A Look Back at Our Letters to our LPs and Capital Exuberance
When we started Aleph, I decided to take on the responsibility of writing the annual letter to our Limited Partners, our investors. I was inspired by Warren Buffett and Jeff Bezos, but also intimidated by these unique thinkers. Honestly, it is hard to write something unique and insightful year in and year out.
After reading Josh Wolfe’s post on Lux’s annual letters and his tweeting out sections, I went back to look at our last four years of letters. My conclusion is that uniqueness, newness of thought or blinding insights were overrated. There was one consistent theme we went back to year after year. In fact, it was the only topic repeated in the letter, which typically spans 10–12 pages.
”My conclusion is that uniqueness, newness of thought or blinding insights were overrated.”
What was it? The market is overheated. There is a lot of capital chasing deals and this aberration won’t last forever. Consistency of focus on that single message became our strategy. We did not leave it at punditry, instead actively implementing this insight by tanking up on capital at our portfolio companies for the coming winter that we are now in.
I thought it would be useful to share a few snippets from those annual letters along with some advice, in the hope it will both help explain our thinking and the way we informed our LPs of our concerns, opportunities and focus.
In our annual letter summarizing 2017, we discussed the seismic shift in funding dynamic and its poster child: Softbank. We recognized Softbank was only the harbinger of a new era, the “weaponization of capital.”
“Flush with Money
Last year, we wrote about the growth imperative – the need for companies to grow fast in order to become breakout successes. Hypergrowth in early stages seems to correlate with big outcomes. This recognition has come contemporaneously with tech becoming a larger part of the overall economy and one of the few spots where you can invest in growth. With the emergence of deep learning, AI, software and mobile device ubiquity, every industry is up for grabs. This is attracting more and more capital trying to own some of this growth and maybe have a shot at the next Amazon, Netflix or Google. Or even Uber, WeWork or Slack.
This is creating different dynamics in the venture industry. The headline of this shift is obviously Softbank. Never in history has more capital been deployed in this short amount of time into innovation or hyper-growth tech companies. It would be foolish to try to understand its long-term implications or consequences. However, we can discern some short-term consequences.
The first is that capital is becoming an ever more present competitive weapon and, conversely, a threat…
Softbank has also established the zeitgeist that bigger private funding is better. This is also bringing classic PE firms into the tech growth equity game. Flush with cash, PE firms are funding companies with “traction” with minimum-sized checks of $40MM. Large growth equity funds and ever larger VC funds are pushing the same narrative. This is loading up cap tables at the top of the stack.
Unquestionably, there are advantages to this situation for leading companies. However, like any teenager given too much money, having too much cash too early, or even the specter that you need to raise a ton of cash, can lead to economically irresponsible behavior. In this zeitgeist, it is getting harder to emphasize to entrepreneurs that unit economics and responsible spending while still in early phases is synonymous with amazing growth and ultimately raising large, but appropriately sized, rounds.”
– January 2018
Don’t Stop the Party
This weaponization was an explosive cocktail when mixed with young founders who had never experienced an economic downturn first hand. This would result, we reasoned, in an explosion of exuberant spending to grow at all costs, leaving behind first-principles business thinking like positive unit economics and profitability.
“Moreover, the rallying market since 2008 and the general flow of dollars into tech, innovation and Israel has created a reality where there are a lot of founders out there that have not seen a down market. They don’t know what a tight funding environment is. If you are under 30, you cannot recall the last downturn and when funds are throwing cash at you, it feels like it will never end. Many entrepreneurs and the funds that back them are underwriting to valuations that we think will be unsustainable if markets tighten a bit. In many cases, we will get a second bite at the proverbial apple when that happens. It will help separate the real entrepreneurs from the pretenders and those that are faint of heart.”
– January 2018
To be candid, sitting here in 2022, it’s evident at every board meeting I attend that venture capitalists have never seen a downturn, either.
Much like with many other trends coming in across the Atlantic from America, Israel was fashionably late to the party. But in 2019, the flood of capital came into Israel with full force. Free food, company perks and parties and super-sized funding made aliya (immigrated) to Israel.
“This was also the year in which the increase in venture capital money inflows to Israel (that began with the Chinese and some early-stage funds two to three years ago) reached a new apex, with every growth fund in the world turning up in Tel Aviv. Koch Industries, Insight, Oak and others invaded the market, probably because SoftBank was less present here, and some of the larger Silicon Valley funds, like Sequoia Growth and Bond, almost never come to Israel. Perhaps everyone just likes the good weather, bars and beaches that Tel Aviv has to offer. Strikingly, we now have self-described venture and growth funds buying Israeli venture capital funds to increase ownership in target companies.”
– January 2020
The Second Act, Secondaries
Another sign of the times was that of the rise of outsized secondary stock sales alongside primary funding rounds. Unlike primary capital, which is injected into the company’s coffers against the issuance of new shares and can be used to support the operations of the business, secondary transactions involve the sale of existing shares held by founders/early employees/early investors to new investors and therefore do not end up in the company’s treasury. Taken at face value, reasonable secondary transactions can be a net positive and fill a dual purpose:
- Employees do not typically enjoy the benefits of a diversified portfolio, such as those held by their investors, and likely have most/all of their wealth tied up as paper gains in their company stock. Unfortunately, you can’t pay for groceries or take out a mortgage with your illiquid private company stock. Taking some chips off the table can remove the financial stress that gnaws at the founders’ mental resources, allowing them to climb up Maslow’s hierarchy of needs, eliminating short term thinking and enabling focus on going after the big prize.
- For existing investors who want to cash out (to manage risk, or because their fund is reaching its contractual end of life or must cajole LPs ahead of raising a new fund), they get an opportunity to do so, eliminating misaligned incentives around the board table. Existing investors that are in it for the long haul don’t suffer dilution that would otherwise occur in order to allow new investors to hit their target ownership. Everybody wins.
However, as we were all taught and as the great Jewish philosopher Maimonides stresses, any virtue when taken to an extreme can become a vice…
“Since we took your money, we told you that we advocated some secondary selling after risk had been mitigated, to align interests and build big value for the long term. However, the secondary purchases on offer now are a lot more than “some” and we are viscerally aware that there is no such thing as free money. When interim liquidity becomes a goal in and of itself, it can cloud founder and board judgment. This is doubly true since the IPO market has been pretty rational, only according great valuations to exceptional companies. This creates a perception among entrepreneurs that the IPO promised land is remote, M&A is unpredictable and Softbank and its ilk are the Messiahs of liquidity. They may be the bearers of short-term liquidity but long-term, top heavy cap tables with high valuations can be a burden, particularly on the venture investors. After all, this is only partial liquidity.
Moreover, ever larger amounts of capital can also cause unit economics to become tertiary considerations to “growing out of the problem” and growing to catch a secondary. Companies that are flush with cash can also confuse unlimited growth opportunities with good businesses.”
– January 2018
In 2018, the market was still “pretty rational.” But that changed.
Last Call
Coinciding with an explosion of investments in private technology companies, in 2020 public market tech stocks soared to unprecedented levels (that is, until 2021), reinforcing the thesis that outcomes for the venture capital asset class are an order of magnitude larger than those of yesteryear, and thus justifying getting into the “winners” at all cost. “Cloud” software does, in fact, sound lofty! The acronym “SaaS” became the modern day equivalent of adding a .com suffix in the late 90’s, when companies in the category automatically garnered lofty valuations. Some of us are old enough to still remember that. At the same time, many growth investors compared the risk of SaaS companies with those of bonds.
“Economic values shift and valuations change when platforms change and evolve. We are now living in a world of four trillion dollar companies, a 10-year bull market in stocks and an even better 10 years for many leading tech stocks. However, it has not been a uniform rise up and to the right, and, most recently, there has been a disconnect between public and private markets in some cases, and some wild valuation gyrations in the public markets themselves…
As previously mentioned, public markets have rolled out the welcome mat for SaaS companies over the last 18 months. Many investment categories are trading at robust valuations, but this phenomenon is even more pronounced with SaaS companies. They are trading at the high end of multiple ranges, especially those that are growing quickly at scale, such as Okta, Shopify, Atlassian, Zoom and Datadog.”
– January 2020
Avoiding a Hangover
Here is where we turned view into actionable insight. Punditry is best left for the media. Investors need a strategy.
Punditry is best left for the media. Investors need a strategy.
One of the positive side effects of my age, unlike insomnia, is that I have seen this happen before. Though the backdrop and narrative always changes, the mechanics stay the same: fear is replaced with greed and FOMO, cash becomes trash, valuations soar and tourist investors rush the scene seeking alpha. Pundits tell stories of how “this time it’s different.” But those of us with real scars and losses from the early 2000s and who have stuck around long enough know that though markets and technology may change, the underlying force that drives markets hasn’t changed in thousands of years — human behavior.
The underlying force that drives markets hasn’t changed in thousands of years — human behavior.
And it is that same human behavior that causes history to repeat itself with incredible predictability, creating boom and bust cycles. It is a prerequisite for VCs to be optimists, but that must not be used as an excuse to rid ourselves of the imperative to understand where we are in the market cycle, for the tide inevitably turns, and when it does, it is our duty to our entrepreneurs and investors to help navigate the choppy waters that ensue. You cannot time the market precisely, but you can be prepared for its U-turn. Simply recognizing the market is in the late stages of a bull market is insufficient. Sitting on the sidelines is not an option, as markets can stay irrational for a very long time and stopping all investing is a losing strategy in venture capital. The bottom line, as Bill Gurley and Jeff Bezos say, is that you have to play the game on the field.
You cannot time the market precisely, but you can be prepared for its U-turn.
We consistently told our investors that we would be paranoid about tanking up on capital at our portfolio companies and consuming it responsibly.
We actively encouraged our portfolio companies to raise capital. A lot of capital. And though I suspect this was purposefully, or inadvertently, done by many simply as the result of the sheer quantum of capital seeking investment opportunities, and though there aren’t any brownie points for intention when the outcome is the same, this is worth pointing out nonetheless. Moreover, because we did it consciously, we paid attention to terms that could be detrimental in a down market.
The quantum and cost of capital put against a given business strategy or unit economics was also something we paid close attention to. Therefore, I suspect others were perhaps less cognizant of the way that capital was consumed. We developed an internal chart (my partner Eden Shochat drove it) that showed months to “out of cash” for every company. The same chart showed every company’s revenue plan and whether they were hitting it. If not, someone asked a question on execution — particularly on how to extend runway by as many YEARS as possible to be able to figure this out. The cost of capital was our North Star. Take it when it’s cheap, as long as you can spend it wisely. We reviewed this every week in the years leading up to the current market, lest we be caught without a bathing suit when the tide went out. We obsessively lived the old adage that there is only one reason companies go bankrupt: they run out of money.
Graph 1: Comparison of the amount of primary funds raised across the Aleph portfolio, contrasted with the number of active companies in the portfolio that calendar year.
“P&P: Paranoid & Prepared
For a number of years, we have talked about tanking up on capital to buffer our companies for a recession and liquidity crunch. We feel like a broken record. Candidly, we have been wrong. There has been no liquidity crunch. We still have not lost a company. We are hesitant to yet again suggest we are tanking up at the portfolio companies in advance of a tightening, but… alas… we are. History favors the well-prepared and competitive dynamics favor the paranoid. We are also focusing on the aforementioned capital consumption dynamic. One piece of consistent feedback in the market is that even if it will tolerate losses, the buy side is focused on improving capital consumption both in marketing spend and total losses. Rising marginal customer acquisition costs have been a significant negative signal at consumer-facing companies and even at SaaS businesses. Public market investors want peak capital consumption to happen in private markets and not in public view. Quite predictably, these two issues are conjoined. As late-stage private capital abounds, private companies are spending more in general and on marketing specifically, driving up costs of customer acquisition and lowering returns on marketing. The public market has had enough of this, and they are right.”
– January 2020
Huge thank you to Gali Baram for his help with this post.
In Part II of this series, “Rising to a New Dawn,” we will focus on how this impacted our investment strategy and what the change in capital markets means for companies.
