The Early-Stage Game; Part II

Indexing works for the S&P, why not for VC?

TLDR: Proposed principles for building a competitor to the S&P 500. And as byproducts, a global community for the most ambitious people in the world and a mechanism to fund nearly every meaningful technology company on the planet.

Last week was the best week in MMM history.

Subscribers grew 20% week over week.

I wrote, in part, about how venture funding for founders and for fund managers had pulled back significantly, and how big of an opportunity that is for both to gain market share in a down economy.

For example, 2,725 VC funds disappeared last year at the same time that Antler was growing itself methodically to becoming one of the most active funds in the world, according to Pitchbook.

I also mentioned why the early-stage game shouldn’t be lumped in with the rest of PE & VC.

While total early-stage deal volume is expected to be 16,000-20,000 per year, there are really only about 5,000 companies started each year around the world that are venture-backed and worth competing for as an early-stage investor. The 4X delta in that number is primarily bad checks and the massive volume of angel investments.

But if you only focused on the top 5,000, and you gave each of them one million dollars, you could own a significant stake of nearly every meaningful tech company in the entire vintage for $5B.

Said differently, for $5B per year, you could seed the vast majority of meaningful tech companies for 8 years with the amount of money Elon Musk spent on Twitter.

All of that to say, it’s not a lot of money in the context of private equities.

And, as an asset class, early-stage venture has produced 19.7% IRR’s historically.

The problem is, even if you wanted to, there is no infrastructure to simply buy the asset class. At least not without becoming an LP in dozens of funds and/or funds of funds with additional layers of fees.

Or at least there hasn’t been one yet.

That’s because there are fundamental challenges to doing it effectively:

1. How do you create infrastructure to evaluate 500,000+ founders annually and decide on which 5,000 to back?

2. Who has both enough capital & a long enough time horizon to deploy $50B over 10 years?

3. How do you support 50,000 companies?

4. How do you rebalance the fund toward the most valuable companies to produce outsized returns, like the S&P index?

5. And with companies like Apple, Microsoft, NVIDIA, etc earning 99% of their value after their IPO’s, how do you extend your time horizon to 20, 30, or even 50 years?

All of this is possible, it’s just going to take some time.

To start, we have to build the infrastructure to evaluate and back founders as early as possible. And I’m not talking about accelerating companies that already exist as that’s a pretty well-defined business model.

I’m talking about making entrepreneurship accessible to every single ambitious person on the planet. Specifically, I think access to entrepreneurship should be as ubiquitous as education. The backlog of code that needs to be written and the number of companies that need to be built is endless with respect to our human potential, and yet there are still more coal miners in the US than there are founders.

Inevitably, that is backwards.

And the reason is basically because it’s too risky to be a founder.

• You make no money. You’re putting your family and your livelihood at risk.

• You have no team. Everything, the entire burden, is on your shoulders.

• You have no clear path to success. It’s not linear or straightforward, but rather an endless journey of unknowns.

So the world needs a destination for these people. A destination for future founders. A place for people who have the ambition but lack the capital, community, and coaching.

Historically, the industry just doesn’t know how to support that.

Instead, we send these people to Harvard Business School for $150,000, to a studio where they give up 30-90% of their business on day one, or to an accelerator where they don’t receive enough money to last the company a year.

The fact is, 99% of the talented people in this world do not have the kind of resources or risk appetites that those paths require, but VC funding has been set up to invest in those who do. It’s been set up to fund the founders who went to the good schools, or paid for the MBA. The ones who have great networks developed by virtuous cycles of good fortune and family ties.

And you can’t exactly blame the VC’s either, they’re putting many millions of dollars into each company, so there needs to be some method of underwriting and risk reduction. And truthfully, that model worked quite well until now.

But unfortunately, models built for the 1% don’t work for the 99%.

That’s why, the infrastructure, this destination so-to-peak, needs to be built to provide the time, space, and resources for founders to demonstrate their potential rather than continue to be a dog and pony show of pedigree-sourced and pedigree-based investing.

So here’s what needs to be done

First, residencies need to replace accelerators.

A residency gives founders the community & resources required to de-risk the endeavor of becoming a founder in the first place. Lowering these barriers to entry for the smartest people in the world will increase both the volume and quality of new companies generated. Greater volume of better deals would allow an expansion of VC into more specialization with the ability to pay lower valuations due to supply, and simultaneously produce meaningful returns with smaller exits.

Second, capital deployed by residencies needs to be commensurate with both the runway required and the risk being taken.

Specifically, founders need two years of runway or more, and investors need reasonable valuations to maintain the health of their business model. These two things cannot be at odds with one another or the entire system breaks down. At Antler in the US, we commit $250K to companies so they can burn 15-20K during the exploration phase for 12-24 months, and then we commit another $250K in capital that is matched 50 cents on the dollar to new money in which both makes it easier for founders to raise, as well as easier for us to rebalance toward the fastest growing companies. For our LP’s, it is also a mechanism by which the founder can prove the value of the business with the inclusion of additional investors, and without us over-committing capital up front.

Third, capital deployed by residencies needs to be invested after the investors have reached conviction on the operators.

In my opinion, it’s borderline irresponsible to invest capital with an 8-12 year time horizon without spending significant time to get to know the founders before you invest. What’s worse, is thinking you can pick and choose great ideas at day zero. If that’s the case, go buy a lottery ticket, or become fortune teller. When you invest this early, you need to have very low ego on ideas and very high conviction on execution. This is incredibly important, particularly in weeding out the delta between the 20,000 receiving angel funding and the 5,000 that actually matter each year.

Fourth, the LP’s of the fund need to change. Traditional high net worth individuals are not the right customer for reinventing venture capital. Sovereign funds, public money, and economic development groups are.

This is not the hope & pray for a 10X fund game. The early-stage game is about transforming the world through technology, while creating economic opportunity and global prosperity. It’s about creating new businesses, new jobs, and bringing a reasonable quality of life to every corner of the globe. Sovereign funds, public money, and economic development groups possess the capital, long-term time horizon, and economic goals that align to the reinvention of VC.

Fifth, this fund needs to be able to rebalance toward the fastest growing companies, and be able to hold positions for decades.

The S&P 500 isn’t one of the best investments you can make because of the fact it doesn’t have fees or because stock pickers aren’t good at their jobs. It’s an unbeatable investment because it rebalances for speed, growth, and leverage. If you owned the S&P the past 20 or 30 years, you also owned Netflix, Apple, NVIDIA, Meta, and so on. In the early-stage game, there are no funds that effectively rebalance from day zero to 20-years post the IPO. Although some firms have been updating their regulatory status, it still doesn’t truly exist yet. But imagine if you seeded Microsoft or Apple and continued to double down for a few decades. Talk about power law returns. Seeding, rebalancing toward, and owning a trillion-dollar company would absolutely, and without a doubt, pay for many decades of future day zero investments that would drive our global economy and quality of life forward. Yes, it might take 30-50 years to get it spinning, but if it did happen, it would be one very powerful flywheel.

Sixth, the fees from the later stage rebalancing funds need to offset the costs of origination.

It is far more capital efficient to run a PE shop than an incubator. One is an allocator and the other is a services business with a mandate. If you can build what I am talking about, then the growth funds used for rebalancing need to also subsidize the management fees and overhead of the origination business. When you do this, costs of origination shift to zero and the return profiles rise dramatically, shifting from what is an incredible opportunity for an economic development fund to achieve 3-5X while also creating new companies and jobs, to as close to a long-term prosperity guarantee as one could reasonably make.

And look, if you have the patience and the personal ambition for it, the math checks out.

Roughly 1-3% of these 5,000 companies are becoming fund returners, and in YC’s case as an accelerator, 6.6%. So if you make enough bets, at a valuation commensurate with the risk, an average performance at this stage will be 3-5X over 10 years.

Most people don’t get that, or believe it. But it’s not a matter of belief. Think about it like roulette, when you play a number on the board, you have a 2.6% chance of winning which is a 35X payout. But in early-stage VC, you have a 3% chance to return 1,000X or more. And, as an early-stage VC, you also get to create your own odds with the fund model you build, and the operations you set up. Here’s an example:

Fund A has $50m dollars. The mandate is to do seed stage investing, with a target of 25 initial investments. Average investment and ownership might be $1m for 10%, with about half the fund reserved for follow-on. The result is 25 portfolio companies. And while only something like 5% of seed stage companies made it to Series A last year, Seed investing has historically been a lot safer and closer to 60-80% graduating to the next round. So now you have 15-20 Series A companies remaining, and the fund owns 10-15% of each. For easy math, graduation rates beyond Series A are about 40% per round, leaving you with 1 series D company to return the fund.

Fund B also has $50m dollars. The mandate is day zero investing, with a target of 100 initial investments. Average investment and ownership might be $250K for 10%, with about half reserved for follow-on. From there, 50% on average make it to seed. The result is a seed portfolio of over 50 companies which yields 30-40 Series A companies and 10-15% ownership depending on follow-on. You now have 2x the shots on goal at Series A for the same capital deployed, and at entry valuations 70% lower. That’s both more potential fund returners, and more mid-stage exits at reasonably high multiples.

As an investor, which fund are you picking?

Now do all of that 50x per year, and in-line with principles above, and you’ve indexed the entire VC ecosystem, building a real competitor to the S&P 500. Of course, if you did this, you would’ve also developed a global community for the most ambitious people in the world and a fund that was originating nearly every meaningful technology company on the planet.

Ambitious? Maybe. Impossible? More like inevitable.

Think about it.

See you Monday.