December 9, 2020

#100 When Investors Take the Hot Seat

by The Pitch

Background show artwork for The Pitch

This week, we've got a show like no other. Instead of startup founders asking for money to grow their business, we hear investors Jake Chapman and Howie Diamond pitch their new venture capital fund. And they learn right away that things on the other side of the table are a lot harder.

Transcript

Today, on the 100th episode of our show. I have something special for you. A pitch that we’ve been holding onto for three whole years. This one has been under lock and key because to publish it earlier would have been...illegal. Against the law. That’s right, our show’s 100th episode is our most dangerous.

That’s because today on the show. Instead of a startup founder pitching to investors. We have two investors, pitching their new venture capital fund. And under federal law, it's illegal to make this pitch public, until they successfully raised the money. Or... they completely fail and the whole thing falls apart. Well, one of those things most certainly happened, or we wouldn’t be here.

From Gimlet, I’m Josh Muccio. And this is The Pitch.

Let’s meet today’s potential investors in the fund.

Jillian: I'm Jillian Manus

JIllian is a partner at Structure Capital

Charles: I’m Charles Hudson

Charles is with Precursor Ventures

Daniel: I’m Daniel Gulati

Daniel is the founding partner of Forecast Fund

Our 100th episode special is coming up right after this.

Room: sound of investors talking over each other

Jillian: You’re right, you’re right. What are you doing here? 

Howie: What’s up?

Jillian: Get out of town. 

Jake Chapman and Howie Diamond as you can hear, know the investors well. Usually Jake and Howie are on the other side of the table - taking pitches, in fact they were on a few of our previous seasons as investors. But today they're bringing an idea of their own to Jillian, Charles and Daniel. Howie and Jake are asking them to invest cash in their new VC fund - to become what's called a limited partner, or an LP for short. So that Howie and Jake can then invest that cash into startups.

Howie: All right, we're breaking barriers here.

Jillian: Let it roll. Let it roll boys.

Jake: All right.

Howie: So it's a really interesting story, because Jake and I met on The Pitch. Since then, we've looked at tons of deals together, we've gotten to be great friends. 

Jillian: I can understand that. 

Howie: Umm so I'm kind of creative, more idealistic, a lot of contrarian things. Um, Jake pulls me back down to reality sometimes, he's more analytical. And we just started organically really vibing together...and we want to join forces and take our compounded learnings that we had from our first funds, and apply it to our next fund that we're going to be doing together... 

Charles: Wow.

Howie: Called Alpha Bridge Ventures. We thought that’d be a really cool thing to do.

Charles: Cool. What's the thesis?

Jake: Yeah. So, the thing that Howie and I first started seeing together is that we were really attracted to companies in the post-seed, pre-A bridge space. And it turned out that those deals were the best deals we invested in across our portfolio. So they were raising A rounds within six months. Much higher valuations. The revenue was growing really quickly in those companies. And so...we saw that trending. We're like, "You know, I think if we would raise a fund tomorrow, we would now raise a fund in the post-seed space." We both had that realization. 

M’kay... the post-seed space. Let’s break this down. First, you need to know that the main job of an investor is to get their companies to graduate to the next investment round. So, for example, angel investors want their companies to move to the seed stage, and the seed stage VC wants their companies to hit series A. But here’s the thing. There's a massive pileup of companies hoping to graduate to the series A. They’ve raised seed money, but they can’t get to the next stage. So what do those founders do? They have to go back to their previous investors and say, “Hey um, do you think you could give us some more money to help bridge us to the series A?” And that isn't exactly music to an investor's ears. But Howie and Jake see it differently.

Howie: ‘Bridged’ means something completely different today than it did 5, 10 years ago. There was a negative stigma attached to the term ‘bridge,’ and now people are calling it post-seed, seed extension, whatever.

Charles: Seed two.

Jillian: Yes, seed two.

Howie: There are companies that are in these bridge rounds that are distressed companies, that are looking for an influx of capital to help them resuscitate and get them back on track. However, we started seeing a small subset of these companies that were doing quite well, they were over-performing against their growth projections. We started seeing this crazy performance from this particular cohort of companies we were investing in Anywhere from like two X to two point five X over the course of 12 months from when we invested to series A. Pretty significant. And so we proved out the model, we had this hypothesis. We started proving it out and we were like, "Why don't we just have a dedicated fund that focuses on this as our core investment strategy?" And that's where the impetus of Alpha Bridge Ventures came from.  

Jake and Howie think they’re on to something. But there's another factor that makes investors wary of investing in a bridge. They figure, if the company is so great, their previous investors, the insiders, will reinvest and take the entire round. So if the founder is having to ask other, outside investors for more money. Something must be really wrong. 

Daniel: So I've always struggled with this. If I'm seeing a seed bridge deal, like why aren't the insiders stepping up? Why am I seeing this? As a new investor into a bridge, like, I automatically pass on those deals, just off of that bias.  

Jake: So there is definitely a negative selection bias problem that we'll face. Which is if Sequoia comes in and leads a seed round in the company, and it's a great company they're going to want to take the entire bridge round. And so one thing that we think sets us apart, which gives us access into those deals, which we haven't talked about yet, and it's actually what we're most excited about is a founder support program. What we're doing is, we're creating a coaching program for founders. And then also a physical support program, and an emotional and mental health support program for all of our founders. 

Howie: So we believe in investing in people, we think that's the nucleus of any great company. Existential threat in the early stages are management, interpersonal relations and execution. And there are stats around this. There's 30 to 40% of founders that deal... experience emotional and mental health issues or disruptions.

Charles: That seems, that’s wildly That's wildly understated, it should be 100%.

Jillian: I just was about to say, I said 90%, or 95.

Jake: 30% can be diagnosed with clinical depression, 30% can be diagnosed with ADHD. It's about 29% can be diagnosed with problematic anxiety, to where a clinician would take an issue with it. And there's some overlap, but it still ends up being like way over half of founders have clinical problems. And all of these are things that we think we can help founders address and give them tools to overcome. And, ADHD for instance is not necessarily a problem if you know how to address it, it could actually be an asset.

Howie: And it's kind of a taboo to talk about up until this point, but now there's some big... Jillian, I know you're an advocate of this.

Jillian: Yeah, I am.

Howie: You've spoken about it. What this really is like a founder support and development program.

Jillian: So what's that look like? What does that look like Howie, exactly?

Howie: So we’re breaking it down into three tranches. So it's physical health, so even potentially maybe working with a primary care doctor, or figuring out nutritional habits, sleep all that sort of stuff. On the emotional fitness side, that's more of the mental health stuff. The third one, is leadership development. So physical health, emotional development, leadership development, it's very comprehensive. And so we’re ear-marking a million dollars from the fund to pay for the program we justify it because we feel like we’re going to get into the best deals based on this program 

Daniel: So what happens... Question I've always grappled with, with these stage specific funds is like, suppose you wake up one day and you get introed to the next Mark Zuckerberg that comes out of Stanford, and he's never raised, or she's never raised a dollar of capital in their life, and you really love the business, and you love the market and you love everything about the opportunity. Like, do you pass on that deal? 

Howie: We start building the relationship in the seed. We won't invest, but we'll start building rapport with the founder, we'll start helping in certain areas, so that when they do raise the bridge... Or we tell them it might be in their best interest to raise a bridge, because as you know, the series A is being stretched.

Daniel: Yeah. But where I'm coming from is, so as an LP, I would want you to invest, because I would worry that you just won't get access post the seed, and like there might not ever be a bridge. And so like, I just think your job is to get into the top companies, and whether you say see them at this seed-bridge stage or whether you see them at the seed stages, it's just like, just get into those companies.

Howie: So there’s a huge gap.....What I'm seeing is there's a huge gap between seed and bridge, the bridges that we're investing in. So, when you say get into the great companies at seed, arguably you're talking...everything's speculative. You're talking about growth projections and metrics that are going to happen down the road, and you're really just betting on the person. The reason we like the bridge, and that what we've seen, is that when we invest in these particular bridge rounds, I have per unit economics, I could look at. 

Daniel: Yeah. 

Howie: These are not just projections and speculation on what's going to happen in the future. It's like, "This is what I've done the past two years, and I know how to build a viable business on top of this great idea and we're getting in on the upward trajectory here on that hockey stick curve, and we get in right before the A. That's why we think this is this untapped opportunity because it's this significantly discounted A. 

Series A is highly competitive, and as such when a company gets it - their valuation tends to go up a lot. If Howie and Jake can sneak into these thriving startups right before the Series A, they're kind of getting Series A deals at seed stage valuations. Which means, if it works...their investment is worth a lot more money, almost overnight.

Jillian: I'm wondering if you're going to be able to get in, I mean, y even if you have the relationships. I think it's going to be... I don't know. I don't know if you're going to get, be able to get in at that level.

Howie: We’ll get in, trust us.

Daniel: I just think you need to be so religious about...All of this, I think is alleviated, if you, if you just say like, we're going under seed and bridge, like we're going to...

Howie: I honestly don't feel comfortable doing seed anymore because I hear the seed pitches and they're, they're pre-product, pre-revenue and I'm like, I don't know.

Daniel: Not all of them.

Howie: You seem great. 

Daniel: I just wonder whether we're getting caught up in the nomenclature. The whole job is like, just work with great founders at the early stage pre-product market fit. Get a good valuation. Like, why do we need to label it…?

Howie: We don’t need to label it. It's not a label. It's just how you need to be at a certain point in your company lifecycle for me to feel comfortable investing in you. And there's an opportunity for that to happen before I like to get as close up to the A as possible.

Jillian: But you can do that without labeling yourself as bridge, which I actually think is undermining this because of the negative.

Daniel: Me too. 

Jillian: That's why, because you guys are both smart. You've done very well. You have tremendous reputation, incredible integrity. I think putting yourself in a bridge is really actually boxing yourself in...to a corner that I don't think you guys need to be there.  

Howie: Yeah, but no one else is touching that. That's why I kind of like it.

Jillian: Nobody’s touching it for a reason, Howie. 

Howie: But it's different now, bridge is different now Jillian, it's a different thing.

Jillian: Yeah, but it comes with it -- this sort of distressed. It comes with it a negative connotation. And I know you want to redefine it.

Howie: Who does that matter for? 

Charles: LPs. So I think is the LP are lagging they’re a lagging... You're on the front end of this. You're seeing that like a bridge and that was no longer a bridge. My analogy I'm on, on fund two now and like LP is not like, ‘We kind of believe that pre-seeds a thing’ three years later, ‘We're like not convinced no longer convinced it's not a thing.’ And they're just a lagging indicator. So by the time that the bridge, by the time you've won the nomenclature battle on bridge, you've had to fight a lot of unnecessary battles. 

Jake: I don't think, I don't think we're actually having an argument about. 

Charles: This is not about strategy. 

Jake: This is not about strategy. 

Howie: I think It’s about semantics. 

Jillian: It is a bit about strategy because Daniel asked, would you start with them at seed? And you said, no, we're going to wait till right before the A, to where their bridge, where they have a bridge. And then that makes me, that concerns me because...

Daniel: Jillian, would want you...as an LP. My point is...

Jillian: I don’t think you can get into any of the good companies... good companies by just waiting that late, right before the A.. 

Jake: Yeah. So the discussion of the wellness program was a really long answer to your question about adverse selection, and this question too, which is just that we've talked to a lot of founders outside of our portfolio this year that are in hot deals, and have explained what we're working on. And it's like a light bulb goes off in their head, and they smile and it means a lot to them. So I think we won't have trouble getting into deals that are hot deals, because of the value add we're bringing. I think that that really does move the needle with founders. 

Daniel: What's your target raise?

Jake: 20 million.

Daniel: Okay. 

Jake: So 20 we’re like thinking about 20 companies, let’s say average half a million dollar checks and 20 companies, a million dollars will go into the wellness program or the founder support program. 

Jillian: So. I love the support piece. I'd actually like to see this built out a little bit more. I'd like to really better understand that, because if that is one of your differentiators... And I think it's a really important one. It's not even a differentiator, it's a huge value that none of us have. And so that would be one reason I'd want to share a deal regardless of seed, pre-seed [inaudible 00:43:53], whatever you want to go in.

Howie: You should talk to our program coordinator. she has all these amazing ideas that she's fleshed out. We're already speaking to some partners, and yeah, we're just getting this off the ground but-

Jillian: I assume that's in your deck, yeah?

Howie: Yeah.

Jillian: Okay, well, I'd love to see the deck. For sure.

Howie: Great.

Jillian: But I would never invest in this if your selling point is a bridge. Sorry. Because I think this so limits you, and limits the deal flow. And also limits your capabilities, because I know the both of you want what you guys can do.

Howie: I just don't understand...If we're talking about semantics. I don't understand.

Jillian: No, it's not. It's optics. You're wrong.

Howie: [crosstalk] No, no. Fine, so then-

Jillian: Howie.

Howie: Then if we call it something else, then you would invest in us? 

Jillian: After I...

Howie: We’ll call it Seed XX.

Charles: I can tell you what my experience is. I went out with 100% pre-seed, and people ask me if a great person is a repeat founder who's raising two on six. You won't do it, and at first I was like, "Yes." They're like, "That's stupid." Like your job is to be in on the first institutional round these companies raise. And the answer doesn't have to be you'll do it 100% of the time, but you should move the slider. I admire the fact that you pushed back because I was like we’re only going to do pre-seed - we’re only going to do people who fit in our box, but then I realized that I was missing out. 

Jake: That’s great feedback. Because I really, I worry about being criticized for strategy creep. Sort of the exact opposite, which is, we find three or four earlier stage companies. And then they say, "Hey, what's this that you guys did? I thought you said you were only investing in bridge." umm 

Jillian: Okay. Some of this is messaging. the brand is critical right now. I'd rather you not have such a laser focused sort of limited one. I’d rather you be a little more thought-through on this. 

Howie: Thanks for the feedback, everyone. We really appreciate it 

Jillian: Yeah, absolutely. 

OK, Jake and Howie didn't get any takers that day. 

When we come back, three years have passed. And I call up Jake and Howie to ask, were Jillian and the others right? Did investing in companies at this stage really take them somewhere? Or did it turn out to be a bridge to nowhere?

[BREAK]

Welcome back. So I caught up with Jake and Howie a few weeks back. And found out that the fund is alive and kicking! But before we get into that. I wanted to know what it was like for them to switch roles on our show.

Josh: In 2017, this is like November, 2017. You guys go from investors on our show who are sitting alongside your peers, Jillian, Charles, and Daniel, to then you're making a pitch to them. You're on the other side of the table. What was that like?

Jake: It sucked.

Howie: I liked it. I thought it was great.

Josh: But Jake, you didn't care for it?

Jake: No, no. I kid, I mean, it sucked because we were on the other side of the table. Right. It's nice to be the investors, not that being an investor is easy. But the dynamic in the room, you get to sit back, make a decision, you sort of have the power, the control-

Josh: You're not the vulnerable one.

Jake: ... as opposed to standing up in front of the mic. It's actually a pretty high pressure, tense environment. Usually when you're pitching an LP on the fund. It's really just a back and forth conversation, as opposed to standing in front of the mic and looking at the four faces glaring back at you, I think it was also a little bit more stressful because it was literally the first pitch Howie and I gave for the fund. 

Josh: Yeah. What stands out to you from that day? 

Jake: I distinctly remember Jillian, at one point, saying, "Why focus on bridge rounds exclusively? What are you going to do if you see the next Uber and it's a pre-seed round or a seed round, are you going to just let it go?"

Josh: Right.

Jake: And the answer is no. We adjusted the strategy where post seed really is still the focus, or what we call the sweet spot, for the fund. But, we're not turning any Ubers away if we find them. Right? 

Josh: Oh, wow. So, you did take their feedback?

Jake: We did. We did. 

Josh: Jake, at one point you stepped in and acted as a peacemaker between Howie and Jillian. "I think we're both saying the same thing, here." 

Jake: Yeah. There really was this idea that companies that needed to raise a bridge round or a second seed, or a seed extension, or whatever it is that you want to call it, were fundamentally flawed in some way. They were struggling, and were likely to die. And that is the myth that Howie and I were really setting out to dispel, is that this stage was fundamentally a bad place to invest. We thought, based on what we had seen in the market, that people just had that wrong. It's a great place to invest if you know what to look for retrospectively, I think we've been proven right, like.. People don't talk about bridge rounds anymore they talk about seed extensions and seed plus rounds and mango seeds. And it's all-

Josh: Mango seeds? 

Jake: Yeah, that's stupid.

Josh: Because they're big seeds?

Jake: They're big seeds.

Josh: Like a mango has a big seed?

Jake: Yeah.

Josh: Stop.

Jake: I never use the word mango seed. I like post seed, personally.

Josh: Yeah.

Josh: Yeah. What was the fundraising process like for you guys? Howie, did you enjoy going out and pitching LPs?

Howie: I enjoy it until I stop enjoying it. It's typically about, I think after about a year to 14 months is when I start feeling burnt out. You know it requires hundreds of meetings and lots of rejections, and you got to have thick skin and you just got to have the right mindset for it. Otherwise it could be really defeating 

Josh: Sure Like what was the most surprising pitch to an LP you’ve ever made?  

Jake: I'll share a funny one. So I'm going to change his name to protect the innocent, but uh We'll call this guy Donnie. So we were in Manhattan pitching a bunch of folks in New York. And this is like the last meeting we're taking and the investor we’re meeting with is running late to our hotel. He gets there, he shows up, pulls up in like a half a million dollar supercar, parks it in front of the hotel. When I say park, he double parks because there's no parking in front of this hotel. He just like pulls up, stops in the street, gets out of his car and they don't have parking or valets, but he finds the like bell boy and like throws his keys to him and says, "Park this." And the guy's like, "We don't do parking." And so he takes like a wad of money out of his pocket and just like shoves it into his hand. And he's like, "I'm going to be meeting upstairs in the bar for the next hour. Like make sure it doesn't get towed or nothing happens to it." And that's how the meetings starts with this guy. So we're thinking this is going to be like a total waste of our time and this guy's just going to be a huge a-hole, right?  

Josh: This guy sounds like Russ Hanneman from Silicon Valley.

Jake: Oh, totally. Tres Comas. You do not want to Russ Hanneman on your cap table. And we don't want a Russ Hanneman as an LP because they have a certain amount of power. They have demands on you, on your time and for some of them it's just not worth it but we ended up having like a great conversation. I wouldn't call him down to earth, but I would say like a very reasonable person and yeah, I think the meeting went great. He wanted to invest. And then there were some regulatory issues that didn't didn't get him into this first fund. But probably the most unique experience to kick off a meeting I've ever had 

Josh: Wow

Josh: In the pitch room, you wanted to raise a $20 million fund. How much did you end up raising in the end? 

Jake: Just shy of 10 million. 

Josh: So half... about half of what you wanted?

Jake: About half of what we initially wanted, yeah. When we actually went on to start fundraising, we had reduced the target, I think, down to 12 million. It was coming together fairly slowly. And it was in that window we were like, "12 million's the target, but do we really need to get to 12 million to execute on the strategy?" And the answer was no, right? So the idea is, you know raise what we raise, go out, invest it in great companies. And then in the next fund, we will have shown what we can do and then we can raise the amount that we want to raise. So that was the thought process.

Josh: Got it. So...where are you guys now? Like how many startups have you invested in?

Howie: 40 

What’s funny is, half of those 40 investments were not in companies at the bridge stage. They were actually in companies at the seed stage. Which is exactly what the investors in the pitch room were pushing for!

Josh: It sounds like the investors in the room were right.

Jake: Yeah. It's half and half based on number of investments, but it is 90/10 or 80/20 in terms of capital deployed.

Josh: In terms of dollars?

Jake: In terms of dollars.

Howie: Yeah.

Jake: So I don't know. I guess you could say we were both right the other thing that's important to think about as a fund manager that I don't think is obvious, is that even if the best strategy is to invest in pre-seed, seed, and post-seed. There is a lot of value to, at least from the external perspective, having a really clear focus. Because if you have no focus, you'll do any deal, but no one thinks about you for any deal, right? It's like, "Oh, I'm going to send this deal to Jake." No one ever thinks about that because they've got five people they work with. But if you're known for being the firm that does post-seed, and there's not a lot of firms that do it, then someone who's got a post-seed deal are going to send it to you. So there is some marketing value to carving out a clear niche and putting your stake in the ground, even if you're actually willing to go outside your niche a bit.

And Jake says, that strategy is working, 5 of the 40 startups they’ve invested in so far have gone on to raise a series A. Which is about what they expected. But the founder support program that program to help founders with their mental and physical health is doing really well. Jake told me that that program really has helped them get into deals they otherwise would have been excluded from. 

Jake: I think it's exceeded our wildest expectations in every possible way. What we ended up doing was we spun it out as a separate business. We've had firms, other firms reach out and say, "Can we send our founders through Atlas?" And so we've started partnering with other venture firms or we're taking their founders. And it's totally unexpected when we launched the program. 

Josh: Wait. So it's become its own business where people can just come and pay Atlas directly.

Howie: Yeah. 

Jake: Yup.

Josh: Wow. So you haven't had any exits in the fund yet, which is to be expected. Right. You're just three years into it, but presumably it sounds like you're making money off the wellness program.

Jake: Yep. We’ve had companies we were talking to where we passed on the company and the founders is like “Great.I understand you don’t want to invest, but can I still go through the program? Can we make that work somehow?” 

Josh: What?!  

Howie: Laughs

Jake: It’s alright. I’m going to back to school to become a therapist.

Josh: Jake found his true calling  

Jake/Howie: Laugh

Josh: What's next? Are you guys going to go out and start raising fund two next year?

Howie: My stomach, I just got like a pain in my stomach. Um. We're exploring what fund two is going to look like and what to do next. I want to spend the least amount of time on fundraising as possible. That's my goal. 

Josh: It sounds like you really don't like fundraising.

Howie: No. Who does? I would love to talk to someone who loves fundraising. 

Josh: I don't know. Jake hasn't complained.

Jake: Yeah. I'm not a huge fan of fundraising either, but I love the job,  every day is something new and exciting. Like this is the perfect job for someone who is insanely curious and has a touch of ADHD because I have 10 meetings a day, they're all with different people on slightly different topics. I get to go deep with them and then flip to the next. As someone who's like super curious. And if you have an intellectual itch, you want to scratch being an investor is a great thing to be because you get paid to educate yourself on a topic. And you can reach out to the world's foremost experts on that topic. People who are building companies or technology around it, and play with their toys and dig deep with them and maybe go along for the ride. I don't think there's any other job in the world that gives you that opportunity. So I wouldn't trade it for anything. And if it means I got to go out there and pound the pavement, even if that part's not fun to do some fundraising, then that's what I'm going to do. 


The Pitch is hosted by me, Josh Muccio. Produced by Chris Neary, Heather Rogers, and Max Gibson. We are edited by Blythe Terrell. 

Original music in today’s episode from So Wylie, Breakmaster Cylinder, Emma Munger and The Muse Maker. We are mixed by Enoch Kim. 

Lisa Muccio planned the recording of this episode three years ago.

The Pitch is a Spotify original podcast. You can follow us on Spotify, we’re also on Twitter and Instagram @thepitchshow.

Thank you so much for listening. I hope you and your loved ones have a wonderful holiday. We’ll talk again soon.