Venture Buyouts
Look where other investors aren't looking
Jeremy Giffon’s ‘venture buyout’ fund is the most interesting investment model I have seen this year.
His strategy?
Restructuring venture-backed software companies which have unrealistic valuation targets, stripping out costs and running them profitably.
In 1980, there were only 50 venture funds.
Today, there are ~40,000 VC funds globally, up 800x.
As venture capital grew as a category, so did valuations, and fund sizes. Investors funded an army of unprofitable ‘zombie’ companies that won’t ever realise the growth underwritten into their valuations.
The ‘venture treadmill’ forced companies to try to achieve hypergrowth at the expense of profitability, breaking most businesses in the process.
But many of these businesses could be incredibly profitable if they weren’t forced to target the aggressive growth rates necessary to raise future venture rounds.
Enter Jeremy Giffon.
After 8 years building Tiny Capital, Jeremy is building the KKR for the startups ecosystem - recapitalising unprofitable software companies and running them like a traditional PE firm.
I’ll break down:
How Venture exploded as a category
Why Venture funding misaligns incentives
The investment opportunity
Why traditional PE isn’t going after this asset class
Let’s begin
How did we get here?
In the 1980s, the total size of the venture capital ecosystem was only ~$2 billion, with about ~50 VC funds.
In 2022, the size of the ecosystem has ballooned, with nearly $180bn USD raised in 2022 alone, and more than ~40,000 venture funds globally.
That’s an 800x increase in the number of funds.
Venture went from a ‘high margin cottage industry, to a low margin asset management industry’ as Doug Leone puts it.
As the industry matured in size, two key trends emerged:
Investors became price takers not price setters
Fund sizes grew dramatically
To the first point; as the ecosystem grew, capital became commoditised, and investors were forced to become less sensitive to valuations.
But more importantly, fund sizes grew so large that the investment size needed to return a fund is so much bigger.
Take Softbank for instance, notorious for their large fund sizes. Softbank’s Vision II Fund has $56bn in committed capital.
Assuming Softbank invests $2bn in a company’s growth financing round at a $10bn valuation for 20% of the company, if the business went onto 10x and reach a $100bn valuation it would only return about ~1/3rd of the fund. Crazy.
For most institutional VC’s with billion dollar+ funds, unicorns don’t move the needle anymore.
VC’s need decacorns.
Misalignment Breeds Inefficiency
Because VC’s need to chase bigger and bigger outcomes, and there is far more competition for deals, a series of weird trends have emerged.
1/ Investors are willing to underwrite deals at crazy valuation multiples.
Competition forces VC’s to accept higher valuation terms as capital has become commoditised.
Founder’s accept better terms because they get more cash for less dilution. A win for founders … right?
Well, sort of.
Ceterus paribus - founders should try to raise funding on better terms.
But raising money on crazy multiples makes it far, far harder to reach the milestones necessary for each subsequent funding round.
Just because your Series B investor is willing to underwrite a deal at a 50x ARR multiple, doesn’t mean your Series C investor will. But more importantly - potential acquirers, and public markets are extremely unlikely to do a deal on these terms. So in the process of raising on incredible terms … founders can make it incredibly unlikely to ever realise a liquidity event, buried under a VC preference stack, and forced to work indefinitely without any hope of exit.
2/ Founders prioritise growth at all costs
Even more importantly, in the process of ‘staying on the venture treadmill’, founders will burn incredible amounts of cash to fuel growth.
So not only are founders unlikely to ever reach their next milestone, but they’re also (usually) unprofitable.
This is despite the fact that venture backed software companies should be capital efficient machines.
Once the core product of a software company is built, there isn’t actually that much work to do.
This is why tech jobs can afford to pay their engineers 500k+ to work for 5 hours per day. There just isn’t that much to do.
Venture backed software companies can’t strip back costs, stop building new product lines, and grow at 20-30% per year.
But PE backed software companies can.
3/ Investors don’t care about the losers in their portfolio
For billion dollar funds driven by a power law outcome, its’ economically irrational to waste time with a flailing portfolio company when the fund performance will be driven by the largest winner in the portfolio.
As funds have grown larger, this impact has been magnified.
The reality of these fund economics mean that funds are often indifferent to what happens to their losers.
But investors need to continue to work with these portfolios to protect their reputation.
The result is a weird game where founder can’t win, investors aren’t moving the needle for their portfolio, but both parties continue to work together indefinitely, trapped by the terms of their last financing round.
The Opportunity
All of these factors mean that there is a unique opportunity to restructure these software companies and run them sustainably.
Enter Jeremy Giffon.
After 8 years building Tiny Capital, Jeremy recently raised a fund focused on going after this exact opportunity.
Buying out the venture investors at a reasonable valuation is a win win for all parties because:
Venture investors realise a return on a company that would otherwise wind down & never get liquidity
Founders get the opportunity to continue running their business on terms that allow for them to actually make money (either through distributions or an exit if the acquirer re-sells the asset)
The acquirer gets a high-quality software company that can be run without needing to grow at 50%+ YoY.
Most people dramatically underestimate how much more efficient software companies can be ran when they are incentivized to do so.
Thoma Bravo, one of the most successful SaaS private equity firms, realises a 25-40% margin improvement post acquisition - an absolutely phenomenal increase.
Elon Musk fired ~80% of the Twitter workforce without impacting the quality of the core platform.
I think the jury is out that more businesses can run leaner, especially those which leverage technology.
Barriers to Entry
I know what you’re thinking.
If these flailing venture backed businesses are such a ripe opportunity, why isn’t everyone else going after them?
There are a few interesting themes at play here:
1/ The category is nascent
2/ This asset class sits at the intersection of traditional venture and private equity
3/ The best deals are off-market
1/ The first reason why this strategy can work is that the category of institutional venture capital driving this opportunity is relatively new. Any time a new category emerges, there are usually new sources of alpha.
2/ This category sits at the intersection of startups and private equity. I’m not sure that most Private Equity guys on Wall St would have heard of Y Combinator. Similarly, most venture investors aren’t thinking about take privates of their portfolio companies. Jeremy previously worked at a startup during high school, but also at a tech-focused holding company, so he has a unique background in both of these fields.
3/ Most importantly - the opportunity exists to strike deals which would otherwise have not occurred. There are loads of founders who probably aren’t even aware that restructuring is an option … and so they continue to operate their companies indefinitely. By going to founders directly before a deal is ‘on the table’ and investment banks are involved, there is a massive opportunity to win proprietary deal flow.
Conclusion
All in all, I’m a huge fan of Jeremy Giffon, and this investment strategy.
His story is pretty incredible, working at a startup at only 14, helping Tiny from inception to IPO, and now raising his own fund before 30.
If there is one clear takeaway - it’s to pursue authenticity - go after opportunities which are uniquely suited to win at.
I think we are going to see someone build a household name restructuring these businesses, bring efficiency back to the startup sector and build a generational investment firm in this category.
Will it be Jeremy? Only time will tell.