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How I Invest with David Weisburd
E182: Lessons from 17 Years at Menlo Ventures and Accel w/Tyler Sosin
00:51:47
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- [00:00]
Interviewer
So everybody comments on your name, villain. What is the origins for your name and how did that come about?
- [00:09]
Tyler
Well, the origin for villain comes from a quote from Batman. Harvey Dent said to Batman over a dinner, quote, you either die a hero or see yourself live long enough to become a villain. And just as like a cinephile. I always loved that quote. But when I reflected upon my investing career, it truly resonated with me as sort of a North Star of what success can be. And that is finding companies that basically survive and grow and continue to survive and endure through many decades, often and become essentially the dominant players in their category. And obviously these companies, when they're young, they start off as heroes, but if they do manage to get to a 20, 30 year mark, they're often villains at that point. They express really interesting tendencies that rational capitalists should love. They have got amazing customer lock in really dominant relative market share, pricing power, and they're really hard to dislodge. That's why I like them as my North Star.
- [01:17]
Interviewer
What are some examples of some now villains that you invested at Menlo?
- [01:22]
Tyler
Well, I'd say more generally, like, hey, the universe of tech companies out there, like, who would be in my opinion, a villain? And this is coming at it from a compliment, like Oracle would be a villain. They've been around for a long time in the vertical software categories that I love so much. Jack, Henry and Fis in core banking, Vertafore and Applied and Insurance, Epic and Cerner and Medical Health Records. These are companies that have been around for multiple decades. They're very large, they are extremely dominant in their categories. And often, if you were to ask people who use the products or people are trying to disrupt them, they are the targets because they're no longer innovating. They capture a lot of economic rent, but it's in some ways almost impossible to displace them.
- [02:16]
Interviewer
It's almost like this full circle of the innovators dilemma. It's a startup incumbent now disrupted by a new startup, but on its way to being a hundred or five hundred billion dollars company.
- [02:29]
Tyler
Yeah, and I should say I don't think villains necessarily have to be enormous to be that way. I think they just need to be very dominant in the categories they compete in. As Peter Thiel would say, like, he hates competition, he likes monopolies. Competition is for losers, Competition's for losers. And I feel the same way. I'd rather be in a business where for a variety of reasons, at some scale, it's very hard to compete with them. And so then they can start to display some villainous tendencies and basically have amazing shareholder returns as a result.
- [03:03]
Interviewer
Villainous tendencies are a side effect of having so much market power.
- [03:07]
Tyler
It's also the capacity to have a relationship with a customer where you can extract economic rents. And you know, that's very hard for most businesses to do. Most businesses compete in commoditized markets. They have to basically run on that treadmill or sprint on that treadmill forever. But there are a few companies out there that don't have to do that. And those are the best investments.
- [03:33]
Interviewer
I know you didn't define a market cap, but let's define that now as a hundred billion dollar company. How many of those companies have this kind of extractive relationship with their customers? And how many are their customers just love to give money like a Starbucks?
- [03:44]
Tyler
There's different sorts of customer lock in that you can appreciate. I sort of see myself as an anthropologist. And so the question is, what are the circumstances and the behavioral tendencies that create lock in with a customer? And on the human side, habit formation is a huge one. It's why the nicotine companies have been so successful over time. It's why the Starbucks of the world have been so successful. In fact, if you look at, I believe it's either the profit margins of addictive businesses, there's a strong correlation between how addictive they are and how profitable they are over time. And then there's some secondary effects, reinforcement effects that really matter. But for I'd say consumer products, addiction is a major point. And then the other major point is things around habituation and just becoming really familiar with something and therefore not wanting to give it up because it's what you know. And there's a friction to changing to something new. You have a bank account, that bank account is connected to all these different bill play partners. Your entire financial life is set up on it. It's a hassle to move. And it's that cognitive load and perceived friction that keeps people from switching, regardless of whether it's easy to do or actually really difficult to do.
- [05:13]
Interviewer
So you invest at the earlier stage into these companies that you want to be a villain, to be mature and be a villain at some point. What characteristics are you looking for?
- [05:22]
Tyler
When I come back to what I'm doing at villain, I'm very focused on vertical software and technologies. I'd say vertical software, vertical AI, vertical payments. These are the sort of substrates that I will be dealing with at this firm. The very best companies have very, very sticky relationships with their customers over time. In a more Dry sense. It's basically, they develop annuities with these customers, and the best businesses build a widget or whatever it is, and that widget creates an annuity by selling it to that customer who basically consumes it for, you know, many, many years. And so I want to see the earliest evidence of that annuity and the earliest evidence of a founder who knows how to sell that annuity with some amount of efficiency. And if I find that in a vertical software market, I can get really excited.
- [06:15]
Interviewer
That's evidenced by a low burn rate. So soft customers continue to purchase the product month after month. Is there any other metrics and leading indicators that you're looking that a customer has this annuity type of relationship with the company?
- [06:32]
Tyler
You'd have to see what their behavior and usage are. You'd have to test pricing and their willingness to churn if you were to suddenly raise pricing. I'd like to know that a founder with an initial wedge in the market that's efficiently developing, generating these annuities has a roadmap for basically building new products and features that they can sell to that existing customer to deepen the relationship significantly over time.
- [06:57]
Interviewer
And you would argue that you're creating more of a feedback loop from the customer when they're buying multiple things from the same company, then they're more likely to become a longtime customer.
- [07:06]
Tyler
Yeah, and there should be two, maybe three reasons for that. One, in cloud software, and this is like an important tenant of this business, like, you have this data plane that you're creating maybe with that initial wedge product. And you know, in the best of cases, that data can be used in a second or third product to give you the right, like the permission to build a product that would be better than what someone else building that product de novo would build. Because you're already using, you already have the data that's relevant. So it's a matter of a different workflow system or a different set of computations. But you have an advantage by having the core data set that's used in a variety of different tasks. So that's number one. Number two is as you develop a deeper relationship with a customer and have multiple products to sell them, there's a very powerful phenomenon, cross subsidization, that can occur. You are pricing and packaging multiple products together. Often these products work better together in terms of a synergistic outcome, but also in terms of pricing, you might be able to say, hey, if you buy this product and this product, they both work together and we can give you a discount. Discount where if you bought these products separately, it would be more expensive and over time that's a very compelling way for more incumbent companies to compete against startups. It's the bundling effect.
- [08:26]
Interviewer
Give me an easy to understand example of a company that started with one product and then successfully sold multiple products that most people would be aware of.
- [08:34]
Tyler
Microsoft would be a villain and would be very well known for having multiple products in a bundle where over time they have a lot of success, you know, bringing out that new product, bundling it into their existing suite, and ultimately, you know, killing competitors or really driving competitors into, you know, sort of a state of commoditization as a result.
- [08:57]
Interviewer
Going back to these companies that you look for that you think could be villains or market leaders, what's the first kernel in a company that you see that this might be one of these companies?
- [09:08]
Tyler
When you think about competition and how to find markets where competition is less of a threat, there are probably a few ways of doing it. One is network effects. That's a wonderful business model if you can attain it. The second is something like a Carvana where it's like the amount of infrastructure and capex spend required to get to a scale where there's this virtuous cycle that is just so hard to disrupt is enormous. Amazon would have similar characteristics working for it, I'd say The third that's lesser discussed is market size. And I read a book probably about 10 years ago that just opened my eye to this and it was a fascinating book called Competition Demystified. I encourage everyone to read it, but it was basically this anthropological survey of monopolies and how they fail. So you think of monopolies as like, hey, these things really, they shouldn't fail, but every once in a while they, they get disrupted. And the question is why? And the answer, which is compelling to me is it's an exogenous effect or something happens that actually increases the size of that market. And as a result it creates this sort of pocket of oxygen that allows a new entrant in to get to a certain amount of scale where then they're able to basically compete with the incumbent and that it comes back to one of the big areas where competition can be controlled is, you know, one of the big factors is market size. And actually it's smaller markets that I tend to like or sort of midsize markets because you have, there's just less revenue to go around. And this results in behavior where because the market size is perceived smaller or is smaller, there is less capital funding new companies in that market because the perceived outcome is smaller. Often these markets, when they're smaller, they're just like less understood, they're more niche, they're more technical. It requires someone who has exposure to that market and a build mentality that's hard to find. And so there's fewer, I'd say, credible entrepreneurs who go into these markets. And as a result you have fewer competitors. And when you have fewer competitors competing with each other, maybe a couple can grow up to be at scale and that's fine. And then there's usually some sort of rational consolidation that occurs. And so in smaller and medium sized markets as a result, you end up with these market share constructs that are often quite lopsided, where it's like, hey, there's three players who control 85% of the market or two players that control the market. Look at a lot of the businesses I mentioned earlier, Epic and Cerner, vertafor Applied. These are relatively large markets, but they're dominated by two people. And it's largely because they were small markets to begin with that grew over time, but these two players captured those markets. And then once you are a large player in a small market with a lot of the lock in that I described earlier, even if someone wants to disrupt you, the fixed cost of doing so can feel prohibitively high. And so that keeps a lot of people out. So again, my thesis for vertical software, it's not to say that vertical software can't build really big businesses, but I think a lot of great vertical software is great because it is actually going after a smaller market where you can have less competition from day one, less competition entering over time. And therefore it gives you a lot more freedom, a lot less pressure to have to grow at any certain rate or to have to have a build velocity that's keeping up with seven other competitors. It affords you therefore a chance to be much more capital efficient and take a much longer term view.
- [12:45]
Interviewer
Put some numbers on it. What is considered a small market in your playbook?
- [12:48]
Tyler
I would say anything below 100 million of SAM or TAM, total addressable market.
- [12:58]
Interviewer
Is considered 100 million of customers spending money in that market.
- [13:04]
Tyler
Yeah, we're like the perceived, hey, if we acquire this entire market, we could build $100 million business. I think that is relatively small and for me I would be interested in companies pursuing markets of that size up to 500 million.
- [13:21]
Interviewer
Let's just go in the middle of that $250 million total market per year, a bunch of venture capitalists are going looking around the Table at different firms, and they all see the same $250 million market, and they say, this can't return the fund. Double click on the rationale on why it's not as competitive.
- [13:38]
Tyler
Exactly. That I think you would find a business. I mean, my ideal villain investment, you find a company that is expressing that early efficiency, building an annuity with the wedge product that they're selling, and therefore is growing efficiently. And when you look around, you see very little competition. Right. Like, maybe there's one legacy incumbent, and then that's it. That's great. And then the venture guy looking at that says, well, geez, you know, it's a nice business, but my opportunity cost is like, enormous. And so if I put a $5 million investment in this company, like, I might make a 10x, but that doesn't move the needle for me.
- [14:19]
Interviewer
That doesn't make my fun.
- [14:20]
Tyler
Yeah, I need to believe that I can make 150, 200x on this investment. And I hopefully with the funds, the way they're organized now is I need to believe I can not only invest at 5 million, but to really make it worth my time, I need to be able to invest another 50 million.
- [14:36]
Interviewer
Behind that or minimum viable check size or company check size per company.
- [14:42]
Tyler
Yeah, there's a minimum check size. That's the way most funds work is like, hey, they've got a certain amount of slots, a minimum check size, a.
- [14:51]
Interviewer
Fixed number of board seats.
- [14:53]
Tyler
There's a fixed number of board seats. And then they think about the amount that a investment can return as a percentage of a fund. And they're looking to basically, with every investment they make, believe that they have a fund returner on their hand. Funds, as they've gotten a lot larger, it's just much harder for them to get excited about a business where it's like, wow, that's great. That's a $400 million TAM company's growing really nicely. Like, whoop, Dee Dee. It doesn't move the needle because I'm looking for the $50 billion company that I can write that first check, and then I can write a much larger check from my growth fund, and then I can do something even larger from an spv. And that's a very different mode of thinking and capital allocation.
- [15:37]
Interviewer
How do you make your math work?
- [15:38]
Tyler
Three things matter. One is fun size. I think a Fun size of 150 million or less is suitable for this strategy because you could have a bunch of 3 million, $5 million investments where you're making a 5 to 7x and I think that those could have a real, like, they could be needle movers for that fund. Fund size matters, concentration matters. Like, I think we would be looking for a portfolio that's a bit unusual in the venture industry, where it's 15 to 20 investments versus I'd say 25 to 30 or 25 to 40 and nominal pre money matters, it's most liquidity in venture outside of the mega IPOs are acquisitions in the 100 million to $500 million range. And so building an investment philosophy and a strategy where we make a lot of money on those outcomes. And then if you were to reverse engineer into that, let's just say the average outcome you're thinking about is a 200 million EV once you sell it. Therefore, what does the pre money have to be in order to make a 5-15x return? And my guess is that for us it's going to be somewhere between and 30 million pre, depending on some of the underlying characteristics of the company. And so then you might say, hey, well, Tyler, how do you find companies that have that early product market fit that you're looking for, where you can sort of get them at pre monies that sort of make sense that are nominally on the lower end? And the answer is, well, you're looking for businesses where there's a fly in the ointment. There has to be something that is countervailing, that is uninteresting to the mainstream vc. And for me, the two things that I'm willing to take risks on are one, the market size, and two, is the growth rate. And so market size, we discussed earlier growth rate, it's a longer conversation. But when you look at the venture industry today, I think there was a guy, like a benchmark partner interviewed on a podcast recently where he said, hey, like, these new AI companies, like, are growing at like 4x year over year. Like the new. It's, it's now Venture 2x is 4x. Venture guys always speak in like multiples of growth rates for the first three or four years. I never understood why exactly, but it's like now it's like you got to be 4x 4x and then 3x or like, you mean nothing to me, right? And you look at these companies and it is incredible. That can grow from like 0 to 100 million in 18 months. Like, it is phenomenal, right? But like, I'm delighted when they say this because it means, like, there's this like wide swath of companies out there who are only growing at like, you know, 120% who are like completely uninteresting as a result. And so when you get those factors like, hey, they might be growing a little bit slower and 120% is like exceptional growth in my opinion. They might be growing at like 70 to 80%. That would be fine with me too. They might be going after smaller teams. That's fine too. As long as the pre money valuation makes sense and the companies are efficient and the founders and I lock arm in the ethos of compounding the business as opposed to just growing the business at the highest rate possible at all costs. We can have a very, very productive and lucrative partnership over time.
- [18:55]
Interviewer
Is there different psychology with these founders that are looking to build a 2, 3, $400 million company? Are they older, more experienced, less kind of in their 20s, looking to become billionaires? And is there something different about these type of founders?
- [19:12]
Tyler
I often think the founders who are willing to grow, go a little bit more slowly have been burned. I was actually speaking to a founder today who has this ethos of growing a bit more slowly but also just efficient, and his last company ran out of money, just cash zero and died. The other phenotype of founder is one that's been in the woods for a while. I've done a few angel investments as we've gotten villain off the ground. And some of these companies have been in the woods for five or six years and they started with something and they had to pivot and they had to pivot again. So by the time they get to this product market fit that I love, I don't know, they've been kind of burned by the venture industry. It's just very hard for them to raise capital. The instincts of survival and frugality are in their DNA at that point.
- [20:04]
Interviewer
In what ways is being burned like that an asset? And what ways is it liability?
- [20:09]
Tyler
I think it's an asset, right? To me it's much because you could.
- [20:12]
Interviewer
Argue the opposite, which is it keeps them from making bold bets and compounding and all these other benefits. But you would argue it's an asset.
- [20:19]
Tyler
Generally, I would say it's an asset.
- [20:21]
Interviewer
In what ways?
- [20:23]
Tyler
Because I think the vast majority of even great businesses that fail fail because they grow too fast. There's this urgency to like, like keep up with the Joneses, which again is like that 4x growth rate. It's, it's this feeling like, hey, if we don't achieve this perceived set of numbers, like no one's going to fund us, we're going to die. Our competitors are going to overtake Us. I mean there's like this panic that sort of you see as they start, you know, walking through their mental models. And I think that can lead to some really, really shitty capital allocation decisions. Right. Like most companies fail in my opinion in the venture landscape because they try to grow too quickly, they try to build too much product too quickly and they basically parallel process too many things that need to be done in a more sequential manner. And some of this also is just like certain markets require just more time to sort of like break. And there's a learning curve to any business being built that just requires time. And so I actually get quite nervous about companies that are just growing fast whether they're permitted to because they have great economics or not. There is something that frightens me a little bit because I think organizational capacity can get strained to the point where things can break in a way that it's hard to put back pieces. And you've seen that in the venture landscape. We've got all of these assets out there that are basically hung from 2021, all these mega funding rounds, chasing a lot of growth. And you could say there's probably an alternative history where if these founders had a different mentality of just growing, I'd say taking a compounding mentality where it's like an endurance comp pending mentality where it's not triple, triple, double, double or 4x, 4x, 3x, but it's more, hey, I'm going to grow this business between 60 and 80% for the next seven years or the next 12 years. And I'm just going to do it on my timeframe. But we're going to continue making progress. We're going to do it with precision and with capital efficiency. I suspect a lot of the founders who now have hung businesses would be in much better places.
- [22:37]
Interviewer
It seems like there's like a dialectic here, like two opposing philosophies. One is about founder market fit. So you have like a Facebook that's literally plowing and burning billions of dollars trying to build their network effect before they even knew whether they had a business model. That was like the question for many years. And then there's a question in 2012 whether they could port their business model into mobile. They had to deal with all that. Sam Altman is another example. OpenAI just burning all this. Like people still don't know whether LLMs will have a sustainable model, but they' just going out there and doing market share. And then there's, you know, the businesses that like Qualtrics that grew and compounded over 20 years and oftentimes not in New York or San Francisco, in these like, you know, second tier cities where they're compounding. And maybe it's one of these industries that starts out as a $500 million TAM and it also compounds 12% per year. And suddenly in year 20 it's a $5 billion industry and they're, they have this kind of monopoly position. So both models could work, but they're certainly different personality types.
- [23:40]
Tyler
You point with Qualtrics, you look at Procore, I think that was a 20 year overnight success. I think service titan was under the radar, building for a long period of time before it really broke out as an asset that VCs and growth equity firms liked. But I think there's something about that journey that makes these businesses amazing. For me, hyper growth is much less exciting than seeing a business that was a kind of a slower grower that actually over time starts to see their growth accelerate. And often it's the case because like the sort of the flywheel is working, the multi product strategy is working, the familiarity of the market with the product is working. They're becoming the standard, the ecosystem is converging around them. And these create these flywheels of operational leverage where a business that was kind of sleepier, you know, growing at, you know, 70, 80% maybe suddenly is growing at 120% at much larger scale. And when you see those things, you got to be like, wow, that's going to be an incredible business.
- [24:47]
Interviewer
Sometimes the different arms of the business aren't, aren't individually that spectacular. When, when you put them into one system, they, they achieve product market fit.
- [24:57]
Tyler
It's interesting, you bring up like you know, Google or Facebook or OpenAI. You know, I, there's a podcast I eventually want to maybe do myself called the first five Years, which would be going back and trying to get to the first five years of financial data of these really amazing companies. Because I actually think that Facebook was quite profitable early on. If I look back at their S1 business grew an enormous amount through the early years. I don't know what the quality of revenue was. Obviously Facebook had these network effects that were just incredible. And so it's a business I really understand and appreciate. And same with Google, I think Google actually was really quite profitable out of the gate growing at several hundred percent a year. And so there are special businesses like that. OpenAI is a very different business. It hemorrhages cash to the extent that these other businesses at their scale did not. As a sort of a someone interested in company history or economic history. It reminds me a lot more of the memory business where like the need to reinvest in the next generation model feels like it's important for surviving and continuing to be the best LLM out there. And I personally just think that's a really, it's a hard place to be. I do think it's an interesting study today of these businesses that are being funded that have enormous burn rates in their early years and they're growing fast. And the question is when they get to be more mature, how valuable are they and how defensible are they?
- [26:29]
Interviewer
Startup history. It's also something that I'm really interested in just how these things came about. And one of the most interesting things is this kind of three person club that Reid Hoffman, Mark Pincus and Peter Thiel had talking about social networks. Before Facebook talk about having a prepared mind, they would just talk about this. Obviously Reid hoffman also started LinkedIn and I think Mark Pink has started a social network that ended up not getting off the ground. But they were kind of developing this thesis in real, both in real time, individually and also as a group. So they had this really powerful prepared mind for when Facebook landed on their lap. They were almost waiting for the Facebook to come about versus to the rest of the world, the rest of the, you know, 7 billion, 7 billion people. It just seemed like a totally novel, totally idiosyncratic business. They were like really ready for it.
- [27:17]
Tyler
For Facebook, it was probably some combination of cloud computing and modern software engineering and behavioral psychology, understanding addiction and how to get users engaged that like all of these things needed to come together to make a network effect that we understand it as now viable.
- [27:38]
Interviewer
And before villain, you were at Menlo Ventures, storied venture capital franchise, best known for Uber and I'm sure many other deca unicorns. When you were inside Menlo, how much more powerful is it to be around a group of really smart people kind of workshopping these ideas versus I have this thesis. How much did having a group help you formulate your thinking?
- [28:03]
Tyler
Certainly in terms of blind spots, I think groups can be helpful. Just sort of seeing something from an angle where you didn't see it or you're not being intellectually honest enough with yourself about that potential issue or that potential upside that you just like haven't been able to accept. And so I think for that reason, like having people around who you can talk to about investments and get their feedback, people you trust is important and I, I definitely benefited from that during.
- [28:35]
Interviewer
My time and now as a solo gp, how do you build that around you so that you have people to, you know, riff with and to keep you honest in your thesis?
- [28:45]
Tyler
There's a very small subset of people out there who have similar mental models as I do about these types of companies. And they're at other small little firms. And you know, I think you can be very collegial. Your partnership almost becomes this extended group of people who, you know, you're just happy to talk to about investment opportunities. You're happy to have them look at investments and you know, maybe that changes. But I think when it's a bunch of small firms looking at stuff like you can be in a situation where you can like both invest in a.
- [29:17]
Interviewer
Company, the incentives are aligned for you guys to both co invest versus one firm has to take the.
- [29:22]
Tyler
Exactly.
- [29:22]
Interviewer
So conscious about not having mediocre or poor thought partners. Do you think that information could, could negatively affect you as well?
- [29:31]
Tyler
Any information can negatively affect you. I think you, you know, thought partners are like this repeat game. You work with them on something and you can decide after that you don't want to like you just discounted their thoughts or they might impress you, in which case you reweight them even higher sort of in your estimates. I feel like I've been fortunate to surround myself and be part of firms where there's a bunch of really intelligent people. And so I've figured out the people who I like and when you talk to them over the course of several months, looking at several opportunities, kind of riffing, like you get a sense of like, do they provide some insight that really helps your thinking?
- [30:14]
Interviewer
And part of that sense is you know what excellence looks like, what a tier 1 VC looks like. And that's the standard that you hold.
- [30:20]
Tyler
Your network to, whether It's a Tier 1 VC. My brother is one of the smartest people I know. He founded a, it's now a hedge fund called CAS Partners. Like, I've learned a lot from him over the years, just mental models around endurance. He invests at companies much later stages than I do. But like, I think our thinking is similar. Like what causes these businesses to like, continue to compound for, for many years to come. Like, what's the, what's the advantage? It's both within top tier firms like Menlo and like Excel. It's within a broader network of people who invest in different asset classes but can bring unique insights. It's from reading. I mean, I think reading is like a wonderful place to find mental models like competition, demystified people Like Peter Thiel. And you might have your own variant on it. Like Peter Thiel is thinking about how do I build monopolistic businesses? And he has a different substrate that he can work with. He's like, I've got the Elon Musk Empire, the Founders Fund franchise. He has advantages compared to me that allow him to invest in incredible businesses that look very different but can achieve similar economic returns. For me, I'm taking a more off the beaten path approach. And, but again, I think our North Star is like, how do you find businesses that can, that can persist?
- [31:38]
Interviewer
When you look at tier one funds, is it kind of FOMO and herd behavior or is it more just rational, rationally following incentives? What percentage is herd behavior versus rational first principles thinking?
- [31:55]
Tyler
I think a lot of it is herd behavior around certain themes and founder Personas and then again kind of coalescing around certain metrics that would basically qualify or disqualify a company as being. And sometimes I think some PCs don't understand why those metrics are what they are. You're like, well, this company needs to be growing at 400% year over year. Okay, why? Or this company needs to have a 3x LTV CAC. Okay, that makes sense, but why? What's the underpinnings of that from an economic standpoint?
- [32:31]
Interviewer
And are all 3x LTV CAC companies the same?
- [32:35]
Tyler
Are they same? Or is a 3x LTV CAC company where the company has a 9 month lifetime value with its customer different from one that has a multi year customer relationship? Are they the same or different? The answer is very different. But I think there are a lot of very smart VCs. I think there are like any industry, I think there's a wide variety of thinkers out there.
- [32:55]
Interviewer
One of the things I really think about in asset management as a whole is there are these incentives for herd behavior in that if everybody goes down, if every long only fund goes down by 5% and you're down by 5%, the LPs are going to re up. But if you're down and everybody else is up, even if the last three years you were up, that's going to put pressure not only on the fund to re up, but your champion within that LP having to vouch for you. So there's this kind of rational herd behavior where you could be safe in a losing strategy as long as the entire industry is going in that direction.
- [33:29]
Tyler
The way LPs think, obviously sort of puts pressure on GP thinking.
- [33:34]
Interviewer
There's some really interesting dynamics that I think people don't fully appreciate unless they've been in that seat.
- [33:41]
Tyler
Yeah, sometimes I question it. I think that, for instance, people give me feedback that okay, hey, 15 to 20 investments, like that's just not a lot of diversification. I'm like, well, you also have 15 to 20 managers. Like you're diversified at the GP level. So then like, why do you want so much diversification at the individual investment level? I don't always get great answers. I just think like things are done the way they're done and it's better to have okay returns with no obvious black eyes than, you know, great returns. And so, you know, I think that thinking sort of can permeate through the industry.
- [34:20]
Interviewer
Part, part of the art of being a GP is knowing which rules to follow and which rules to break, knowing which hills to die on and being very conscious about that. And sometimes you could even tell people, I know everybody wants this, this is why I'm doing this. And a lot of, you know, top, top LPs will accept that, but there's only so many variations to their business model they could also accept. One of your paradoxical strategies is that you're companies will be bought by pe growth equity incumbents. Tell me about that. And is that a fundamentally different business that's gets bought by strategic M and.
- [34:53]
Tyler
A and IPOs vertical software. When these companies get to a certain scale, and by that I mean 10 to 15 million of ARR where they can basically float, they can be close to profitability or profitable, depending on how fast they want to grow. They become very attractive assets to a larger universe than what I think is available to any random venture backed company. Because again, vertical software companies, they build these annuities, they have these very sticky customer bases. They're highly sought after by private equity firms or growth equity firms. Those become an additional set of buyers for the companies that we'll be investing in. And then, you know, related to that, there's companies like Constellation Software who like their entire business is buying vertical software companies. And so it's not that I don't want to build businesses that incumbents don't want to buy. Like when I look at my investments at Menlo and the acquisitions that occurred, fieldwire was bought by Hilti, an incumbent in the construction space. Indio was bought by Applied, again, another incumbent in the insurance space. Calstone was bought by Carlyle. Flywire went public. Carta I think will go public. And so there is more of a diversity. I just think that at some scale, vertical software companies become great assets and that's just not the case for most venture backed companies. And so I think there's just better liquidity characteristics for these businesses. So we're not going to orient selling these companies to PE just for the sake of it. I just prefer that there are additional off ramps. The vast majority of M and A in the venture market is still 1 to 500 million and I want to play to the fat part of that curve. And so that includes all the potential liquidity participants.
- [36:44]
Interviewer
Does that make your fund kind of a mix of VC and pe? Almost like a combination of both?
- [36:50]
Tyler
Yes, I think it's kind of VC and like micro growth equity. I think the distinction is, I think a lot of PE firms when they buy businesses like that's the end of innovation or it's a lot about cost reduction and rationalization. I want to invest in businesses that are pushing products. I want to invest in product centric founders who have just a long timeline ahead of them to build and compound their businesses at some reasonably high rate. And I think that's a different ethos than what like P would be bringing to the table for most of these assets. I'm on the boards of several companies now in that are vertical software businesses that have, have grown to be much larger than I probably ever anticipated they could be. And so that, that is a core tenet of this thesis which is that like I, I think that one of the hardest things, one of the areas where VCs make the most mistake, most mistakes around actually saying no to businesses that end up being very successful is saying no to businesses that at their earlier stages look like they're in Nichier markets or smaller markets and they turn them down for market size. But the businesses are working and eventually as they scale they discover new areas to expand into. For me for instance, when I was at Excel sourced this business called PeerTransfer at the time that turned into a company called Flywire. And I remember like this was a company that sold a reconciliation platform to college universities. Actually they gave it away for free but it allowed them to monetize international student tuition payments. So the value proposition was hey, really hard for these college universities to manage international student payments and also very expensive for students to send these payments through their traditional banking networks. So you kind of solve the problem on both sides and you actually monetize through fx. And we did it as like a series A investment with Spark at the time. And I remember the company went out to raise like a series B. And like everyone turned down this company except for small town Small town. It was like, hey, this could be 150, $200 million.
- [39:07]
Interviewer
So even after your investment several years later, it's too small.
- [39:10]
Tyler
Even then, yeah, it's still a small business, but it's working. Small but working right. And so which might as well be dead for VC, might as well be dead for some VCs. One of the partners at Bain ended up funding it at the Series B and the company eventually ended up compounding to be much larger than anyone imagined, including myself. And I think it's a $500 million revenue business today. At one point it was a $5 billion market cap. It's I think closer to 1.3, which is still much larger than 150 million in terms of enterprise value. I remember my colleague at the time, Adam Valken, he was talking to the. And this was after the company IPO'd. He's like, did you know, did you have any sense that this company was going to be like a multi billion dollar outcome? He said, no, I underwrote it to a forex. And I was completely surprised. On the upside and in my career I've seen that time and time again. Whether it's Carta, which today is close to a $500 million business, starting in the small dinky market of cap table management, or it's something like Qualia, which is like a really amazing business in title software, where ostensibly the core TAM that they were going after was 2 to 300 million or even Everlaw, which today is an amazing business in eDiscovery, where historically the size of eDiscovery outcomes was quite tapped or I should say quite limited. There is a history of VCs when they say no to deals, they say no to companies that are growing really nicely, have really strong founders with great product DNA and where the blemish is the market size. I think what really people should be thinking about is how receptive is a market to the product. If it's a small market but people are buying, that's something worth investigating.
- [41:03]
Interviewer
What are some patterns across those four companies?
- [41:05]
Tyler
You get to a certain size and credibility where like you start to see adjacencies, whether it's like an adjacent constituent in the ecosystem that you can sell products to because the data that you're harvesting for your core product is relevant to them, or it's just other products within the broader stack of the constituency that you're selling to. Just it becomes like bigger and bigger and bigger. People could challenge me on this, but I have never found a business that has been like, well I ran out of market size. Like I just stopped every single customer and I ran out of market and could never figure anything out again. That is not what happens. Companies stop growing, they may start to saturate their market but they typically stop growing because their ability to build new product declines. And so for me, if we're going to go after, if we're going to invest in a company that ends up being the size of Carta which now has four or five products, or the size of Qualia which has several different products, it is a long term commitment to building product. I don't necessarily think it needs to be in some hyperbolic eight year period. It could be over a longer period of time and as long as you have a really efficient business, it affords you that time to build that product. Never underestimate a business that's working and a founder who builds while a business is working to unlock new opportunity. It happens. It's almost like a belief system, but it's magic.
- [42:37]
Interviewer
I would add one other factor to that is ability to fundraise and storytell. Henry Ward has done a phenomenal job telling the story of Carta and connecting all the threads together into Carta's competitive advantage. But other founders as well are able to sell past their current vision. Good fundraise is something about selling the future, but the ability to sell the future is what makes the best fundraising are the best.
- [42:59]
Tyler
I agree especially in the, in the venture context that that is.
- [43:02]
Interviewer
What are those components that allows you to grow to 50 million saturated market now grow to 500 million. What are the like double click on that.
- [43:11]
Tyler
The number one thing is you have to become dominant in a certain vertical. Like the size doesn't really matter, but you have to become dominant. That sort of dominance allows you, you know, affords you a book of business like Arrow that gives you just a lot of cash running through the company and you have resources you have, so then you can sustain.
- [43:32]
Interviewer
What about team? You've built a team that executes that. Not a big factor.
- [43:36]
Tyler
Team is very important. You know companies can fail because there are, there's a deficit of quality hires and inability to attract talent. But I think people can mistake like hiring lots of people for like hiring a great quality versus like you can have a much smaller team that really kind of does incredible things over time. And so I think it's about keeping the bar high. Especially for the businesses that I'm going to be funding, like especially in the earlier days. It's like they've got to approach the Problem from, hey, everyone that we hire is high, high impact but we're not hiring a lot of them.
- [44:16]
Interviewer
Yeah. So as your company, as you invest in these companies and they, they saturate the market, should they be taking small, small shots on goal for their next market? How do they operationalize finding the second market?
- [44:27]
Tyler
Often I think it's very continuous conversations with customers and with, you know, counterparties.
- [44:36]
Interviewer
To customers, seeing where the market is pulling. Yeah, yeah, I wish you'd have this product.
- [44:40]
Tyler
Yeah, it's like, oh wow. I remember India was ultimately sold to Applied, but it was, it was kind of an interesting story. Like they started out as this product that sat next to the AMS system that enabled cords data to be collected more efficiently from customers of commercial insurance agents, you know, brokerages. And they built this like this was a wedge product. Right. Like AMS systems are their data architecture. Like they are not structured to collect houses data, do anything with it and they didn't have the front end workflows. And so this is what Indio built and got this really nice flywheel going building, you know, like basically a nice book of ARR with, with insurance agencies. Lo and behold, you know, as we're starting to get to a certain scale and thinking about the next products, obviously there's a bunch of other stuff we wanted to sell into the insurance agency. But these insurance companies came knocking on our door and said, well look, you have all of this of course data that we essentially take from you in a PDF and then re key it into our underwriting system so that we can create a policy or a quote for that customer. Can you sell us an API and we'll just consume the data that way.
- [45:57]
Interviewer
Another way to look at it was what is a company? It's mostly a brand promise. So I go to Tyler and he delivered this to me. Let's say you do, you do laundry and I come to you and you do laundry so well. And I'm like, oh man, I wish you would do dry cleaning. Why don't you do dry cleaning? And I could start selling you for many months. Like this is the market. I could bring my friends, the customer. Actually driving the supplier to start something is even next level to product market fit.
- [46:25]
Tyler
Hey, if you built this like I would love this. This other product sucks. Like we've got this huge problem and then it's a question of sequencing. Like when you've got an empathetic founder who's product driven and listening to their customers and has good instincts themselves, then it's a question of Prioritization. All right, there's these five different things we could build. Maybe three of them are for the existing customers. So that's an easier sell because you're selling to that existing customer you already have a relationship with. Oh, two are to their counterparty that we could get some sort of network effects selling to them through our initial customer. There's some sort of forcing function we should consider that. And you just have to think about, okay, well, how scaled is our business, how much volatility is there in our core business versus how many things do we need to solve in our core before we start to think about what's next? That's always the question. Then once you feel like you can do something next, it's all right. Of these five different things, you know, what is the thing that we are most excited about? Either in terms of like confidence in it succeeding or hey, it really opens up this big new opportunity for us.
- [47:37]
Interviewer
And you used a very specific term, sequencing, which is not necessarily shot selection. I have these five industries. I'm going to pick one. I might do three of these five. But here's the exact order. Do it because if I do it this way I'll get more profit, which will allow me to hire and solve these two problems faster versus if I go this way, it's going to take 10 years to build a profitable business and then those two opportunities might not be there. So it's also like the literally the sequence, not necessarily which business do I want to go to? And I think a lot of times people confuse those two. In asset management, for example, you know exactly what your business will look like at a trillion a there's five of these companies. They'll have real estate, private equity, maybe some venture capital, some secondaries. So it's not actually what will your business look like. It's what is the best and most efficient way to get there. It's kind of like this maze. One thing that I always kind of look down on is these founders like Naval Ravikanth. I would sit and he's like, I make nine months to make a big decision. And I always egotistically thought, well, he's just being, he's just not proactive enough. He doesn't have the courage to go out and act like, why doesn't he just go do something? But oftentimes these are one way doors you come in and you're now committed to this business for five, maybe 10 years. So spending nine months could be very efficient to make that decision versus to use Jeff Bezos's analogy two way doors, you could go in and go out those, maybe you do act quicker. So there is a lot of wisdom to knowing when you do spend a lot of time deciding the next, the next stage of the business. If you could go back 17 years ago when you first started Venture in 2008, what would be your advice to a younger Tyler? What nugget of advice would you give him in order to accelerate his career?
- [49:23]
Tyler
Hmm, that's a great question. You know, you stumped me.
- [49:31]
Interviewer
I could ask myself that question. I just started thinking about it. The number one concept I would teach myself is this concept of ignorance debt, which is when you start something, there's a lot that you don't know about it. And you have to methodically go out to seek the knowledge to make at least the known unknowns. If you can make the unknown unknowns into known unknowns, you're going to progress much faster than if they remain unknown unknowns. And I think the way to do that is just to get the right peer group and the right mentor group around you to accelerate your knowledge. And then I've tried to teach myself how to do that because that's also. You have to learn those skill sets. But basically trying to pay down my ignorance debt as quickly as possible, that's a term coined by Alex Hormozi.
- [50:17]
Tyler
I like that. You've flummoxed me. The Tealians are an interesting bunch. I feel like sort of being close to that kind of Founders fund kind of group would have been interesting. I clearly take a much more conservative, almost growth equity approach to venture building. But there's very clearly a, you know, I don't know if it's the classic venture model, but like kind of more the risk frontier model. And not to say that I would be good at it, I just, I think it's fascinating, you know, what he's able to accomplish.
- [50:57]
Interviewer
So the Thiel Fellowship and that whole ecosystem is really interesting.
- [51:00]
Tyler
It's very powerful. It's like it's a very powerful, interesting ecosystem. I think it's a very. Their thinking is extremely first principles based and, and it's quite foreign to me. So I'm not saying I would want to do anything differently than I do today or think necessarily differently. I like the mental models that I've accrued over time, but I'm impressed with what they've been able to build.
- [51:25]
Interviewer
How do people follow you and stay up to date with everything that you're working on?
- [51:29]
Tyler
If you're interested in getting in touch with me, either through LinkedIn or tylerillancapital.com awesome.
- [51:37]
Interviewer
Thanks Tyler for sitting down.
- [51:39]
Tyler
It was a real pleasure.
- [51:40]
Interviewer
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