(Ep.57) The Acquirers Podcast: Alex Rubalcava – Seed Stage, From Value Investor To Seed Stage Venture Capitalist In Los Angeles

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In this episode of The Acquirer’s Podcast Tobias chats with Alex Rubalcava, Co-Founder And Managing Partner at Stage Venture Partners, which is a seed venture capital firm that invests in emerging software technology for B2B markets. During the interview Alex provided some great insights into:

  • The Seed Investing Framework
  • How To Invest In Enterprise Software Startups
  • The Age Of The Trillion Dollar Company
  • What Do You Fear In Investing?
  • The Ghostbuster Rule For Managing Investors Capital
  • How To Calculate Returns In Venture Capital And Private Equity
  • What Is The Best Defence Against Commoditization?
  • Venture Capital Investing Is All About Your Biggest Three Winners
  • From Value Investor To Seed Stage Venture Capitalist
  • Investing In Movies Is The Hardest Way To Make An Easy Living Imaginable
  • How Does Amazon Track Counterfeits?
  • How Placer.ai Is Providing Unprecedented Visibility Into Consumer Foot-Traffic

References In This Episode:

The Age Of The Trillion Dollar Company (Alex Rubalcava)

What Do You Fear? [In Investing] (Alex Rubalcava)

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Full Transcript

Tobias Carlisle:
All right. So when you’re ready, let’s get going.

Alex Rubalcava:
Sounds good.

Tobias Carlisle:
Hi. I’m Tobias Carlisle. This is the Acquirers podcast. My special guest today is my old friend Alex Rubalcava. He’s a value investor turned seed stage venture angel investor. His firm is Stage Venture Partners. I’ll be talking to him right after this.

Speaker 3:
Tobias Carlisle is the founder and principal of Acquirers Funds. For regulatory reasons, he will not discuss any of his acquirers funds on this podcast. All the feelings expressed by podcast participants are solely their own and do not reflect the opinions or Acquirers Funds or affiliates. For more information, visit acquirersfunds.com.

Tobias Carlisle:
Hi, Alex. How are you?

Alex Rubalcava:
I’m well, Toby. Glad to be here.

Tobias Carlisle:
So you’re one of the folks I’ve known in the States for the longest. You, Chris Cole, and a handful of guys. You also know Chris, funnily enough. Small world.

Alex Rubalcava:
Yeah. I haven’t seen Chris in a long time, but he’s off doing really exciting things.

How To Invest In Enterprise Software Startups

Tobias Carlisle:
So tell us a little bit about Stage. What do you do there?

Alex Rubalcava:
So my firm is a seed venture capital firm that invests in enterprise software startups. What that means is that we’re typically coming into a company where there are four or five, or maybe six or seven people. They’re about a year or two old. They’re raising anywhere from $1 to $3 million in their institutional round of capital.

Tobias Carlisle:
Right. So let’s talk about enterprise software. What is enterprise software?

Alex Rubalcava:
So enterprise software can mean a bunch of different things. It can mean developer tools, things like Atlassian or Stripe or stuff like that. It can mean network and telecom and data center related products, something like a PagerDuty. Or it can represent an application layer product, like Sales Force. I tend to play at the top of the stack. I tend to invest almost entirely in application layer products or middleware. What that means is I’m typically investing in high-end, expensive software that is used by business customers within a specific vertical.

Tobias Carlisle:
And what’s the reason for targeting that part of the stack?

Alex Rubalcava:
I target that part of the stack because if you are investing in more horizontal type products, think about something like Zoom or a Slack, at the seed stage, it’s very difficult to tell who’s got any kind of product differentiation. It’s very difficult to tell how you’re going to figure out customer acquisition, and it’s immensely competitive. Once you sort of figure out that Zoom is better than anything else, then the challenge becomes how do you make sure you get in the Series B or C or D round of that company, and there’s intense competition to do that. Whereas if a startup comes out with better software or an entirely new class of software to do something in clinical trials for pharmaceuticals, you know you have a pretty tight group of customers that you’re targeting. You know you have a pretty compelling and easy to articulate value proposition and you know that there are not going to be a thousand startups competing against you because you need very serious domain expertise to be a credible founder in a market like that.

Tobias Carlisle:
So are you looking at … when you say vertical enterprise, that’s something similar to Constellations, famously looking for vertical market software. Is it a similar direction?

Alex Rubalcava:
Yeah, somewhat. Constellation is typically buying up legacy products that may not have gotten super large but that are companies that serve their customers really effectively and that have a long basis for renewals. I’m looking for things that have all of that but that also have the potential to scale from zero or close to zero in revenues at the time that I invest to hundreds of millions of dollars of annual recurring revenue, or more, within ten years.

Venture Capital Investing Is All About Your Biggest Three Winners

Tobias Carlisle:
Right. What’s the expectation of these companies? What’s your expectation for the hit rate at that stage?

Alex Rubalcava:
To a certain extent, the hit rate doesn’t matter. It’s a funny thing to say, but portfolio management in venture is more about how big your biggest three winners in a portfolio with 20 or 25 companies are than it is about what percentage of investments that you make money on. If I make one or two or three X my money on a startup, that’s a nice thing but that also doesn’t really move the need for my portfolio. What moves the needle is how big are my three biggest winners going to be? If my three biggest winners are 25X, 12X and 8X, my fund is going to be pretty mediocre, because I’m going to have a bunch of zeros in the portfolio in addition to those winners. I need my biggest winners to hopefully be somewhere around 100X in order to generate returns that compensate my investors for taking a risk on an asset class as a liquid and as risky as seed stage venture.

The Seed Investing Framework

Tobias Carlisle:
So given that you have this long right tale of returns, how then do you go about constructing a portfolio?

Alex Rubalcava:
So you construct a portfolio from a few different ways. Number one, you have to think about what’s your valuation when you’re getting in? What percentage ownership of a company you’re buying, number two. Number three, you have to be thinking about how much money do you put in up front and how much do you reserve for follow on and then where and how do you deploy your follow on reserves? Everyone wants to use their follow ons for Perrata when you have a company that you did the seed round in and then the Series A is led by Kleiner Perkins or Sequoia and you have all of the social validation that comes with that. But that will happen some of the time. Some of the time, you’ll also need to deploy your reserves to help a company where it took a little bit longer to get to product market fit than you had hoped and you need to give them another six months of runway in order to get there.

Alex Rubalcava:
Sometimes you need to use your reserves to bridge a company through a downturn. Downturns do come from time to time. It’s been a while, but we will have those. Sometimes you need to think about using your reserves another way, and so portfolio management for venture is largely a question of reserve management and it’s very different from public market investing, where you get to visit and revisit that decision every single day, where you have a high degree of reversibility, and you have the liquidity that’s available in anything other than the most liquid microcaps to make high resolution decisions. Decisions in venture are largely irreversible. They are very low resolution, in the sense that you only get a few chances to do it, and often the decisions are binary and have a social pressure that come along with them. They’re infrequent and unpredictable.

Tobias Carlisle:
Let’s just back up a little bit and talk about what are reserves and what do you mean by follow on? Let me just ask a little bit more detail.

Alex Rubalcava:
Sure.

Tobias Carlisle:
When you’re making your initial investment, you’re assuming that there will be some follow on or some reserve investment, and so what portion of your anticipated total investment are you making at that first stage?

Alex Rubalcava:
So at the first stage, I’m probably putting somewhere between 35% and 50% of the total amount of money that I expect to invest into that company to work. I am holding back the rest of it to invest in the company at some later time. You do that for a few reasons. You do that because you want to maintain your ownership when a company raises future capital and you can use your right to invest in that round. That’s called your pro rata rights.

Alex Rubalcava:
You also use it because you get more information as you go farther along in time. When I’m investing in a company that is … the youngest company I have ever invested in, I met when they were three weeks post-incorporation, and that was a team of four people. They had a logo and a deck and some early customers that they were talking to, but there was very little information there. When I’m looking at a company like that, a year or a year and a half or two years from now when the next round comes up, I’m going to know a lot more about how well they went about the big things that a startup has to do. How well did they hire? How well did they ship product and how quickly and efficiently did they ship product? Did pricing come in on the software anywhere near what we expected it to? What did customer acquisition look like? All of these questions, I’m going to have far more answers to and far more information about in the next round. So usually that means I am probably paying a higher price per share for the shares, but the upside is still so large that it’s a good decision to hold back some amount. How much you hold back is one of these questions that there’s endless debate about in venture and theses go back and forth, on blog posts and on Twitter, debating this kind of stuff endlessly.

Tobias Carlisle:
What’s your ideal target look like?

Alex Rubalcava:
In terms of what? In terms of characteristics of the company or return characteristics or?

Tobias Carlisle:
Yeah, in terms of the characteristics of the company. What are you looking for when you’re first making these investments? What stage should they be at? What should they have done?

Alex Rubalcava:
So some of the companies I invest in are pre-revenue and pre-product. When I invest in a company that has not yet shipped a product and generated revenue, I am typically looking for a team that has substantial domain experience. I’m looking for customers who have said in writing that as soon as this product is ready, we’re going to use it and we’re going to spend money on it, within a reasonable bound that is up for negotiation, that are willing to get on the phone and talk with me to verify that. I’m looking for some sense that the market is big enough to support the return expectations that I have for my fund.

Alex Rubalcava:
When a company is in revenue and has some early customers, I want to be able to talk to those customers, understand why they’re using it. I want to look at how those customers were acquired and whether that says anything about how we will be able to acquire customers going forward. You know, a lot of startups acquire the first customers from their relationships and that’s fine, but if your first customer is your father-in-law’s company, I need to know how you’re going to get beyond your father-in-law’s company.

Tobias Carlisle:
Do you have any preference for very big ticket items and fewer of them, or lots of smaller investments? Is there any guideline for which of those is a better investment opportunity?

Alex Rubalcava:
In terms of the price of the software that we’re talking about or the size of the investments I make?

Tobias Carlisle:
I’m asking you if 100 duck sized horses will defeat one horse sized duck.

Alex Rubalcava:
I tend to be moderately concentrated in terms of investments, so per fund, I’m going to make 20 to 25 investments. In my Fund Two, which I fully deployed into 20 companies, and my current Fund Three, I’m planning on about 25. when it comes the question of who these folks are selling to, my portfolio companies are tending to sell software that is pretty expensive that solves very critical business needs and as a result, is not software that’s selling for $9.95 per month. It’s often software that is $10 to $50 thousand for point software then for systems of record or systems of engagement. It’s software at $100 thousand plus, per year.

From Value Investor To Seed Stage Venture Capitalist

Tobias Carlisle:
So let’s just take a step back. You started out as a value investor and you’ve transitioned across to venture. What prompted the transition?

Alex Rubalcava:
I actually started as a VC and then went into public market investing, and then came back to VC. So my first job out of college was as an analyst at Anthem Venture Partners in Santa Monica, where I worked for just under three years. That firm is now the second oldest, continuously active venture firm in L.A. There are now over 200 venture firms in L.A., but Anthem is one of the granddaddies of them.

Alex Rubalcava:
While I was there, we were Series A investors in companies like True Car, MySpace and Android, all of which were deals that I supported the partners on as an analyst. We were also investors in tons of chip and semiconductor companies that nobody outside the semiconductor industry would know. After that, I transitioned to running a long oriented fund focused on special situations on public markets. Did that for a number of years. Along the way, I would do an occasional angel investment. I didn’t do a huge amount. I did seven or eight, you can count them on your hands. I’ve only lost money on one of those.

Alex Rubalcava:
I have one that’s still active and all the others had substantial exits, and I was looking at that track record and those exits that were coming seven or eight years ago and I could feel at the same time the diminution and alpha around value oriented strategies in the markets that all of us have experienced. I said, “You know, I think there’s something interesting happening here. I think the universe is trying to tell me something, that I’m probably better at this venture stuff and that I should be orienting my career in that direction.” So I flipped back. I started Stage in 2015 and have been running it ever since.

The Similarities Between Value Investing And Venture Capital

Tobias Carlisle:
What skills do you take across from value to venture?

Alex Rubalcava:
There’s a few. Both value investing and venture capital are disciplines that are built around fundamental analysis. We are business analysts studying competitive advantage and capital efficiency and returns on invested capital. Whether we are looking for high quality, mispriced businesses of the public markets or whether we are looking at recent startups. We’re also patient long term investors. When I write a check to a startup, I have no expectation of getting a return on that investment for six or eight or ten years. It takes that long to go from three guys and a dog in a WeWork to ringing the bell on the Nasdaq at your IPO. That is not something that can be rushed. So the time orientation that value investors tend to have lines up really well with the time orientation that VCs have to have.

The Age Of The Trillion Dollar Company

Tobias Carlisle:
You’ve written some interesting blog posts on the side. The first one I want to discuss is the trillion dollar company idea. So let’s talk about that. What’s the thesis of the blog post and then I’ve got some questions for you.

Alex Rubalcava:
The thesis of the blog post is that we now have a handful of public companies in the United States, Apple, Microsoft, Google, and Amazon, in addition to dozens of other companies that are almost as big as them that are so big that I think that they have escaped regulation from their investors, from the regulatory bodies in this country, and from consumers and that we have this issue where there’s a fundamental mismatch between the ability of people to exercise any kind of governance or accountability on companies of this size. When you think about a trillion dollar company and you think about the fact that the largest activist hedge fund in the world has what? Thirty or forty billion dollars in assets under management that-

Tobias Carlisle:
Who’s that now? Elliot?

Alex Rubalcava:
Someone like that, yeah. So they can put 1% … if they bought $3 or $4 billion worth of a trillion dollar company, they would have a 1%, 1.5%, 2% position, and I don’t think you can rattle sabers with that little power. There’s no one, now, who can exercise governance over companies of that scale.

Tobias Carlisle:
Yeah, you made the point in the blog post that the biggest P fund has about $26 billion, biggest activist fund say $40 billon. They can’t dedicate the entire fund to one position so they have to-

Alex Rubalcava:
Right.

Tobias Carlisle:
Maybe they can get 25% of the fund into one position, although that would be pretty concentrated. That’s $10 billion for the activist fund into a trillion dollar company. There’s no influence at that level. So what’s the solution to that? Do we need to regulate them more, or what happens? Do we need bigger activist funds?

Alex Rubalcava:
I think ultimately we’re going to have to have activism go hand in hand with passive ownership of public companies, because that’s where all the ownership lies. That’s where the capital is going. It has been anathema to the corporate culture of large, passive owners of public equities to exercise any kind of influence or activism on their holdings, but there’s nothing that says that has to be the case. You could have a passive, ETF oriented manager that exercises very strong activism and accountability on their underlying public companies, even if they’re invested in thousands of them.

Alex Rubalcava:
I think something like that has to happen. How that works, how you pay for that on a few bits of management fees is a really interesting question and I don’t have a good answer for that. You know far more about that world than I do.

Tobias Carlisle:
Well, CalPERS, of course, was always willing to support activist, but it’s been … index funds have largely been passive as the name suggests, but then looked like there might be some moves on the ESG front by firms, so I think it is BlackRock that has come out and said they’ll move on environmental issues. Do you think that extends perhaps to governance as well?

Alex Rubalcava:
I think it’s a start. I’m hesitant to ascribe anything resembling strategy to announcements out of CalPERS. They’re blown in the wind pretty easily, and so I’m not looking expectantly as Sacramento as a savior here.

Tobias Carlisle:
What about from a policy prescription? Do we need to bus these companies up through anti-trust or something like that?

Alex Rubalcava:
I guess the challenge is so many of these companies have not grown through anti-trust. A few of them have an excellent track record in M&A. Google’s acquisitions in the middle part of last decade from Android itself, which my prior firm was involved with, to YouTube and Double Click and a few others. Applied Semantics here in southern California. That’s a hell of track record. But no acquisition they have made recently has or will move the needle as much as those did and Google was not perceived as a threat on an anti-trust level back then in the way that they are today.

Tobias Carlisle:
You don’t necessarily need to stop at the acquisition stage of this. Certainly precedent for this things being busted up like the Ma Bell and the Baby Bells. There’s an argument to be made that Google has this sort of stranglehold on many different industries. It’s a travel OTA. Travel companies that sell over the internet have encountered the issue where you have Google coming in and now sales are competing. Flight travel service. So I just wonder if that inspires them to do something.

Alex Rubalcava:
It could, and certainly Google making any attempt on a transformative and anti-competitive acquisition today would be met with a lot of skepticism that would prevent something like that. Most of the deals that they made that put them in a position that they are today were done over a decade ago when nobody perceived them to be as dangerous as they perceive them to be now.

Tobias Carlisle:
Yeah, I remember that YouTube acquisition. A billion dollars seemed outrageous at the time, and it’s probably outrageously cheap in retrospect.

Alex Rubalcava:
Yeah, when he was asked about, Eric Schmidt said at the time, “I will have either wildly overpaid or wildly underpaid.”

Tobias Carlisle:
Don’t know which.

Alex Rubalcava:
He was right about that.

What Do You Fear In Investing?

Tobias Carlisle:
Next blog post you discussed what do you fear? I mean aside from great white sharks and spiders, what do you fear?

Alex Rubalcava:
I wrote that because I was asked that question by an LP, an LP prospect, an institutional allocator. What I was referring to there was what do you fear in investing, and in VC it’s very common for there to be ideas that everybody gets at the same time, just something that’s latent in the world that everybody realizes is an opportunity, like when Leibniz and Newton invented calculus simultaneously.

Tobias Carlisle:
Synchronicity. Right. That’s what I think it’s called.

Alex Rubalcava:
Synchronicity. Exactly. So a few years ago, that was VR content and then it was influencer marketing and I’m trying to think about … there were crypto ideas out there. In general, I am very skeptical of any investment where the thesis is that 20 other people have pitched me this idea and the 21st team that pitches me the idea is going to be better than all of them and will beat the other 20. I really fear competition when I am evaluating investments and I am really looking for opportunities where a company will succeed or fail for some reason other than competition. That takes me into really wild and wooly areas where software has typically not been a solution to an existing problem in the past, but there is some reason to believe that that business problem can now be solved by software in a way that it could never have been before.

Tobias Carlisle:
Can you give an example of something like that?

Alex Rubalcava:
Yeah, I’ll … I have a portfolio of company called Slingshot Aerospace that does computer vision analysis of aerial imagery, primarily imagery coming off of the giant fleet of micro satellites that now exist in the world. Up until five or six years ago, you didn’t have low cost launch systems like SpaceX and you didn’t have low cost imagery and radios and solar power and all these other components that were mostly developed for cell phones that would enable you to put a satellite in orbit that’s the size of a loaf of bread that could take high resolution images of anywhere on earth, and now there’s hundreds.

Alex Rubalcava:
There’s literally hundreds of these satellites up there and they are taking so much imagery every day that if our government, the NSA or the National Geospatial Agency or anyone who does this kind of stuff wanted to actually analyze of this imagery by hand with people, they would have to hire a hundred thousand people. Literally a hundred thousand people to just sit in front of computer screens and look at images before and after every day and say which of these has changed. Obviously no one’s going to do that, but that’s not a job that a person should do. That’s a job that software should do. That’s a job for machine learning and computer vision and now that anyone can order up this imagery from all of these satellites, you don’t have to be the National Geospatial Agency to do that.

Alex Rubalcava:
It opens up all sorts of new use cases. You can assess damage after a natural disaster. You can look at real estate development trends. You can do all sorts of stuff, and Slingshot is building a platform to enable all of that.

Tobias Carlisle:
I recently learned that the early spy satellites took photos with film and in order to get the film back to earth, you had to send a canister with a parachute.

Alex Rubalcava:
Yup. That’s awesome.

Tobias Carlisle:
The Russians knew where roughly they were going to land and so they used to send ships out to try and catch these things before the Americans could get them, but the Americans were able to get them with plans that could fly through and catch them midair. We’ve come a long way.

Alex Rubalcava:
Yes. It’s quite the game of capture the flag. One of the interesting things there is that often one aspect of technology advances faster than others, and so right now there is more imaging capability in orbit than there is bandwidth. About 90% of the images that are taken by these satellites, by these micro satellites, every day aren’t even being down to earth because we don’t have enough orbital bandwidth to handle all of that right now. There’s a bunch of startups that are working on different technical approaches to debottlenecking that particular issue.

Tobias Carlisle:
So how does it prioritize what it sends down?

Alex Rubalcava:
Who pays the most?

What Is The Best Defence Against Commoditization?

Tobias Carlisle:
Fair enough. You also mentioned in the what do you fear blog post commoditization, so let’s talk about that a little bit.

Alex Rubalcava:
Right. So competition I believe creates commoditization and you have to really be worried about is your product and is your company enough of a company and enough of a product that you don’t become a feature in somebody else’s solution. That’s a really, really challenging thing. It’s a really challenging thing to think about what is that is so hard to do today that it’s the basis of a new startup will still be the case like that and will be something that will just be given away for free by Google or anybody in ten years.

Tobias Carlisle:
What are some signposts in making that decision?

Alex Rubalcava:
Often it’s some kind of a customer lock in. It’s some kind of a network effect. It’s some kind of dependency. If you can build an open architecture platform where other people can build useful products on top of your platform, that can often be a really good defense against commoditization. Ultimately, you just have to drive commoditization into other parts of the value chain, except for where you are, and you have to create more value for everybody in your value chain than you take yourself.

Alex Rubalcava:
Bill Gates was asked about this in the 1990s. Somebody did some math and calculated that of all the value that Windows created as an operating system, Microsoft was only capturing about 10% of that. The PC OEMs were capturing a portion, the application developers were capturing a portion, the peripheral makers were capturing a portion, and somebody said, “Why don’t you drive price, Bill? Why don’t you capture more of this?” What he said is, “We don’t need to capture more of this. We need to just be growing the pie for everybody and it will be better for everybody if they do that.” And that’s why even today, 20 years later, 25 years after he was asked that question, Windows still generates tens of billions of dollars a year in operating profit.

Tobias Carlisle:
Yeah, and they cleverly switched to a software as a service, so now I get the $8, $9 fee every month and don’t even notice it.

Alex Rubalcava:
Exactly.

Tobias Carlisle:
Rather than having the $350 or whatever it was. $800 once every four years.

Alex Rubalcava:
Yup.

Tobias Carlisle:
Let’s talk about the limitations of portfolio management, because that was one that particularly laden with VC specific jargon that I think is interesting to unpack for folks. Let’s talk about pro rata rights. What are those?

Alex Rubalcava:
A pro rata right is the right to invest in the next round of a company, proportional to your ownership in the company prior to the round. So if you own 5% of a company and they raise another round, you have the right to out your own money in equal to 5% of that round. That, theoretically, helps to maintain your ownership in the company. Your ownership will diminish anyways because of new stock options being issued and a few other things. If you own 5% of the seed run, you’re not going to 5% by the Series D, even if you exercise your pro rata rights the whole way up. You can still minimize your dilution as much as possible.

Alex Rubalcava:
That right, which is a contractual right, is also a right that is also subject to negotiation. It is very common for me to have pro rata rights in a deal I do and then a big time Sand Hill Road firm comes along and says, “We want to take the entire Series A, because we have our own ownership requirements and I know that you at Stage Venture Partners have pro rata rights, and that’s adorable. You’re going to waive those rights because we’re going to not come in the company if you don’t allow us to do.” In cases like that, I will probably have to do what is best for the company.

Tobias Carlisle:
So you talked about you have a balancing between … the most return is probably going to be from that very early investment, but then you get to deploy more capital if you follow on. How do you make that decision?

Alex Rubalcava:
I think the best way to make that decision is to be realistic with the fact that most companies take more than a year, often two or three years, to go from a seed check to Series A. Most of the time, they’re going to need more money and the most likely place to look for more money is from their existing investors.

Alex Rubalcava:
At the same time, I don’t need to reserve money to invest in the C, D, and E rounds of my portfolio companies because at that point the price per share will be so high and the dollar amounts required will be so high that another $250 thousand from me, the seed round investor, is not going to make a difference to them or to me. So it doesn’t make sense for me to hold back money to participate in a round like that.

Alex Rubalcava:
There’s a balancing act as to when a company is dependent on me and when my dollars make a difference, when I am still making investment decisions that are commensurate with my position in the ecosystem as a seed investor, when it makes sense to sort of bow out of future financing obligations at the company and let the next stage investors handle that.

Tobias Carlisle:
When you move from seed to A to B, C, D, so on, is that just the number of rounds that the company has raised or is there some expectation that seed stage could be anything. Round A, you need to have revenue. Round B, you need to have whatever. Profitability or whatever the criteria may be.

Alex Rubalcava:
Yeah. The boundaries are fluid. They’re ill defined. They’re different for different types of industries, and they’re ever changing. It drives startup founders totally bonkers to try to figure it out. It’s hard even for us as VCs sometimes to figure out where those lines are moving. I wish there were a more concrete and defined way of drawing those distinctions, but no one has figured it out yet.

How To Calculate Returns In Venture Capital And Private Equity

Tobias Carlisle:
Right. It seems the darkest start in private equity and venture capital is in the calculation of returns. There are two methods for doing it. DPI and IRR. Can you unpack those acronyms and tell us what they mean?

Alex Rubalcava:
Yeah. So IRR is the Internal Rate of Return that is often measured for a venture firm. It’s very different from a compound annual growth rate that a public equity oriented fund will have because we don’t call of our capital at once. I might raise a fund today and still be deploying into new startups three years from now and then still be doing follow on investments two years after that. I don’t hold the cash today that I’ll be investing five years from now. My investors have committed it to me, but I haven’t called it down. So the timing of the cash flows impacts the IRR.

Alex Rubalcava:
Because of that, IRRs in venture and in private equity are always higher than any CAGR in a public equity portfolio and you need to adjust for that and sort of have a mental model as to what kind of an IRR is equivalent to what kind of a CAGR. It’s one of these things that makes VC and PE look a little bit more glamorous than it is, because the IRR is going to be very eye-popping. I’ve seen IRR numbers for PE funds where they only made a multiple of capital of 50% or 60%, so 1.5X on DPI on the fund, but they had a 30% IRR because they did a few investments and then exited or recapped those real quickly and sent cash back to their investors. That’s an okay outcome, but ultimately what matters is what is the multiple of capital that you send back to your investors? What is the DPI, the Dollars Paid out to Invest in capital that you return?

Alex Rubalcava:
In VC, in a seed venture fund, you’ve got to be sending all fees and expenses, more than 3.5 or 4X in order to compensate for the crazy risk that any investor takes to invest in seed venture capital. Really good seed funds can return 10X or more.

Tobias Carlisle:
And so the distinction is from the investor’s perspective, they’ve committed a certain amount of capital to you, but you don’t draw it all down at once. You draw down some portion of it and so they have to have that commitment liquid and available. So they might have it in cash or something equivalent. Not only a great return, but your return is only calculated on the portion that you draw down.

Alex Rubalcava:
That’s correct. That’s why most investors like me raise money from institutions that have the internal capability to manage their cash flow commitment needs for capital calls in the future or when we work with high net worth individuals in family offices. We either make sure that they have some kind of internal capability, whether they have a wealth manager or a financial planner or something like that who knows how to do this kind of stuff, or we just call it all up front from investors like that who may not be as sophisticated and who don’t want the hassle of sitting on and planning for capital calls in the future. So that’s a case where you have to know your investors really well. You have to communicate very clearly with people and where you have to make sure that everybody is equipped to deal with the realities of the asset class.

The Ghostbuster Rule For Managing Investors Capital

Tobias Carlisle:
If you make an investment from one fund, is it possible for another fund to follow on? Another one of your funds, so you have one, two, three, and so on?

Alex Rubalcava:
Yeah, it’s possible to do that. Generally, that crosses into an area where there can be very serious concerns about governance because the investors in my Fund Two are not going to be the exact same group of investors in my Fund Three, let’s say. There’ll be some overlap, but there will be new investors come in. There can be the perception that you are throwing good new money after bad old money to salvage a deal when you’re doing that. So different firms have different guidelines for how they do that. I have always just said, “You know what? It’s really good to have bright, clear lines,” and so I follow what I call the Ghostbusters Rule. Don’t cross the streams. I don’t cross the streams. I do not invest from … all my Fund Two companies are a totally separate and distinct group of companies from my Fund Three companies, let’s say. I write the rules in black and white so there can be no ambiguity there.

Tobias Carlisle:
I wondered about that. What’s the industry standard on that? Is it common or is that uncommon?

Alex Rubalcava:
That’s a good question. I think most people who just want to keep things simple and clean write the rules in such a way that it is somewhat like mine. Others may have LPs who have a degree of comfort with the ability of a firm to make those decisions and make those decisions on a case by case basis. Often it might go to the LPs through the Limited Partnership Advisory Committee, the LPAC, to get a waiver or special permission to make an investment on that basis. So there are ways where it can be done that ensure that proper governance and notification are followed. I just … when I was thinking about it, thought through it and said, “You know, the return on invested brain damage would not be high enough to compel to want to do that,” and I went for simplicity.

Tobias Carlisle:
I’ve heard in producing, in film producing in Los Angeles often a firm will have a number of projects, might have a dozen projects working at various different stages and they’ll have … they’ll raise for each individual project and then they’ll have one of those projects, they’re often very difficult to see which one will be popular. Not that any film investors ever make any money at all, but one of them might win an Oscar and then people will be upset about the fact that they weren’t in the one that won the Oscar.

Alex Rubalcava:
So that approach, deal by deal financing, is also something you can do in startups. You can do individual, special purpose vehicles. There are online platforms like AngelList that make that very easy and straightforward to do now. It, again, has the issue of arguing the right deal at the right time and are you making a long enough commitment. It has benefits and drawbacks associated with it, just like investing in a fund would. It’s funny that you mention film financing, because film finance is obvious a big business here in L.A., and it’s probably the only type of investing that makes what I do like [inaudible 00:40:01].

Tobias Carlisle:
Well, I think that there’s an expectation of return in seed stage whereas I don’t think there’s much expectation in film financing.

Alex Rubalcava:
Yeah, it’s … boy.

Tobias Carlisle:
I think it all gets spent along they way.

Investing In Movies Is The Hardest Way To Make An Easy Living Imaginable

Alex Rubalcava:
That sure seems to be the hardest way to make an easy living imaginable.

Tobias Carlisle:
What in your portfolio are you particularly excited about? In terms of … rather than returns, in terms of changing the world or making the future more interesting and bright?

Alex Rubalcava:
I have a number of portfolio companies that are doing really interesting, really unusual work. I have a company called VeriSIM Life that builds biosimulation models of the way that drugs are absorbed, metabolized, distributed, and excreted in the bodies of over two dozen animal species. Right now, that technology is being used by some pretty big pharmaceutical companies. In fact, they just published their research with Genentech a few days ago so I’m now allowed to name Genentech as one of their early partners and customers, which I have not been able to do up until now. But Genentech is using VeriSim’s software to make much higher resolution decisions about which of their drug candidates should go into animal testing, and then eventually as software gets better and better, we’re going to be able to skip that step. We will not need to do animal testing to get drugs to human testing at some point in the future.

Alex Rubalcava:
The reason that’s possible is because when you test a drug in an animal, you are not doing so in order to tell does the drug work or not. That’s what human testing is for. Animal testing is all about toxicity.

Tobias Carlisle:
Right. Then the first … I mean, I’m aware that they test in humans as well for … they’re just testing to see how long it takes you to break it down and for it to exit your body, right? That’s something that a lot of university students used to do when I was at college.

Alex Rubalcava:
Yeah, so is that how you paid for college?

Tobias Carlisle:
That’s not how I paid for it. No, I was very fortunate to be in Australia with a different system. There are a lot of people who did that. A lot of medical students did that.

Alex Rubalcava:
Yeah. Enrolling human patients in testing is another very large problem in drug development and I have a portfolio company that is working on that as well. That one is much earlier stage and so I can’t talk about that one as much as I can talk about VeriSIM. Both of those companies are examples of the kinds of things that I like to invest in. There’s almost no software companies that are doing this kind of thing. It’s a new area for software to go into, and the impact is going to be very large.

Tobias Carlisle:
So what else have you got in the portfolio?

Alex Rubalcava:
Let’s see. What else do I have? I have … the biggest area that I invest in is software companies that are building the tools, the arms really, the weapons, that are necessary to compete for survival against Amazon. Amazon invests so heavily in the eCommerce experience that if you are not matching them, if you are not matching them tool for tool and product for product, you will lose. I have companies that do everything from enable same day shipping for any eCommerce merchant to enabling lifetime value analysis with a degree of precision that has never been possible before, to tracking counterfeiters and rogue sellers. All sorts of stuff in eCommerce.

How Does Amazon Track Counterfeits?

Tobias Carlisle:
Does Amazon track counterfeiters, because I get the impression that Amazon sells a lot of counterfeit goods.

Alex Rubalcava:
They sure don’t seem to care.

Tobias Carlisle:
I think that the shopping experience there has certainly deteriorated. I think if you go through … I would say that we often buy things that aren’t the real thing. It’s very hard to tell.

Alex Rubalcava:
Amazon has made a bunch of interesting choices as they’ve grown. Putting ads on the search feed generates 90% gross margins for them. It’s an incredibly lucrative product, but it fundamentally draws into question the promise that they’re making to the customers of presenting them the best and the right product for their search and making it easy for them to find what they need. The ad product really, I think, marked a line in the sand where Amazon said, “We’re really not as committed to our customers as we have been in the past. We’re going to look monetize in ways that are not directly serving the interests of our customers,” and a lot of the decisions that they have made subsequent to that decision continue in that vein. I think that as strong as Amazon is, the company is now old enough and large enough that there are very large gaps where they are not paying attention and where they are … either they’re not paying attention or they’re squeezing too hard on their customers or their suppliers or their partners that it’s going to create opportunities for other people to come in and create value. It’s going to be really interesting to watch the business strategy of all of that.

Tobias Carlisle:
Yeah, I couldn’t agree more. We’ve seen that in a micro example in my family where we often go to Walmart and Target because we at least know that the goods that come from those stores are going to be the real thing rather than … because I’ve got little kids. Don’t want to give them the counterfeit stuff.

Alex Rubalcava:
Exactly. Exactly. So yeah, there is going to be a lot of opportunities there, and because Amazon spends so heavily and because the choice of matching them is an existential one for their competitors, there’s a giant tailwind to adoption for any kind of eCommerce tool. All the companies that are in eCommerce know that they have to be trying everything, they have to be on the forefront, they have to be giving the customers the most compelling experience with them possible or they will die. It’s a great business to be an arms dealer in.

Tobias Carlisle:
Yeah, so retail’s notoriously tough, but if you’re in the picks and shovels to retail, you think that’s a slightly better space than being directly facing the customer.

Alex Rubalcava:
That’s correct. And so to be clear, I am not investing in any digitally [inaudible 00:46:57] vertical brands. I am not investing in anyone trying to sell paper clips on a Shopify store. That’s not what I’m in the business of, but anyone who would like to sell paper clips on their own Shopify store will needs all sorts of tools available in order for them to make money selling paper clips online. My portfolio companies stand ready, willing, and able to supply them with everything they need to be successful in the paper clip business.

Tobias Carlisle:
So is that sold in parallel with Shopify, or is that something that competes with Shopify?

Alex Rubalcava:
Shopify is eCommerce storefront technology, integrates with all of the other tools that my companies offer. Shopify has a pretty robust API layer available with it that allows us to exchange data with Shopify at all times. At the same time, Shopify cannot solve every problem for every need that their customers, their merchants, have and so there are opportunities for us to build products that Shopify would not.

How Placer.ai Is Providing Unprecedented Visibility Into Consumer Foot-Traffic

Tobias Carlisle:
One of the interesting companies on your site was Placer.ai. What do they do and what’s the opportunity there?

Alex Rubalcava:
So Placer collects data in a passive and anonymous way from cell phones. They collect location data. When we think about location data, people often think about things like invasion of privacy and stuff like that, but where you, Toby, or I, Alex, are at any given time does not have any business value for real estate or advertising or anything like that. You don’t spend enough money, I presume, I don’t spend enough money for anyone to care where you or I are. But where all of us are in aggregate is immensely valuable. And so Placer has location data that they have gotten from their partners, mostly mobile app makers, about where a large number of people are. They don’t care about real time data. Real time has no value on an aggregate basis. They do care about patterns.

Alex Rubalcava:
So Placer has an anonymous map-based interface that will show people where foot traffic patterns are growing, where they’re declining and it can be used for all sorts of applications. You can use it for lease negotiations for commercial real estate. You can use it to analyze things like store cannibalization. So if you want to open a new Buffalo Wild Wings, for example, and there are already three other Buffalo Wild Wings in the region, you can look at five different locations that you could have as possible sites for the new store and determine which one will draw in the most new customers, will cannibalize the least, and will be close demographically to the type of customer that you want to reach. That is the kind of data that has never been available before for owners, lessors, brokers, and others involved in the commercial real estate market. Placer is growing tremendously and is doing a lot of really interesting stuff in that regard.

Tobias Carlisle:
That’s absolutely fascinating. We’re coming up on time, Alex, so if folks want to get in contact with you, what’s the best way of doing that?

Alex Rubalcava:
The best way is to … anyone who is interested in pitching or sending a deck or something like that can just email me, Alex@stagevp.com, and anyone who wants to just see what Stage is up to and the kinds of things we do can follow me on Twitter @AlexRubalcava. Then the firm also has a Twitter page, @stagevp.

Tobias Carlisle:
That’s great. I’ll make sure all those are in the notes to the podcast.

Tobias Carlisle:
Alex Rubalcava, Stage VP. Thank you very much.

Alex Rubalcava:
Thanks, Toby.

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