Semil Shah:
Raising a Seed Round In a Recession

This week we’re having tea with Semil Shah. Through his seed fund, Haystack, he’s invested in 70+ startups including Instacart, DoorDash, and Opendoor. He’s also a venture partner at Lightspeed.

In this episode, Semil shares:

Highlights from Series Tea with Semil Shah

This interview has been lightly edited for length and clarity.

How did you get into investing?

I was writing a lot online while I was working at startups. I met a lot of VCs and one thing led to another; they bankrolled my first little microfund and those first two funds just took off. It’s the only career I’ve ever really had.

There’s a lot of things that VCs or seed funds do that don’t always make sense to entrepreneurs. A lot of it is fueled by the incentive. At a high level, can you talk about portfolio construction?

The job of an entrepreneur is to create value through entrepreneurship, and to build a product or service. The product of an investment firm, whether it’s Haystack or Lightspeed or something in between, is actually investment decisions. That’s the only product. So how you make all those investment decisions becomes the thing that you build. And the actual building unit of these funds are actually portfolios.

What am I doing in the portfolio? You’re basically trying to allocate money in a diversified way to things that are hopefully uncorrelated. This is the whole Ray Dalio thing.

You may have a sector-focused fund that focuses on autonomous vehicles or on Bitcoin or something like that. If you don’t hit that properly as a trend, it’s really dangerous. So you’re going across the internet or across software and you’re trying to invest in some B2B applications, some infrastructure, some consumer. And there you have how your portfolio is constructed.

So are funds trying to be uncorrelated? You’re saying actually a fund tries to not have too many bets in each sector.

There are very few funds that have been very focused in terms of sector that have performed well. You could argue Ribbit in fintech; Ribbit Capital has been a stellar performer.

But when you build a portfolio you’re saying, “I want to have exposure to these things.” You could have a portfolio construction that balances geography, although I don’t think that makes as much sense any more. You could have a portfolio construction based on stage and maturity of business; Benchmark historically has done 70% of their checks into Series A and the remaining in B and opportunistic.

Then you think about sizing and percentage ownership. How much do you own of a core company? What’s the reserve strategy? All of this could be a semester-long course at Stanford Business School. For people who are interested, feel free to contact me. I’m always happy to talk about it.

What are the dynamics that an entrepreneur needs to care about?

There’s a lot we could talk about, but there’s two things I would encourage entrepreneurs to take as reality. Number one, let’s say you were running a fund and you have all these consumer home services startups in there. You may not want to invest in the next one because you already got the exposure in those.There’s this cognitive gap where the entrepreneur thinks, “Let me go talk to Joe because Joe has invested in these companies and my company is like that.” What he or she doesn’t realize is Joe has already got that. He’s looking for something else.

The second thing is just the salesmanship or saleswomanship that goes on from a VC to the entrepreneur. They feel like this investor is really interested, they’re really committed, and they have a lot of conviction. Well, if they had a lot of conviction, they would invest more and more in your company. And what they’re doing is investing in 20 to 30 companies, because portfolio theory shows in venture that only a few, if any, have a chance of returning any of the fund.

So understand, “When I talk and interface with investors, I don’t need to expect the world from them. I need fuel for the company, and I need someone to not do harm, but they’re also going to be making other investments. And so I need to filter out what they’re saying.”

As an entrepreneur I look at a list of 200 investors and say, “These people understand my sector” and email them first. You’re saying those people already have exposure to the sector.

For entrepreneurs, certainly reach out and pull on those threads. But understand the layer deeper that people may already have things going, and you may be also giving them competitive information.

This may not be politically correct, but I think the best way for an entrepreneur to get in front of the right investors is to have a group of core investors that are so excited about the company that they talk about it with other people. Get into the rumor mill and the chatter mill of this stuff and then people will find you. It’s a little bit trickier when you’re not in the Bay Area.

You did an interesting blog post recently about public markets. Your feeling was that the private investment sector is still fairly negative. Is that what you’re seeing and why do you think it’s not matching the public market?

This is all driven by liquidity. When you can move in and out of a stock or capture a gain in an hour, you feel more comfortable moving cash around. But when I’m giving the next Immad 10 million bucks as a private investor, that’s a one way wire. There’s commitment-phobia because of the uncertainty that’s happening.

I also feel like the data’s pretty clear that economically, we’re not going up from here. We’re going down from here. And that could take a year for reality to sink in for different people. If you’re someone who’s managing illiquid pools of capital like venture capital, there’s really no incentive to invest unless you’re forced to, because the likelihood that the pricing will go down is extremely high.

I’ve met entrepreneurs today who are like, “I don’t want to raise when the environment’s bad. I’ll just wait.” It is going to get worse. It is going to get worse. Pushing off something today for Q3, Q4 is a very calculated risk. If someone has a bird in the hand, I would strongly encourage them to consider it.

Isn’t a VC supposed to be betting 10 years out? Why does a one year economic downturn affect their decisions? Is it just because valuation should fall because of public market comparables?

The venture capitalist, if you look at it in its most craven form, is basically an agent for the money source to negotiate pricing with people who can create value. As a money source, whether you’re CalPERS or the University of Virginia, you hire these agents who are going to negotiate the price. The issue here is that the pricing in order to drive the multiples is really different. For example, one of the best investments I’ve ever been a part of was a $575k round at a $3.75m post-money cap. This was in 2013. That deal, if it was done in the last couple of years would have been $3m on $12m right out of the gate. So not only is the multiple compressed, the entry price really gates the ability to earn from that. So if you’re an investor, the entry price is super, super important. Doing $2m on $12m is not the same as doing $1.5m on $6m.

What was that investment?

It’s called HashiCorp.

That’s a great investment. There’s this counter narrative, “If it’s going to be a billion dollar company, it doesn’t matter if you enter at $5m or $12m.”

A lot of that depends on the Series A, when you have some data and signal and you can start to dream with the entrepreneur about how big something can be. If you look at the chatter around Clubhouse, there is an actual case to be made that it could be a billion dollar business. You have to dream with the entrepreneur.

If you see that upside as a Series A investor and you see early signals, you make that bet. You say, “I’m writing this at a $100m post-money, I have to bet this can be a $5b to $10b company.” You’re trying to build a narrative of how the product can go into these markets and adjacent markets.

At the seed level, you don’t have anything. So you need to make sure you have the right exposure to these companies so that should one of them work out, they pay for the rest. The way I describe it to entrepreneurs is, “There are going to be 25–35 companies in Haystack 5, and we would like to work with you. What we’ve learned, and what other people have shown in their portfolios, is it’s very hard to return the value to the fund. It’s a mix of luck and skill, and you don’t get to decide which one. Ultimately if the fund is lucky, one company will return multiples of the fund, and then a couple of those companies, again if you’re lucky, will subsidize the work of the other people. And it’s not that the other people didn’t do a good job or they weren’t worthy of the capital, it’s just how things fall out.”

To put it another way, you think post-product-market fit, you see the billion dollar bet and maybe valuation doesn’t matter. Pre-product-market fit, seed stage, valuation sensitivity matters.

For sure. The classic case here is Snap. Four or five great funds all fighting to do Snap in 2013 or 2014. You could build a case very quickly. So you do it at $60m post, $70m post, $80m post? If you know Instagram, you know Facebook, you just do it.

Is valuation a lever that entrepreneurs can pull? Like, “I’m going to drop my valuation and make this a very attractive deal,” or does that cheapen the deal?

Entrepreneurs who I’ve seen be successful in difficult times will say, “We don’t have pricing expectations. Here’s our funding history.” They’re transparent with that and understand the venture business model, which is code for saying, “We know that you have to make money too.”

The other approach is to set parameters that are fair. Maybe pre-pandemic you take on 15% to 25% dilution, now you take 20% to 30% dilution, and you set a parameter with the investor. “In the seed round, I’m not comfortable with taking more than 25% dilution. There are a couple of reasons. One, it makes me uncomfortable and I want to feel excited about the deal. Two, I have to think about the long term viability of this cap table. So if I raised three rounds of financing to get 10 to 15 million bucks and each one is 20 to 25, it’s too much of a hit.” The valuation piece is really a mental trap.

The only other thing I would say is that we’ve exited a period where people have unlimited shots on goal. The shots on goal are going to be given to people who have proven they can build and ship a product and service before, and there are going to be a lot of entrepreneurs who are one and done. They’ll start something, it’ll flame out, they’ll move back to wherever they came from. That cycle is going to be a faster cycle.

What’s a company or product that you’ve invested in or not that you’re excited about recently?

I was an investor in Paul Davison’s previous company, Highlight, which is the original contact tracing app. I think Clubhouse is just a fascinating zeitgeist moment and I think there are a lot of different ways it can go. It’s unclear whether Paul and Rohan will get it there, but they’re super great people and I’m super excited for them.

Has he let you invest yet?

It’s an interesting story. We were talking a lot in January and February because he had Talkshow, and I was a big fan of Talkshow. He said he was probably going to kill the app, and we talked about it for a long time. But I believe more in curation and more of one-to-many or few-to-many. And I think Clubhouse is going in the many-to-many direction. I have a fundamental disconnect with that, and so actually didn’t invest. It’s probably going to be a big mistake of mine given that I’ve known Paul for years and I invested in his previous company, but I also feel I have to stay true to what I believe.

But you could go into Steph Curry after a game opening a Clubhouse room. You can have secret rooms with digital passwords or knocks, you could make it live-only so there’s no record of it, you could turn it into a social group app where you and I may do a phone call for work over Clubhouse so it turns into Zoom. The unknown of that is a real challenge. But also I think it’s super exciting.

It reminds me of Secret when it was still only a small community. When they opened up it became way too many trolls.

Think of Quora. Quora was one of the best betas of a product ever. Then they went into verticals, and growth in India, growth in Australia, England. The social aspect went away and the information aspect came down. It’s a really hard challenge, but it’s a company that’s the talk of the town now, and maybe I’ll be kicking myself even more. I’m sort of kicking myself now.

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Thanks,

The Mercury Team