I’m Optimistic: Extending my Thesis to Early-Stage Venture — Part 2.0

This a second post as part of a series. You can find my other previous and later posts here:

1. I’m Optimistic: My Thesis on Startups, Venture & Technology — Part 1
2. I’m Optimistic: Extending my Thesis to Kanata’s Strategy — Part 2.1

In my previous post I’m Optimistic: My Thesis on Startups, Venture & Technology — Part 1, I explained that despite the widespread risk-off position for many venture GPs and LPs, persistent geopolitical volatility, supply chain disruptions, restrictive monetary policy, high cost of capital, and revaluing of venture portfolios, as an Entrepreneur, a Technologist and an Investor, I’m still optimistic about technology and venture for three reasons:

1. We are currently experiencing the start of a new economic cycle with asymmetrical upside over the next several years;
2. I believe we have entered a new technology paradigm with AI (collectively in all of its definitions), which should last at least a decade, but I suspect will last several decades, and
3. The Aggregate Total Addressable Market (TAM) for all Technology is growing to become a larger ratio over the overall economy.

In this post (Part 2.0), I’ll dig a layer deeper and extend my thesis to explain why I’m optimistic about early-stage venture investing, specifically the pre-seed market. In the accompanying post (broken out into Part 2.1 to improve readability), I’ll also show how my optimistic outlook is being reflected in Kanata’s Fund Strategy.

In follow-up posts (i.e. Parts 3 and 4), I’ll explain how my optimism extends into focusing on B2B Enterprise and international emerging markets such as LatAm, CEE, and APAC.

Why I’m Optimistic About Early-Stage Venture

Reason #1: The VC Industry is Bifurcating Between Large “Blue-chip” Multi-stage Firms & Early-stage Artisanal Firms

I found this Mattermark article in my notes from 2016 (does anyone still remember Mattermark?) that nicely predicts this longer-term trend:

“Two ends of the venture investing spectrum attract the bulk of attention. First is big, established firms with assets under management in the nine-to-ten figure range. These firms have been top of mind in the tech and finance communities for decades at this point. But more recently, there has also been an uptick in attention paid to smaller, scrappier VC firms whose coffers are much smaller.”

The genesis of this longer-term trend comes from the evolving structure of US capital markets, specifically the concentration of public markets (number of public companies is declining and 14% of the S&P500 market capitalization is represented by 7 tech-ish companies), and the expansion of private markets. This structural change manifests into three catalysts for the venture industry bifurcation:

1. Entrance of New Institutional LPs: The last few years have seen an influx of new very large institutional LPs into the global venture ecosystem, such as pension funds (here and here), large family offices and sovereign wealth funds (here and here). This has created an incentive for point #3.
2. Migration of Traditional Private Equity Firms: The recent migration of traditional private equity firms such as KKR, Blackstone and Apollo into alternative asset management firms, focusing on an increasing number of asset classes such as infrastructure and private credit. This has created whitespace in the private markets for point #3.
3. The Institutionalization of Venture Capital: Large “Blue-chip” VC firms less resemble traditional partnerships managing funds, and more like asset management corporations with services platforms. While lately, Private Equity firms have migrated across asset classes, Venture Capital firms have migrated across stages and product offerings all the way into public markets. These multi-stage firms are building products (funds) that are bigger, often multi-stage and drifting later-stage, which are attractive to the new large institutional LPs mentioned in point #1.

Source: Crunchbase

Reason #2: This VC Industry Bifurcation is Creating More Whitespace for Smaller Early-stage Artisanal VCs

In May 2022, Frank Rotman of QED Investors published a white paper called “The Three-Body Problem” which predicts that there are four types of firms that will have any competitive advantage in the future VC industry: “Scale” and “Late-stage generalist” firms on the large end of the spectrum, and “Non-consensus alpha” and “Solo capitalist” firms on the small end of the spectrum. The Acquired Podcast described the same idea during their Andreessen Horowitz Part II episode:

“It’s the same thing that’s happening in the media ecosystem where there is no more middle. If you are going to be one of the few who succeed and you’re big, you have to have a big ass cost structure. Andreessen Horowitz is the New York Times of venture capital.”

“Simultaneously, it will be true that there’s this long tail of people. They’re like, F that big cost structure. I’m going to start kindergarten ventures and take my small amount of capital and no team, and I’m going to play a completely different super niche game. There is some room in the middle, but there’s not the room that there used to be in the middle.”

Source: Acquired Andreessen Horowitz Part II and Spotify

I believe this bifurcation creates whitespace for smaller artisanal firms for a couple of reasons:

1. When a large, multi-stage, “blue-chip” institutional VC firm has a ten-figure or eleven figure AUM, there is an opportunity cost to allocate capital, time and energy (source, conduct due diligence, write small cheques and support) to small check portfolio companies.
2. The practice of early-stage artisanal VC is not scalable.

Reason #3: Early-Stage (Pre-seed & Seed) is the Most Level Playing Field Between Large & Small VC Firms

Early-stage venture as defined as pre-seed and seed is too large, wide spread, random and inefficient for large “Blue-chip” firms to have a complete monopoly on relationships with high quality entrepreneurs. This reduces larger firms’ edge when it comes to seeing and competing for high quality deals. For example, according to Crunchbase, there were:

• +4,100 newly formed pre-seed and seed companies founded globally in 2023, +1,800 in the United States, and
• +19,000 pre-seed and seed transactions globally in 2023, and +7,700 in the United States (Pitchbook says 4,841 pre-seed and seed transitions in the USA in 2023).

The volume of both annual new company formation and deals in the market is too large and inefficient for any class of firm to have complete coverage.

Why I’m Optimistic About Pre-seed Specifically

Reason #1: Pre-seed Offers a Better Risk Adjusted Return than Seed

The logic is pretty simple here:

1. Pre-seed deals traditionally have lower valuations, and therefore smaller cheques can buy a larger percentage of ownership relative to seed deals.
2. According to Michael Kim of Cendana Capital, based on data they have collected from their portfolio, pre-seed and seed have the same mortality rate of 9%.

Smaller Investment per % of Ownership + Same Risk of Loss = Better Risk Adjusted Return

Reason #2: Adoption of AI Tools Should Make Startups More De-Risked & Capital Efficient at the Earliest Stages

I covered this in my previous post:

“If you started a software start-up in 2004, before the launch of Amazon Web Services, you needed to raise millions of dollars in investment to buy servers to be installed in a colocation data centre before writing any code. Post-2006, the SaaS business model became incredibly capital efficient due to the adoption of 1) cloud service providers, and 2) compounding recurring revenue models.

However, for the last 10 to 15 years, the scarce and expensive resources limiting a startup’s product development and speed to market was technical and product talent. I don’t think ChatGPT code will replace a skilled CTO, but Founders and early teams should be able to leverage AI Agents, co-pilots, etc to hack together an early working version of their product and generate early customer validation on almost no investment

Reason #3: Pre-Seed has the Least Competition of Any Part of the Venture Market

The concept of a seed round has been around for about 10 years longer than the concept of pre-seed. So it makes sense that seed-stage has better investor coverage. According to Crunchbase, there are half as many active (has made an investment in the last 18 months) pre-seed investors (+4,300) in the United States as there are active seed investors (+8,500) in the United States.

I argue that early-stage VC firms have a natural and perpetual incentive to migrate later in the maturity spectrum:

• VC firms are economically incentivized to raise bigger funds 2 and funds 3, etc. (Management and carry fees).
• As fund sizes grow, cheque sizes eventually need to grow, as there is an upper limit to the number of portfolio companies per fund. Fund sizes grow exponentially (see a16z Fund Size chart above) and number of portfolio companies per fund grows linearly to an upper limit.
• Startups compete for funding by having more traction, less risk, and being more mature than their peers seeking funding (i.e funding milestones for each stage get pulled forward).
• All of these factors cause startups to look more mature, have higher valuations at each stage compared to the previous generation, and causes cheque sizes to increase in tandem.

Assuming my logic is sound, there should be a never-ending cycle of new emerging managers starting at the earliest stage, and naturally migrating into later stages, leaving whitespace behind them for the next cohort.

In the accompanying post (Part 2.1), I’ll also show how we’re applying these ideas to Kanata’s Fund Strategy.