Reflecting on first ten investments (~$33M) versus mandate
How closely did we adhere to stated mandate investing in the first ten companies on whose Boards I represent us - and what have the results been so far?
The conviction of, and money from, LPs is what allows a venture practice to exist- but it is of course ultimately defined by its portfolio companies. I now represent us on ten of our portfolio boards (a couple new investments by end of year 2023 puts that total cost basis at about $33.25M). One of our LPs posed an interesting question to me as I was getting ready to head to this year’s DICE conference that is worth sharing here: to take a step back and reflect on what these ten say about the 1am practice at this point in its development, our adherence to stated mandate, and any early implications for how we believe our first fund as a new firm will perform over its decade-long lifespan.
As discussed in previous posts, outside of mandate and portfolio construction, we base our underwriting for an exponential venture-scale liquidity outcome (10x^y invested capital) on founder/team caliber, size of addressable market, and proof of ability to execute on thesis. The latter two of these are relatively straightforward. We have to believe there is a multi-billion-dollar addressable market with a sizeable enough SAM/SOM within it to drive that venture return off of price paid, and we have to see a viable prototype and/or soft launch data that surpasses top benchmarks.
The first of these is thus by far the most critical. It typically means we are investing in entrepreneurs who either have significant prior exit(s) as founders, and/or played a critical leadership role in building a multi-hundred-million-dollar to billion-plus-dollar product inside an industry leader. This roster of founders has seven prior exits, and led seven such products (the latter count goes up to ten depending on whether one includes functional leadership too).
This is a “young” crop of companies relative to our fund lifespan. We target a 5-7 year liquidity horizon (i.e. investment date to exit and money back to LPs) at the earliest within the ten-year lifecycle of the fund. The oldest investments amongst these ten date only from 3+ years ago, so we’re still in early innings, but we’ve seen some interesting data points across the set that corroborate the “bar” set by the mandate for that first variable of founder XP. Prior to exit in that liquidity horizon, we look for several “health indicators” to assess the initial trajectory of a portfolio company: commercial milestones (launching/monetizing products, revenue and profitability, etc.) achieved, go-to-market strategic partnerships or deals secured, early acquisition offers received, and ability to attract more capital. The last of these is critical to the growth lifecycle, but in our view is more a symptom rather than a root cause and thus less of a trajectory indicator. Ultimately, the success of an investment is predicated on the multiple of money in; whether we’re looking at a 100x+ return on our dollars or less, these indicators tend to correlate well with a trajectory that culminates in liquidity.
Some examples of the data points across the companies in which we invested at least a year ago (n=5), all early stage investments, that get us excited are the following:
All companies have raised subsequent financing at higher valuations with the exception of a profitable company that has intentionally not gone to market
60% of companies have achieved profitability
40% companies have achieved multi-million-dollar annual revenues
One company turned down an attractive acquisition offer from a top strategic in favor of continuing to grow
One was acquired by a strategic
One was fully funded through launch by a strategic with mutually favorable go-to-market geographic deal option attached
Among the companies in which we invested within the past twelve months, key is product development progress in terms of either metrics or signal from the market. We evaluate a given company’s health based on whether it is on track for:
$M+ repeatable revenue with top decile metrics (engagement, retention, conversion, unit economics, etc); or
For products with higher upfront development/publishing cost, a strategic partnership deal that funds one, preferably both
All five on the <1 year since investment side of the portfolio are on track, but need to cross the chasm and achieve these within the next 12-18 months on the way to the longer term liquidity path.
If a company struggles to do so, we work closely with the team to realize maximum value on a slightly different trajectory. There are several paths in those cases that we can follow. We prefer not to go down any of them, of course, but absent the two options above, we strive to at minimum maintain par value on the investment and ideally still secure a multiple on the investment (albeit smaller than the 10x^y against which we initially underwrite).
The most obvious is managing burn to allow enough time for additional shots on goal to see whether a subsequent game can achieve profitability and/or enough interest for a new financing and/or publishing deal with a strategic.
If/when there is no possibility of such, co-development, in which a large strategic hires the team to develop a full game or a critical pillar of a larger ($100M+) game is an attractive option for teams with this development pedigree that are not able to achieve a successful game launch (and/or downstream deal) within the runway provided by the initial financing. Often some combination of IP licensing can make such deals more lucrative / higher expected value for both sides. Co-development is much higher margin than other “services” contracts in most other verticals and in itself can be the foundation for a venture-scale exit. Multiple $B+ exited gaming companies built the foundation of their business on co-development, and the work is lucrative enough that companies can choose to finance additional original games with free cash flow that can represent venture-scale value on their own. The gaming vertical is rather unusual in that this second path, even taken after any possibility of launching a successful product within the runway of the initial financing is still a viable one toward a venture-scale exit and retains significant downside protection. More on that in a subsequent post.
The premium that can be commanded by teams that have proven their ability to deliver a $100M+ revenue, coupled with the ruthless level of competition in the industry to continue delivering those games to consumers constantly looking for new content, makes these services tremendously valuable; the sheer complexity of live games, in which no component of the development stack is commoditized or fully solved by technology, contributes as well. New or improved technology in gaming (such as the rapidly evolving engines that have accelerated development so much) tend to elevate the bar for content rather than lowering it. Instead of replacing given critical path N developer(s) with technology, at the strategic level it tends to force multiply N critical path developer(s) and allow that much more content/fidelity to be built by N resources rather than keeping content/fidelity at the status quo level and reducing N (by critical path I am referring to backend/frontend engineering, UI/UX, design/art, production, etc.). This does allow smaller upstart teams looking to take market share a resource bump, however- a designer with limited technical chops at a startup can still work within Unreal, rather than needing to immediately kick the can to an engineer. A fascinating dynamic thus emerges between small upstarts and big incumbents competing for market share with the inevitable progress of gaming technology- but that’s a topic for another post.