by Kunal Mehta
Ten years later, FirstMark Capital has had success in the venture market with investments in companies such as Airbnb, Pinterest, DraftKings, inVision, and Riot Games. With this reputation, it is able to quickly raise large funds to continue to build on that vision with the original hustle that Heitzmann alluded to. Through the slow grind that Jacob Yormak and Nicholas Chirls are now familiar with, Heitzmann and his partners have built a deep level of trust with their LPs. This trust has convinced LPs to commit over $1.5 billion to FirstMark Capital’s different funds.
Establishing an Investment Case
Heitzmann told a compelling narrative to his LPs in 2008 when the New York City startup ecosystem was still collectively a handful of startups challenging the dominance of Silicon Valley. Heitzmann established FirstMark Capital in New York City to generate outsized returns with the vision that it would continue to grow in tandem with the ecosystem. According to Heitzmann, their investment approach needed to not be informed by the current macroeconomic environment of the financial crisis, but instead be more forward thinking:
“Launching right before the financial crisis, we hoped that our fund and our thesis would last more than one economic cycle and that we would have headroom to expand. We started FirstMark Capital on a few different themes. The first theme, which over 10 years ago was a contrarian view, was to focus our investment focus only on companies built in New York. The second piece of our thematic focus was to be industry-focused and experts in certain sectors. In our case consumer and enterprise software. This would give us a proprietary advantage in deal sourcing and be uniquely qualified to help our portfolio companies. We were focused on the early stages of development and looking for businesses that took advantage of open source, Amazon Web Services (AWS) or additional tools that helped people get traction quicker. Most importantly, we wanted to be a service business, when that was not common at the time. When we started FirstMark Capital, venture capital as an industry was viewed as an ‘old boys club’ sitting in an ivory tower deciding who would and wouldn’t get money. They often invested in former colleagues or within their own networks. It was a hierarchical structure with many providing little value add. It was more of a reporting relationship than a collaborative relationship. Our belief was that we could work with better entrepreneurs if we flipped this model on its head.”
This model has been fruitful for FirstMark Capital, its LPs, and the other venture funds that recognized the potential in the New York City startup ecosystem and invested heavily in the early days. Heitzmann attracted New York City-based LPs with a strategy for the VC model: not only was FirstMark geographically localized in New York, making Heitzmann himself uniquely privy to regional deal flow that national or Silicon Valley based investors weren’t, but also, FirstMark specialized in select industries and business models, enabling them to approach deals with a propriety advantage that broad-stroke VCs at the time simply didn’t have. It’s that unique specialization that Story and Notation Capital are mastering today.
Eventually other investors arrived at the New York City startup scene and began to capitalize on the growth in this market outside of traditional venture markets of Boston or Silicon Valley. Over a decade later, startup funds continue to emerge and find opportunity and returns by working alongside these veterans and establishing new focus areas. From 2012 to 2018, over 500 micro-VC funds were raised in the U.S. This indicates a growing number of investors who want access to the technology and startup scene.
While Heitzmann focused on geography as a narrative to his LPs, other funds look at funding lifecycles and find opportunities to invest in smaller amounts, as part of smaller rounds, to bring value to a different group of investors. As funds have ballooned in size, so too have the investment round sizes of companies. The larger funds do not want to invest the first $50,000-$250,000 into a company anymore because it is not worth their time to take hundreds of small bets. This has transformed the venture landscape to make space for new funds such as Story Ventures, Notation Capital, and Betaworks that are willing to make small bets. When thinking about their second fund, Peter Rojas and Matthew Hartman of Betaworks discusses how the landscape has changed to create an opportunity for new funds like theirs:
“The seed investing landscape has changed over the past decade. Because of increasing round sizes and valuations, writing $25,000-$35,000 checks does not cut it anymore. Seed rounds are now hundreds of thousands of dollars all the way up to $4 million. A $25,000 check into a round such as that would be a waste of time.”
Operating with a model of making smaller investments, Nicholas Chirls realized that funds like Notation Capital would still be able to add value to founders despite the resources and capital that larger firms promised. That’s the narrative Notation is uniquely providing LPs, as Chirls explains:
“We worked together for five years and developed a thesis around the New York market, which now had a critical mass of high-caliber technical and product talent. Many of these folks were leaving the bigger tech companies that were established here after 2008 and starting new things. At the same time, as the New York market matured, the seed VCs that had been historically funding experiments had now raised so much money that they spent more of their time writing bigger checks and migrating up the venture capital stack. So, who would fund that first $1 million? It’s unrealistic to expect every person to have a wealthy ‘friends and family’ party round. We knew we could be helpful early as lead investors in rounds that are typically under $1 million to start, and we raised a small fund to do just that.”
Limited Partner Perspective
A common frustration I heard from emerging venture capital fund managers is similar to the frustrations entrepreneurs have with venture capitalists. The concept of transparency is an issue that plagues all sides of this market as information is not always readily available. Some GPs claim their goal is to be more transparent about the companies they invest in, what stage of the company’s lifecycle they will likely invest at, and what industries or business models are interesting to them. These same GPs, however, believe that LPs rarely do this about their own investments. As a result, it is often difficult for an emerging fund manager like Yormak or Chirls to identify LPs and understand their motivations. While the preceding anecdotes help to demystify what drives the GPs of a venture fund, the LP perspective is one that entrepreneurs should be aware of. William McQuillan, a partner with Frontline Ventures in Europe, discussed this further and the implications on their fund:
“Limited Partners affect how fast you can invest, the checks you can write, the geographies you can invest in. People think the strategy is on the venture capitalist’s website and is solely determined by the General Partners. That is only true up to a point. The strategy is heavily influenced by the investors in that fund and there are factors that aren’t always clear. It is important to understand who the investors of your investor are, and the longevity or tolerance of those investors. Some investors are willing to wait much longer for a return and some are new to the venture game. If an entrepreneur asks, I’m willing to share that information but oftentimes they don’t ask when they should.”
With the goal of bringing further transparency to this market, I spoke with LPs from different entities, including investors from J.P. Morgan’s growth fund, Cambridge Associates, Hearst, pension funds, and wealthy individuals to better understand their perspectives on venture capital as an asset class to invest in. Resoundingly and to little surprise, the primary motivation continues to be driven by financial returns, but the metrics they use to evaluate fund managers are similar to the frameworks that venture capitalists use to judge entrepreneurs. One LP from a Fortune 100 company who is making investments into venture funds off of its balance sheet stated that she had conducted over 15 background checks to make sure a fund manager had developed a positive reputation within the venture community. Other LPs place less importance on one monumental success in a portfolio of 10 companies and preferred seeing balanced returns acros
s multiple companies in a portfolio to prove that the investor has not just been lucky with one outlier. When asked if LPs are interested in strategic investors who claim to have a thesis-driven approach behind investing, the LPs vehemently stated that they will back generalists who come from a successful operating background but prefer funds that have a strategic focus or insight on a specific vertical or business model.
David Lee, the managing director of Laconia Venture Asset Management (LVAM), has gained a unique insight into the LP perspective over his 20-year career. In 2017, Lee started a business advising family offices on a strategy to invest in emerging fund managers who were investing in the Seed to Series A stages. Today, he works with dozens of wealthy family offices to help source and evaluate venture funds for them. Lee breaks down the LP motivations into a few categories:
“One thing family offices as Limited Partners are often looking for is expertise they could not do in house because they are a certain size. When they are looking to invest $30-50 million over a 3-5 year period, they cannot internally hire a staff that would make sense. For family offices, venture capital is a small portion of their total assets, anywhere from 2% to 8% of their total assets. It’s not like public equities or real estate that would take a ton of their time. So, they want outsourced expertise where they could still have investment decision control. Secondly, venture gives family offices insights into the future of the economy. If a family has established its wealth in real estate with shopping malls and had been exposed to venture over the past 10 years, they would have been exposed to next-generation e-commerce and would have seen how these behaviors are moving online and how they should adapt their businesses. Similarly, if a corporation is currently in transportation and logistics, and not aware of autonomous vehicles, the new fleet, and shipping companies, it is missing out on what could seriously impact its underlying business. It is often easier to invest a few million dollars into a transportation-focused fund or a consumer-focused fund for knowledge sharing. Finally, LPs, be it family offices, corporates, foundations, endowments or wealthy individuals, are being driven by the excitement around unicorns and the fast-growing nature of the startup ecosystem.”
Lee’s points around knowledge sharing and exposure to the startup ecosystem hold true across most LPs. In some cases, family offices or large corporate organizations who saw themselves at risk of being disrupted sought to diversify their exposure across funds that were actively invested in future technology and industry shifts. These funds, through knowledge sharing, provide LPs with a glimpse of this new world. Sharon Rutter, with the Empire Development Fund, New York State’s investment vehicle which has invested in dozens of venture funds to boost New York State’s economy, shares that Governor Cuomo sees venture capital as essential to building local economies in regions beyond New York City.
As for the qualities of a good GP, Lee thinks that the days of ‘two older, experienced men deciding to launch a venture fund’ is no longer compelling to LPs. Similar to venture capitalists and their future makers, LPs are searching for a compelling story on fund managers. Today, a partner must articulate a good story, have some investing track record, and also share a ‘secret sauce that gives them a competitive edge at deal flow.’ Lee discusses some of the funds that he has helped secure investments into:
“We’ve invested into funds that view themselves as contrarians, where they find deals that are outside of New York City or Silicon Valley. They have exposure to emerging hubs that other venture capitalists do not. We have invested in funds that are using a more data-driven approach to find investments by scraping the web for companies that meet certain metric thresholds. We have invested in founder-focused funds, where we believe the GPs have a unique ability to assess talented entrepreneurs. The range of funds that we can invest in is vast. There are deep domain expertise funds that focus solely on investments in artificial intelligence and machine learning companies or funds that focus only on virtual reality or fashion or consumer technology. As an LP, we need to see that the GP has a unique thesis on where these technologies or sectors are going and why their specific fund will capitalize on that trend. There is no one-size secret sauce to picking a ‘genius’ GP, but the minimum hurdle that we must be able to clear is that a partnership of general partners has a coherent investment thesis, a track record of working together, and some traction in an existing portfolio of work.”
Measuring Performance
On measuring venture performance, the LPs alluded to the internal rate of return (IRR), the measure of profitability of a group of investments, being most important. However, there are other metrics used to measure a fund’s performance, including metrics such as Distributions to Paid-in Capital (DPI) or Total Value to Paid-In Capital (TVPI). DPI is how much money a venture capital fund has returned to its LPs divided by the amount of money the LP invested into the fund. TVPI is the total value of the venture fund’s holdings (realized and unrealized) divided by the capital that has been called by the fund. In breaking down these venture fund performance metrics, Rob Go, the founder of NextView Partners, writes about the implication to entrepreneurs:
“VCs have an incentive to make sure that successful companies raise more money from new outside investors at higher prices, as this allows them to increase the value of their own position in the company. This is great if you are interested in raising more capital but it can lead to raising too much money too fast at excessively high valuations if not kept in check. It’s also part of the reason why VCs don’t usually lead inside rounds unless they have to, because it’s hard to justify increasing the value of their holdings if they are marking themselves up. Ironically, some of the best-performing funds are the ones that resist these incentives. They realize that raising more capital increases their effective post-money on their investment, and so are mindful of external capital unless it really has a multiplicative impact on the value of the company. And those that are able to lead multiple rounds also realize that intermediate holding values matter a lot less than how much of a winning company they own at exit. If you have a really big fund, and you really believe in a company, and you don’t feel external pressure to mark up your investments, why would you let anyone else buy additional ownership of the company instead of buying more yourself? This is a fairly rational strategy, but one only a few funds tend to employ.”
The metrics of venture capital funds and how they are measured is important and I have only briefly touched on the topic here. If you would like to learn more on this topic, I would recommend reading Rob Go’s blog post on the topic or Brad Feld’s book, Venture Deals which I have included in a resource list compiled at the end of the book.
CHAPTER 3
GENERAL PARTNERS AND THE JOB OF A VC
“If you can’t invent the future, the next best thing is to fund it.”
John Doerr, Kleiner Perkins Caufield & Byers
Trae Stephens was a senior in high school on September 11, 2001. Through the horrific events of that day, and in seeing the geopolitical climate transform around him over the next few years, Stephens chose to pursue a career in U.S. Intelligence to work on counterterrorism projects. He went to school for foreign service at Georgetown, a common feeder for jobs within the intelligence community, and majored in Arab studies. Upon graduating, Stephens worked at one of the large U.S. intelligence agencies. With respect for the work the agency had achieved historically, Stephens believed he could be a force for change in the government. With a growing interest in the accuracy and speed with which modern technology could analyze threats or offer insights, Stephens made it his goal to push the intelligence community to adopt more private sector improvements. In particular, Stephens pushed his leadership to license technology from a Silicon Valley-funded company known as Palantir to augment their intelligence work.
Instead, Stephens grew frustrated by the bureaucracy and his superiors’ unwillingness to adopt new private sector technologies. The leadership refused to adapt and Palantir poached a frustrated
Stephens to join their internal leverage team to try to change the intelligence community from the outside. Several years later, when the government was leveraging Palantir with credit to Stephens’ work, Bloomberg media described what the organization had succeeded in doing:
“The company’s engineers and products don’t do any spying themselves; they’re more like a spy’s brain, collecting and analyzing information that’s fed in from the hands, eyes, nose, and ears. The software combs through disparate data sources including financial documents, airline reservations, cell phone records, social media postings, and searches for connections that human analysts might miss. It then presents the linkages in colorful, easy-to-interpret graphics that look like spider webs. U.S. spies and special forces loved it immediately; they deployed Palantir to synthesize and sort the blizzard of battlefield intelligence. It helped planners avoid roadside bombs, track insurgents for assassination, even hunt down Osama bin Laden. The military success led to federal contracts on the civilian side. The U.S. Department of Health and Human Services uses Palantir to detect Medicare fraud. The FBI uses it in criminal probes. The Department of Homeland Security deploys it to screen air travelers and keep tabs on immigrants.”
While the future of Palantir is still hotly debated, Stephens developed a unique understanding of a specific technology, the inner workings of the government, and how purchasing decisions were made by a bureaucracy as large as the United States Government. He had succeeded where so many other entrepreneurs had failed and began to advise other companies on how they too could navigate that sales process. Stephens’ skills could have landed him many jobs back in intelligence, within the tech sector or within government, but a request from Palantir and PayPal co-founder Peter Thiel took him in a different direction.