Ep. #3, Ep. #3 Feat. Redpoint’s Scott Raney and Lenny Pruss

Scott Raney: Our philosophy on how we want to help companies is we want to make the founders of these companies successful. And if we feel like we can make the founders successful, the business will be successful.

Lenny Pruss: Developer tools are really eating the entire enterprise market. So we think it's one of the largest opportunities in venture.

Scott: At this point in time, the opportunity set is as compelling as I've seen as a venture capitalist in all the years I've been doing this.

Tom Drummond: Hey everyone, my name is Tom Drummond. Welcome to Venture Confidential. This is a regular podcast featuring candid conversations with top VCs from Silicon Valley.

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This week I'm joined by Scott Raney and Lenny Pruss from Redpoint Ventures. We talk about Redpoint's investment philosophy, founders and investors changing expectations, and the current funding environment and the outlook for 2016.

Inside Redpoint

This week I am very excited to have on the show Scott Raney and Lenny Pruss from Redpoint Ventures. Thank you guys for joining us.

Scott: Thanks for having us. Thrilled to be here, Tom.

Tom: That's awesome. Well Scott, why don't you kick us off? Why don't you tell us a little bit about yourself and about Redpoint?

Scott: Great. Yeah, thank you. I am a venture capitalist with Redpoint. I've been at Redpoint since the early 2000s and have spent quite a bit of time looking at a variety of opportunities and spaces within the enterprise landscape. I spend most of my time these days spending time on cloud, cloud infrastructure, and developer-oriented businesses.

Lenny and I are both members of the Redpoint Ventures team and Redpoint's an early stage venture capital firm based here in California. And we currently are investing out of two funds, an early stage venture fund and an early growth fund that focuses on companies that are a little bit farther along.

Tom: Great. And Lenny, how long have you been with Redpoint?

Lenny: So I joined recently. I joined about six months ago. Previously I was at a fund out on the East Coast called RRE Ventures where I was doing most of their enterprise and developer focused investing and found myself spending a good amount of time out here and then sparked up a conversation with these guys and then said, why don't you just come out here and do what you've been doing, and thought it was a good fit.

So been working with Scott on a lot of cloud infrastructure, distributed systems, developer tools type companies, and it's been great.

Tom: Awesome. And are you working specifically on the early stage side or kind of mix of the growth in the early?

Lenny: I'm exclusively on the early stage team.

Tom: So how big's the early stage fund, Scott?

Scott: Early stage fund is four hundred million. Seed, Series A, occasional Series B. A growth fund, early growth fund, is a four hundred million dollar fund and that is focused on occasional Series B, Series C, or bootstrap oriented companies.

I work on both funds. Most of us at the firm work on both funds, although in practice it ends up that we tend to orient ourselves around different stages.

Tom: Four hundred million dollars, that's a pretty large fund for making a lot of seed and kind of Series A investments. Typically, how much are you investing at the seed level or the Series A?

Scott: Yeah, well let's start with the Series A. So there's the amount that we invest up front and the amount that we ultimately invest in the company. And I would say that typical Series A investment for us is somewhere in the four to seven million dollar range probably, initial dollars in.

We ultimately are modeling probably ten to twelve million dollars, but in the end, we're gonna do what's required to help support that company and there really is no, this is an average. I mean that can vary widely across deals. What I would tell you is that has trended up over time over the last few years and that's a function of the environment that we're in. As folks can raise money at higher valuations, they tend to raise more money and so the size of these rounds has gone up.

So I think we feel like four hundred is a perfect fit for us because it allows us to invest in companies early on, maybe put a couple million dollars to work in companies, but also affords us the opportunity to have enough diversity within the fund.

Ultimately, we target somewhere in the neighborhood about 35 investments per fund. And a $400 million fund allows us to do that.

Rethinking Seed Investing

Tom: And so for the series seed investments or the super early stage stuff, Lenny, what are this kind of average check size, or how much do you think about investing in seed stage deals?

Lenny: Yeah, so I think we as a firm sort of re-architected our strategy on the seed stage side a little bit a little while ago to start writing bigger checks anywhere from the sort of five hundred thousand to one million dollar range and really taking a more active role in the companies.

And we really treat the seed opportunities as venture checks and like to roll up our sleeves and really work with these companies with the intention that these companies are ultimately gonna blossom into opportunities where we're gonna write five to seven million dollar Series A check. And sort of get started along that path with them.

Scott: For a long time, over the last I think five, six, seven, eight years, the seed strategy for most firms is really about buying option value, right? Especially the larger venture firms. It was about putting a little bit of money to work in a bunch of companies and seeing what really started to take hold and what was sprouting and hoping that based on that small investment that you may have made that you were in a better position to actually lead the Series A financing of the company.

I think in retrospect, and Redpoint did not do a lot of that, but I think in retrospect the venture industry realized that probably wasn't the right thing to do. It wasn't good for entrepreneurs because we really weren't adding a ton of value if you're writing a small check.

I think it's hard for venture guys to be able to justify spending a bunch of time. And the other thing is, ultimately, and I say us, the venture industry more broadly, I think a lot of firms were realizing that they were making these little checks, they weren't spending a lot of time and I think in the end they were kind of frustrating the entrepreneurs. They were feeling like they weren't getting a lot out of it.

And so I think we recognize that all along. We do typically eight to ten seeds a year. That's kind of right where we are now.

I think the thing for us is that we want to make big commitments to these entrepreneurs and I think our hope is that this is just the first step in a long term relationship and by investing a reasonable chunk of money, but also a reasonable chunk of whatever round they're raising, it kind of elevates the expectations on both sides.

Tom: Do you think that's kind of why a lot of, I mean it sounds like a lot of VCs are kind of cutting back from their seed investment deals. Do you think those returns aren't there?

Scott: I think everyone's kind of trending towards a strategy that's more consistent with the way that we've approached it for some time. I think that they're realizing, forty to fifty investments a year, which there were a couple firms that were doing that, in the end it was actually just damaging their reputation.

I think they couldn't possibly add value to forty to fifty seeds per year and entrepreneurs were growing frustrated. In the end, the entrepreneurs had to ask themselves, is this in my best interest? Having one of those venture firms on my cap table if they're not spending a lot of time, what is that? I'm giving them option value, right? What am I getting in return?

And I think it was one of those things that mutually the entrepreneurs and the venture community kind of realized in the end that's probably not the right approach. And if you're gonna take money from a venture firm as part of seed financing, it should be a bigger commitment.

Tom: I mean you guys spend a lot of time doing workshops, office hours, those kinds of things with portfolio. Can you talk a little bit more about that?

Scott: Sure. I think that what we've discovered over time is that there's only so much you can cover in a board meeting, right? And it's only so much you can cover in the one-on-one conversations.

What we like to do is to create ongoing dialogues with our entrepreneurs. We want to make sure that we're having regular interactions with them.

And so the idea of this kind of concept of the brown bag lunch, right, where we get together and we aren't talking about the issues and challenges that a particular entrepreneur is facing building their company, but maybe take a step back and think more globally about the kinds of challenges that fellow entrepreneurs are having and the kinds of things that are likely to emerge, the challenges, or frankly where the opportunities might be.

And so we've been hosting a variety of things. I mean in the SaaS space, Tomasz Tunguz is one of our partners who's one of the most prominent bloggers in the space, is posting regular office hours for entrepreneurs in the cloud space.

Lenny and I are running tech talks for portfolio companies where we bring our portfolio together and we'll bring, for instance, kind of cutting edge, bleeding edge, open source projects and leaders in front of them to actually talk about what's on the horizon.

We have regular events around talent that our talent head, Amy Knapp, will run where she'll bring the portfolio together and talk about some of the issues and challenges associated with hiring, recruiting.

So those are a handful of examples of a variety of things we do, but I think it's again, it's a lot of fun to actually think about how we can change the way that we are interacting, communicating with our entrepreneurs.

Tom: You talked a lot about kind of adding value. I mean, what are some of the things that Redpoint focuses on? Do you have a big operational staff as well as an investing staff? What are the things that you really think bring to the table?

Lenny: We have invested in, I guess, what some venture funds would call a platform. We've got a head of marketing, head of talent, director of events. And I think that's sort of table stakes at the area that we compete at today.

As far as what we bring to the table, I think like I said, we like to really get involved with our companies and try to impart whatever learnings that we've had along the way. And that could be in sitting down and doing whiteboard sessions on go-to-market. Could be introducing them to the people in our network that we think bring a lot of value to the table that have lived through these problems, as well as customer intros.

Scott: So maybe I'd take a step back and say our philosophy on how we want to help companies is we want to make the founders of these companies successful. And if we feel like we can make the founder successful, the business will be successful.

And so what that doesn't mean is that we want to offload a bunch of work for them and do it for them. I think what it means is we want to arm them to do the things that we think are required to be successful better.

And there's a handful of things. There's talent, clearly. Identifying and recruiting and retaining talent is a core function for every startup out there, right?

And so rather than outsourcing a bunch of those functions for our companies, because the reality is there's a bunch of talented recruiters out there, what we've done is hired Amy Knapp as our head of talent and Amy's job is to help the founders and the executive management teams do a better job of identifying, recruiting and retraining talent.

And she does that in a variety of different ways, but spends a lot of hands-on times with our companies helping them build the recruiting pipelines and to think about how to do that at a high level. And so we've done that similarly with the marketing function as well.

I think a lot of the value that we bring to the table is going to come through the years and years and years of institutional experience that we have and helping guide hundreds of companies through the growth phase from an idea to hopefully what is a very, very successful and scaling business. And there's a lot of institutional knowledge.

We take a team-based approach to investing where we're in ourselves around a consumer team and an enterprise team internally and we really do like to have those teams manage the investments that we make because we feel like the more people we have around the table, the more value that we ultimately will be able to provide.

So I think there's a lot of things that we do. In terms of the tactics, we don't need to get into that. I think it's probably pretty obvious. But I think the role, the expectations of what venture firms provide has changed quite a bit.

And I think it's all for the better. And we're excited to be able to offer these platform services to our companies.

What Redpoint Looks For

Tom: Investing across early stage seed investments all the way through to kind of Series A and Series B, I mean you see a lot of different types of deals, even within the enterprise space. Are there different things that you're looking for at different stages of investment?

Lenny: Yeah, I mean I think at least me personally, I sort of triangulate around product, market and team and more importantly is sort of the alignment within those three, right? You sort of think about, you talk about product market fit. You talk about sort of founder market fit and founder product fit.

And ideally you want really passionate entrepreneurs who are solving a problem that they know sort of inherently or innately and have the capabilities to go out and sort of deliver, bring to market a really compelling solution. And I think that sort of transcends, that cuts across stage.

But if you're investing in an earlier stage, you just don't have a lot of data. And so you tend to weight those three things a little bit differently and probably skew a little bit more towards the individual that you're backing, and him or her operating in a really compelling market.

Obviously as the company begins to execute, begins to bring product to market, it starts to scale, you've got some metrics that you can sort of zero in on and really sort of quantify objectively how that company's doing. And that tends to be a little bit more of the game in later stage and growth investing.

Tom: There are a lot of SaaS metrics that people understand well, CAC and LTV and things like that. Given the space you guys look at, enterprise software, developer tools, are there other metrics that you think are particularly interesting, either at an early stage or a Series A stage investment?

Scott: I think that every deal, every situation is different. And I think that the philosophy that we have as a firm is that we don't want to apply one universal set of rules or metrics to the investments that we're considering, because if we do that, then we're gonna make foolish mistakes.

And I think in the end, the most important thing that we can do as investors is to kind of lock into the three things that Lenny said, investing in great people building disruptive technology in large markets. We want to be a part of industry-defining companies.

And so sometimes that comes in shapes and sizes that are really difficult to measure in ways that might just pop out in a metric.

But clearly when we're looking at, for instance, developer-oriented businesses, I think our philosophy on those companies is first and foremost winning over the hearts and minds of developers.

And so we really like to believe that you're building a large community around your product and so we're gonna measure things like the size of that developer community and that engagement.

In some ways it looks a lot like what a consumer deal might look like. It might look a lot like what a social network company looks like in the early days when you're measuring monthly active users, right? We value that highly because we know that once you have that, it makes it that much easier for you to think about how you ultimately build a business, and build a business in a way that can be measured by some of the metrics that you laid out.

Tom: It's kinda hard to measure developer love and attention. Are there other non-standard metrics? I mean you look at GitHub stars and number of people building something with a tool.

Lenny: Well sure. I mean I think you try to sort of focus on a couple of variables and sort of hope that they lead you to a version of the truth. I think looking at GitHub stars, GitHub forks is a step in the right direction. Looking at chatter on Twitter, looking at chatter on Stack Overflow.

I think these are all measurable indications of froth or excitement about a product or a service. And they certainly help, but nothing really beats going out and talking to users, talking to customers.

When we hear our portfolio companies talking about or getting excited about some of these tools, I think that serves as the best sort of proof in the pudding.

Tom: For a founder coming and talking to Redpoint, what's a kind of standard diligence process look like? I mean, if they get in touch with Lenny or get in touch with you, Scott, how can they expect the conversations to go?

Scott: Very pleasantly. Again, there's really no uniform way of approaching this, but I would say that if you're a seed stage company, our attitude is that individuals can ultimately make those decisions so we don't run you through a full process and we can move very quickly. And then it's just making sure that we feel like we found something where we feel like there's a good match in both directions.

For Series A investments, our diligence really orients a lot around team and team diligence and it'll orient a lot around product and technology and the market. Typically we're investing in companies that are building or creating markets, and so there's not a lot of analysis you can do there. And so that a lot of times is more of a subjective kind of gut feeling.

As you progress and you turn from an early stage business into Series B or into an early growth, then obviously we spend more time looking at the data that you're generating, the traction that you're getting, both in terms of maybe users, but also in terms of sales. And so the farther you go, the more data we will look for and the more time we'll spend digging into that data.

In the end, what we're trying to do is assess the risk reward. And what we like to believe always is that particularly in the early days, we're taking a lot of risk, hopefully a lot of reward. On the spectrum of growth investors, we still take a lot of risk because we're going earlier than most, but we would like to believe that some of the risk has been wrung out of the equation because we're obviously paying higher prices and there's gonna be smaller reward.

The Size of the Developer Market

Tom: So you mentioned finding companies or finding founders that are going after big markets. It's kind of one of the criticisms of the developer tools or the developer ecosystem is that it's not a big enough market or the developers don't pay. I mean, how do you think about making investments in that space? You've obviously been long term developer tools and developer ecosystem investors, right?

Scott: We would like everyone out there, all the other investors, to believe that that is still the case. Because I think for a long period of time that was true. And it was also a function of the way in which those products were being delivered and built and sold.

It is our belief that the markets that we're addressing now are very, very significant in size, and we've been fortunate enough to be a part of a handful of companies that are building really big, scalable businesses leveraging developers.

But the way that we look at it is you can either build tools for developers or you can build tools that are sold through developers.

And we spent a little bit of time talking about this on Memory Leak. But there's money to be made by accessing developer budgets. There's also money to be made by leveraging the fact that developers are increasingly becoming power brokers within organizations and are making decisions which have ramifications that kind of go all the way up to the senior levels of companies.

And companies like Twilio and Stripe are great examples of that. Their budgets don't come from the developers, they come from the business owners. And so we're accessing budgets that traditionally would not have been accessible if you were leveraging developers to go to market, but today they are.

And we still think we're in the early stage of that trend and it's likely to play out and become more and more important over time.

Lenny: And I'd say part of that notion that you can't make money selling to developers or developer tools is sort of a smaller market is really a taxonomy problem that's I think changing pretty rapidly. I think as more of our world gets instantiated in digital bits and ones and zeros, everything fundamentally touches a developer in one way, shape, or form.

And so whether it's infrastructure, so now servers are basically developer products, right? Whether it's any sort of business, whether it's analytics or whether it's any sort of productivity software, it's becoming again via APIs and SDKs instantiated in bits and ultimately touches the developers generally first.

To us, developer tools are really eating the entire enterprise market. So we think it's one of the largest opportunities in venture.

Scott: I think we could talk about these APIs that are playing that, but right now there's a big phenomenon happening in the way in which applications are being built and operated and run and driven by things like containers and microservices. And these are all phenomenon that'll be driven by developers. So ultimately having massive implications in terms of the way that enterprise software is gonna be constructed.

And I think that is a great example of the power of the developer. And the reality is the developers are unleashing that trend, but the budgets are going to be coming from a whole variety of different sources.

And so we talk about developers, we don't just want to build businesses that sell to developers. We want to build businesses that enable developers to empower them and help advance their organizations in ways that can be really powerful for their companies.

Tom: And are there particular kind of segments or parts of the developer ecosystem, the enterprise software market, that you think are particularly interesting right now?

Lenny: Yeah, I think just to take a step back, I think we broadly lump developer tools into sort of four larger categories. One's sort of around developer productivity, and that's generally writing code, collaborating around code. We talk about sort of application lifecycle tools, so tools that help you literally get code from your terminal, developer's terminal, into production, and then infrastructure as code.

So the emulated compute, network and storage that you see on services like AWS, Heroku, and then obviously services as code, which are basically sort of end-to-end products delivered via APIs, so Twilio, Stripe, two Redpoint examples.

And within there there's real disruption happening, I think, in all four of those verticals. Obviously I think we'd be remiss not to talk about some of the trends across sort of the way applications are being built and deployed.

And today we're seeing applications, sort of a whole remake of application architecture, sort of from these traditional monolithic apps deployed on single servers to these distributed systems that are being deployed across data centers, across multiple regions, and that's having a fundamental impact on the entire toolchain that's used to build, manage, and deploy, monitor these applications.

And so when we're looking at opportunities, we see infrastructure as beholden to the application. And so fundamentally every part of the stack is being remade to support these decentralized apps.

So we're seeing it in new paradigms and persistence and storage and monitoring. These are all areas that we're really excited about.

Scott: Yeah, and these are multi-billion dollar markets, which is what's really exciting about what's happening. And I think we're gonna look back five, six, seven years from now and we're gonna realize the time we're in now has been a pretty meaningful fundamental transformation on the way that software is built, then it's gonna be in a large part driven by the approach that developers are taking, actually how they want to build software.

Winner-Take-All Platforms

Tom: I mean we've seen some extremely large financings for companies in the space, right? I mean kinda Docker, probably most notably, right?

Obviously having a large market is a key rationale for raising a lot of money, but it seems like a lot of these markets are kind of winner take all markets or they're markets where the lion's share will go to number one. Do you agree with that and does that inform your investment hypothesis as well?

Scott: I personally do agree with that. I don't know about Lenny, but I think that we talked earlier about the dynamics around winning over developer mindshare and a lot of them are kind of reminiscent of what we see in kind of the consumer phenomena out there.

And in the end, you realize that those networks ultimately accrue to one or two leading platforms. And I think that we're gonna see the same thing in a lot of these developer oriented platforms.

Look, I think Docker, taking that one specifically, that's a company where what they've been able to do over the last couple of years is pretty extraordinary in terms of their winning over mind share and actually transforming the way that people think about the portability of software.

And I think that that valuation and the size of the investment was justified by the idea that people believe that Docker's the next generation of virtualization, that they look at and say this could be the next VMware. We can get into this a little bit in some further conversations about the challenges associated with trying to build something like a VMware and enterprise today. It's hard to do today.

What I would say is I think that the enthusiasm around Docker is warranted because I think it speaks to the size of the disruptions that we're seeing and a lot of smart people believe that it could fundamentally disrupt something like a VMware. I think that it's not often that we see those kind of tectonic shifts in the way that we're seeing right now.

Lenny: And the one thing I would add is, for companies like Docker, for Kubernetes, for Mesosphere, whoever, right? I think the challenge is to platform and platform quickly and build sort of tentacles into the stack because the barriers to adoption innovation have been smashed in a pretty dramatic way. So we also live in a world where it's sort of best tool for the best job and it's a real meritocracy out there.

So developers will flock to the tool that does a certain thing that makes their lives easier and does it in the most efficient automated way a lot of times. So we've seen some leaders emerge, but in our minds, the winners in this, at least in this call it cloud native ecosystem, I think are very much still to be determined, which is exciting.

Tom: Well there's one, I mean, kind of very big winner at the moment in AWS, right? I mean that's kind of the biggest developer platform or cloud infrastructure platform out there. Will they leave any air for the rest of us? Is there room for another AWS? Or how do you think about the infrastructure market evolving given how big they are already?

Lenny: It's something that keeps me awake at night a little bit and I wonder what the future for the enterprise and infrastructure innovation cycle becomes with someone like this extracting, or really accruing, so much value so quickly.

I tend to believe that these things tend to be cyclical. And if you sort of follow the history of enterprise compute, sort of ebbs and flows between periods of aggregation and disaggregation and there's always some sort of change on the horizon that prompts new winners and new sort of patterns of computing to emerge.

So I think today it seems like everything's sort of headed in the direction of AWS and a world of three or four cloud vendors dominating everything. But I'm optimistic as an investor that there's gonna be some sort of paradigm or architectural shift that prompts some sort of, this isn't to say that we're gonna start to see enterprises building giant data centers again, proprietary data centers.

But the minute we start saying this is sort of it is when things tend to change.

So I'm hesitant to say that.

Scott: I wrote a blog post not that long ago saying that I think Amazon might be the most interesting enterprise software business in the world today. I mean it's incredible what they've done in short order and I think it speaks to the power and the potential of the cloud.

I think obviously there's a number of people in the ecosystem that worry about the power that they've had. So far, they've wielded in a fairly benevolent way where they've been aggressive in driving down prices and the ecosystem, and they certainly have executed on a product roadmap that is pretty extraordinary and I think we're all within the startup ecosystem benefiting from the tremendous work that the folks at AWS have done.

I do think over the long run though that it's hard to imagine a world where all the compute and storage is sitting on top of one data center. And I think that there are companies like Microsoft and companies like Google and even companies like Salesforce who look at this and say, this is a scary precedent, and as we kind of flash forward, if we aren't able to steer the ship in some interesting and meaningful way, those guys will accrue enough power that it actually could end up being something that is detrimental to the ecosystem.

I think we're a long way from there, but I would also say that I think the leadership changes we've seen in some of those companies and direction that we see within Microsoft and Google gives me hope that there is going to be a very competitive landscape here for infrastructure as a service going forward.

I don't know exactly how it's gonna play out, I don't know exactly what might change or tip the competitive balance in some way, but there are companies that are worth a whole bunch that have a lot of money that are looking at that and saying that that is an area in which we must be a strong and viable competitor if not leader and I think all this is only good for all of us in the startup ecosystem. So we'll see. We'll watch it and keep a close eye on it.

But one example I give on Amazon, which is pretty amazing, is, I don't know how much you guys have looked into Lambda and what Lambda actually is, is this idea of serverless compute. What's really amazing about that is the creation of Lambda works for certain workloads, not others, but basically it completely undermines Amazon's own business model.

So it's a product they've launched that essentially reduces the cost of running certain applications by, it cuts it, it's at least an order of magnitude. No, it's about five percent, right? It costs about five percent. And so you imagine a company that's a leader in a category that has a dominant market share that is pushing forward, by all rights could just continue to do what they're doing, but is launching something like Lambda that would absolutely eat into their own business. And I think it speaks to the kind of mindset they have.

What they really want to do is build disruptive technologies and they want to deliver experiences they think will be differentiated for developers.

And believe me, Amazon's not without its issues and challenges. I think every developer out there that works with AWS could speak to that at length. But I think in the end we have to look back and say this has been a phenomenal development for all of us as we try to build the next generation set of companies out there.

Tom: So these big kind of platform providers, phenomenal enablers of another generation, of a whole suite of developer products that are coming out. Do you think they are gonna make good exit opportunities as well for some of the portfolio companies?

Lenny: If past history is any indication of the future, I think infrastructure companies will be hard-pressed to exit to the likes of Amazon and Google, right? I think these guys view infrastructure and sort of their ability to create software and rack servers to a certain degree as a core competency.

I think Microsoft has definitely shown a bit of an acquisitive streak, particularly in areas that are highly strategic where they can tend to differentiate themselves from these other two competitors, right? They've flirted with Mesosphere, the rumor that's been widely discussed. They've been very acquisitive in security. So I think they're more of a traditional large enterprise that I think views M&A as a potential for sort of fueling long-term growth.

But I think you see Amazon doing some tuck-ins, but these are two of the best engineering organizations in the world and they generally, and probably correctly so, think they could probably do it better than a whole lot of startups.

Scott: I do think that the likes of Google and Microsoft are going to look at companies that have managed to acquire a large developer community as a very attractive acquisition candidate. They're playing catch up and they're trying to build communities around their platforms and to the extent they can accelerate that through the acquisition of startups that have those communities, I think that they will absolutely embrace that.

Tom: I mean that's something they did with the Firebase acquisition, right? For example.

Scott: Yeah, and obviously I think that's a great example and I expect there'll be a lot more. The question is whether or not they're gonna want to acquire those at the point at which those guys are still in the process of building those communities before they've actually kind of nailed down their business models, because once they've nailed down the business models, the value of these businesses go up significantly. And so I think that'll be one of those interesting dynamics for any entrepreneur that's building businesses around a developer community, that transition from community to business model has always been, it's a challenge. It's hard for any business.

And in all likelihood there's going to be a lot of acquisition opportunities that will pop up for you. It makes it a very difficult decision.

Lenny: It's an interesting change to note. It struck me that before, companies, at least in the enterprise world, you look at acquisitions, were generally driven by some sort of strategic IP. Now it seems like, to Scott's point, that it's very much sort of developer evangelism and these developer communities that are the most sort of strategic assets that startups in this space can build and leverage.

Valuations and the 2016 Outlook

Tom: It's pretty hard to value any privately held company. How do you guys think about valuing some of the deals that you're looking at?

Scott: Man, I wish to tell you there was science behind it. There isn't. What we do is there's a certain amount of ownership and there's a certain amount they want to raise and you do the math and it pops out.

But I think in the end it's an iterative process where as an investor, ultimately I have to get comfortable with how big of a business you think can be built and you kind of work back from there. And as an entrepreneur, you have to think about in terms of the amount of money I need to get from here to there and how much dilution I'm willing to accept at the different stages. And hopefully at some point those things converge.

Tom: Are you worried about the current state of valuations? I mean it seems like 2015's been a very highly valued year, or it's been a lot of very high valuations in 2015.

Scott: Yeah, we've been concerned for a little while about valuations. I think that there's, here's what I would say.

I think that at this point in time, the opportunity set is as compelling as I've seen as a venture capitalist in all the years I've been doing this. The opportunity to create really disruptive businesses and build big businesses, it's a phenomenal time.

And we've walked through a handful of the opportunities here, but there are plenty more. And so I think there's a lot of enthusiasm and optimism throughout the startup ecosystem and community here in Silicon Valley that, hey, we can build really, really big companies.

And as a result, that ends up eventually translating into higher and higher valuations in these businesses. At some point those valuations get beyond probably where they should be from a risk reward standpoint.

And I think Bill Gurley said it and said it well, which is that in cases people have kind of dropped the risk premium and essentially we're not paying for risk. We're assuming flawless execution on these companies. And so I think we kind of got to that point.

I would tell you that I feel like here we stand at the end of 2015 that things are changing and have been changing actually probably for four or five months. And I think the valuation environment is softening. It's starting at the late stage.

And so some of the companies at the very late stage that were getting very large valuations, and really hard to justify at some level because they're close to going public and you look at the public comps and these guys were getting two to three to four times the multiples the public comps are getting.

And as these companies that people invest in, in high valuations, are going public, realizing that that last round is underwater relative to the public valuation, of course some point valuations will adjust. And that has actually started. And so we're seeing that and I think it's in full swing at this point.

It's probably not readily apparent to everyone yet, but I think it will become more apparent. And so I think that will ultimately kind of work its way down through most stages, and I think that we're probably going to see some rationalization of valuations.

That having been said, I do believe that valuations still will be a great time for an entrepreneur to raise money. I think that the valuations we're going to see at the early stages are going to be very attractive. And I think that the opportunity to finance companies in the private market over a period of time to take on very ambitious projects, the math is still going to work out and look very attractive. It's going to look very attractive to everybody.

The one thing that could happen here if we do see an adjustment in the way in which companies are valued is just how much risk investors are gonna be willing to take, and some of these projects that are burning a lot of money, some of the ones with very speculative business models that have raised money at very high valuations, they could face some challenges in an environment that starts to look for that risk premium once again.

Tom: Along with valuations, do you think the supply of capital has changed at different stages of the business? Is there less money kind of sloshing about at the Series Bs, the Series C's? I mean, do you think the same thing is happening at the Series C as well?

Scott: I think we're awash in money right now. I think we're still awash in money and we'll be for a while.

I think at the seed level, there's plenty of seed capital that's available; in Series A and Series B, there's plenty of capital available. In later stages, there's lots of capital.

I would say that at the very late stages, some of the investors, those guys will move in and out of the private market because what they do is they look at the arbitrage between private and public, and they feel like they can put their money to work in the public markets and generate a better return, they will.

And so you see that capital being a little bit more fluid at the late stages, but the reality is all those companies at that stage, all the private companies, could probably opt to go public if they were to so choose.

So I think we have a lot of capital sloshing around, which is one of the reasons why I said that even as we see an adjustment in the way the companies are valued, we still believe that they're gonna be valued very highly because there's a lot of capital, and that I don't believe will change anytime soon. There's been a lot of money pumped into the venture ecosystem over the last four or five years, and it takes a long time for that money to kind of work itself out.

So, good news. There's a lot of money available and it should allow us as an industry to continue to kind of take on big, bold, ambitious bets.

Tom: Yeah, I mean I remember back from the follow-on from the first bubble where people used to talk about the venture capital overhang and the number of massive funds that got raised all the way through despite there being no real place to invest it. And it seems from the statistics, or from the NVCA stuff that I've read, like 2014 was like the most amount of money going into new VC funds for the last decade. I think 2015's gonna be the same as well.

Scott: It always happens that money moves in right as things get really exuberant, and it takes a while for it to move out.

And in the scale of things, what happened in 2013, 2014, and 2015 is still very small relative to what happened in the late 90s. And so the size and scope of any kind of venture overhang is not nearly what we maybe saw in the early 2000s. So I don't see it as a kind of fundamental challenge to the asset class.

But I do believe that there's gonna be a lot of money out there and as investors, we're still gonna be competing in an environment where there's lots of capital flowing.

Competing for Deals

Tom: Arguably it's harder for institutional funds to make early stage bets because you're competing against investors with non-financial incentives. You have folks doing it for the love of entrepreneurship. You have Twitter, Facebook kind of millionaires or billionaires who are redeploying capital and really don't give too much of a concern about making a return on that initial investment.

I mean, how do you think about competing against someone who maybe doesn't care about making money?

Scott: Yeah, that makes it hard. At the seed stage clearly we run into that from time to time where there are investors who come in with a different kind of return profile or threshold and also frankly different motivations, like you said. And in those situations we can decide whether or not we think it's worth making that individual bet or not.

I think that the reality is that becomes less of a factor at Series A and later when we're talking about larger checks. The individual investors who can come in and distort particular financings in the way you described, those folks tend to move in and out based on what's happening within the environment, and so at very frothy times they tend to be leaning forward, but if there's any kind of pullback they tend to pull back very quickly.

And so it's hard for us to strategize and plan around that because the reality is over the course of our fund, I suspect that it's not something that is a consistent challenge or issue for us.

Tom: So I guess the goal is to be differentiated capital, as you were saying earlier.

Scott: That's it, exactly. I mean the reality is that we're very rarely the highest offer on the deals in which we do. I mean most entrepreneurs, kinds of companies that we want to be investing in could raise money at very high valuations from individuals who again would think about things differently than we might.

It's a partnership and it's about finding a set of entrepreneurs who we really believe in, and for the entrepreneurs it's about finding a set of people that they believe are gonna be highly engaged and are gonna be there to support their company over the long term. Not just that round of financing, but the next round and the round after that.

And are also going to be dedicating serious significant time. And I think it's safe to say that as investors at Redpoint, we've been able to prove time and time again our ability to actually help and support our entrepreneurs, and as a result, we find in many of these financing discussions that it becomes less about valuation.

I mean certainly always a part of it, but the deciding factor also often is really more about, well, do I believe that this person can change the trajectory of my business in a meaningful way?

Lenny: And we've talked about alignment within a company around market, product and team, but there's also investor alignment, and you want to find a partner that sees eye to eye with you on the company you build. And this is why we spend a lot of time going deep on particular sectors and really fleshing out our perspective, our point of view, and I think there's something to be said about having some deep domain expertise where you're not just capital, where you could be sort of a real strategic partner for the entrepreneur.

Scott: I would say one observation: the venture business has changed a bunch in terms of the expectations entrepreneurs have about the people that invest in their business.

And it used to be a lot about, hey, you understand what it takes to actually grow a business over time. Well now entrepreneurs want that, but they also want folks who have a lot of specific domain knowledge and expertise.

And at Redpoint, we are generalist across areas in which we invest, but we find ourselves, and we gravitate more towards, specific areas or ideas or themes that we're interested in and really spent a lot of time, energy, and money investing in ensuring that we understand those industries and those sub-segments that we're interested in very, very well. And so that we can sit across the table from entrepreneur and they believe not only can we help them think about how to, just entrepreneurship 101, but we can also help them very specifically with the kinds of day-to-day tactical issues you're gonna have building a business in a particular space.

Memory Leak

Tom: So you guys obviously spent a lot of time focused on developer tools and enterprise software. We're excited to see that you've actually launched a new kind of content, or a new publication, on the topic.

Lenny: Yeah, so I guess, what, a month or two ago we launched a new blog called Memory Leak, which is really dedicated to the business of developers. I think as VCs, we occupy an interesting place in the market where we're sort of part historian, part rational pragmatists and part sort of dreamer, and so we've lived a lot of experiences, we've seen a lot of business models, we've seen a lot of successes and failures associated with launching businesses targeted at developers, and we also have a front row seat to the cutting edge, the bleeding edge in what's happening in the stack.

And so we thought a lot of these lessons should be sort of shared and explored, and Memory Leak is really targeted at developers or folks that are building tools and products for developers and exploring sort of tactics and strategies around that, around those businesses, and exploring themes around go-to-market, product, product management. And also highlighting some of the overarching trends we're seeing around containerization, around sort of APIs.

Tom: Sounds good. And so is it all Redpoint content or are you kind of getting contributors and people to syndicate into it as well?

Lenny: Yeah, absolutely. So Scott and I produce a lot of the original content, but a lot of it is gonna be interviews and inspired by conversations we've had. We just posted an interview a few weeks back where we spoke with James Lindenbaum here. We've got another one teed up where we spoke to Paul Biggar, the founder of CircleCI. And I think it'd be foolish of us not to talk to these guys who are really sort of luminaries in their respective fields.

Scott: Yeah. I mean we're excited to have an opportunity to start a dialogue with folks that are building those types of businesses and also talk directly to developers as we consider the shifts that we talked about in the technology and the stack that's evolving, and it's been a lot of fun so far, and we've gotten a lot of great feedback and we look forward to again having this dialogue, this ongoing dialogue. So hopefully everybody out there joins in.

Tom: So where can we find it?

Lenny: Yeah, so the URL is memleak.io and Scott and I link to stories from it all the time so you can follow us on Twitter. I'm @LennyPruss, L-E-N-N-Y P-R-U-S-S.

Scott: And I'm @sraney, S-R-A-N-E-Y.

Tom: Cool. Is that the best way for folks to get in touch with you if the founder's got a hot new deal?

Lenny: Yeah, that'd be great. Hopefully exclusively us.

Tom: Exactly. Great. Well I think that's all we've got time for, but Lenny, Scott, thank you very much for joining us this week.

Scott: Thanks for having us. We appreciate it. Cheers, guys.

Tom: Thanks for listening to this episode of Venture Confidential, brought to you by Heavybit. To learn more about Heavybit, visit heavybit.com and while you're there, check out our library, home to great educational talks from top investors, entrepreneurs and other industry leaders.