dimension to it. I think when a company goes public successfully or even moderately well the founders get knighted by capitalism.

There's this English class I took in college, and I feel like in college, you remember three things that kind of like land with you. One of them was I read some writing from Andrew Carnegie. Now, if you're a history nut like I am, you'll know that Andrew Carnegie was from a different day, and there's a lot of complexity around that.

Putting all that aside Carnegie had this mindset that capitalism tends to break after people get rich. And the reason why is they'll take their money and they'll retire and they'll put money in the stock market or the bond market, and they're essentially giving money to more or less bureaucrats to go and run with it.

What he wanted people to do is to use the capitalistic system to essentially self select them, to give them capital for their capable hands, his language, to go build more. And so you get founders who get to the end of a journey, they IPO and now they've got hundreds of millions of dollars, if not more, the social potential, the impact that these people can have is massive and it's sitting there waiting.

For them to be unlocked. Yeah. And I think what you're really

Mike: saying is it's risk, right? And the entrepreneurial mindset, typically when they have a big exit, they're not just Hey, let's go put this in the SMP or bonds. So I want to reinvest this in the next generation of entrepreneur. They become angel investors.

They become company buyers and builders. And back to the initial point, that's the circular nature of the innovation

MPD: ecosystem or they start the next thing, but they might have a different risk profile. They might say, look, I'm already loaded. Yep. Incremental hundred million billion doesn't really change anything in my quality of life, so I'm going to go out and tackle something that's really hard and really daring and really risky and do it with their own money because there's not capital markets always to support those endeavors, the early stages.

Totally. You look at SpaceX. You can't just go and raise VC money to buy your first myth like rocket.

Mike: There's a perfect example from our own interplay community and max hoat from from launcher. Exactly. Yeah. Exactly. Yes. Successful entrepreneur sold his last businesses in a totally different sector.

Came back, had money, said, you know what, I'm going to build spaceships. Rocket engines actually in his case. And I'm going to see you with my own money and go raise capital around that. And you're right. Those are the hard problems that move mankind forward.

MPD: No chance he would have been able to even turn the light on and that new venture, if he hadn't have already had some success with a couple of ventures prior.

Totally. So it's this system of training people, but also the system's selecting out who can really move it forward. And it like Knights them. That's my language for my head. It dubs them and says, yo, you're the person here's the money. You identify the problem. You have the capable hands.

Go make it happen. Not everyone does it, but when they do it, we're getting some of the more aggressive, imaginative envelope pushing opportunities coming out of society. And that's on hold right now as we've got all these really awesome founders locked up in companies and they'll get out. But a year or two from now, they'll be armed with cash and probably lots of fresh ideas and exciting things can happen again.

Mike: Totally. What did happen with these IPOs? And I think what is a really interesting road for founders out there who are thinking, what do I do? Or where can I exit the next couple of years or even in the next cycle who cares, right? Is the IPO mechanism will relieve you of your preference stack. Yeah.

So what I think will happen in the next year, To two years is we might have some quote unquote bad IPOs, not bad, I'm saying not the massive

MPD: medium plus,

Mike: but what it will do is it'll free up what is a big log jam in this system that you just spoke about so eloquently, I might add like that.

And that is the preference stack because a lot of founders are looking at their cap table saying. I can't IPO now because I've got 200 million of LickPref on there and maybe the business isn't worth that or whatever. And we've got to figure out how we're going to get to this next stage. The IPO market is a pretty clean way to flip everyone into common, float the shares, let the market tell you what the thing is worth.

If people are long term believers in the business, they can hold onto their equity. And if they're not, when their lockup ends, they can get out and then recycle that capital back into other things that are interesting to them. It's

MPD: like we have a clogged artery right now. Yeah. And like the whole system is starting to get backlogged on it.

Totally. It's got it. We gotta get a stent in there, break this thing open money back to universities, foundations, back to new VCs. The whole system needs to keep flowing again. Agreed.

Mike: With that said the one market which hasn't slowed down that much is the kind of pre-seed. Space.

Yeah. It's crazy. It's crazy. I think we could map this previous conversation to this too, because a lot of people were talking about the amount of dry capital in the ecosystem. Where's that going? It's not going to grow right now where it's a really clogged machine per the conversation, where people are doing it in two to 4 million seed rounds because it's such a long cycle from there to IPO exit or sale.

And two, it's smaller checks. So it's pretty easy to validate and understand how you can, quote, unquote, value these companies with the seed capital and putting early, early dollars in.

MPD: Yeah. I think the underpinning logic there, which holds is, Hey, you're looking at a five to nine year timeline before these companies are looking at real M and a five to 15.

Yeah. Or for certainly for an IPO. Yeah. So current IPO dynamics. Not a risk factor, but what I think a lot of folks are missing is that capitalized growth funds right now can really strike incredible deals if they're repriced properly. And again it's this classic, you want to zig when everyone's zagging, if you want to make money.

So I think from the LP community, there is a real opportunity right now to be funding and growth for the growth investors that are disciplined. In this market and our budgeting and planning for a lag of the artery remaining clogged a little longer than anticipated. Yeah, but there is value.

There's deals to be made. And when I say that I cringe because usually the people who get screwed over and that of the founders. The founders who have got the company to the growth stage that did everything right, in most cases, and they land at some weird market environment at the last minute, or they got too excited in a good market environment.

And then it flipped. It's just heart goes out to those folks a little bit, because that's bad luck of the draw right now.

Mike: A hundred percent. And it does show you like timing your business exit for a market cycle is almost as important. As or if as important as the core foundation of the business yeah, people

MPD: who don't think luck is part of business wake up.

Mike: It's definitely part of life and business and we can get really meta on it. But the data is the seed market now. It looks a lot like the seed market in 2021. Average round size and post money valuation. So we really haven't changed. We're down slightly from the top of the 2022 market.

And, I'll lean in for a second and pull some stats. But data 18 million post money on seed rounds right now. So we really haven't seen like a ton of change from where the market maxed out,

MPD: right? Is it lower volume? Are we seeing the same kind of strike points on price, but the volume is down because there's just fewer players in it?

Yeah. Or is it every rich uncle is still funding a lot of folks and they're in that and there's a lot of volume going on or

Mike: What's happening? Somewhere in the middle volume still high deal flow is still high. But down from like max, but round size holding steady and price holding steady.

And I think that's You know, really like a sign of the times because there is so much capital floating around and people are just going earlier because it's the safest place to be investing right now. You

MPD: know, it's interesting in these cycles is venture funds generally don't have a lot of longevity.

If you compare VC to private equity, for example, when I say private equity, leveraged buyouts, the distribution curve of yield for LBO firms. I don't know, I'm making it up. This is wrong, but like two standard deviations each way, you're looking at five percentage points difference in performance.

Everyone's in the same band, right? You're getting 10 percent to 18 percent returns. You're not like striking out and hitting home runs. In VC, it's five to 10 percent of the firms make all the money. And so what ends up happening in that paradigm is once a couple cycles, a firm goes through a couple of vintages, if they're not in that winning group, they fold.

And so the names and logos in New York today are very different than the names and logos in New York. When I started the business in oh six, there's a handful that have carried through, they're the kind of the iconic names we all know that have continued to perform and they're institutional in the way they operate.

But there's this every five to 10 year washout. And so actually for seed, while it's still active, I'm expecting that there's going to be a washout of logos. It may be the same people that they may reorganize. Whatever, but there'll be new firms. So we're in the, usually this is the point where you see a kind of a lot of turnover in the icons.

And,

Mike: And seed has changed fundamentally too. From when you started NVC in, in what, 2012,

MPD: 2012, 2006, a firm that we started interplay in 12, first year in the business as an intern, 2006 seed was synonymous with friends and family. It was not yet an institutional product when you're raising your seed round.

It was like doctor's lawyers, right? Which is crazy. And now it's, it's, we're cycles from that. Totally. That kind of institutionalized in 08. Makes sense.

Mike: And what have you seen like from a company building shift? Do they hire slower? Does the capital actually get them further than what you saw early in the market?

Or are we living in the same paradigm except people are just spending more money? Yeah, I

MPD: think there was a major shift in capital requirements by company. Yeah. That happened right around the turn of the century. And the big shift was actually hardware, right? In 99, 2000, 2001, pre Amazon web services and the entire industry that's formed around that, a company to get started would have to get 3 million bucks just to buy servers to stick in the corner that they plug into the wall.

That was the baseline. And now that's a hundred bucks. And you can usually get a credit if you have a good incubator or partner and you're getting it for free, you get 10, 000 plus. And the cost in my opinion of starting a company has asymptotically declined approaching the cost of labor and in a world where founders will work for equity in some case, all that, that the cost is really low to start a company.

Now, it's not even in the same universities used to be like 2 to 10 million bucks to get the lights on. Totally. But after it came down the patterns on how much capital the companies have needed Has vacillated up and down, but I think we've seen more movement in the language of how we talk about the funding stages than we have actually in the capital requirements

Mike: itself.

Got you. Okay. Helpful. Today, I think it's worth talking a bit about the series a market today, our core focus here at interplay on the investing side and, and what we're seeing in the market, the data today shows that the pre seed round is typically 2 million bucks.

So that is completely replaced, even post your time, what the seed round looked like or exactly. So it's bigger than the traditional seed round. In

MPD: 06, that was like an A. That was an A, exactly. And then the seed was friends and family. Now pre-seed is the old A. Yeah, it's all shifted. It's shifted

Mike: two steps.

If we look back 10 years, let's say 2012 numbers, the seed round was one and a half million bucks. This, the pre seed now is 2 million bucks. Series A's then were 5 million. The seed rounds today are 4 million bucks. Series B's then were 13 million bucks. Series A's now are 12 million bucks. So the whole paradigm has really just shifted.

I think I can chime in for a minute here on what I'm seeing in the market. The series a, I think is. Used to be around where I say used to in this previous market cycle. If you had some data and metrics and you were showing some revenue growth, you could probably get capital. That is not the case today.

I think the bar is as high as it's been in my career, at least, which is about eight years now for raising a series a and by series a, I mean like a true up round from the seed. Probably over 5 million of capital raise closer to 10. You really need to be growing fast with good unit economics in a big market.

And of all the characteristics of a top 1 percent company where again, that was not the case previously, people were taking bets on things that did not look like that. What's happening to the majority of founders, and there's nothing wrong with this, by the way, some companies just take longer to really find that core product market fit if they're raising a seed extension of 5 million bucks.

I would just call that a small series a, but a lot of them like to call it a seed extension or et cetera. And again, that's fine. Not everyone is on that same path. Most companies struggle or find product market fit or iterate or pivot. That's a totally normal thing to do and start a plan. But. The bar for founders going out to raise their series a, if you're going to put a deck together that says, I want to raise 10 million bucks for series a, you better have tight numbers.

And this thing better be growing fast and you better be able to sit there and look everyone in the face and say, we are one of the best companies in the market right now. Otherwise shrink the round size, raise a bridge, figure out, figure it out.

MPD: Yeah. I think to take a big step back, not the last five years, but You could make an argument that the operational milestones and the amount of capital raised at each milestone is roughly in the same universe.

It's just all been relabeled. Yeah. There's this first stage, forget the word for it. Which is you're architecting out a business concept, you're getting some early cash, it's a drawing on a piece of paper, you've got a design of an engine, then there's another phase where you've built the engine, you put a little gasoline in it, you can test the efficiency of it, you can see the machines turning, then you've got a phase where you're driving laps and you know this thing really works, and then you've got alright, let's make this thing hot, let's put great tires on it, let's put a bunch of cash in it, let's take it across the country, That was when I started Friends and Family, A, B, C, whatever.

The problem is there aren't letters before the letter A. So as it shifted in this pattern. That's now precede, seed, A, B. I think when I started, what is now an A was probably called a B. B or even a C. It's just, it's totally off, but I think the core concept that there are operational milestones in this conveyor belt that is venture capital, where people are looking for certain risk profile to be mitigated, to get to the next round of funding in a systematic way, because this is an innovation supply chain.

We're trying to systematically produce things that advance society and make everybody money in the short term. I think there's probably a lot of parallels if you can strip out the language, but the language has obviously changed. Yeah,

Mike: I think that's dead on and I think. The issue that we have in this current market is founder's mentality is that they have to have a certain size, name, title, all of the the front end metrics that don't actually matter for running a business, right?

And we run into this a lot with founders trying to call things by a certain name or raise a certain price to validate either their worth or their company's worth or some. Made up thing that doesn't actually have anything to do with where the end outcome is, which is, selling for a large number and during which her

MPD: investors are your employees, right?

Everyone's watching formula one right now. Would you rather have the dopest car, right? Or the best sticker on top of it? Yeah, exactly. Have the dopest car. It's a no brainer. Have the dopest car. And so it's all about operational efficiency, hitting your KPIs, The investors follow everything else follows.

Yeah.

Mike: The only thing I will say, which is, you had a conversation with a portfolio company founder the other day and they were a little stressed about how fast they grow versus how much they invest in products. And I think the one really nice thing about the market right now for founders who are in that situation is growth numbers are the expectations for growth.

They're not as high as they were. They were. So for founders who are thinking, Hey, should I invest? Should I grow at? 100 percent year over year or 80 percent year over year, but then focus that extra money on improving our product. My answer would be focused on the product side right now, because I don't think investors will weigh the mild differences in growth, whether it be 10, 15, 20, 30, even 50 percent if you can build the best in class product.

Best products win. Like we know that hands down,

MPD: but that wasn't the common mindset in the boom of a, of 18 months past 100 percent because everyone coming through was buying growth with every dollar at a loss. In some cases, just crazy. And so when you're indexing everything coming through the door and 300 percent growth, 300 percent growth, 300 percent growth, 80 percent growth, you pass on the great company that 80 that was probably doing the execution with great discipline.

And was building a longer term venture, got a little bit overshadowed by some of the noise of the market. Founders

Mike: were told to grow revenue at all costs. And what that means when you're an asset, when you're a capital allocator, which founders are at their core, is you have to choose where you're going to invest that capital.

So you invested in sales or invested in products. And every founder was told invest in sales because we only care about sales. Now, to your point on the engine analogy, All the engines blew up,

MPD: right? Extremely un

Mike: fuel efficient. Extremely un fuel efficient. You're getting two miles a gallon.

MPD: No real tech.

Endless gasoline, so it didn't

Mike: matter. Didn't matter, but now the gas is gone. So you gotta build a fuel efficient engine. And you're seeing a lot of companies pivot back, to keep using that analogy, to building that fuel efficient engine. For some of them, it's too little too late. Some of them will turn it around and get there.

And that's great for them and their teams. But I think if you're a founder now going out to raise a Series A, my advice is like, yeah, you have to grow because, VCs and the team want to see growth and growth is important. But having a best in class product will fuel that growth in a sustainable way, which will get you to that A or that B, even if it means you raise a bridge or whatever it is, it doesn't matter.

The mark to market on these rounds is not a real price for you selling or exiting a company. The key is to minimize dilution. Maximize ROI for yourself, your employees and the company and their shareholders.

MPD: But for every founder who got in this game after 2008 bust, this is the time where they're getting their PhD, take notes.

Yeah. Because see it once, you don't need to see it again. When you start the next company, even if the market's hotter than hell, fuel efficiency matters. Totally. And you can make tough decisions and allocate resources differently than the hype might dictate. Knowing that the, there might be a scarcity of fuel at some point and you can be ready for it in

Mike: looking into our portfolio.

You can see the repeat founders in our fund who had been doing that the whole time. Totally. Now, we won't name names, but they're near and dear to our heart. And, they built the business that way from the ground up. And they're

MPD: like, all right, there's extra fuel. Cool. We're gonna, we're gonna go 30 miles a gallon.

Yeah. And we're gonna put a bunch of fuel in. But it's not the tank's full, right? That's a different mindset. And so everyone coming out of this vintage now should be trained up. All the companies being started this year, next year, the year after. Doesn't matter how hot the market gets. No one should forget this.

If the, if you're in the game right now, this is your training critical to longevity, critical because, Hey, that was a long bull run, right? It's not always that long. Sometimes it's three years, four years, five years. Yeah. If the average time to exit is nine plus totally, you could be riding a cycle or two during a venture.

Yeah. And

Mike: we've talked about this before the zero interest rate world that we just came out of is extremely uniquely beneficial to tech. Because if the cost of capital goes to zero, which is what we just saw, the lowest it's ever been in our lifetimes. And I think the lowest it will ever be, honestly, I don't, we won't go into rates right now, but I don't think rates will go to zero again in our lifetime.<