022 From Wall Street to Startups with Gene Munster @ Deepwater

I just remember this feeling of this weight going into the office that first day of like it's up to you now, like you got to build something. And that was the shift of what a calling is. And it's just any founder knows, I'm sure you feel the same way and know what that feeling is like. And I remember walking down the street and looking at people down the street and thinking, do they have any idea what it means to feel like I'm feeling right now? And the answer is very few people do. And that's what's just so special about being a founder.

Awesome to be here, Neil.

Well, it came down to team and opportunity. And so I've been doing the sell-side analyst job for about 20 years, and you're exactly right, it was a career. And I absolutely loved it. I loved the people at Piper, I loved doing what I was doing, and I especially loved the two people, three people that were on my team with me at the time, was with for 10, 15 years. And the four of us started talking about really moving from an observatory role to getting on the field and actually starting to make a difference. And part of that, like venture capital is you are investing in companies, and so you're on the field in some capacity there. But when you start a new business, you also have the unique perspective of what it means to actually grow a business. And so as venture capitalists, I think we've had a unique perspective over the last eight years, just in terms of not only investing in largely early-stage companies—we have a fund that does later stage now—but invest in these early-stage companies, but also know what it means to grow a business. And so as I kind of put it all together, I started to do the math. And I'm 53 years old at the time, I'm in my mid-40s, and I was thinking I probably can do this sell-side thing for another 10 years and do it with excellence, but then I'm probably at a point where I would be at a point of retiring. That's like the last thing I want to do. And so I thought, these guys are around me, and it's Andrew, it's Mike, it's Doug, this core team, and I know how important founders are, and they were ready to do it. And so I made that shift from a career to a calling. And it's a very different mindset. Remember the night before we started, so I told Piper that we're going to do this kind of the middle of the year to give them time to figure out the transition. So we also had time to get our new office space and get ready. So I finished at Piper at the end of the year, and then on January 2nd kicked off Deepwater. And I just remember this feeling of this weight going into the office that first day of like it's up to you now, like you got to build something. And that was the shift of what a calling is. And it's just any founder knows, I'm sure you feel the same way and know what that feeling is like. And I remember walking down the street and looking at people down the street and thinking, do they have any idea what it means to feel like I'm feeling right now? And the answer is very few people do. And that's what's just so special about being a founder. And so had the opportunity to turn a career into a calling and loving what I'm doing.

Now, you know, I like referring to this as the pressure point. You don't waste any time at knowing what was like kind of the critical things going on. And that's exactly right, is that we had the blessing of Piper. We also had that as the anchor investor, which was really helpful. So our first fund was a $25 million fund, and so they're an anchor investor in that, and that was a nice endorsement that allowed us to raise that fund. It took us about probably a year to close that first fund. And I think that the feedback we generally had was, you did these mega-cap companies, and how does that apply to what you're doing in venture? That was the, I think, kind of the rub on some people. But so I would say that from my perspective, we've always been about emerging tech, about identifying like critical alien founders. And so from my perspective, it was all very similar. But understandably, from the world of risk management and how people allocate capital, that this is a different, very different asset class. And so it turns out, I knew this was going to happen, is that I'll look back eight, 10 years later and say how little I knew at the time. And of course, it's always the case. And so I think that how that went is, you know, I'm grateful that we had a good network and we were able to get off the ground. And you know, that second fund, or we just last year we closed our second fund, it was about $45 million. These are early-stage funds, so in my view, they shouldn't be more than at most $100 million just because of the way the portfolio construction is. And so, you know, that was a nice step up, but you know, we were able to raise that fund in half the amount of time that it took because the first fund's in a great place, got some nice winners in there. And so how I think about it is, you know, there were some times there kind of early on like, is this really, is this really the right move to do? I'm happy to report just loving it. That's great to hear. There's no regrets.

Both funds, we have about 100 LPs in them. And I think that on the other, you know, the second fund as I mentioned is bigger, and so the checks tend to be bigger. I think the probably the look-to-book from perspective of people looking at us was probably two to one. I think there were two people that looked, we had one invest, which felt really good about that. A lot of these were, I mean, it's in the broader class of friends and family. None of them were my actual friends and family, but they're just acquaintances that I've known over the years. And so that network was really important to get us off the ground, forever grateful for them. Our second fund was probably 70% to 80% of it was from investors from our first fund. And so as we approached this, you know, that first fund, we're based on the Cambridge data, we're in the top quartile pretty much across the board. So we're in a great place. But for us to get to the point of really breaking through to the family offices and more institutional, we've got call it five or seven institutional investors in fund one and about 10 in fund two. But for us to really break out and get to more, you kind of need the full stakes in the ground in terms of capital returned on that first fund. And so we're in the top quartile in the capital that we have returned, but for these family offices, you know, they really want to see, you know, it's a 2018 vintage, so we're coming into our seventh year, but they really want to see the fund kind of play itself out. I remember right when we were starting to raise money, I left Piper, we were starting to raise money, and we met with a lot of venture people to get advice. And one of them mentioned that, you know, your first carry check is like eight years away or something like that. I thought, that's, there's no way, like you're gonna get your first carry check before then. We're gonna get carry on our first fund. I think it's gonna end up being a top 10% fund, top quartile. Still believe we can return, and we're on expectations what we told our LPs initially, 3 to 4x return on their capital x fees. We're on track to do that, but we still haven't taken any carry yet because the fund hasn't returned all the capital yet. And so we got companies to do that. But I would just kind of remind, like when you're thinking about it, you just really have to be in this mode of a calling here versus a job or a career. If that's what you're after to make some money, probably not the right business for you. If you're after this to build something and just be committed to it at a really intense level and put up with that suffering, commitment to suffering we call that, to get to those carry checks, I think it's an awesome place to be.

I agree 100%. And I think it's really, really hard. What's the cliche, you know, you can't get extraordinary results with ordinary effort. I think the same thing is true about commitment.

Well, I think the world of venture is still largely a club. And so I think it's about establishing yourself into the club. One of the benefits that we had before as an analyst, we'd spend a couple weeks a year going to meetings with venture people. I always loved meeting with the venture people because they always had, I think, the most insight in terms of where the world was going. It was like they were operating on a different clock. I was thinking about how a stock was trading in a given day, and they were thinking about how a business is evolving over a quarter. I think that getting into that club is really important. And I think that's why most, you know, the vast majority of venture funds, you know, underperform. It's mathematically, there's an average, but most of them don't. I think it's about getting into the club. It's one of the reasons why I remain optimistic about how AI impacts investing in ventures, because it's still about a club. I think it's less about, like on the public side, AI is going to be everywhere. There'll be tools to help asset managers. We also have a long-only business, it's a nice piece of our business, it's doing well, but we're using more and more AI tools. And we're even experimenting with using machines to pick stocks. It's a bold view. The goal is to build the BlackRock of AI investing. It's called Intelligent Alpha. It's run by one of our partners, Doug Clinton. And so, but I would just say is like, it's a very different dynamic. Like the public stuff, you got to use these AI tools. It's an information speed game. When it comes to venture, it's about the club.

Is you have to recognize that there are some investors that just, this is a lot of pattern recognition, pattern definition around what it takes to be a good founder, around what the cap table looks like to be able to support these companies as they undoubtedly go through some sort of revision of their strategy. And I think that ultimately is that this venture group looks around the table and it just defines, you know, this competitive but cooperative approach to investing. I mean, you compete, the leads compete for deals, but then they always want to fill out the syndicate with other venture people. You know, this is venture 101, but it kind of adds support to that. And so very different, much more like relationship-based. I just thinking, we're looking at a deal today that we've been following this founder's, I don't want to say too much because really, really early here, but like we look for these alien founders. But this is just an example about like venture versus public, like we're watching this team of two, and I'll just say they're below 20 years old each of them, and they're doing something really unique on X. We've seen their product evolve over the last three to six months, and we direct message them. I mean, that's one way that it's pretty unique. And obviously the calls we do with other venture people for deal flow is super important. But you kind of got to be creative to find those alien founders.

There are really three attributes to it. One is an uncomfortable level of insight. So if something is just like obviously this should be done, this is a great business, it's probably not a good fit for us. We want somebody who's kind of going beyond the obvious and thinking about something that's beyond that. So an uncomfortable level of insight. The second is an uncomfortable level to suffer. We talked about that dynamic of each of these businesses, it's rare that the business that you're investing, this is why we put so much weight in the founders, rare that the business that you're investing, the business model is going to be the same one. The ones that survive, half of them aren't going to make it, half of them are zombies, and a quarter of them make it. But the ones that survive, their business model is very different than where it was when you invested. And so having that ability to be committed to this through some sort of a transition, I think, is really important. And the third is an uncomfortable level of ability to communicate and to do it concisely. And so we'll look at, we book 20-minute meetings, and the expectation is that they're 20 minutes. And the expectation is that the founder can communicate that well and interact with us. And it might seem like it's a very subtle test, but some of them can get to the point and some of them really struggle. It's the classic, the time versus how you make the watch kind of a scenario. And so those are three things that we ultimately look for for that kind of initial. And then there's kind of another fun one that we'll do is like, do you believe this person can be a billionaire? Do they have a look and a feel like they can be a billionaire? And it's a pretty rough test, but there are just people in your life where you can look at them and say like, I could imagine that happening. There's other people where you think there's just no way that's ever going to happen. And so that's kind of the billionaire test is another filter that we look at.

It's a swagger. It's a little bit of, I don't know if indifference is the right word, but sometimes it's, yeah, it's confidence and their vision, but not for the sake of being confident. I think it's somebody who's like, you can tell, like people who just somehow, there's little subtle cues you can pick up on. Like the billionaires, there tends to be something that's a little bit off with them. Sounds kind of goofy, but they're not like, it's not Gene Munster. I would say that like, I mean, I would love someday to be a billionaire, I'm not, but like I'm pretty much like middle of the road and very reasonable and structured in terms of how I think and process. And I keep my cool and like I just operate probably like a normal human being does. But these alien founders, the ones that kind of have that billionaire, they've got that edge to them. So then we have to check that with, and this comes up sometimes 25% of the time, is you find an alien founder and then you start doing background on them, him or her, and it turns out that some of those founder qualities have kind of blown up with them in the past and they've gotten into some hot water. And so that's, you know, when you're kind of like, okay, we're in the right orbit here, like we're seeing the right looks, we're looking at the right companies along that. So yeah, you want to identify, but also you have to have some form of kind of doing background checks on people too.

How do you think about the sort of static versus dynamic nature of a founder, right? So the founder that you meet in the first pitch may not be who they are a year or two from now, or three years from now. Or the cliche is right, like lines not dots, right? So when you're thinking about these characteristics, like communication skills or confidence or these kinds of things, that could evolve quite a bit over time in either direction, right? It's not always up and to the right. How do you think about that as another factor or vector to consider?

As I mentioned, you know, they're going to be doing something different, as you just said too, something different over time. The model is going to look different. And so that's kind of what we're trying to test for with all these questions. How we think about is like, it's the most important. And I think like if you're sitting down, you know, my guess is some venture funds, some early-stage funds, when they're pitching their LPs, they probably, potential LPs, are probably talking about like just the importance of like understanding the business and the market and like what the model looks like. And from our end, it's, we would describe it as 90/10 is about the founder. And so how we think about that question is just we ask the questions, we do these tests if you will, and we make a call. And I think the reality is on these founders, it's a gut call a lot of times. And the crazy part is you look at our first fund, 40 companies in it, what we told our LPs is half of them are going to go away, half will be basically return your capital, and the other quarter is going to provide all the upside, which is pretty standard. But each one of those 40 companies, we thought we were investing in these alien founders that could figure it out each time. And so we get it wrong, you know, we got wrong half the time, I guess. And so I think how we think about that is just like, that's the decision you got to make. And I would just say one other thing to any founder who's listening to this, is just the importance of those first two, three minutes on a call. Hard to describe, like I can't give a recipe for what that means, like what do you need to do in those first two minutes. But I think that people make up their mind relatively quickly whether they want to hear more or they're just, their mind's off someplace else. And so I really think of a pitch to be, think of it as really a two or three minute pitch. And encourage people just to go off script, like tell some story about why this is your calling and just to try to shake it up. Because we look at so many companies, every venture fund look-to-books of 1% or 2%, something like that. You're looking at more than a thousand companies a year. And so it's, you know, you just got to find ways in those first one to two minutes to break through the noise. But that's the stuff we look for, the people who can break through the noise, and then we build some sort of confidence that they can do that pivot whenever that ultimately comes.

So the, I mean the simple math, the typical fund for our early-stage fund, we're making 40 investments over about a three-year period, so call it about 13 investments per year. And our look-to-book is ranging between 1% to 2%. And so, you know, we're, I haven't seen the numbers more recently, but it's probably average is between 500 and 1,000 companies per year typically what we look at. Now, look at what does it mean to look at a company. If we look at a company, like just go to the website, read about the founders, get a sense about what they're doing, that's not a look. A look would be an inbound, a call, and from one of them, typically what we do is there are four partners that are doing the vetting. After one says okay on that 20-minute call, then I'll go to an hour call where we bring the rest of the partners in, and then usually we'll vote after that. So I think that's just a little bit about how it looks on the look-to-book. Another piece that we strive for is really just the quick answer and quick capital. And you know, those are small funds, 25 and $40 million fund. We've got a late-stage fund as I mentioned, we got SPVs, we got a public fund, so the firm overall is much bigger. When you have these small funds, one advantage that we can do is move fast. And that's from a founder's perspective, especially early on, having a bird in hand is really powerful. And so when we think about that, you know, these number of deals, one of the commitments that we have of those 500 or 1,000 plus companies that we'll look at in a year, one of the commitments that we have is we're just going to get a clear answer to you within a few days. And so I think it's just good hygiene. I think venture capitalists do a terrible job of it. I think it's disrespectful to founders. I can't promise that every time we've given that two to three days, but that's our goal has been.

I think most venture focus on founders. I think that they would probably say that half of our decision is based on the founder, 60% of the decision is based on the founder. You know, it's hard for me to really know what other funds are looking at. I think that, you know, when I do hear like estimates, I would say like, we don't care about estimates. And when we meet with a company, they say this is what we're going to do next year, it's almost a strike against them because in the earliest stage you just have no idea. And to think that you have an idea, I think, is so, I would say that any firm that really puts emphasis on what the modeling is of the company, I mean, we want to have a general sense of how you're thinking about it, but like when we see these going from zero revenue to X, X, and X over the next four years, it's kind of a, doesn't line up with how we think about this stuff. So to the extent that somebody puts weight in that, I would say they're probably focusing on the wrong things. And the other, like you mentioned, like team and market, like we have a sense of the market, we're deep tech people, and so we got a good understanding what's going on there. But like total addressable markets are yawners in my, like that slide, it's just pain for me to see because it's always huge. I mean, pick the industry and it's always going to be hundreds of billions or trillion-dollar addressable market. So there's a little bit of an eye roller there. So I think anybody that looks at kind of those two, you just have an intuition like this is generally a big market, I think that this business model, I kind of like how it's positioned, you know, less capital intense for example. But those are I think some of the things that I would guess. The other piece is occasionally we'll go, probably the hardest part about this isn't venture capitalists, but when you do seed and pre-seed, you also orbit within an angel community too. And sometimes they are well-known angels and sometimes they're not. And I think that that's been kind of a, I think a hard part for me is to see like the difference in deal quality between somebody who's a recreational angel versus like an original gangster type of an angel investor. And I think that like, that's the, those ones are hard because the hardest part is when somebody brings deals to you that is in kind of like an angel community and you know it's just probably not a good fit and they've already invested their money and they want you to invest. And I would just say is like, if you're like a recreational investor in some of these companies, I'd say, I mean, Deepwater would love for you to invest with us, but that's not the point of my comment. I think you just go with a venture capitalist who gets a lot more reps at looking at these companies and can do pattern recognition and kind of have a better sense of what's north. And so not where your question was going, but just kind of another observation that I've seen is I just wish some of these kind of recreational angel investors would go to somebody else in venture to help them out.

There's a couple of them, and both of them came down from what was amazing founders. One of them is a company, Masterworks, founded by Scott Lynn, and he's a serial entrepreneur, had massive success kind of in the advertising space, and has evolved and just had like a true passion around art. And so what they've done is fractionalized blue-chip art, so you can own a Picasso, a percentage of a Picasso. Think of this as a very stable asset class that does well when markets aren't as good, surprisingly. And the piece there was just knowing Scott for the years that we've known him and just know how like he's a, like just defines visionary in my book. And I knew how passionate he was about art. And so I kind of put, we put those two pieces together. And so that was a great outcome from our perspective. Another is a company, Invisible, and they're moving along, they would like compete with Scale AI, but they basically help the hyperscalers. They basically work for all the hyperscalers to prep and train and with the AI data. They also can help with expert networks to improve expert data too and train expert data. And so that's been an example. And I mean, that's, the founder there is just like buckle up when you meet with them because his mind moves really fast. And it's just one of those people you just gotta meet to understand it.