Jason Lemkin: Why Pricing is Worse Than Ever and There is More Funding Than Ever | E1157

Intro (00:00:00)

• Seed investing is broken due to limited founders capable of triple-digit growth.
• The best investments grow from $1 million to $10 million in 5 quarters or less.
• To IPO, companies need to triple their market share in their core market and have a churn rate of less than 3-4% per month.
• The market is flooded with capital, leading to higher valuations and unrealistic expectations.
• Founders are raising larger rounds at higher valuations, making it harder to achieve profitability.
• The pressure to grow quickly and achieve high valuations is leading to unsustainable business practices.
• Many companies are burning through cash without a clear path to profitability.
• There is a record amount of capital available for startups, but it is becoming increasingly difficult to raise funds.
• Investors are becoming more selective and are demanding higher returns.
• Founders need to be prepared to pitch their businesses effectively and demonstrate a clear path to profitability.
• The market is still competitive, and founders need to be realistic about their chances of success.

The Science & Art of Successful Deals (00:01:27)

• Jason Lemkin discusses his best deals by cash and by NAV.
• His best deals by cash are:
  • Sales Loft: $2.5 billion cash, $100 million ARR.
  • Pipe Drive: $1.5 billion cash.
  • Harry's: $300 million cash.
• His best deals by NAV are different from his best deals by cash.
• He didn't predict that Sales Loft, Pipe Drive, and Harry's would be his top three cash returners.
• He learned that even though VCs say you have to go long, you don't always know how companies will perform later in life.
• He also learned that some founders just can't lose, like Kyle from Sales Loft.
• He was surprised that both Sales Loft and Outreach were able to survive and win significant market share.
• Jason Lemkin discusses why pricing is worse than ever for startups.
• He says that there are three main reasons for this:
  • The cost of customer acquisition has gone up.
  • The competition is more intense.
  • Customers are more demanding.
• He also says that there is more funding available for startups than ever before.
• This is because:
  • There are more venture capital firms.
  • Venture capitalists are investing more money.
  • Startups are staying private longer.
• The combination of these factors is making it more difficult for startups to succeed.

Lessons from the Best & Worst Deals (00:05:03)

• Investors now have less time to get to know founders and their products, so it's crucial to have an ultra-committed binary team.
• Great CTOs can demonstrate their exceptional abilities within a short conversation and are hyper-transparent about their challenges.
• In the early stages, the CEO is usually better than the CTO, but a 10x feature can help a startup succeed up to a million or two million in revenue.
• Venture funds can be profitable with multiple billion-dollar exits, and the speaker now focuses primarily on the CEO and CTO when evaluating early-stage investments.

The Qualities of Great CTOs (00:15:54)

• To identify great CTOs, it may take interviewing 20 candidates.
• Look for candidates who can demonstrate their work and explain their thought process.
• Ask open-ended questions and pay attention to their answers.
• Observe their passion and excitement for their work.
• Don't lower your standards when interviewing for a functional area you're not familiar with.
• The best CTOs have built great software, even at early stages.
• Look for signs of "crappiness" or shortcuts in their work.
• Slow or buggy software at a million in revenue is unlikely to improve as the company grows.

Investing in Competitive Markets (00:19:28)

• Jason Lemkin believes that passing on great founders and CEOs solely because they're in a competitive space can lead to missing out on significant deals.
• Lemkin acknowledges that big markets tend to have more competitors but believes that hyper-agile teams with superior engineering and product capabilities can benefit from competition as it helps grow the market.
• PipeDrive, in which Lemkin invested, was acquired for $1.5 billion with $100 million in revenue despite having five co-founders involved in decision-making and facing challenges such as the rise of HubSpot as a dominant player in the CRM space.
• HubSpot entered the CRM market with a free product and eventually surpassed PipeDrive, becoming the largest source of growth for HubSpot.
• The timing of investments and founder departures can significantly impact a company's success, with founders' departures leading to reduced competitive agility and innovation.
• Lemkin expresses skepticism about the ability of private equity firms to make money on certain investments due to cannibalization and decay rates.
• There is uncertainty about whether venture capital firms will receive a "mulligan" or partial forgiveness for their 2021 investments, which were made at high valuations during the funding bubble.
• Timing is crucial for exits, as seen with Slack's sale at $27 billion with $1 billion in revenue, potentially being worth $12 billion at $2 billion in revenue today.
• Distribution is key to success, as seen with HubSpot's Pipe Drive competitor reaching $700 million quickly due to effective distribution.
• Founder-led companies should be wary of expanding into different categories, as it may not always be successful.
• Founder-led companies can be just as agile and successful as larger companies, especially when they have a clear vision and are willing to invest in long-term growth.

Founder-Led Companies & Product Expansion (00:31:13)

• Founders often want to expand product lines and move away from core focus, but investors usually advise against it and emphasize the importance of nailing the core market first.
• The right time to expand product depends on the specific situation, but a good rule of thumb is to start considering expansion when the company reaches 10% market share in its core market.
• At 10% market share, growth starts to slow down, and it's important to have a second act or plan in place to maintain growth.
• The second act doesn't always have to involve a second product; it could also involve expanding the target market, going more enterprise, or entering a new country.
• Many investors create narratives in their minds to simplify investments and may not listen carefully to the founders' vision for the company.
• It's important to listen to the founders' goals and understand their specific aspirations for the company before making investment decisions.

Investing Mistakes (00:34:43)

• Jason Lemkin discusses two significant investment losses: a company sold for $100 million during the lockdown but could have sold for much more and another where he lost $5 million due to a dishonest CEO and poor hiring decisions.
• Thorough due diligence is crucial, especially for follow-on checks, as investors often overlook details beyond the top line during these checks.
• Founders should be transparent about their company's financials to maintain credibility with investors.
• Manipulated metrics and fraudulent practices can cause long-term problems for companies and investors.
• Customer references should be used to confirm an investor's positive impression of a company, not to change their mind about an investment.
• The best investments still grow from $1 million to $10 million in revenue in 5 quarters or less.
• To IPO, a company needs to triple, triple, double, double its revenue.
• Despite founders' complaints, the IPO markets only care about efficient revenue trajectory, not past fundraising rounds.
• Insiders are flooding fast-growing startups with capital, which can be negative as it leads to less work and a different bar for success.
• Companies are getting overfunded at inflated valuations by insiders, resulting in unrealistic market caps.
• Some companies use structured or flat rounds to conceal financial struggles.
• Zombie public companies with low growth and unexciting roadmaps are potential targets for private equity firms due to their high operating margins and potential as cash engines.
• The current funding environment is challenging, with pricing becoming more difficult, but there's still potential for good deals if market conditions improve.
• Examples like HubSpot and LinkedIn show the importance of making the right bets and capitalizing on market upturns.
• Churn rate is a key metric, and understanding acceptable levels in different market conditions is crucial.

Acceptable Churn Rates for SMB & Enterprise Companies (00:52:28)

• For Enterprise companies, a net retention rate (NRR) below 110% at $1 million in revenue indicates a fundamental problem.
• For small businesses (SMB), a monthly churn rate of 3-4% is common and can be tolerated for a few years if it means achieving 100% NRR.
• Highly volatile churn rates pose a significant risk and make it challenging to make accurate projections.
• The last-four-months (L4M) model can provide valuable insights and predictive power for startups approaching $1 million in revenue.
• Pricing is more challenging than ever, and venture capital funding can obscure churn, making it harder to identify unsustainable businesses.
• SMB software has a lower margin for error compared to enterprise software and needs to be self-serve and product-led to succeed.

Assessing Burn Rates & Revenue Projections (00:59:00)

• Burn rate is a crucial metric for assessing a company's financial health, especially if the company has low margins or an unclear funding strategy.
• Founders should be ambitious with revenue projections, but investors should challenge overly modest projections.
• Evaluating revenue growth of AI tools, particularly PLG AI tools, can be challenging due to their experimental nature. Investors should distinguish between real revenue and hype.
• The current funding landscape involves high burn rates and valuations, making it difficult to assess startups' true potential.
• Low ownership stakes due to high valuations and small fund sizes pose challenges for VCs in securing meaningful returns.
• YC's batch funding model prioritizes quick funding for most startups rather than focusing on individual deals or accommodating specific VC fund structures.
• RevenueCat's strong founder commitment and market dominance make it a promising investment despite initial misunderstandings and slow sales development.
• Backing founders with a long-term vision and deep industry knowledge is crucial for successful investments.
• Pursuing seemingly good deals may not always lead to great investments.
• End-of-fund investments should be evaluated with the same rigor as start-of-fund investments, and recycling capital from successful exits early can significantly impact the fund's performance.
• The speaker aims to invest more rapidly in the future and believes that existing investments will yield sufficient returns, but plans to invest in two more funds to increase successful investments.

Quick-Fire Round (01:13:04)

• Clavio, an undervalued SAS company, has achieved remarkable success and is poised to surpass major competitors in terms of revenue despite recent price increases.
• The success of Clavio has led to an overvaluation of many other SAS companies in the venture market, creating a market where almost everything is undervalued.
• Companies like Atlassian and Anaplan are facing challenges and uncertainties, raising questions about their long-term prospects.
• Upstart companies with consistent growth and reasonable margins can yield significant returns over time, despite criticism.
• The venture capital landscape is changing, with some successful managers becoming less active or leaving the industry altogether.
• Making concentrated bets on promising founders with the right drive and track record can be a more effective investment strategy in the current environment.
• Venture capitalists are increasingly getting smaller ownership stakes in startups, which makes it harder to return the fund.