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More Thoughts on the Existential Crisis in Seed: One Question, Two Views of the World
There has been a lot of additional chatter since I shared my post on the existential crisis facing seed investors. There are too many to share, but I’ll include links to a few of my favorites at the end.
These posts and other IRL conversations have spurred a new framework through which I am understanding the market today.
There is essentially only one question that drives investing strategies: What is the most profitable inefficiency to target in a given market? Market inefficiency is where returns are generated. Figuring out what inefficiency exists and developing a strategy to attack it is the name of the game.
In the domain of startup investing, there are two predominant answers to this question that lead to two very different worldviews. The first is what I’d call the “classic venture” approach. This view is that the market is most inefficient in the early stages. These are companies that are largely pre-traction, with teams that may or may not be proven. Classic venture is about sourcing, selecting, and winning these opportunities, and hopefully investing at a cost basis and with a success rate that leads to superior fund-level returns.
The second approach is what I’d call the “super-compounder” approach. The belief here is that the biggest inefficiency is underestimating the ultimate potential of the super-compounders. This worldview fully embraces the extremes of the power law and drives the strategy that the only thing that matters in venture is getting into the one company each year that matters. The name of the game is access: getting into that one super-compounder at all costs, and making sure it’s the blockbuster that you’re hoping for. For all you Wire fans out there: “If you come at the king, you best not miss.”
Three thoughts related to this.
First, these two approaches become more or less attractive depending on what’s going on in the broader market. We are clearly in a moment where it seems like the super-compounder approach is winning. We’ve seen capital concentrate very narrowly into a very small set of companies that seem to be enjoying limitless demand—both from customers and follow-on capital. The fact that we’re so early in a platform shift drives the attractiveness of the super-compounder approach. The current belief is that the kings and queens of the AI era are being anointed right now, and the concentration of winners in the early infrastructure phase of an innovation wave tends to be greater.
Martin Casado also pointed out an interesting dynamic: early in a market’s development, being perceived as the winner provides greater advantages than what you see in a more mature market. This is because, early on, buyers don’t want to be left behind and will just go with the best-known solution. Later, when the market is better understood, customers are more willing to consider a wider set of alternatives or more specialized options. This further fuels the super-compounder approach.
On top of all this, the exit environment has been very lethargic. When the number of M&A, PE exits, or small-scale IPOs is limited, investors decide that they may as well bet the farm on the super-compounders—because it’s not like there are many other ways to win. In fact, the M&A that does happen tends to be in the AI core, as the super-compounders seek to accumulate talent and scale using their war chests of capital and inflated equity.
There are a bunch of other reasons why this has been an era that favors the super-compounder strategy (interest rates, lower cost of capital from sovereign wealth funds, etc). I’ll move on for now, but the point is that in recent years, the broad market environment has been more friendly toward the super-compounder approach vs. the classic venture approach.
Second, the laws of competition ought to drive rotation between these two investing approaches. In a world where the vast majority of capital is chasing the super-compounder approach, the market will cease to be inefficient. At some point, prices rise so quickly for the super-compounders that returns will significantly degrade. In desperation, super-compounder investors will start to deploy capital into less and less attractive businesses at higher and higher prices. The flood of capital and unrealistic expectations of these companies’ terminal scale will actually hurt the performance of otherwise quality assets.
We’ve seen this movie before during the peak exuberance of SoftBank’s late-stage investing, and I’ve discussed this effect at length in my post on express trains and warp zones.
While this exuberance is happening, there will eventually be such a dearth of contrarian early-stage capital that valuations in that segment will start to drop and companies with great potential will be largely overlooked. The substrate for classic venture investors will become more and more attractive, leading to better and better performance in this segment of the market. The tricky part will be that the downstream financing risk for these companies will be significant—because the big pools of capital are all chasing a tiny number of opportunities of the same profile. But this is precisely why seed entry prices will drop, and why there will be market inefficiency that rewards the classic early-stage approach.
Third thought: I think it’s critically important for managers to know which of the two games they are playing. Trying to oscillate between the two is likely a fool’s errand, as the two approaches require vastly different skills and strategies. You’ll likely miss many of the best opportunities in the time it takes to adjust course. Also, irrespective of which approach you take, the industry as a whole is getting more efficient. So whatever your strategy, you must constantly pound the rock to keep elevating your game.
For those chasing super-compounders, this means you’ll have to pay a fully-priced valuation much sooner in a company’s life. It will also be increasingly difficult to gain access, requiring you to offer a more robust set of value-added services or unfair advantages to convince a founder to work with you. Also, the reality is that there are really a tiny number of super-compounders out there—especially as you enter at high prices. The failure mode is paying up to invest in what you think is a super-compounder when, in fact, the company is really only destined to be a normal, run-of-the-mill unicorn. That might be fine for a classic early-stage investor. But not for those pursuing a super-compounder strategy.
For the classic venture investors, elevating your game means pushing more and more toward the edges of convention. Betting on the prototypical profile of a Silicon Valley founder working on a mainstream software opportunity won’t cut it. You’ll need to find greatness in markets, geographies, founder profiles, or spaces that seem weird or uncomfortable. And you’ll need to be insanely aggressive about finding these founders and opportunities before the rest of the market figures it out.
So, stepping back, where are we today?
Coming out of COVID, we were clearly in a ZIRP-induced everything bubble. Both strategies seemed to be humming, resulting in high pricing and indiscriminate investing across the board. The market correction coincided with the big-bang event of ChatGPT, which ushered in a rapid infrastructure build for the new AI innovation wave. This has clearly led to a period where the super-compounder strategy has ruled, and we have rotated hard away from the classic venture strategy. This has created unprecedented growth and exuberance for a few companies, while creating difficulty for the majority of businesses that don’t fit the mold of these few anointed kings. Follow-on financing has become very difficult for all but a tiny few.
This dynamic will eventually flow through the rest of the market. Today, the only companies that seem to get funded are ones that fall into a narrow band resembling the most recent wave of super-compounders. But a huge part of the market is being ignored, and pricing outside of this band of consensus bets will become increasingly attractive. This will coincide with a boom in application-layer innovation powered by this new AI infrastructure, hopefully resulting in a period where a broader range of companies will emerge with successful outcomes. Over time, I think we’ll also see many high-fliers become fallen angels as they fail to reach escape velocity or collapse under their own weight. This will make super-compounder investors more skittish and lead to more rational funding approaches across a larger number of companies.
The market will rotate back to the classic venture approach, which will have its day—only for the cycle to repeat once again.
Additional Reading:
https://x.com/martin_casado/status/1959485916894167162
https://lesliefeinzaig.substack.com/p/andreessen-horowitz-is-not-a-venture
https://x.com/patk/status/1964684266438369299
https://joincolossus.com/article/ai-will-not-make-you-rich/
https://insights.euclid.vc/p/we-have-met-the-enemy-and-he-is-us?utm_campaign=post&utm_medium=web
https://tomtunguz.com/death-of-small-seed-round/
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