Capital Formation Trends in the Technology Sector

You see 2022 had four consecutive quarters of declining deals in venture capital, four declining deal count and declining venture investment. Four quarters, those same four quarters, you had four quarters of consecutively declining exits. Both the number of exits and the dollars generated by those exits, but at the same time, you had a banner year for limited partners investing in these funds. We saw, I think, over 160 billion invested into a smaller number of funds, but the highest investment ever. So a crazy time, but as I say, everything was happening, valuations going down, it's the year reality started to set in and I think we'll see more of that.
AW:Let's talk about valuations for a second because I've been reading that valuations are in the early stage and in other stages of VC investment could be down 35%, 40% from where they were a year ago. If you go back historically and you look at the dot-com crash, if you look at the global financial crisis in 2009, it took about 18 months for the market to bottom out. And so here we are, maybe we're 12 months into declining valuations. Are we at the bottom? And do you see VCs kind of waiting to invest now until the market hits the bottom? Or where are we?
MK:Well, I don't know if we're at the bottom. As I said, we've got four consecutive quarters of things going down. I'm sort of believing that things are going to start to stabilize probably. It wouldn't surprise me if all of 2023 consisted of what the fourth quarter of 2022 looked like and run roughly at that rate. I anecdotally, I didn't actually feel that the evaluations going down until about the beginning of the second quarter last year that... And I was just shocked through going through 2021 and saying, "How can these numbers still be this high?" And they were, but then you really saw it happening in real time by beginning of Q2 last year.
AW:And any correlation between... We've seen seven in the Fed has increased interest rates seven times in the immediate past.
MK:Yeah.
AW:Or do you see any correlation between interest rate increases and valuation declines?
MK:Well for sure. Well first of all, the private valuations are going to be based somewhat on or they're going to draw their visions from the public markets. And then you've got these early stage companies and they've got inflation problems, they've got economic problems, you've got the Fed. These are impacting their ability to grow. So anyway you look at it, all this stuff is pushing together and valuations are coming down.
AW:And now with valuations coming down, I guess we're now subject to the thing that every investor, every entrepreneur wants to avoid. And that's the proverbial down round and tech council ventures as a series A and series B investor. I mean the last thing you want to see your portfolio companies experience as a down round, how are you looking at that this year and how are you preparing your portfolio companies for that may be inevitable point.
MK:Well down rounds are real and they will be happening. And I'm seeing it on new deals that I'm bidding on right now. What's happened is if you think 2020, 2021, these were years when maybe those valuations were inflated, maybe some of these down rounds, it's just a rationalization. And the notion is that if you had had a more reasonable series A, maybe your series B would be flat and not down, but we're going to see them and you just got to put up with it. And the funny thing is, you need the capital. Right now. You need cash. And if it's got to be a down round, that's got to be what it is. You just try to work through it.
AW:You know, it's interesting because you read in the press over the last six months, last eight months, the number of tech companies laying off employees is becoming quite common. And it seems like there's sort of a change in philosophy that it used to be in the venture capital business that was growth at all costs. People weren't concerned with profitability until they got to be much larger enterprise. But now it seems that not only do companies have to grow, they have to grow profitably. And are you seeing that now with all these layoffs that you're seeing in these larger tech organizations?
MK:Well, think back to the world that I'm usually engaged in, which is the early stage company, all right? The message I'm giving all of our CEOs is just don't run out of cash. Plain and simple. Do not run out of cash. And if that means managing growth and profitability, if that means managing hiring and spending, if that means changing some of the milestones or your objectives, here's what you want to accomplish. It's manage your cash to not run out of cash and not obviously until you've got achieved sufficient milestones that you are able to raise another round.
AW:And how are you working with, especially at the earlier stages like tech council ventures investing, how do you work with your portfolio companies to conserve cash? How do you size your portfolio?
MK:Oh, it's different for every business. It depends. If you've got a software business and they've got some product out there and they're trying to grow revenue, you're carefully managing how do you... What's your sales process, what type of sales team do you need, how well can you execute there? But we invest in the healthcare world too. So we've got several pre-revenue companies, medical device as well as a regenerative medicine company. And these are ones where you've got to manage your staff. You're focused on clinical trials, right? You're focused on how do I...
AW:But you're capital intensive.
MK:Yeah, exactly. So it's different in every business, but the key is you've got to have solid planners. You've got to have finance people who are willing to look carefully at what they're doing and think ahead, be thoughtful and the obvious, make tough decisions sometimes, right?
AW:And I guess also the sort of optics of the industry now where the IPO market sort of fall off a cliff. SPACs are a thing of the past. And those were great sources of liquidity for tech back, tech... For venture backed businesses. And now that market sort of disappeared. And unless larger VC company funds come in with large capital they can deploy with these early stage companies, it's going to be tough for them to continue on.
MK:Well, you got to take all... As a venture investor, you've got to take all this into consideration. You've got to imagine what's happening out there in the IPO market and so on. When we look at an investment, we try to... Part of our process is to do a return analysis and we try and understand what are we going to be planning on investing, and what do we think the return could look like? And to go through that, we sit there and we imagine what's the growth of this company going to look like? What are the margins going to look like? What type of exit? Is this potentially an IPO or is this really, is this just going to be an acquisition? Not just an acquisition, but an acquisition? And then we try and imagine what those multiples will look like and you go through the whole analysis and say... You look at a best case and most likely and so on, and you say, "Here, I'm going to put 3 million bucks in and I'm hoping to get 18 at the other end."

But the whole IPO market and the idea of what the potential exits are, you factor that into your thinking. You just deal with it.
AW:So when you look at an early stage VC fund like yours, what are the return metrics that you guys talk about at your partner's meetings? What's the expectation? And I'm sure those expectations have sort of been downgraded because what's going on in the marketplace today?
MK:Well, I don't think my partners have downgraded their expectations. Well, I mean, you do this for a living, you get it. People are looking at looking either multiples or IRR, all right, that's it. There's no magic there. How much is invested? How much is returned? IRR, you throw timing into the whole thing. What's interesting to me is you can go to PitchBook and you can look at funds in the past and see what they've done. And generally they're looking at maybe a total returned to... Total return capital and so on or an IRR. But in any case, the numbers are all over the map. You can see funds that got a 10 x return and you see funds that didn't return capital. And it's shocking, but it's real. I think we look at venture and say, as an IRR, "I'd like to see between 20 and 30%."

And it depends a little bit on the risk. The earlier stage the fund is, it's probably going to... What you're probably going to look for, it's probably riskier and you're probably going to look for a higher return. Now when we look at our fund in particular, we're really looking at money on money. My partner, Jim Gun, who I think his first fund was a 4.4 x fund. A little bragging on Jim there, top 1% of vintage. But right now in this fund we're... Our target is three x. That's what we'd like to do. We'd like to have this be a three x fund. And frankly, it's doing pretty good so far, so...
AW:Because guess I've always been told that sort of the venture capital game is a game of thirds, one third of your investments, you get nothing back. One third of your investments, you get your capital back and one third of your investments, you get back a huge return. Is that sort of true for your...
MK:I think that's roughly right. I think that's roughly right. Actually, we do a lot of work on reviewing the past and looking at where we've been successful and why we've been successful and so on. We're probably skewed to a lot in the middle that we got. I mean, certainly got your deals that fall off the table and the two...
AW:And you want those to fail fast.
MK:You sure do. But we've historically had a lot of five Xs and six Xs. In the current fund, I mean, I'm hoping we'll have some more than 10 Xs, but maybe two, at least one. But that's right. That's how you look at it and you have to... You play that game.
AW:Let's witch gears a second. One of the new component, well not new component, but more common component of the venture capital space today is really the concept of corporate venture capital. And I think there was a number I saw published maybe 70% of VC deals last year, had some level of corporate venture capital in it, and probably 90% of the Fortune 500 companies have a corporate venture capital unit. Not that you compete with corporate VCs, but why should an entrepreneur take your money rather than a corporate venture capitalist money?
MK:Well, so corporate, or I'd also call them perhaps a strategic investor. There's a lot, there's certainly pros and cons to that, okay. The corporate money usually, first of all, they're usually softer terms and they're usually a good investor in terms of bringing credibility to the company. Usually there's some network effect. They've got some talent that they're bringing in some relationships, which certainly that we do as well. The strategics, some of the cons are... My favorite quote out of the movie, the Devil Wears Prada. Meryl Streep says, she says something like, 'Oh, come on, just keep moving at that glacial pace, you know how much that pleases me." And I've heard it said that the strategic investors are the ones that move at a glacial pace. And I think, so that's a bit of a con. Funny thing is strategic investors, if they're on your cap table, that could have an impact on an exit at the other end because then when other strategic acquirers are there, they're looking at who's already in there, they're wondering do they want a bid and so on.

The other thing about strategics is, oddly enough, sometimes they'll bid the price up too much and you say, "Well, why would that be a bad thing? The entrepreneur will be thrilled about that." But if the price is up too high, then that may keep other investors from coming in. And then that may also, if you do one round it an evaluation too high, then the next round, if you don't go into that valuation the next round, you go back to the down rounds you're talking about too, right?
AW:So I know a lot of entrepreneurs I work with are thrilled when they get a relatively high valuation for their business at an early stage. That's good and bad, as you just said. And especially now where valuations have come down dramatically. Those companies that raise money at a $50 million pre in 2020 or 2021, and now we're going to look at a $30 million pre on the next round, that's a tough pill for investors to swallow.
MK:So in a personal investment I made several years ago, what happened to be convertible debt into an early stage company, the entrepreneur got a strategic to come in and for a series A, bid it way up, I was thrilled. I'm looking at my convertible because I had a cap on that. I made four x on that right then. And I thought this is great, was way too high. The strategic, which happened to be a European company, ended up getting bored. The growth that was anticipated coming out of that relationship didn't happen. The entrepreneur went back to do the next round. It was clearly a down round. She wouldn't even do it. She wouldn't do the down run because it was so much, she ended up circling the wagons. The company ended up being successful, but it just took years longer because she lost so much time from not being able to do that. It's a problem raising money at too high evaluation and we'll see more of that now.
AW:So when we look at fundraising today, limited partners have really embraced the venture capital space. I think we've raised about, the venture capital industry has raised about 300 billion over the last seven quarters, couple years, okay? 2022 was 160, $180 billion was raised, it was a record year. So there's a tremendous amount of capital on the sidelines. So how do we balance the capital on the sidelines? And now with a scenario where it's becoming more difficult for entrepreneurs to raise capital, how's that money going to get deployed?
MK:Well...
AW:And is sort of the deep decline in valuations going to help that capital be deployed because now it's being invested at much more realistic numbers.
MK:Well, look, I've heard some people say that some of the VCs are sitting on the sidelines right now and waiting for things to bottom out. And I've not seen that per se. I mean, again, I've heard it. My sense is that people have lots of capital to deploy. Okay? We certainly do. And there's a lot of entrepreneurs out there. There's a lot of innovation, there's companies that need funding. What this calls for is just being more disciplined and more selective. It's just harder work. Right now as an investor, I've got to really focus on our criteria and the type of deals we're investing in, and I've got to just be more disciplined there. There's a deal in New Jersey I want to do right now. Right now, I like the business, I like the entrepreneur, the space. I like all of it. And it's not going to get done because the entrepreneur is stuck on evaluation that I can't get to.
There's times you have to stick to your guns on this stuff here, but nonetheless, it just calls for more discipline and more hard work. You can't stop. And I don't see how anybody's going to just say, "Well, I'll sit tight for a year."
AW:Because the problem is that entrepreneur is probably looking valuations from 18 months ago and...
MK:That's exactly...
AW:... Refuses to accept your evaluation.
MK:That's exactly what's going on. Yep.
AW:Crazy. Absolutely crazy. No discussion of venture capital in this time would be complete without at least a reference to FTX, certainly a debacle for a lot, a number of large venture capital firms. How is the FTX situation changing how you and your partners deal with your portfolio companies from an audit perspective, from a governance perspective? It was crazy what happened there in terms of just the lack of transparency in that company and what they got away with.
MK:Just crazy running a company with Slack and QuickBooks, it was terrible. A lot of people got very hurt in that. I mean, that had our fund and most of the early stage funds I know just had nothing to do with that unless you were specifically focused in the world of crypto. But to your point, I think we're going to see a lot more regulation. I think we're going to see a lot more looking under the covers at the source of things. To be honest, I don't see how that's going to have too much impact on the early stage role that we play in. And if it does, it's only going to be beneficial. Some more of that transparency and so on.
AW:I mean, do you see the SCC and other groups creating additional regulation for the venture capital industry to make your lives a little bit more difficult?
MK:I'm hardly an expert there, but it wouldn't surprise me at all. That's certainly an area of some of your background too, man. What are you thinking there?
AW:Because I think they're going to have to create additional oversight over the activities of venture capital entities. I mean, they've just gotten so large and now, you see the raising of a billion dollar fund every other day and they're writing a hundred million dollar plus checks. I mean, there's got to be some level of regulation, some oversight. There's got to be compliance, it has to be held accountable.
MK:I expect. I expect.
AW:And I just don't see it continuing as it's been occurring right now.
MK:My hope is that it doesn't hurt the type of investing we're doing other than maybe slow it down just a little bit.
AW:Because the other concern is, I mentioned before how LPs embrace the venture capital space. Now everyone's reading about what happened at ftx, is this going to impact fundraising in the future? We've had record years of fundraising, it's bound to slow down.
MK:Well look, you know as well as I do venture capital as an asset class over, if you take any horizon, a three-year horizon, five, 10, even a 20-year horizon, it's always been one of the top performers. Okay? It's just been this past year that it's been so challenged, so troubled. Investors, particularly investors in these fund, they're 10-year funds. You've got to take a long term view that the key from the investor's standpoint is do you trust the team that you're investing in. Trust that team of general partners, you're giving them 10 years to work with your money. And so I don't think that that's going to be a big impact. I think we're going to continue to see a lot of money poured into it, and I think a lot of work's going to come out of it.
AW:So let's talk about the team for a second. And I'm a big believer in the adage that you invest in the jockey and not the horse and the team is the jockey in most companies. And one of the things that I think most entrepreneurs don't fully understand, I think there's two things they don't fully understand. Number one is how much capital do they need to raise? Because it's not what you want, it's what you need. And number two is they don't understand why the investor venture capitalist says no. And as you know in your business, you say no many more times and you say yes. I mean, your deal funnel is hundreds if not thousands of companies. And the number that flow through the bottom to get your money is a small number. You can count on one hand or two hands. So if you're advising entrepreneurs today, how much money should they try to raise? How should that capital be deployed? And what milestones would you as an investor expect them to achieve?
MK:Okay, well first of all, it's all about the specific company. And what they need is a real solid plan. Both a plan, a strategic plan. What am I going to be doing here? And then a financial plan, how am I going to execute it? When you think about it, you're raising... And how much money to raise? You're raising money to get to either to get to a position where you don't need more money or you're cash flow positive or you're raising money to get to the next round. And in that case, you've got to say, "Well, what milestones do I have to hit? What do I need to do that is meaningful enough that an investor will come in and invest at the next round?" So a couple years ago, I might have told people, "Raise..." Assuming this, they're not looking at this as their last raise. I would've said, "Well, try to raise money for 16 months, cover you 16 or 18 months, and be sure you've got specific milestones lined up that you're going to execute to so that you can be ready for the next raise."

These days I'd err on raise more money. I'm telling all my companies, "If there's more money, don't worry about the dilution, get the cash." And I'd say focus on getting 24 months worth of cash and milestones. Look, investors don't want to see pictures of hockey sticks anymore. Investors want to see results, all right? If it's a SaaS company, show me my recurring revenue growth, all right? And show me a real sales process that works and show me a sales engine that knows how to execute and show me a genuine pipeline. If it's a regulator company like ours, show me the progress you're making towards clinical trials. Show me the device. It's milestone based.
AW:So when you look at... You made a comment before, try to get as much money as you can when you can.
MK:Within reason.
AW:How does an entrepreneur deal with that today when the money's coming in at a much lower valuation than they would've expected? And as a result, their dilution at this stage is maybe more than they were willing to consider. How do you convince them that, you get... Our money's important, you're not going to get any further without this capital?
MK:Well look, like I said before, from an investor's standpoint, you got to stick to your guns. You've got to be disciplined, all right? I'll have that conversation with an investor and us, or I'm sorry, with an entrepreneur and say, "This is how it is. I'm sorry, this is the economy. This is where the valuation is." At the end of the day, if you don't like what I've got to say, listen to somebody else. And if someone else gives you money at a better valuation, take it. And even that's not always the right answer, but...
AW:So Mark, let's spend a couple minutes talking about deal terms.
MK:Okay.
AW:And as the industry has evolved, I guess there's been changes in how venture capital deals are structured over the years, and what are some of the changes that you've seen in your career? And also what are some of the terms in an agreement with an entrepreneur that there's no negotiating at on, they have to be included in deal?
MK:Well, so first of all, there's lots of ways deals get done these days. You've got your safes and you've got your convertible notes, you've got your preferred stock and so on. And as a fund, frankly, we were willing to do all of those. We would prefer to do a priced round, but there's situations where that's just not appropriate. As an investor, I try to look at the situation and I look at... Obviously after you've done the diligence on the company and you're confident in the team and such, you're sort of looking at, well, what's the deal? What type of instrument is most suited for this deal? You're looking at what's the amount they're raising and you're looking at deal terms, you're looking at evaluation number, you're even looking at your co-investors because you're trying to put this... As an investor, I'm trying to put this all together and see how do I work this? It's you take a holistic approach to all these pieces.

And so when you say what's not negotiable, a lot of it's negotiable. It has to get sort of pushed around a little bit to come to a satisfactory end there. Again, going back to what I said five times, you got to be disciplined and there's certain things that I'm not going to go past. There's certain terms that are very difficult to deal with. An example would be a non-dilutive warrant. You're saying now that's something that I just don't know how much it's going to be if I'm worried about pricing it later. So there's things that are really difficult, but again, you manage through all these things.
AW:And when you talk about having a preference for price rounds, I certainly understand that. But also when you deal with an entrepreneur or a team and you're investing your capital in their business and you're getting a piece of the equity, do you guys want the entrepreneurs to have a certain amount of equity available to them after the round? I mean, you want to make sure that the entrepreneur has skin in the game and has enough of an interest in the company that he or she is still working as hard as they can to make this successful.
MK:That's very much the case. And as you know, typically when you're bidding these deals, one of the stipulations is how much stock are you going to leave in a pool for future employees? And a typical thing is to say, "Let's make sure that there's 10% of unallocated shares that we can award to new employees coming in."
AW:Which would be their option pool.
MK:Yeah, the option pool. But at the same time, yes, you'd like the senior team. In a venture world, you want these people, you want salaries to be lower and you want them to have more equity because you want them to be focused on making the big win on their equity. And oftentimes, especially after a raise, you may have to rearrange some of that to just make sure you've got the senior team all properly incented.
AW:So a lot of the people seeing this program are going to be entrepreneurs or raising capital for their businesses. What would be the three points of advice that you would have for them?
MK:On raising money?
AW:Mm-hm.
MK:Well, the first thing is you've really got to have a clear plan. You've got to have just real clarity in what... Both, again from the strategic side, what you're trying to do and a solid financial plan. The next thing is lots of transparency, okay? Don't try to hide anything at all because people are going to figure it out. And the third thing, and this is the most important point, as an investor, I'm always looking at the team. I know it's an anecdotal buy into a first class team with a second class product over a second class team with a first class product. Everybody says it. Turns out it's true. That's why they say it. So get the right team there.
AW:And final thought, so where's the market going to be in 2023? You had your crystal ball. What's it going to look like?
MK:Well, I said it a little bit as earlier on, which is to say I think we're going to see this year be pretty flat to last year. I don't think we're going to go down. I think deals are going to get done. It was a difficult year last year. Reality set in, came in last year, we got it now. I think we'll see it sort of flat from a venture investing.
AW:Mark, this was a great session. Thank you so much for participating and talking about what's going on in venture capital today and your predictions for the future. And once again, to everyone who's viewing this video, thank you so much for participating.

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