Dave McClure on Network & City States with James of Ârc

I ran the first four funds which was about 2,000 companies. Partner co-founder Christine has run another 2,000 companies or so. 2% of those don't suck. It turns out about one out of every 500 companies we would get a Canva, a Solana, a GitLab, a Talkdesk and those could be 500 to 1,000 maybe even 2,000x and that was not expected. Fair amount of experience in messing up a lot of things and some experience in things going correctly. We are terrible people. You should not trust us at all. We don't add any value. We inflate our numbers. We're really not any better at picking winners than most of you are. You all suck, too, by the way. But 20 years ago, I was looking at where to buy a private island. You know, wartime CEO, get your ass in gear. Like, move up your ticket. Get out of here. And I was like, 'Yes, sir. You're right. Yes, absolutely. Make sure gravity works.' And then start building rocket ships on top of that. But I had nothing.

Not probably some interaction with Brent Hoberman and the rest of you all.

Sure. I am an escaped hillbilly from West Virginia. I ended up in California in late 80s early 90s. Originally I was a software developer and then an entrepreneur and then started doing angel investing. Got to work at PayPal in some of the early years with some pretty amazing folks and like a lot of folks there got into investing and then gradually ended up moving into venture capital first with Founders Fund with Sean Parker and Peter Thiel and then started a firm called 500 Startups about 15 years ago and like the name suggests we did a lot of early stage investments in probably about 70 or 80 countries around the world and helped set up a bunch of small funds in different places around the world. And did that for many years and that was actually a lot of work and a lot of travel and now I'm old and lazy and boring and I do a lot of late-stage investing in secondaries, mostly in companies doing say $50 million in revenue or more and we provide liquidity to people who are early investors or employees at companies and also investors in funds.

When I was there I ran the first four funds which was about 2,000 companies and then since then my former partner co-founder Christine has run another 2,000 companies or so.

Yeah, and that works, right? The portfolio effect works, right? Well, yes and no. I guess to kind of give you a basic set of numbers, probably about 70% of those investments fail mostly or completely. Those fail fast and half of those fail slow. We might get a little bit of money back on those but generally those are zeros. About 20% of the portfolio you probably make around 2 to 3x, maybe a little bit more if you're lucky. Maybe about 10% of the portfolios you make decent wins that are 10 to 20x outcomes. Those are probably like hundred million dollar exits. And then about in our experience about 2% would go public or get large enough to be called unicorns. Hopefully those get to exits. And those were maybe like 50 to 100x outcomes and that's where probably most of the majority of the returns come from. But it also turned out that along the way we found about one out of every 500 companies we would get a Canva, a Solana, a GitLab, a Talkdesk and those could be 500 to 1,000 maybe even 2,000x and that was not expected. You probably only see that in very very large portfolios that people like YC or Techstars or Antler or maybe a few other folks have experience with. But in general the idea that we were trying to do was to, you know, most startups fail, a very few number of startups succeed at scale and so we wanted to have large portfolios to have a better chance of those large outcomes and that generally worked. We tried to do that not just in Silicon Valley but lots of places around the world and that also has seemed to work at least in some places. And then we also tried to help a lot of people get small funds started and so had a fair amount of experience in messing up a lot of things and some experience in things going correctly.

It was very straightforward. I was a customer. I had done fairly well with the carried interest in my first two funds but they were still illiquid and I was looking to buy a house, put some money into the new company, pay for some kids going to college. And so it turns out it's not so easy to sell carried interest in a fund. That's a very small number of people who would consider that type of transaction. Long story short, was able to go through that, take some money off the table, but the terms were very favorable to the other side and I thought, wow, these guys are getting a great deal. Maybe I can figure out how to do that and be on the other side of that transaction. And so we started looking at how to structure and buy pieces of funds or pieces of companies that are maybe only five years or less away from an exit. And so one of the challenges with venture capital is occasionally it works but it sure takes a long time. Companies now going public are typically taking close to 15 years. And median revenue required for companies to go public in the last year or so has probably been about 800 million. You don't see too many companies going public for less than 400 or 500 million at least in the states. So that has really lengthened the time frame for investors to get money back. And as a result you have a very large amount of capital that's illiquid and some people are not super patient. You know, large institutional investors, pension funds, they're more patient, but a lot of individuals, family offices, corporate investors might want money back in less than 10 years. And so we're seeing a really increasing amount of capital in secondary market. Some of that is in very large funds, some of that in medium-sized funds, some of like us are smaller funds.

Not too much. I mean we have positions in Canva and SpaceX in our portfolio but those are from work that I did at Founders Fund and 500 from many years back. The market is very concentrated in a small number of big companies. So like the public markets where you see Magnificent 7 which are a pretty substantial amount of the overall market in the private markets OpenAI, SpaceX, ByteDance, Anthropic, probably a few others that are in that 200 billion to 500 billion size. Five companies make up probably a trillion to a trillion and a half dollars of an overall maybe three trillion dollar market. But there's still another thousand companies that make up maybe the next trillion dollars of capital. And that's probably more where we play. Those top 10 to 30 companies are in extremely high demand. Those prices are not usually cheap. In fact, would argue they're very expensive. And sometimes they're not even available except through multi-layered vehicles and you may not even know if the things you're investing in actually have access to the underlying security. So the secondary market is very opaque. We're trying to, you know, help educate people about what's going on in the secondary market, bring more fundamental valuation analysis to that market. But that's really kind of boring. It makes money, but it's not the most exciting stuff that people are interested in here.

We buy typically 1 to 3 million maybe 1 to 5 million tickets. Usually from early employees or founders in a company or early investors in a company, sometimes also from early investors in a fund. Usually if it's a company we're looking at companies doing 50 to 100 million in revenue or more. If it's a fund, it's usually funds that are seven to 10 years old or more where at least one of the companies fits that profile.

The real question is discount to what? Because usually most of the marks these days are and there are a lot of companies that are based on valuations from 2020 and 2021 which are not real marks. So notoriously VCs are pretty terrific liars. We are terrible people. You should not trust us at all. We don't add any value. We inflate our numbers. We're really not any better at picking winners than most of you are. You all suck too, by the way, but just to be clear. So, like just, you know, a level of humility is probably required, but not often common among VCs. So, anyway, I make fun of the asset class and I tell people it's the shittiest asset class ever, but I really am a big fan of when venture capital works, it can do amazing things. So I'm a small investor in about 40 or 50 other small VC funds. I try and help a lot of people get into the business and, you know, some of them are successful. But it is a very challenging asset class that takes a long time and you know you hear mostly the good and positive stories about venture. You don't often hear all the not so great stories about venture. So 500 was an experiment in trying to make that a little bit more predictable through large portfolios. Practical Venture Capital which is the name of my firm that's kind of a joke because it's actually not practical at all. We try and make venture capital a little bit shorter time path to liquidity. So you can think about what we do as kind of like cutting, you know, the investment horizon of a fund or company in half and buying the back half. Hopefully at a discount and I would say we typically buy stuff probably at 30 to 70% discounts to the listed price, but hopefully that's more like 20 to 40% discount to the actual value. And then we're still really looking for compounding in the range of 30 to 50% for a few years. So we are trying to get basically about a 3x return in 5 years. If it's only 2x that's not terrible. That's kind of roughly a 15 to 25% IRR if you think about that investment term. That's correct. But it's a little less risky than early stage venture capital. But we still mess it up occasionally and there's still mistakes.

Yeah, when was the time? I'm trying to remember the first time I think I thought about owning my own private island was probably between the ages of 8 to 10. At least 20 years ago, I was looking at where to buy a private island. And at the time, I think Nicaragua and Lake Titicaca, which is the world's largest freshwater lake, was where I was thinking about. The governance in Nicaragua probably maybe not the best place to be looking for that. And I somewhat randomly fell into working with microfinance in India and other places. As a result of that, I got involved with an organization called Unitus which has done some amazing work particularly in India but in other places and that organization spawned even though it was a nonprofit it did a combination of for-profit investing in both debt and equity and later spawned a couple of other venture capital firms that were also doing impact related work and there's still a couple of those that operate today. But I think it's always been interesting looking at emerging markets, the growth of emerging markets. I've always had a particular interest in, you know, what people today call the global south, but that's probably South Asia, Southeast Asia, Africa, Latin America, and the Middle East. That's probably, you know, maybe at least a third, if not half the world's population. It's more young population, and it's a growing population. And so a lot of the thesis behind 500 and even before that I was looking at where is growth happening in the world and you know will Silicon Valley replicate in other places and we see sort of similar growth and I think that is true although we're seeing a little bit of a reconcentration back in Silicon Valley at the moment. But the idea of sort of real estate if you look at asset classes the several large asset classes around the world are real estate, equities, fixed income, cash and cash equivalents and then alternatives. People talk about alternatives a lot but they're really tiny compared to those others which are hundred trillion or more asset classes. Alternatives in total is maybe 15 to 20 trillion dollars including private equity, hedge funds and venture capital which is a piece of private equity used to be only maybe 1 trillion now it's probably three or four trillion depending on how you look at it. That sounds big but again, public equities is probably over hundred trillion, fixed income maybe about the same, real estate it's probably I don't know 200 trillion actually debt and fixed income might be in that same range as well. So a lot of people who are investors in the world have very conservative investments. Used to be sort of 60/40 in sort of equities and fixed income, but you know, housing, real estate, whether that's your own home or housing that you invest in, is still a pretty big asset class that most people around the world are familiar with. And it's somewhat volatile, but not crazy volatile. Maybe in certain areas it is, but you know, most people probably think about real estate appreciating at on the low end between 3 to 5% per year. Maybe on the high end 5 to 10% per year. So it's kind of in that range of maybe the same as fixed income on the low end, maybe equities on the high end. Venture capital people think about as needing to be in the 15 to 20% IRR range. Does it really hit that? Most at zero, right? Yeah. Well, the story is that venture capital in the average case performs well, but in the median case performs like crap. And what that really means is four out of five VCs suck and one out of five VCs is amazing. Probably more because they're lucky, not good, but they will tell you that they're amazing. And so, you know, it's almost always a hit-based game that is somewhat unpredictable. And we of course try and convince you that it is predictable and it's because we're really great stock pickers or because we really help the companies. I generally feel like that's usually not the case. It's the entrepreneurs that are amazing, not us. But this idea of that, you know, venture capital is generally a highly volatile, illiquid asset class that can occasionally perform well and real estate is a more predictable, steady, not so risky asset class that performs predictably. And so if you could merge those two, you might be able to get the best aspects of both. Ideally that would be more liquidity and more predictability. And so the example that I started thinking about was how can you use venture capital to drive occupancy in commercial real estate. And you might be able to do that by investing let's say half of your money in the real estate and the other half in a venture fund or even a fund of funds. And the basic idea is to take either the fund of funds or the funds to invest in funds in companies that occupy the building. And so what that might look like is let's say I had a $25 million fund of funds and I agreed to invest $5 million into each of five VC funds. They each had a floor of the building in exchange for that $5 million investment in the fund. I wanted them to maybe sign a five-year lease or longer that might pay anywhere from a quarter million to a million dollars a year. And then they in turn would take the money that they invest in startups and do short-term leases with the companies they invest in. And so they might write 50 to $250,000 checks in exchange for those companies co-locating in the building for six to 12 months. And so you can kind of almost take the dial on the amount of money that you're investing in these funds and companies and fill the building. And then from a real estate perspective, if you have a high occupancy building, hopefully with talented people and eventually hopefully with companies that are functional and working, you've got a great real estate investment. And then if you're lucky and maybe good, you might actually make money in the venture capital fund as well. And so the idea there would be I take a reasonably low-cost commercial real estate building. I fill it with smart people and companies and funds. Maybe I can double the value of that real estate in five years, generate a return on the real estate, and then hopefully in the next 5 to 10 years, I generate returns with the companies and funds. And so by mixing those two asset classes together, I get a little bit predictability, steady return from the real estate side, but I'm sort of juicing that return with occupancy from the venture side. And then if I'm lucky with the venture outcomes, I see those returns in more of a 10 to 15 year time frame. And maybe those also perform, maybe they don't. But at the very least, I've got functional real estate. Hopefully out of my large number of investments I get maybe a small number of companies that are functional. So again using that math that I talked about before if I make a hundred investments maybe I at least get five companies that get to maybe 10 million in revenue 100 people or more as employees and those might be your anchor tenants for that building. And then you build the residential real estate around that to fill the employees and you build services companies to support that community and you kind of have this MVP that's maybe in the range of say 500 to 5,000 people and you know a small maybe not village but at least neighborhood.