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VC Fundamentals Part 4: Portfolio Management (with Jaclyn Hester & Lindel Eakman of Foundry Group)

Limited Partner Episode

November 30, 2020
November 30, 2020

Despite many advances in industry transparency over the past decade, much about the actual "jobs of a VC" remains locked inside venture's apprenticeship model and institutional knowledge at firms. We aim to change that with the VC Fundamentals series: our goal is to draw back the curtain on the actual tasks that VCs do day-to-day, how you can learn them, and ultimately what's required to succeed. We hope this series will be helpful both to anyone looking to break into the industry (and even to those who are already practicing), and also for entrepreneurs and consumers of venture capital to understand more about the motivations and activities of VCs across the table.

We continue our VC Fundamentals series with Portfolio Construction & Management — how do you build and manage a fund's portfolio as a whole, beyond each individual portfolio company and investment decision? We brought in two of the very best people in the world to help us dissect this topic: Jaclyn Hester & Lindel Eakman of Foundry Group. Jaclyn and Lindel have been early and longtime LPs in some of the best venture funds in the world: USV, True, Spark — and of course Foundry — and now also sit on the GP side of the table at Foundry. Tune in for a master class on how the best VC managers think about generating and optimizing fund performance.

Topics Covered:


1. The bar for what "good" venture fund performance looks like in terms of returns:

  • Where venture sits on the spectrum of capital allocation options available to limited partners
  • The difference between "gross" and "net" fund returns and why IRR is still important
  • The distribution of returns across venture firms & funds — how many hit the performance bar — and the importance of diversification vintage years

2. Portfolio construction: how do you allocate the fund's capital across companies?

  • Why have a "portfolio" at all vs. loading up on a few high conviction investments — and what an LP's incentives are for diversification vs. a GP's
  • How to determine overall $ size you should target for a fund
  • Concentration vs diversification and the concepts of "shots on goal" and "groups" of high-potential companies within a portfolio
  • Fund reserves planning — are you "making your money at the buy", or able to buy up over time in your winners?

3. Balancing playing offense and defense:

  • The upside potential of "interstitial rounds"
  • Whether it's possible to save a company with more capital, and if pivots are a good idea

4. Time allocation vs capital allocation within a fund:

  • Understanding and managing your own cognitive biases
  • Why time & effort allocation across a portfolio rarely matches capital allocation (and shouldn't)
  • Why a firm's partnership dynamics are typically the most important driver of funds' outcomes


Links:

We finally did it. After five years and over 100 episodes, we decided to formalize the answer to Acquired’s most frequently asked question: “what are the best acquisitions of all time?” Here it is: The Acquired Top Ten. You can listen to the full episode (above, which includes honorable mentions), or read our quick blog post below.

Note: we ranked the list by our estimate of absolute dollar return to the acquirer. We could have used ROI multiple or annualized return, but we decided the ultimate yardstick of success should be the absolute dollar amount added to the parent company’s enterprise value. Afterall, you can’t eat IRR! For more on our methodology, please see the notes at the end of this post. And for all our trademark Acquired editorial and discussion tune in to the full episode above!

10. Marvel

Purchase Price: $4.2 billion, 2009

Estimated Current Contribution to Market Cap: $20.5 billion

Absolute Dollar Return: $16.3 billion

Back in 2009, Marvel Studios was recently formed, most of its movie rights were leased out, and the prevailing wisdom was that Marvel was just some old comic book IP company that only nerds cared about. Since then, Marvel Cinematic Universe films have grossed $22.5b in total box office receipts (including the single biggest movie of all-time), for an average of $2.2b annually. Disney earns about two dollars in parks and merchandise revenue for every one dollar earned from films (discussed on our Disney, Plus episode). Therefore we estimate Marvel generates about $6.75b in annual revenue for Disney, or nearly 10% of all the company’s revenue. Not bad for a set of nerdy comic book franchises…

Marvel
Season 1, Episode 26
LP Show
1/5/2016
November 30, 2020

9. Google Maps (Where2, Keyhole, ZipDash)

Total Purchase Price: $70 million (estimated), 2004

Estimated Current Contribution to Market Cap: $16.9 billion

Absolute Dollar Return: $16.8 billion

Morgan Stanley estimated that Google Maps generated $2.95b in revenue in 2019. Although that’s small compared to Google’s overall revenue of $160b+, it still accounts for over $16b in market cap by our calculations. Ironically the majority of Maps’ usage (and presumably revenue) comes from mobile, which grew out of by far the smallest of the 3 acquisitions, ZipDash. Tiny yet mighty!

Google Maps
Season 5, Episode 3
LP Show
8/28/2019
November 30, 2020

8. ESPN

Total Purchase Price: $188 million (by ABC), 1984

Estimated Current Contribution to Market Cap: $31.2 billion

Absolute Dollar Return: $31.0 billion

ABC’s 1984 acquisition of ESPN is heavyweight champion and still undisputed G.O.A.T. of media acquisitions.With an estimated $10.3B in 2018 revenue, ESPN’s value has compounded annually within ABC/Disney at >15% for an astounding THIRTY-FIVE YEARS. Single-handedly responsible for one of the greatest business model innovations in history with the advent of cable carriage fees, ESPN proves Albert Einstein’s famous statement that “Compound interest is the eighth wonder of the world.”

ESPN
Season 4, Episode 1
LP Show
1/28/2019
November 30, 2020

7. PayPal

Total Purchase Price: $1.5 billion, 2002

Value Realized at Spinoff: $47.1 billion

Absolute Dollar Return: $45.6 billion

Who would have thought facilitating payments for Beanie Baby trades could be so lucrative? The only acquisition on our list whose value we can precisely measure, eBay spun off PayPal into a stand-alone public company in July 2015. Its value at the time? A cool 31x what eBay paid in 2002.

PayPal
Season 1, Episode 11
LP Show
5/8/2016
November 30, 2020

6. Booking.com

Total Purchase Price: $135 million, 2005

Estimated Current Contribution to Market Cap: $49.9 billion

Absolute Dollar Return: $49.8 billion

Remember the Priceline Negotiator? Boy did he get himself a screaming deal on this one. This purchase might have ranked even higher if Booking Holdings’ stock (Priceline even renamed the whole company after this acquisition!) weren’t down ~20% due to COVID-19 fears when we did the analysis. We also took a conservative approach, using only the (massive) $10.8b in annual revenue from the company’s “Agency Revenues” segment as Booking.com’s contribution — there is likely more revenue in other segments that’s also attributable to Booking.com, though we can’t be sure how much.

Booking.com (with Jetsetter & Room 77 CEO Drew Patterson)
Season 1, Episode 41
LP Show
6/25/2017
November 30, 2020

5. NeXT

Total Purchase Price: $429 million, 1997

Estimated Current Contribution to Market Cap: $63.0 billion

Absolute Dollar Return: $62.6 billion

How do you put a value on Steve Jobs? Turns out we didn’t have to! NeXTSTEP, NeXT’s operating system, underpins all of Apple’s modern operating systems today: MacOS, iOS, WatchOS, and beyond. Literally every dollar of Apple’s $260b in annual revenue comes from NeXT roots, and from Steve wiping the product slate clean upon his return. With the acquisition being necessary but not sufficient to create Apple’s $1.4 trillion market cap today, we conservatively attributed 5% of Apple to this purchase.

NeXT
Season 1, Episode 23
LP Show
10/23/2016
November 30, 2020

4. Android

Total Purchase Price: $50 million, 2005

Estimated Current Contribution to Market Cap: $72 billion

Absolute Dollar Return: $72 billion

Speaking of operating system acquisitions, NeXT was great, but on a pure value basis Android beats it. We took Google Play Store revenues (where Google’s 30% cut is worth about $7.7b) and added the dollar amount we estimate Google saves in Traffic Acquisition Costs by owning default search on Android ($4.8b), to reach an estimated annual revenue contribution to Google of $12.5b from the diminutive robot OS. Android also takes the award for largest ROI multiple: >1400x. Yep, you can’t eat IRR, but that’s a figure VCs only dream of.

Android
Season 1, Episode 20
LP Show
9/16/2016
November 30, 2020

3. YouTube

Total Purchase Price: $1.65 billion, 2006

Estimated Current Contribution to Market Cap: $86.2 billion

Absolute Dollar Return: $84.5 billion

We admit it, we screwed up on our first episode covering YouTube: there’s no way this deal was a “C”.  With Google recently reporting YouTube revenues for the first time ($15b — almost 10% of Google’s revenue!), it’s clear this acquisition was a juggernaut. It’s past-time for an Acquired revisit.

That said, while YouTube as the world’s second-highest-traffic search engine (second-only to their parent company!) grosses $15b, much of that revenue (over 50%?) gets paid out to creators, and YouTube’s hosting and bandwidth costs are significant. But we’ll leave the debate over the division’s profitability to the podcast.

YouTube
Season 1, Episode 7
LP Show
2/3/2016
November 30, 2020

2. DoubleClick

Total Purchase Price: $3.1 billion, 2007

Estimated Current Contribution to Market Cap: $126.4 billion

Absolute Dollar Return: $123.3 billion

A dark horse rides into second place! The only acquisition on this list not-yet covered on Acquired (to be remedied very soon), this deal was far, far more important than most people realize. Effectively extending Google’s advertising reach from just its own properties to the entire internet, DoubleClick and its associated products generated over $20b in revenue within Google last year. Given what we now know about the nature of competition in internet advertising services, it’s unlikely governments and antitrust authorities would allow another deal like this again, much like #1 on our list...

1. Instagram

Purchase Price: $1 billion, 2012

Estimated Current Contribution to Market Cap: $153 billion

Absolute Dollar Return: $152 billion

Source: SportsNation

When it comes to G.O.A.T. status, if ESPN is M&A’s Lebron, Insta is its MJ. No offense to ESPN/Lebron, but we’ll probably never see another acquisition that’s so unquestionably dominant across every dimension of the M&A game as Facebook’s 2012 purchase of Instagram. Reported by Bloomberg to be doing $20B of revenue annually now within Facebook (up from ~$0 just eight years ago), Instagram takes the Acquired crown by a mile. And unlike YouTube, Facebook keeps nearly all of that $20b for itself! At risk of stretching the MJ analogy too far, given the circumstances at the time of the deal — Facebook’s “missing” of mobile and existential questions surrounding its ill-fated IPO — buying Instagram was Facebook’s equivalent of Jordan’s Game 6. Whether this deal was ultimately good or bad for the world at-large is another question, but there’s no doubt Instagram goes down in history as the greatest acquisition of all-time.

Instagram
Season 1, Episode 2
LP Show
10/31/2015
November 30, 2020

The Acquired Top Ten data, in full.

Methodology and Notes:

  • In order to count for our list, acquisitions must be at least a majority stake in the target company (otherwise it’s just an investment). Naspers’ investment in Tencent and Softbank/Yahoo’s investment in Alibaba are disqualified for this reason.
  • We considered all historical acquisitions — not just technology companies — but may have overlooked some in areas that we know less well. If you have any examples you think we missed ping us on Slack or email at: acquiredfm@gmail.com
  • We used revenue multiples to estimate the current value of the acquired company, multiplying its current estimated revenue by the market cap-to-revenue multiple of the parent company’s stock. We recognize this analysis is flawed (cashflow/profit multiples are better, at least for mature companies), but given the opacity of most companies’ business unit reporting, this was the only way to apply a consistent and straightforward approach to each deal.
  • All underlying assumptions are based on public financial disclosures unless stated otherwise. If we made an assumption not disclosed by the parent company, we linked to the source of the reported assumption.
  • This ranking represents a point in time in history, March 2, 2020. It is obviously subject to change going forward from both future and past acquisition performance, as well as fluctuating stock prices.
  • We have five honorable mentions that didn’t make our Top Ten list. Tune into the full episode to hear them!

Sponsor:

  • Thanks to Silicon Valley Bank for being our banner sponsor for Acquired Season 6. You can learn more about SVB here: https://www.svb.com/next
  • Thank you as well to Wilson Sonsini - You can learn more about WSGR at: https://www.wsgr.com/

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Transcript: (disclaimer: may contain unintentionally confusing, inaccurate and/or amusing transcription errors)

Ben: Welcome Acquired Limited Partners to part four of our VC Fundamentals series. As a review of what we've done to date, the first one was on sourcing, how do you find investments? The second was making initial investment decisions, how does a fund run a process to figure out what companies to invest in? The third is the company building of actually doing the work afterward with the founders and helping to add value and build great companies.

Today, we have a very important topic—portfolio construction and management. Of course, this is useful to venture capitalists to understand but also to founders. In the first few episodes, David and I tackled these topics on our own, but for this one, we wanted to bring in the heavy hitters.

David: Some actual LPs.

Ben: Indeed. What better way to do this and have this important and complex conversation and do it justice than to have your very own investors for the conversation. Here are some intros. We want to introduce you all to Jaclyn Hester and Lindel Eakman.

First of all, Jaclyn and Lindel are investors of ours in our current and past lives. They are partners at Foundry Group, a top venture fund based in Boulder, Colorado that invests both directly in startups and as a fund-to-funds, as an LP, and many fantastic early-stage venture firms. They are investors in mine at Pioneer Square Labs both in our Startup Studio and they are limited partners in our fund, PSL Ventures. They actively help my partners and I think through a lot of the topics that you're going to hear on this episode on a regular basis, and we are thrilled to open that conversation up to all of you too.

Jaclyn is Foundry Group's most recent partner. Congratulations, Jaclyn.

Jaclyn: Thank you.

Ben: She joined Foundry Group in 2016 and works across their direct investments and their portfolio of venture funds. She helped launch the partner fund strategy and she works with emerging managers on fundraising strategy and firm building.

Prior to Foundry Group, Jaclyn practiced corporate law at multiple firms including sponsor and friend of the show, Perkins Coie. She also worked closely with her husband and his family on their SaaS startup, FareHarbor, which was acquired by booking.com from the very earliest stages through acquisition.

Lindel is also a partner at Foundry Group and has been investing in venture-backed companies and venture firms for nearly two decades. Like Jaclyn, Lindel works closely with partner fund managers while also leading new direct investments into startups.

David and I can speak from experience and say that he is a sought-after mentor to emerging managers advising on strategy with fundraising, portfolio construction, firm-building, and navigating the ups and downs of venture capital.

Prior to Foundry, he managed the private investment program of the University of Texas Investment Management Company, or many of you may know it as UTIMCO. For folks who don't know, UTIMCO is a hugely respected LP in venture funds and Lindel really built the endowment's venture capital program. I've heard his partner, Brad, recall that Lindel was one of their favorite LPs. They liked him so much that they recruited him to be a VC and LP with Foundry itself.

We truly have two of the very best and most respected LPs in the business with us today. Welcome, Jaclyn and Lindel.

Lindel: Thanks, Ben.

Ben: All right. Let's open with a little bit of exposition before we dive into the nitty-gritty here. We set the playing field for why we're having this conversation and what the guardrails are to even cast the umbrella.

Lindel, let's start with you. What do the returns look like of a good "venture funds" in terms of cash-on-cash multiple? What are people shooting for here?

Lindel: I think the things we always tell our LPs, we have success when we make a three times return for them and so it's a net return. Many GPs tend to talk in gross terms, and we think that's just inappropriate. What is the cash to the LP? They're targeting at 3X and there are many different ways to think about what good returns are, but from multiple standpoints, that's it. But you also have to compare it to what they're doing in capital markets, in the public market side, and you have to think about private equity and other private options to think about where a venture fits in the portfolio of your LPs.

David: And by net, you mean net of fees and carry. The management fee that the fund manager's going to take for managing the money and then more importantly, hopefully—in impacting returns—the 20% or sometimes even greater percentage of the profit, so they're going to take in the carry. Wash all that away. You want three times your money back that you put in as an LP.

Lindel: That's right. I'm sure that we can point to several different posts to talk about the value of recycling and putting the work, the total 100% of the fund. It's not just easy to carve it out for listeners. There's a whole methodology. You forgot the expenses of the fund itself that we have to repay. Understanding the difference between gross and net can be meaningful for LPs.

Jaclyn: An important thing for GPs to remember is that institutional LPs get paid on IRR often. While we talk in multiples a lot of the time, it is important to keep a close watch on your IRR because LPs feel that directly.

Ben: Jaclyn, what do you mean by that? Talk about the relationship between IRR and why the 3X net has become the magical number that everyone seems to use as a bit of a proxy for a good IRR.

Jaclyn: For IRR, in general, you just introduce time into the calculus, which isn't done with just a multiple of cash-on-cash returns. Venture capital LPs are patient capital, that's part of the deal. You're looking at 10-, 15-, 20-year relationships. It takes probably at least 7, 8. Lindel might have better data on that year to start seeing distributions cut back, but the time does matter. That's where you get into the IRR calculation. That's where it's reflected.

Ben: We talked about this 3X number, what is the distribution of returns across funds? If 3 is good, what percentage do 5X, 10X, 20X funds?

Lindel: Yeah, that's actually a blog post I've been needing to write. I saw that Goldman had put out some thoughts on returns and the number that people are hitting those returns. There's this ongoing idea that venture as a total asset class is actually a bad investment because there aren't enough funds that actually hit the threshold. If you look at the median venture fund return, it's actually hardly competitive with private equity, and it doesn't earn its place in an LP's portfolio.

Whereas if you look at the top half of those venture returns, there's a wide dispersion of outcomes. To your point, my thinking is that over the course of several funds—because there will be the volatility of outcomes—you do see a 3X net to LPs as a success. If you're taking the right amount of risk, you're almost undoubtedly going to see funds that do very well and are above that 3X and funds that are below that 3X. As a venture investor now—almost for 20 years of doing this—I think you see firms have a successful 5, 6, 7 plus X fund, they might also have a 2X fund in their portfolio.

The better venture franchises, the better venture firms tend to compete even with their laggard funds with private equity, but they still give it the upside of venture-like returns. If over the course of several funds you can hit that three-mark, you've been a great investor and a great return to the endowments for the foundations that you support.

Ben: Good firms—even in their poor-performing funds—are on par with private equity, but every few funds or hopefully more often than not, you do see that venture upside.

Lindel: I think it's also reflective of that part of the capital market cycle that you're in as well, and it tends to be that growth starts to perform in certain parts of the cycle. That's where you see those breakout returns and that's why people talk about the quality or the value of vintages and investing across vintages.

David: I remember back when we both, Ben and I, were at Madrona, Madrona's Fund 2 was a 1999 fund. Thanks to Isilon and a few other companies—one of the top-performing funds in that vintage, and yet compared to the cash-on-cash multiples for Madrona's later funds, much lower. There's so much macro that goes into determining outcomes here.

Ben: Before we move on too, I want to underscore one thing, Lindel, that you brought up there. If you think that as an LP, you are investing in a median performing venture fund or you can get into the median tier, you should not be investing in the asset class. You have to believe that you are much better than the median or at least better than the median in order to be adding venture as an asset class to your portfolio at all. Did I hear you right there?

Lindel: That's right. You don't earn your place in the portfolio, meaning you don't provide enough return for the relevant risk in those returns and for the relevant illiquidity that you're accepting.

When I look at those numbers of the overall asset class returns, I actually don't see that many firms that didn't return capital. There was a group in the 1998, 1999, 2000 vintages that did not return capital. That was a wholly different period in technology, technology cycles, and capital markets. Take that aside, when I look at returns, maybe we're lucky that we only see the top half.

I think one of Jaclyn's problems when she first started with me was that every one that came in for a meeting was in that top half, and it's hard to differentiate between managers if you're only seeing that top half. We had a running joke when Jaclyn started. I'd ask her, do you want to invest with them and the answer was always yes because they were great. It just takes time to build context.

Whether I was at UTIMCO or here at Foundry, we're seeing Bellwether LP, and I think we attract some of the better firms and managers. We just don't see that bottom half. I think part of that is just like any venture firm. You're building a franchise, you're building a reputation to attract talented investors in this case as venture managers.

Ben: That's a great thing to point out and a pattern—especially the founders out there listening, keep paying attention to the similar dynamics that exist between VCs and the founders exist between LPs and VCs. I think that's something that's often missed unless you spend a lot of time raising capital and getting to know what the behind-the-scenes look of a venture investor's life looks like.

All right. Let's dive into the most obvious part of portfolio management which is portfolio construction, how you decide to create the portfolio and allocate the fund's capital across those portfolio companies.

Jaclyn, let's start with you. At the highest level, what's the rationale of having a portfolio itself versus just loading up on a small number of companies that you feel really good about?

Jaclyn: A portfolio approach is certainly something that we look for as an "institutional investor." Something that you're pointing to is really the difference between what angel investing might look like and having a portfolio approach, which is something that we expect of true VC funds and of GPs that we're looking to partner with.

I think the point of it is to understand that if you have a set number, a fund size, you need to return, as we talked about earlier, multiples on that fund size. Each investment has to matter as far as being able to help you get towards that goal of your 3X plus. We'll talk a bit more about this I'm sure, but some folks take the approach of each single investment should have the potential to return the entire fund at least one time over, some have a different approach. But I think having an understanding that there needs to be a portfolio construction is a good step one.

Lindel joked that one of our GPs—they can guess who they are in the early days, and this is very much the emerging manager category. It wasn't even that they had the wrong answer to portfolio construction, they just didn't have one. Having a thoughtful approach around it is a must. Does it mean that there's one way to do it? No. A lot of things depend on the stage, fund size, check size, where you're comfortable playing, your follow-on strategy, and all these different things.

I like to talk about it as a bottom-up approach. Think about what check the size you want to write, how early do you want a back company, how do you want to work with the company, do you want to really, really dig in with a small subset, or have more options out there? How early are you as far as really developing the muscle to write checks that are of substantial size with other people's money? It's different than thinking about a portfolio you might back or have worked with companies in other ways. What kind of success do you have to be able to (so to speak) for a large amount of the allocation and actually lead deals versus having written a lot of $10,000–$25,000 checks and be more of either a party round investor or some of that people bring in?

All of those things are combined to get you the fund size answer as opposed to what I think a lot of managers may do early on in their thought process, which is how much can I raise? They start there and then they try to back into portfolio construction, and I very much think it's the other way around. That said, how much can I raise does matter. You may back into $100 million portfolio construction and realize that you don't really have access to that capital. That certainly matters on both sides, but I like the bottom.

Lindel: That's got the killer strategy but I do need a $100 million properly executed on that strategy and I'd like your help.

Jaclyn: Yeah.

David: One of the reasons we just wanted to cover this with you guys particularly, I really learned about this way of looking at the world from you all. There’s everything you just said, Jaclyn, that goes into how you determine portfolio construction. You would think—and I thought before becoming a manager really—it's all about risk diversification and minimizing the risk that's why you have a portfolio. You don't know what the future's going to hold for these companies, et cetera. 

That's true but there's—I think at least, I'm curious what you guys will say since you taught it to me—a different way to look at it that's more powerful at an early stage, which is it's about shots on goal. It's not about diversifying risks so much as it is just you don't know what's going to happen. You need to put yourself in the line of fire enough to be right and get one of these huge outlier outcomes that are going to drive your fund or hopefully maybe even a couple. But the more opportunities you have to get those outsized returns from a given company, that's more powerful than diversifying risk away.

Lindel: I think we have to talk about the role of agency bias at the different levels of investors. As an LP, look, they would put all your funds in one company, just get it right because I invest in 32 different managers. So I am going to have to play diversification in my fund-to-funds portfolio. I don't need more shots on goal, I just need you to get it right. I don't want you to get it wrong and be upside down in your fund and not want to manage your vehicle anymore. I'm going to say to you, let's find the balance that feels just a little uncomfortable in a number of positions because I don't need you to be more diversified.

Ben: The way you're looking at from the LP perspective is actually to put pressure on him to be more concentrated rather than more diverse.

Lindel: My friend, Michal Kim, is very vocal about that. When he invests, he wants more concentration because he thinks about his portfolio at that level. I agree with that from a pure return standpoint. It's also the case though that as early investors and managers, as early supporters of emerging managers, we want to see them be successful in building their business, and we want to support them as they think about building enough shots on goal to this idea. 

How many shots do you need to get a chance to be right? We didn't really cover the distribution of outcomes but in small seed funds, you're making your money at the buy. Your initial ownership is what you're going to get, you're never going to be big enough to buy up. How many of those initial positions does it take for you to find enough outlier winners to return your given size of the fund?

In your case—and certainly in Fund 1 or Fund 2—I usually tell people you actually want a few chances to be right because that's going to enable you to have a better shot at raising a Fund 2 or a Fund 3. That's not directly aligned with my own interest as an institutional LP that has plenty of diversification already. That's one of the reasons we like it when our managers invest together. We're completely happy when they all find the same company and don't worry about that overlap at all. 

But for you, I think the answer we've been saying is 25-40—depending on your strategy, depending on your fund size. You have a little bit of an agency bias to do more if you think about the ability to raise Fund 2 and have the stories to tell that show you got access to exciting companies, at least enough that they can return their first fund.

Ben: I always thought about that as incentive misalignment. But more accurately framing it as an agency bias and just recognizing that especially a very long-term oriented LP is going to look at this like, oh my gosh, I have access to this manager who now is going to continue to take my capital for the next 20, 30, 40 years and I'm helping them build their business. It's an iterated game, not a single terrain game for you.

Lindel: That's part of the reason Foundry got into the LP business because we wanted to support the next generation without trying to hire them all in the Foundry Group. We wanted them to build their broader networks in that and support what is now a version that Foundry was in 2007 when they spun out from Mobius.

David: There are a bunch of things baked into that discussion, one of which that's going to be relevant for everybody listening—including and perhaps especially founders—is the ownership percentage threshold. Of course, we all know, anybody who knows Michael and Cendana knows they're all about ownership percentage in their managers and concentration.

For listeners, why is that important? If I'm a founder and I'm negotiating with a few VCs and I'm hearing time and time again, hey, we have our ownership targets, we have our ownership threshold, we need 10%, 12%, 15%—it's going to be different by different firms. What's behind that?

Jaclyn: One thing I was going to add to what Lindel was saying is fund size and stage matters a lot to this thinking. Because we generally focus on smaller and seed-stage funds, so we're often focused on that part of the market. I don't think that it matters quite as much for a $30 million seed fund to have really significant ownership.

The calculation that you need to make is that if you're playing the venture game and you're thinking that it's probably a third of your portfolio that gets you to those 3X returns, so maybe a third goes to zero, a third returns capital or you get a little bit of money back, and then a third is really driving the returns, then each company has to have enough ownership that if that's the one that's in that top third, it has the potential—from a return's perspective—to move the needle on your fund. Either return it one time over or be a significant cash flow back to a firm.

Lindel: Right, 1% of a $1 billion company is $10 million. If you're a $30 million fund trying to get to 3X net, that doesn't get you very far.

Jaclyn: Yeah. Those can add up if you're good, but certainly, it doesn't move beneath all for a $100 million fund or $500 million funds. I think that where the seed buyers are trying to buy up early in that first check to make sure that they get to where they need to go.

As a founder, if you're talking to a seed firm, if they're truly a seed firm, they're probably not going to need to buy another 10% of your company over time. Sure, they love to push it up. Their model works if they own 10% maybe get diluted down to 5% given how early they're coming in. But if you look at a much larger fund that's putting most of the capital to work in the series A later and they want to lead your seed around to have the option, that's where you really need to start thinking about that. How much of my company do you need to own over time, not just today? How much will you be pushing into my company over time and needing to get in as I want to bring new investors over time? 

I always caution founders against two things, one, don't sell too much of your company before you know what you really have. I think there's this glamour around raising a giant round early on pre-revenue, but you may have sold off something. You don't even know what it is yet. The other thing is really understanding—I do a talk for Techstars on this—the VCs business model, their fund size, how many positions are they going to take, how much you matter to them, and what do they really need from you to get to that performance that they need for their LPs?

Ben: Just to take a little philosophical detour, we alluded a little bit to the power-law distribution of returns within a venture fund. You've got that one-third that—and this is canonical wisdom or classic wisdom—go to zero.

David: I think Fred Wilson's done some blog post on this that if you look at USV's funds, this actually is how it breaks out.

Ben: Yeah, I think your partner Seth, Lindel and Jaclyn, also did some analysis on correlation ventures there showing it's even more skewed than this. But anyway, one-third goes to zero, one-third return capital, one-third are responsible for their returns. And really, it's the top one, two, three, four companies that really produce the lion's share.

Let's dive in those a little philosophically, why is that? Why isn't it possible to have a little bit of a shallower peak and a wider tail on that curve and do a venture investment portfolio where we have a bunch of 3X to 10Xs rather than this thing where you hope for a 50X, a 20X, another 20X, and then you're okay with the long tail like one to zero?

Lindel: My take on that is that you can win multiple ways. The classic Silicon Valley version of this is to look for the 1500X. In our experience, we think about returning a third of the fund. What can return a third of the fund? In our experience in our 2010 or 2013 funds, we're looking at 8-12 companies that are going to return a meaningful portion of the fund. That's an interesting observation. You don't have to believe that they all are $1 billion, $2 billion, $10 billion exits. 

I will say though that when I look at a lot of funds that underwrite, they have this group of companies that are potentially going to be a $1 billion exit. That's the number that we all frame around and rest on. What actually tends to happen is that a number of those sell for $400-$800 million—and those are great outcomes, they return a meaningful portion of the fund, and then one of them goes to $3 or $5 billion. 

It's not believable when you see a fund that's five, seven years old that they even know which one that's going to be that's going to go. They can identify the group. As I said in our case, it's 8-12 companies, we can identify that group. And then it becomes a matter of holding period and how long you hold that growth before you have that exit. It's going to be a successful company, it's just how long you end up holding it before the right strategic acquirer comes, or before (these days) the right spat comes and wants to overpay. That's a real thing that's happening in our portfolio and other portfolios. My message to an LP last night was their fund is going to go from good to great depending on how far this group of companies runs.

David: This is all a little bit of a sidebar but I want to push on it because it's super relevant right now. How are you guys thinking about—either within Foundry or for your partner funds—these days with a lot of these companies, the end of the value creation journey does not stop when they go public? I'm thinking good friends of the show at Emergence Capital, they had Zoom go public. Zoom went public at a $16 billion market cap, something like that. There's been over 10X value creation in the public markets in a year. Are you encouraging managers to hold? As an LP, you want liquidity, you want distributions, but there's also still this upside potential.

Lindel: It sort of cuts both ways actually. Zoom's a great example. I'm on a board with a guy that led that investment and it's just great. It's so fun to smile and laugh with him. He's still very engaged. I think they still own some of it, that's all. 

But as an LP, you don't really want to pay venture fees for something that you could own yourself in the public markets and at that point, your public managers slightly own as well. There is this natural pull for you to distribute that as a manager and to get that into the hands of LPs where they could make whatever decision they want to make. There are a lot of LPs that have held on to that stock and they've benefited from it without having to pay the 20% toll to the manager, to use your Zoom example.

The other side is also true which that's great. I love talking about this part the most but the other side is also true which it's taken longer to get companies to be ready to go public. That longer holding period really hits managers and companies in two ways. For managers, you're having to feed these companies more to maintain your position at exits. You have to put more capital in. That's dilutive to all the founders out there that are listening, and they start to take dilution hopefully at much higher valuations, but that's still dilution that you're taking.

David: It's dilution to early venture stakeholders too.

Lindel: It's actually my biggest concern for small seed funds is they have no ability to defend their ownership with much longer holding periods, many dilutive financings before an exit. That's a challenge and it affects the things that Jaclyn brought up which is your IRR.

Over that longer holding period reduces the IRR that you're earning. It's compounding over a longer period of time, so LPs should like that. But when they're comparing it to public markets that have gone up—nothing but up—it's a challenging comparison for VCs where an LP is looking for a 20%, 30% type of IRR absolute basis. But you can't compare that to a longer holding period, and it actually brings it down.

There's this challenge of longer hold periods and then to your point, are they sticking around or are they benefiting from the pop that we've been seeing in the public markets? You get hurt both ways, right? You hold it longer and then you don't benefit from the pop.

Ben: Popping one level off the stack here. Lindel, you said something earlier that I think is fairly contrary to classic VC wisdom that is rather than at a time of investment saying could this company be a $1 billion company? Or put a different way for the asset class that we're talking about, could this return our fund 1X, assuming that we get the ownership that we need in it?

What I heard you saying was not that you look at every investment at could this return the fund wants but more could this be a part of the group of companies that could return a third of our fund? That's a little bit more of a spread mindset that I've heard in the past. Do you actively do that at Foundry? Do you actively look at your fund size, cut it to one-third, and say could our position within this investment eventually be one-third of our fund size?

Lindel: We really do that analysis more in the later years of a fund to understand where we should be putting our reserves to work and to think about what is the group of value drivers that we want to defend our ownership in? Remember, we're a much bigger fund, and we're able to invest across multiple rounds than most of our partner funds that are seed and series A. 

They're making their money at the buy. They have to invest early, they have to own as much as they can because they're never going to be able to buy up. Their funds aren't big enough. Having the conviction to have the right number of shots on goal against the right ownership is so important for them because they know they're going to suffer dilution, even the best winners because their holding periods are stretched out.

Ben: That's a great transition to start talking about follow-on investment and reserves? In all these partner funds that come and present to you and say, hey, this is our portfolio construction strategy. What is the range of different amounts that people reserve for follow-on financing? I've heard everything from one-third of my fund is for follow-ons to two-third just for follow-ons. We just had Rahul Vohra on the show and he was mentioning in his angel fund that he has nothing for reserves and that it's only for special purpose vehicles. What do you think about that?

Lindel: He does have a rolling fund for a [...], yes.

Jaclyn: It's definitely a range, and I was going to mention that some funds do zero but they're generally much smaller. I think you see a lot go one-to-one, especially at the seed stage. And then I think you do see a bunch go two-to-one because they're seeing these large highly-valued rounds get done subsequent to their initial round and they feel like they're always just strapped for reserves to follow on. 

The challenge is that at those stages, if you entered at seed, you don't have that much more data on a company by series A. So you're having to make really hard decisions with not that much more data. It's a big challenge.

I often push managers, if you're conviction-driven and you're good, then you should get as much as you can at the seed. I like a 70-30 or 60-40 where that first check is the larger one. And I always think about another option for a shot on goal especially for a Fund 1 or 2 where you just want to make sure that you're hitting. Just think about the delta in your ownership versus what you could do at that cost basis. Could you buy another position to have yet one more portfolio company? 

The funny thing about reserves models or any models, they're always wrong and they're always going to be iterative. You can say we plan to have these reserves but it should move around. At the end of the day, when you see what your portfolio looks like, it shouldn't be equal across the board that you reserved and wrote the same check at every follow-on for every company. You have to make hard decisions.

Concentrating the capital down into a subset of companies can offset, do I have too many positions? We do see a mix across the board.

Ben: Yeah, it's interesting especially the phenomena you specifically referred to where not that much has happened intrinsically with the company between seed and Series A, but its scarcity value and external perception has changed traumatically. The cost basis to buy new shares goes up way more than your inside information would indicate about how much more progress that the company has achieved. There's this incredible internal turmoil. 

I can tell you, speaking as an early-stage VC and all the listeners who have sat in this position know exactly that same thing. It's, hey, is this my opportunity to push more chips or do I say, gosh, I think people might be over their skis a little bit on their excitement about this company. I'm excited for them to get more capital, get more notoriety, and get everything that comes with that big round. When managers call you and say how should I think about this? Do you have any litmus tests or ways to help there?

Jaclyn: It's always based on what they know versus these perceptions. I always go back to what's your delta and ownership versus the additional costs here? Think about the ability to have just one more company, would you want that? That's one thing to think about.

I think also there's this misconception. I was going to say this earlier when Lindel was talking. When you asked why is it that we have to play, that only a couple drive the returns, and why does it come out that way? I think that there's this misconception that if you graduate to series A then you're set and it's completely [...]. I think a lot of seed funds talk about their portfolios that way certainly, they talk about these graduation rates.

Lindel: It's like graduates for pre-school.

Jaclyn: We are more lifecycle investors. Yeah, we've seen companies all the way through, and it's amazing all the successful ones almost die and some do die. Some die after series C. It's wild, and a lot of the reason that they die is that they've raised too much money or they’ve raised a too-high valuation and they can't exceed that. They may have a nice business, but this venture business is driven by exits. 

That's another hugely important thing to consider is that it's not just about getting to your $10 million ARR. We need to actually exit and get liquidity. That should also be something that you're thinking about, does this valuation make sense? Is there a risk that this kills this company? Because I don't see how they're going to grow into this by the next round. There's a lot of different dynamics to consider. It's not easy.

Ben: Lindel, what about you? Any thoughts on that one?

Lindel: For the managers listening, I truly believe that you need to take as many shots on goal at that first investment and buy your ownership, especially for small funds. You’ve got to get that right number of positions. Reserves, after that, are effectively playing defense because you're never going to be able to buy up. If you're playing defense with reserves for your ownership, you then are aligned really with the founders in that you've bought your ownership and any more money that the company raises is also dilutive to you as someone that can't defend your position, much like the founders.

Founder Collective's a great firm that talks about that, how they're aligned with the founders after the initial investment. I really respect the way that they're transparent about that. Sure, they will participate in maybe one more round to give the signal to the next round of VCs. But as much as anything, they believe that they're making the right investment at that initial purchase.

David: Then they'd rather put the capital to work finding more shots on goal.

Lindel: Another initial investment is what they view is more valuable than investing at that marked up round Jaclyn spoke about not having more data, that's exactly right. That's generally true for most seed funds is they should be buying another position rather than adding on at a much higher price.

If they have a separate vehicle, you referred to somebody that had a separate vehicle, that's a whole different option pool and a whole different portfolio construction. As a manager, you have to be a fiduciary for each fund that you manage and make sure you're allocating the right opportunities to that. Many people miss, they don't get the initial portfolio construction right, and that puts them in a bind in that initial vehicle. Then they add a second vehicle and things get confusing and messy for LPs.

Jaclyn: One thing to add that we didn't mention that’s totally worth-noting that we've seen several of our GPs do really well is—and I'm again going back to seed investors—double down before that next round that’s probably going to have an outside lead. We've got a couple of funds that do this really well, and I think it probably takes time and experience to develop the muscle to know what you're looking for. 

I would say often managers can't really describe it but you led the pre-seeder, you led the seed, and you're working closely with the company. You just see something is really working. It's the product clicking, it's early signs of product-market fit, something about the team, and that’s when you try to put more capital in as opposed to waiting. It's basically just going to the company and saying do you want a little bit more runway to get to where we really want to be to raise the series A or to raise whatever the next round is? I think an ability to do that can be game-changing for some of these funds.

David: It's symbiotic with the companies too. In our last LP episode, Rahul talked about this fundraising from the company's side. It's smart as a founder to do this. You raised your last round 10 post. You've made a bunch of progress, you're not ready for a series A yet, but if you could take some more capital at a 20 post, 25 post, now you're starting to step up. Now it's not that big a leap to get to a 50 post on your series A—I'm making up numbers here—because you already have your valuation set in this interstitial round (as he called it) at 25.

Great for the manager too. If you're seeing that this is working, you're seeing conviction. Yes, you can build your ownership in a way here without having to fight with the big boys (so to speak) that are going to come in at the series A.

Ben: This is something that storied firms do and have done for decades, and I think it's becoming more known among seed managers now. I even reflect back on Foundry Group. I think you guys did this potentially—if my memory serves—with Rover, I think with Glowforge. For companies where it's going well, you can see it's going well. You say, hey, look, you don't want to go to the dog and pony show right now. You're not ready right now, you might be ready in three months. What if you didn't have to do it for 18 months? Wouldn't that be great? It's this win-win.

David, we've even talked about it as round-skipping before. I think Sequoia and Dropbox are a great example where Sequoia just kept putting money in and Dropbox didn't go out and raise another round for 3 ½ years after it took the money. My math could be a little off on that, but it's just such a good point that you don't have to wait until there's another term sheet that comes from someone else at a really high valuation then you can decide if you want to push in some of your reserves or not.

Jaclyn: I will just caution managers. That can work really well, and Dropbox, that's a good pick. But you don't want to be the only pockets around the table for too long and continue to set this price and they're like, oh, we're just going to lead your next round because those founders tend to get worse and worse at fundraising over time. If they need to actually go and fundraise, it's been a really long time. 

I do think it can be hugely beneficial. I think founders often love it because they just get to keep executing, and most founders will tell you that these processes are longer and all they want to is just build their company and longer than they expected but you can run the risk of being the only big firm around the table that can write another check and they get a bit too reliant on you.

Ben: This dips into the territory. It's interesting. Lindel, you earlier brought up the word defense around protecting your position and that's defense in the sense that the value's going way up, there's an outside lead coming in, and I need to maintain some of my ownership.

There's another way to play defense that is this company is going okay but not amazing, and this is where we start to get into dangerous territory. I can defend this investment, it won't go to zero, I can put some more money in, and maybe it'll become a good company. That, to me, starts to sound like you're on really thin ice, but it has worked in cases in the past. That's always the way that people rationalize it. I'm really close to this company, I can see how much capital will get them to that place they need to be, even though they're struggling now. You can even hear it in the tone of voice. What's your advice on that form of defense?

Lindel: I think we're actually talking about two or three different things here. One is a high conviction, big fund, ability to really push in and make their best companies go. For our partner funds, that's mostly not the case. It's not the case for smaller sub $100, sub $200 billion funds. That's only you get to play as you've earned that opportunity and you've earned the stripes to have the ability to have that conviction and help fund the companies. By the way, you still make mistakes even after you've been doing it for a long time and you put too much capital in.

Jaclyn's point is right. Those founders don't build the fundraising muscle, and they don't build the network that they need. If you do get hit by a flat spot in the curve of a company, then you have a real problem. That sort of thing won. That's a different animal, it feels like to me.

We talked about the idea of a double down, and I think that really works in the case where you have a company that's hot or a company that's going really well. That series A is going to happen, and Ben, maybe we should agree that David's been down in Silicon Valley too long using those 50 post numbers.

David: That's low.

Lindel: I can't help it.

David: I made up numbers because it's too low.

Lindel: If you have a company that's going well, they are going to get a $10 million, $12 million, or $15 million round almost skipping around to the old B round. That's a different thing. Doubling down before that happens, all the sins in the world.

Here's the problem though, you have that company you think is doing pretty well, you double down in your small fund, and you don't have that many more reserves. It does most of what you thought it would do. It’s still pretty good, but now all of a sudden with a series A market, there's this bifurcation of have and have nots. If you're not in the haves category as a founder and as an early investor, you're in trouble at that point because you've already spent your reserves and you don't have enough capital to signal to your friends in the series A world that this is a company you want to carry in your fund. That's where you run into a really tough spot as a founder, as a venture manager. Most small funds can't play offense after their initial purchase.

Ben: Which is why you said three times now that it's all about that first check for early-stage funds?

Lindel: They just can't play offense. You have to decide, as a manager and frankly as a founder, whose money you want to take at that next financing. Founders tend to glorify financings. Here's the deal, you get money, but you end up with yet another VC on your board and maybe that's not what you were told before.

Ben: Potentially even worse, another VC who doesn't join your board but acts like it.

Lindel: That could be worse. That's right because they have no governance, no control yet here they are loud and forcing their way into the room.

David: Lindel, what about this third situation—where Jaclyn dealt— where you've got a company, you see some potential, but it's not going to be a successful fundraising but you see some reason to believe? This gets into as a firm, how do you make pro-rata and follow-on decisions which we definitely want to cover with you since you see so many styles? What do you do in that case? I could name a bunch of examples of companies that have been in that situation, pulled out, and become multi-billion dollar companies. Of course, there are also lots of companies that take more money and go right down the shoot. What do you do?

Jaclyn: We certainly have had success with it and wear scars from it, I would say. I think the important thing to think about and to really ask yourself is why does more money make a difference here? Think about the fundamentals of the business and really be specific around why this additional capital changes a bunch of things about the trajectory of this company?

We talked to one of our best performing GPs a month ago or so. They did this reflection on the success that they had in Fund 1, 2, and 3. A big takeaway—as they thought about it—was why did companies that failed consistently fail? What are the common themes and the ones that did really well? One thing they came away with is if the unit economics don't work at the beginning, they're not going to work. You could throw as much money as you want at a company and time and time again, that just didn't improve.

Another example they came up with was entirely creating new markets versus we could bring a new customer base to this solution or there are adjacencies that we see, et cetera. And time and again, they would take that bet. Ultimately, looking back, it never worked.

It's really important to be thoughtful about why is it that you can save this with more capital versus other changes that you can make in the business? It's just that nobody else gets this and they just need to do X, Y, and Z and they need this much time and money to do that, then I think you can make those decisions. I definitely think we wear some of those scars.

Lindel: I'd say definitely more scars than successes. Our friends over at Techstars have done a nice job. They've now invested in 2500 companies. They have a lot of data and a lot of rounds. Their conclusion is that you should never invest in a down round. Further, you should maybe never invest in a flat round because it should be a down round if it's a flat round.

Ben: People are just willing to take the down rounds. That’s the take the markdown.

Lindel: The psychological basing's too strong. When you look at that data across a huge spectrum of companies with many successes in the portfolio, it makes it hard to say that you—especially as a smaller manager—should put more capital into the company.

I like Jaclyn's point, it's not just what’s the new money though. If they can't understand why they wasted the initial capital they raised or the mistakes that they've made—getting specifically to Jaclyn's point about the unit of economics—there's no point in talking about new money.

David: The first point you made in the Techstars data, it's opportunity cost. You may pull some winners out of the hat with that, but the opportunity cost is another shot on goal, or if you're a bigger fund, that does have the ability to play offense with your reserves. It's the opportunity cost of not pouring more money into Zoom or whatever into your big winners.

Lindel: Let's go back to portfolio construction. Each fund has a certain number of companies that you invest in, and you are forced to pick the right ones to invest in. If you have a much more limited number (let's say) you have 15 companies instead of 30, you may not have a great place to put that capital—those reserves—because maybe you didn't get it right in your 15 companies. But it's a finite number of options that you have to put that to work. That might change the math on the individual, the micro decision that you're making for that next investment in that company.

Jaclyn: Also if you have too small a number of options, you're going to be incentivized to do the exact thing that, David, talked about. Nobody else gets this because I need this one to work because I don't have that many options left.

David: Some serious agency issues.

Jaclyn: There's really bad agency bias there. Also, I think it's an important thing for GPs to think about is as soon as you raise a successor fund—and we're seeing these funds come back to the market so quickly, the pacing is just insane. I think we're going to see a bunch of funds where their vintage is 70% 2020 because of the pace of what's gone on this year. To talk about Lindel's point, it's a vintage diversification.

As soon as you start investing out of your next fund, that cuts off the ability to add a new shot on goal per se to this first fund. If you want to recycle and all of that, then all of that money is only going into follow-on opportunities. If your companies are generally still at the seed phase—maybe some of them have gone on to A—when you activate that next fund, you’ve got to have enough opportunities there to put the rest of that capital to work. That's another reason where we would want to see you.

I think some funds will say we're going to do 15-20 companies at seed and, to me, it's a dagger. I don't think that's enough because it's hard. I feel like having that closer to 25 number at least—or Lindel said 25-40 earlier—of opportunities to follow into, and again you don't follow all of them equally. You may end up being concentrated into a subset or 20, but that certainly is a better place to be than having 10 that need to work.

Ben: Okay, this is great. Now I want to talk about correlation. Let's take PSL Ventures. We're investing in the Pacific Northwest. We're diversifying a little bit in geography, Seattle, Portland, Vancouver, the broader Pacific Northwest, but pretty concentrated in the Northwest. That is an intentional strategy. That's where we have the relationships, that's where the things that we like investing in grow really well. There's clearly a correlation that's good because that's literally our strategy is to invest in that region, it's also bad if Mount Rainier goes.

David: Let's hope not. 

Lindel: I didn't see that one coming.

Jaclyn: I didn't see it coming.

Ben: I was trying to think of the most facetious or aggressive example of your strategy biting you in the butt. I don't know. It's funny now that we're all remote because it doesn't matter as much.

Anyway, how do you think about I invested in this manager because of the way that the assets they have access to are correlated versus oh, shoot, everything in their portfolio could get wiped out by the same coronavirus?

Lindel: I'm way more diversified than you are, it's not my problem. But if you think about it from an LP perspective, as I said, you could put it all in one company, it doesn't matter to me. It's really your business, your concern, your portfolio that I'm worried about.

You said the word correlation, that's a nice way for saying bias. You have a bias to your region and you have a bias to a certain type of company. We could talk about PSL and the type of company that I identify them investing in is a certain type of company. To me, that's accretive. I think that is accretive to my network, accretive to my portfolio, it's something different. I don't have to worry about that as much from my perspective. 

By the way, we don't like regional funds per se because geography isn't diversification. That by itself isn't an edge, and in fact, you may be biased to those local companies when there's a company doing the same thing in Austin or a company is doing the same thing in Atlanta that isn't getting the attention because you're based there or certainly not getting the Silicon Valley attention. That creates more biases than correlation—I'd use a different word for that. But in your case—let's hope the mountain doesn't blow the top off—we don't have to worry about that though as an LP. As a direct investor, I do.

Let's make this point. As a company founder, you have one option and you're all in on that option. As a GP, the next level-up, you end up with 10 or 15, even in a full portfolio that is really performing. You’ve got 10 or 15, maybe and 30 or 40 to start but there's going to be a group of 10 or 15 at least. 

As a fund-to-funds investor, I'm really playing the correlation ventures game or the Techstars game of now I have 500 companies that can return for me. I get the benefit of all that upside, all that volatility. That's why I think as fund-to-funds investors, it's wiser to go earlier. You're seeking volatility actually as an LP. As a GP, you're trying to find the measured volatility, and as a founder, you're doing everything you can to make that one option pay off.

Jaclyn: I think also LPs don't typically back one venture fund. I think that's important to remember. You really shouldn't if that's what you're going to do. Even backing five venture funds may not be enough. Sometimes you'll have an individual who knows a VC and so they actually just have one VC position for their personal investing, but typically, there are several of them and they may want your geographic exposure because they don't feel like they have enough of it in their other firms.

I wouldn't say that we're anti geographic focus because there's another firm called Matchstick that we've backed that's in our backyard here in Boulder and Denver. It's diversified because they call it the North and the Rockies. There's enough that they cover.

What we're really focused on is what's additive to our network and making sure we do have the exposure. We think that this is all changes you talked about being remote, but for seed, being there and being at the center of a given market does matter. We went out to LA and spent a bunch of time when we started investing in a couple of funds based there, and it was important to us that the market was mature enough, that there were just going to be enough companies. I think that's the question to ask. Is there enough going on, is it robust enough where you're not just doing all the deals in your region but you're actually picking out of a much larger set of companies?

Ben: Does this apply to the sector too? In the same way that you're like I don't love geography as a focus for a fund. If someone pitches you a fintech fund or (God forbid) the 2000 Kleiner Perkins CleanTech Fund, how do you think about vertical-specific funds or a hardware fund? There are hardware funds that have done well.

Jaclyn: We think about it as are those themes actually horizontal? We're unlikely to do something that truly is vertical but I don't think a fintech at this point as a vertical. There's a horizontal aspect to fintech. There's investing, there are payments, there are all these things across the board, and you've got different layers, you've got infrastructure layers, and application layers. Same with hardware. We're investing in a couple of funds that focus on hardware, but we see them as horizontal. They're not just doing industrial robots. If it was that, then we wouldn't be interested.

We are thematic and horizontal investors, and we generally look to invest directly alongside our partner funds. We're often looking for that kind of overlap. I think vertical can work. You'd have to really build a portfolio around that and we see things a little bit more horizontally, but we like to focus. We do have funds that focus on just B2B SaaS, but that's broad in affright.

Ben: It's not like there's going to be one piece of legislation that wipes out all the fintech at this point.

Jaclyn: One would hope.

David: Just put it all in ether.

Ben: I suppose someone breaking (let’s say) cryptography could be a big problem for all of online banking. It hasn't happened yet so it's unlikely to [...].

David: It's like Mount Rainier blowing.

Jaclyn: Then we have other problems than our allocation to that category.

Ben: So true. Let's transition from pure portfolio construction to a little bit of a broader concept here—portfolio management. We're not just in this way thinking about the LP dollars that have been allocated to your fund to manage but also your non-capital resources, your time, and your effort as a GP or as a fund manager. The first question is should this allocation differ at all from the portfolio's capital allocation or should it map one-to-one?

Lindel: I don't think I've ever met a manager that mapped it one-to-one. Fred's written about this but it's very true. The good companies tend to go, and they tend to go with or without your help. Usually, that's the team that you've backed, the founders that you've backed. You can help them with the margins but off they go.

Sometimes you spend the least amount of time on your winners, and that's not fun because you'd rather spend all your time on the winners. It's that middle third—I think the actual verb that Fred used—where you can make a difference and where you do try and bend the curve of the outcomes for that company. You do that with time, you do that with capital. That to me is the trickiest, messiest part of being a venture manager. Now that I'm on the inside and doing that myself, it is hard to allocate your time appropriately.

Let's not forget the last third of companies that just aren't working and you earn your reputation by helping them to do a soft landing. There is future value certainly in spending more time sadly in the second and the last thirds of your portfolio. That doesn't make rational sense except for that reputational piece that allows you to get into the next great company that's working.

Sometimes, by the way, those founders are just in the wrong company. They spin out, they do something interesting, and you back them again because you saw the quality of the person when they handled the struggle. That can give you the confidence to back someone again just like venture managers only get about a third right. I've seen founders, one out of three will be an incredible return. You can't know going in which of the three is going to be the incredible return so you back that person with conviction each time. If you have the quality of the person right, that tends to pay off if you keep backing them.

Ben: It's such a good point in the very same way that world-class VCs don't hit it every time, same with world-class founders. The last guest on the show was Dick Costolo. Dick started Feedburner and sold it to Google for $100 million when that was an absurd amount of money to sell a company for. He took Twitter and built a $2 billion revenue business out of it. Pretty damn good track record. Then he started a fitness company that I think they gave back the money and said actually we're going to stop working on this because it's not working. It just happens even with the very best entrepreneurs. It's a great point to bring up, Lindel.

David: Thinking about the bottom third, the ones that just aren't working, if you can catch those early enough while there's still capital in them, you can do a hard pivot into something else and just be like, hey, the fit isn't here. This isn't working for whatever reason. Let's go find something else to do. How do you guys feel about those situations?

Jaclyn: My favorite story in that category, if you ever have Greg Bettinelli on from Upfront, ask him about GOAT.

Lindel: GOAT's a perfect example of this.

Jaclyn: GOAT started as something food-related. It was something in the food space, meeting up with people, or something like that. It just wasn't working. It was like you guys are talented, what else are you into? They were like sneaker people and amazingly shifted it. I don't know how often that can work, but you have seen it where you just have a great team.

David: Twitter, Instagram.

Jaclyn: They're just chasing the wrong problem.

Ben: TikTok.

David: TikTok.

Jaclyn: Lindel, do you know of any Foundry stories where we've had a real pivot?

Lindel: I'm trying to think of our own portfolio. I would tell you I have a negative bias on those though.

David: The flashy stories of the Instagrams, the TikToks, for every one of those that work, there are the ones that don't.

Lindel: I was in Vegas, I had $100 left, and I put it on Black. That's what you're saying to me, and that's why that story sells. I don't know the numbers, my own bias would be that they have similar success rates as the down rounds and the flat rounds that we talked about earlier. 

Often, you get in a bind because the cap table's already a mess if you have something that's not working, and that can challenge the pivot that could've worked. It's better if you recognize it early I think to return capital, reconstitute, and do that with grace and form. The stories we love though are the ones that were counted out, they made the turn, and it worked. I think that's human psychology certainly in our world.

Ben: What I heard you say was that you had $100 before you got on the flight to Vegas that you could've given back to me and you put it on Black?

Lindel: What is that famous FedEx story? The founder flying to Vegas and spent the last $5000 to meet payroll for his company, and it worked. That's how FedEx got to keep going.

David: Wow. We got to tell that on the show.

Ben: Wow. It's a massive violation of fiduciary duty.

Lindel: Oh, yeah, illegal probably but it worked.

Ben: Much like venture returns, no one's mad at you when you break strategy and it works. They're only mad at you when you break strategy and it's a colossal failure.

Lindel: I tell managers you can do that, it's a franchise deal now. Often people will say I'm going to go all-in on this. I'm going to put 20% into my fund. I'm going to grab money from my next fund and we're going to cross-fund invest, I want to go all-in on this. Great, you can do that. It now becomes a franchise deal. You're risking the franchise with that.

David: We had Santi to do Zoom with us—well over a year ago now. He said it was the largest investment Emergence had ever made at the time, the partners took him aside and they're like, hey, we can do this.

Ben: He wasn't a GP yet.

David: He wasn't a GP yet, but just so you know, you're betting your career on this. Obviously, it works.

Lindel: He's a GP now.

David: Yeah, he's a GP now.

Lindel: I think he's firmly ensconced as a GP at this point.

David: It's a good point. To me, what I took away from that story from Santi—I don't want to put too many words in his mouth, but the lesson I took was to be glad when people are honest with you about that. If you're a GP and your LPs are honest with your bet. I’d be like okay, you have the least but just so you know, I'd rather not have you both shift me and be like oh, yeah, it's all good, no problem. Be like, hey, you can do this but it’s a franchise deal now.

Ben: Last question on this topic. Did the answers to any of these questions change with the amount of capital that you already have in the company? Let's say your normal check size is $1.5 million, but for whatever reason, you bet big the first time, you did a tweener round, and now you're $4 million into the company and it's not going well. Should that change how you spend your time, how aggressively you try to find a soft landing, how much you're talking them up to downstream investors, any of those things?

Jaclyn: It really shouldn't. You should make each investment decision based on what is the company today and not think about the sunk cost. Psychologically, I think that's impossible for people, and that's where you see a lot of poor decisions being made. It very much depends on a lot like your portfolio construction. Going back to that point of if you have a $500 million fund, then you probably should just call it on a $4 million investment and just say we shouldn't put another dollar into this, we shouldn't spend more time on it, we should work with the founders to have the best outcome for them but we're done here.

It's really hard to do because it does seem like a big check. This is again where if you don't have a lot of other options, you're probably going to make the bad decision there and continue to invest more and continue to spend a ton of time on it when you know the answer. I think it very much depends on the specific situation and what your portfolio looks like. That's the luxury that VCs have, the founder doesn't have that luxury. The founder's all in on that one thing, and so I think emotionally it's really hard.

Lindel: I like the question especially in the context of David's comment about Santi not being a partner. Depending on that partnership, you have different dynamics of your ability to put more money in. What's the worst-case scenario is when you have a non-functioning partnership and you're trying to hide that and cover it up with more capital and to put more capital into a company given a second chance. Because think about that, we're talking about funds. Funds have (be it) 20, 25, 30, 40 companies. An individual partner has a much smaller number of those or an individual principal has an even smaller number of those.

David: Talk about shots on goal. If you're a principal, you may get a couple in a fund to prove yourself.

Lindel: There's real agency bias, right? I think where funds, firms, and LPs get hurt is when there's not transparent authentic communication about the prospects of a company inside the portfolio, and people start using their sharp elbows and protecting their errors because maybe they have more power in the partnership. That's where you have negative outcomes in funds is when you put good capital after bad because you're protecting your partnership interest, and you have non-functioning partnerships that don't make the right decisions. That's where you see that lower than media returns is when people are making non-economic irrational decisions because of their agency bias.

Jaclyn: You also have just some baked in partnership dynamics that may drive how these decisions are being made. You've got things like what’s the voting structure? Is it I'm going to support you here because I know that I'm going to bring this deal to the table next week and I want you to vote for me? If you have that dynamic, that can be super dangerous to decisions like this. There are some firms, there are large, very established firms that have deal-by-deal carry for partners. That's going to drive a lot of difficult and probably sometimes bad, sometimes good decisions around follow-ons.

I’ve talked to one firm that has a different team or different person evaluate the follow-on as a completely separate investment, and they like to talk about how great it is. I have someone back channel to me that that person that has to make those follow-on decisions wants to leave because it's so painful for them to try to go up against these things that are owned by the other partners. I don't think that there's a right way to do it, I don't think there's an easy way to do it, but I think, to Lindel's point, the transparency around it is what really matters.

Lindel: This talk isn't about that but partnership dynamics is the one thing that we spend all of our time diligencing when we're investing in a fund. I say that repeatedly throughout the years to all LPs. You're fine, the portfolio construction will sort itself out. We can coach people on a lot of things at this point if they'll listen, if they're coachable, but those partnership dynamics, you can't fix and you can't get them right. That's where you get hurt as an LP, and I think that's where the portfolio and the founders get hurt too. It's important for them to understand from their perspective how that partnership, how that firm works.

Jaclyn: I just want to double-click on that. For founders, understand the partnership dynamics. You will know one partner the best, that's the person that's leading for you. But you really ought to know what it looks like and who you're really partnering with because it's not just that individual person. Sometimes people leave and you want to understand how the decisions are being made for what ends up happening with your company over time.

David: Maybe especially through that lens—for founders before we wrap—how do you guys diligence? You guys are pros, you spend most of your time on this. I'm a founder, I have no idea. What's a question I can ask? What's something I can do? What's a backchannel? Is there anything, which can get me maybe not 80% of the answer but something more than 20% to help me make this decision?

Lindel: From my perspective, it's talking to existing founders in that portfolio. I think they may not tell you the answer if they even know it, but watch out for the things that they're omitting in their answers. What are the blank spaces that they're leaving? Ask them specifically about approval processes for their deal specifically about follow-ons. Who could you tell in the partnership meeting had the most dynamic input?

David: The juice.

Lindel: And who is pushing the most on those? I was trying to avoid using that but who has the juice in the partnership. You can tell that in the meeting when two or three people are sitting together. You can start to see—just like any set of animals—who's pushing the other around. Humans aren't that hard to figure out once you put us in that lens.

Ben: When you do see a person pushing another around, that doesn't mean it's not a good partnership to invest in. What are you looking forward to determine if this is going to be a healthy partnership that returns capital for us or not?

Lindel: Is there space to be wrong? Is there trust, is there space to be wrong? Is there authentic transparent communication about the companies across the partnership? It's hard, it's a hard thing to diligence, it's a hard thing to do to be a partner in.

I used to joke. My dad was an attorney. As a teenager, I helped him move his office on a Saturday twice because he couldn't stand his partners. This isn't specific to venture capital. This isn't specific to our point in time. This is humans, and humans are messy. I think trying to understand the dynamics between a set of humans being a team of founders or a team of partners at a firm—as you both well know—pitching LPs who can get something done in an LP shop. It's a similar dynamic that you have to evaluate and understand.

Jaclyn: It's all about trust. It's the only thing that matters at all levels amongst partnerships between investors and recipients of those funds. I think that's the one thing that matters.

I think for a founder, you can ask questions. I think founders don't realize they can ask questions about the VCs, about their partnerships, and about their businesses. I think VCs appreciate that you actually did the work. I think it makes you look good. If that's a turn off to a VC, then you don't want their money. But understanding just the history of the partnership I think that's a fair question to ask. As LPs, we want to know how you know each other. How long have you known each other? How do you balance each other?

I think you can ask some questions around the partnership. I think you can, to Lindel's point, talk to other founders, and I think you can ask a very important question—which is one that we always ask—how do you make decisions? I think there's a lot in that, and I think that's a totally fair question for founders to ask.

Ben: That's great. As we drift toward wrapping up here, I think this is a great place to leave it. I just want to say thanks to both of you. I think this is super informative, not only for existing VCs, aspiring VCs, current founders—just such a great peek behind the curtain. Is there anything else that you want to leave listeners with today?

Lindel: I'll say something my partner Brad always says, just take it as data. It’s one point-of-view, one piece of data that you should incorporate in your own thinking. There are a lot of ways to win and we've certainly been wrong, but our experience points to these being some of the more successful ways to invest.

Jaclyn: I was going to say the same thing but I will add that it's important to know that there isn't one right way to do any of this. There's no one right way to build a company. There's no one right way to build or invest out of a venture firm. The most important thing is that it's authentic to who you are, your skills, your experiences, your goals, and all of those things. I think that the GP style fit or whatever it is, that’s the thing. Your strategy should fit who you are, and that's important across the board. I think that's the one thing to take away.

Ben: I love that. Jaclyn, Lindel, where can people find you on the internet? Where can people find Foundry Group?

Lindel: We're very public. You can find us on the web at foundrygroup.com. All of our partners have a lot of fun on Twitter. It's easy to find us from there.

Ben: All right. Thank you so much, listeners. We will see you next time. Thanks again to Lindel and Jaclyn.

Lindel: Thanks, guys.

Jaclyn: Thanks for having us.


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