The Shocking Truth About VC-Backed Companies | Josh Wolfe | Zer0es TV

i'm carson block of xeros and welcome to another episode of a short story i'm here with josh wolfe josh is the co-founder and managing partner of lux capital which is i think one of the most interesting and now becoming one of the most successful venture capital firms so josh awesome to have you here thank you very much for joining us great to be with you man great to see you sort of sort of seeing each other um hopefully for real in the not too distant future soon enough yeah well listen uh you know we people might be a little bit puzzled since we usually focus on short selling as to why we're sitting down with a venture capitalist and i think it's really important to point out a that you're not typical for venture capitalists by any means and b you actually have opinions that are subversive uh if anything in the venture capital world um and just you know to illustrate this when you and i first met i think it was probably early 2014 and i remember just you know like asking you what do you do and you say oh i've got a venture capital firm and i hopefully didn't do it externally but i think internally i had like a major eye roll right because i'm just expecting like oh you know social media this and that and whatever but then when i asked you you know i felt kind of the obligatory question oh what do you guys invest in you shocked me by saying nuclear waste disposal and tattoo removal so that was interesting and we then talked uh about how really you you take this approach in technology investing where you know you're trying to look where others aren't and i think just that perspective and that strategy is really why i want to talk to you and understand a lot more about technology investing and the reason why i think this is valuable for me valuable for our viewers is obviously there's a lot of froth out there a lot of it is connected to technology and um i interviewed andrew left this past december and he made a really good point about where a lot of short sellers make mistakes you know they might short and i think this is particularly the case with technology companies he said you need to make sure that you're short a company for the same reason that others are long and so he said that it's common for short sellers to you know become convinced hey this company is about to blow their quarter i'm going to short it but you don't get that the long side has a three to five year time horizon and that and that's often you know much more that growth type investor technology type investor so to really understand how to become better short sellers but also to understand how to better identify on the long side technologies that just aren't going to get there ever that's why i really want to talk to you and and get your perspective on these uh you know and the myriad questions associated with this you know somebody had said recently that um i don't know to who the quote is attributed but that you know if you think about the distinction between like value investing and venture investing value investing is premised on things remaining the same and that you know effectively there's a price deviation or aberration and you know intrinsic value will reach expectations and that the market has you know thrown the baby out with the bathwater and somebody's identified something that was undervalued and then and the distinction that they were making was uh that venture is making a bet on uh things are gonna change and i don't really agree with that because at the end of the day uh maybe the vast majority of venture people are more speculators than they are investors but uh i was sort of raised or groomed and took very early to classic buffett monger carmen just rational people that were sort of truth-seeking and uh to me that is the great virtue of short sellers generally it's you know people that are looking to identify where uh not just accidental misinterpretations which are generally the fundamental analysis gone wrong but overt manipulation of credulity of masses uh which i find to be a great virtuous thing and it's me very resonant with what the fundamental people and asset that we invest in which are scientists and engineers are trying to do they are in some what i consider to be a righteous pursuit of truth you know there's uh you know some scientists out there that claim something and then because of the system of peer review you have somebody else that says no that's total bulk that's not actually true you know and through that constant iteration of like conjecture which could be done innocently or maliciously and then criticism you trend towards truth it's the same thing in markets and so i like to think that i'm on this holy quest of funding people in science and technology that are creating something virtuous and uh and truthful and i like to have lots of friends like you that are i think on a similarly virtuous quest when it comes to capital markets to call bull on people who are just either you know outright lying or manipulating other people so um [Music] yeah the virtue of technology you know we have lots of friends in common that that are focused on short selling and and i think my attraction to them and vice versa has been sort of my focus on the fads and the frauds and the technological obsolescence and in one case everything we do at lux is premised on you know can we find somebody that has solved the problem that's going to disrupt one of the big guys and so yeah when we first met thinking about nuclear waste uh you know most of the big people in that industry were ch2m hill and urs and four and bechtel big engineering primes that were basically uh almost equivalent of beltway bandits but you know just capturing large money from doe and when you learned about the enormity of the nuclear waste problem both domestically and internationally specifically for pre and post cold war bomb making there was a big opportunity to uh you know find technology that that might be superior and uh so we went and assembled the team and you know found technology in people and put it all together yeah so i think the great virtue of you know having an appreciation for technology is recognizing that in some sense you know if we're super cynical about it although it is true most future shorts are going to come from the vast majority of what venture guys are funding and taking public because there are things that um will be legitimate i think great compounding business like in amazon which was venture-backed and then the vast majority of companies that go public you know probably shouldn't be are premised on a narrative have set unreasonable expectations have attracted a cost of capital that is undeserving and have a business that will never ever be able to earn that cost of capital and so you know some people in the early days are rewarded for the speculation and pursuit of you know these momentum and growth stocks and certainly for the past few years you know i think valuations of afforded to companies with growth metrics were somewhere between two and four x people who had you know growth and profitability let alone you know top line and i think eventually we'll see a return in discrimination towards like you know not just quality of earnings which most companies don't have today that are in high value but like the quality of the revenue and i think there's a lot of games that are going to be revealed about people goosing things for top line growth that just is not organic or authentic and you know requires scrutiny from people like you who can be rewarded for identifying that and saying the emperor's got no clothes yeah when when we talk about stuff that gets venture funding um you know i'm talking more the typical you know venture firms that fund this you know the social media space or what have you um you know somebody i spoke to a few years ago and um i won't mention his name just because i don't have permission to although he probably would be okay with this um but any event he he came from he came from that world of you know having been at some startups including some very successful ones and so what you said to me is that when you take a typical say you know software type starter online startup you said you know you maybe three or four founders and you know they're working together and they all want to code the sexy stuff they want to code the application and nobody really wants to code the applications that measure you know that that actually you know that actually track the metrics or create the metrics and that kind of you know whoever gets stuck with that is often like you know like job here doesn't put his or her all into it often and so then by the time they go and they're getting looking for series a series b they probably have a bad measurement of metrics but what i was told is that the vc firms never really diligence them you know they they come in they get the you know the founders come in they've got their you know they've got their pitch and nobody really says you know hey we need to dig into this and see whether you know the user growth is blah or the engagement is whatever um they just are taken at face value and then if they get funding they hire a bunch of people and you know eventually somebody kind of tries to straighten out you know they get some people in in-house who are trying to deal with this really flawed you know metric system but it's often they're just building on top of that so you have these companies that are going public that you know inadvertently a lot of times have just really bad data on you know on what their you know on what their actual users are doing and you know this person also made the point that certain percentage of these companies that get venture funding and even go public um there's been deliberate deception if not outright lying about what these metrics are um how much of an issue do you think that re you know that these these two really you know present i mean how often do you think that this can be a problem i think it's the majority of the time i think you know um i've got this dictum that um i've taken from uh theodore sturgeon which in 1957 apropos uh you know it's called venture it was a science fiction compendium but uh november 1957 and ted sturgeon basically said 90 of sci-fi is crap okay and i actually think that eponymous sturgeon's law applies to everything so ninety percent of everything is crowned ninety percent of people crap ninety percent of music on spotify's crap ninety percent of netflix shows are crap ninety percent of spacks are crap ninety percent of companies are crap right and there's actually sort of a separate bayesian trick which i think always is interesting to reveal how much luck there is in in investing we'll talk about that in a moment but i think it's abundant because i think 90 of companies are crap and so you know 10 of companies have probably a totally legitimate operator who has the experience and understands a priori the metrics that they have to hit they understand tac they understand ltv if it's a software business they understand the product differentiation they understand the incentives that they have to give to salespeople to hit quotas and drive business they understand the attachment rate of you know service or maintenance revenue they understand you know how to run a real business and they also understand their cost of capital and how to raise it and lower it and hit it and so um those people are few and far between i mean great entrepreneurs are by definition scarce and rare now some of the great entrepreneurs aren't great operators but are phenomenal storytellers and if you're a phenomenal storyteller and you can raise money by raising expectations and lowering your cost of capital then you can do exactly what you said you know sort of fake it you know to make it or you know recruit a team and you know you're attracting more and more money on the uh sexiness and the sizzle of it and then maybe you've got enough capital uh in cash or stock currency where you can actually you know make a tucking acquisition or some aqua hires and like get some substance i mean larry ellison was sort of famous for this right of you know he was the the first pioneer of vaporware and just lying about products that didn't even exist and you know in part to send negative signal for competitors in part you know to uh attract capital to be able to fund that kind of stuff and then um yeah i think i think it's i think it's pervasive um the the difference is also a big function of the macro and so you know if you zoom out and just say like what's good for society you know is it better when the cost of capital is higher better when the cost of capital is low for like innovation and my answer has always been yes because when the cost of capital is low very very few things get funded and you can argue that when cash is scarce capital is dried up you know people are sort of going back to like their motherships if you know they left banks or accounting firms or you know big engineering firms they're scared and they go back to shelter and sort of like the most risk-taking high conviction entrepreneurs that really believe in themselves are like okay it's not just a rising tide that floats all boats those are the people that sort of dig in and same thing like investors the level of scrutiny when cash is scarce becomes way higher the amount of diligence that an investor is doing in venture is way higher because the risk that somebody is not there to fund you is way higher and so you got to trend closer to truth and be closer to getting it right when cash is abundant it's great for innovation broadly because thousands of thousands of experiments get tried 90 of those things will fail you know and has always been the case going back you know to time memorial but even looking back from you know 20 plus years ago with dot com boom and bust the detritus what's left behind becomes the combinatorial fodder for the next wave and you pick up pieces and like post facto it's like oh of course like this is great it's obvious we were just early we weren't wrong but i think um when cash is abundant diligence basically becomes non-existent because your financing risk is very low and sometimes you have financing risk that's low because of like a soft bank that comes in and is basically playing a totally different game right and they're just buying into businesses and pricing them up themselves and capitalizing these things ridiculously and and in some cases that then creates the social proof for other people be it growth funds or some public market crossover funds to basically say oh we could do the same thing but with maybe a better reputation and so if you're an early stage venture guy in the past few years you know the price you paid didn't really matter because it was relatively certain that a reasonably high quality management team and a good story you were going to get funding you know in a later stage around now the risk that you were taking was that the terms of the financing that you would take would be a preferred financing with you know 2x liquidation preferences and my god like if it doesn't work out your part of the cap table was screwed and you know the later stage guys are going to basically capture everything but because there's so much competition everything has been super founder friendly you know in some cases big funds that would normally want two board seats are like yeah we'll give you not only our board sheets but we'll give you our votes you know it's entirely yours right and so um i think in a period where you know cash is abundant um diligence is scarce it invites bad behavior it invites fraud um and and i think by the way we're in a period where you know both you and jim and other chains and others have you know referred to as the golden age of fraud and i truly believe that and it'll take some years you know i've been wrong for the past two years thinking that this was imminent to end so i have no idea if it ends in you know two weeks two months or two years but i do think that the the positive feedback that companies have gotten from promoting top-line growth and we you know just alluded to this before the quality of that growth is probably very poor that they're going to employ all kinds of tricks and some of those tricks will be legal they will be immoral but they will be legal to buy revenue from companies to make horrible acquisitions and they'll find ways to just conflate the way that they categorize you know product segments and not reveal others and and the really scrutinous analysts will be able to discern but they will be doing that in a minority of investors when the majority are basically just going off of you know the reuters or journal or whatever headline or yahoo news or whatever who have just been spoon-fed the thing from the ceo or the celebrity ceo who that journalist wants to continue to get access from and so it's a cycle that is just going to take a really long time i think to shake out so how complicit are you know is the venture capital industry in these promotions and frauds i mean you know is there is it you know very willful ignorance is it just hey you know we only provided the money what these guys do with it is is their responsibility um or by some people might think this is kind of tinfoil hat but i've speculated for some years that there's something that i call the silicon valley mutual welfare society which is where you know the well-established silicon valley vc firms and they all have portfolio companies and they kind of scratch each other's back so you've got a portfolio company that's kind of dog i'm gonna have one of my portfolio companies buy yours you know later you're gonna have you know you're gonna have one buy from this guy and then he's gonna buy a company off me at some point and we'll all kind of be able to sweep stuff under the rug so how complicit is silicon valley in the promotions and frauds and um does the skull and bone society really exist do they run the world if it does i'm not an invited member um but uh the there there's there's definitive reciprocity and venture more in getting into deals you know um if we if we form a company which is something we love to do where you started a company with an entrepreneur you have very high ownership for very low dollars you've originated something interesting you're not competing you know for with everybody else for a seat or seriously then you get to choose like okay let's go to these three firms and the people that you pick might be people that you think are both going to be legitimate value-add investors they're well connected they're high signal you know they're going to be supportive in future rounds but also they're in interesting companies and they will reciprocate by showing you something in their portfolio right and so so there's that for sure in the ecosystem which i don't necessarily think you see as much in the public markets i mean you have some high correlations amongst like you know ex tiger cubs or people that sort of think alike or have been trained to like but i don't think that it's like as overt of and it's not like hey like we would never say hey we're showing you this well you know it's just sort of like an implicit we're bringing new deals and if everybody else is like thanks and never show us anything we're not going to come back and bring you our next best deal and so there's there's some expectation in terms of deal flow that's just sort of premised on relationships you know where you're sharing ideas and making introductions to entrepreneurs but at the end of the day we can make an introduction uh you know i don't know the founders fund somebody that we like doing deals with and the entrepreneur gets to decide like we never have the heavy hand to say because we're not like private equity firms where you control the company you know you own between i don't know five and twenty five percent of the company or uh that non-passive minority shareholder you have a board seat um in most cases but uh it's at the end of the day up to the entrepreneur about who they want in the syndicate and the best entrepreneurs have a sense of who they want and the worst entrepreneurs you know are almost begging for help to have you help you know raise the money for them um in the case of like you have a crappy portfolio company i think it's the same sort of thing where again the best firms you're only as good as your last deal and if we went to another firm we're like uh you know these guys are just like flailing and we need help being bailed out um you know and don't worry we'll take care of yours later i i don't think that that happens as much and certainly not you know amongst the people that we co-invest with and the reason is the magnitudes of your winners are so much bigger than your losers you know i mean if you take an average venture fund a third or 10x you know a third or total zeros in a third you make your money back and you end up with like a 3x cash on cash fund over that you know decade or seven years or whatever it is and so if we've got a company that is like you know flying high the idea that we would take some you know shitty culture or crappy technology and try to try to roll it in to do a solid for some you know pure vc or that they would expect that as just you know i i don't i think that's more apt in private equity you know where they're in control positions and you know they sell a company or they're doing some tuck and acquisition but i haven't really seen an inventor although i will say there's times where you see combinations of companies where they merge and sometimes it's in within somebody's own portfolio and it could be because you know and there's one vc again who i also won't name who does all the time and like when you see it you know i'm just like oh my god it's like you know another so-and-so special they have a company that's got cash another company that's basically low on cash this company's got better management team these guys have some management coup and so they take some elements of the assets whereas the people or the technology or a bigger market or a better story they combine these things and then they try to live another day but they typically do that within their own portfolio and then then they might come to us and say hey do you want to invest in this combined entity and we're looking at it we're like no you know we're good because it really is in that case you know one pile of and another pilot is like you know three piles you said something also that a few minutes ago that is particularly interesting to me as well um something i've wondered a lot about you said that from the the the entrepreneur the founder of the company you know he's got to you know he or she has to choose um if you know if they're in demand from among the different potential venture investors and you know decide like who you really want in that you know in your in your company and i was wondering especially for somewhat you know sort of non maybe non-series a or maybe it's you know it is in series a i mean how much um thought is or should be given to the relationship between the the venture firms and investment banks and and i've always really i mean you know diving into that a little bit more i've always really wondered about this relationship between large venture firms that you know produce lots of ipos the banks that underwrite those ipos what's that like and and then i have another maybe kind of tin foil hat question on the back end of that after get your uh your comments there so uh banks for the most part i think are relatively uh held in relatively low regard and maybe there's one exception because they have um an incredible capacity on a daily basis to print multi-billion dollar deals which is catalyst and frank quattro um whose involvement in deals typically is a signal to a potential buyer you're not going to pay a cheap price for this you know and um and anyway so so i i think they have sort of a magic touch but by and large most bankers most you know not all but most bankers do very little work on companies they give some signal value and you basically have an offer in hand from an acquirer uh and you know they happily collect their fee and give some advice and clean up you know some of the presentation stuff but if you talk to most venture guys not you know not just the cynical ones they will say bankers you know don't really matter that much and in this current market where between spax direct listing and ipos it used to really matter the quality of the bank that you had and so more instantly in goldman sachs and you know to extend maybe cs you know when they had strong technology it was a higher quality because they had a reputation of being more discriminating and discerning and then when you see them taking you know crap out you know i just don't think that the institutional buyers today uh to the extent that there are active ones remaining really care and to the extent that it's the passive ones or the large complexes you know fidelity and morgan's family tea road etc like you know they they know which companies they want to be holders and in some cases they've come in pre-ipo you know and got in an allocation that's really been a big change over the past 10 years i mean i'll give you like you know peel the onion back like where there's reciprocity and sort of the you know the secret inner workings of venture um we are constantly courting entrepreneurs and we're constantly doing right by our peers that are you know both competitors and collaborators and i always think that the game theoretic of the number of transactions that you have with somebody on a given year and the number of interactions is like inversely proportional to the morality you know turkish rug salesman you know if you're visiting istanbul and you know you go to the great bazaar or whatever it's going to screw you over because they're never going to see you again you buy a house you know you're a real estate broker you know they're typically not the most reputable honest people because the frequency the transaction is very low even though the magnitude of that transaction is very high i think in sort of game theoretic situations where you're interacting a lot with other prvcs like you screw somebody over or you get screwed over like that's it for a very long time and it ripples across you know the partnership so like i've been very defensive one of our partners got screwed over by somebody else in another firm it's sort of like i'm very quick to be like you're dead to me and so the ethics of how different firms treat each other i think is one thing so that's one layer just between gps adventure firms and we might compete somebody else might outbid us somebody else but typically you know there's an allocation game particularly in very hot deals where somebody might be raising i don't know 50 million dollars and we're coming in for 25 or 30 and there's 15 open and somebody's like hey we really like to invest in that and like if we can try our best effort to squeeze them in oftentimes it's best if it's the entrepreneur making the decision then you know we get a chip so this idea of chit trading is something that matters when it comes to like allocations and deal flow the entrepreneurs themselves then um think about every vc has limited partners and limited partners vary from like high net worth individuals to big wealth managers to large endowments and pensions and non-profits and charities and and we have you know migrated very significantly towards the foundations endowments charities philanthropies because there's some meaning when we invest those people's money we actually feel good when we're fighting for a basis point of allocation in a company our partners are reminded and we explain to the entrepreneurs we might be doing this for the cystic fibrosis foundation or a children's hospital and it feels good to know that those are the end owners but there are also money managers who you know on the first sign that a company looks like it's going to exit uh they've aggregated a bunch of high net worth clients you know into your fund uh and they're coming to the entrepreneur because they want the entrepreneur you know to be a a client themselves and so they might work at a big bank and they might say hey let me introduce you to the bankers um you know that run life sciences or healthcare or whatever and at the end of the day the board still will have to do a bake off between multiple banks but they end up being sort of value-add right let me give you the front line you know speed dial call to the head of banking for that group and so that's sort of valuable but when it comes to capitalizing the companies from round to round bankers involvement in any of those situations is almost always a negative signal you know if somebody's coming and showing us a deal because you know they're shopping it as a banker it's just it's a low quality deal usually it's directly from a board member that reaches out to another gp and says you know hey and then you're you're asking them honestly like is this one of your top three teams and if they're like oh yes this guy's amazing you know and then you're like no this is like not you know then you've lost all credibility um but like that whole ipo allocation game and i think that that's really been undermined in the past decade and and specifically now and we can talk about this too but the spac phenomenon which has you know horrible behavior and then some good virtues um when you do the pipe for the spec you're effectively getting to choose who you want your shares to be in the hands of and that's a market itself which you know i used to joke was like you know it was like the roth capitals and some of the lower tier banks and the places that you would go to go identify shorts you know usually if pitbull or snoop dogg were performing it was like a you know bell to be like okay like there's some companies here you know to look at right and so even a year and a half ago like if somebody was like yeah we're really interested in potentially taking one of your portfolio companies through us back we would have been like thanks so much you know enjoy the concert no you know you started to get some legitimate um sponsors that um added a little bit more prestige or sheen to it and so you know whether it was ackman or stern lake or you know people that would normally not be associated with shady practice um and then you had more promoter types like chimoff but um it it started to just sort of get interesting now the spec itself went from like these very high promotes to the sponsor to effectively what would be no promotes to the sponsor and i think the most natural evolution oh and then by the way the the main thrust and driver was you had all of these spac arbitrage people at a time when rates are low or you know virtually real rates negative that saw this as a cash alternative and many of them were borrowing from canadian banks at ten to one so they would put down i don't know 3 million borrow 30 go into the spac itself um get this cash yield uh if and when they found a target they uh would hold it and if it had some price momentum many times these participants in this pack had no idea what the company even did uh the start of this year 2021 january that started to change if you were a seller into a spec like us we have six companies that have been acquired by specs you don't want that spec mafia in as holders you know you want legitimate long-term traditionally long biased funds you want fidelity but more importantly you want tiger or co2 or d1 or viking or senator xn or bill miller uh you don't really want the arcs you know or baron or you know people that are just or bailey gifford you know more growth oriented less scrutinizing at you know less high signal than somebody else that you know might run along short book but but that was your opportunity to sort of control effectively who was getting allocations because you didn't go out randomly you basically said like let's go to these four or five long funds and so but what i think the next natural evolution is is you'll look at those same people and say wait a second if that's who we want on our cap table and those are the people whose shares of this company we want to put in their hands why not just do a pipe basically as a pre-private round as you've seen many of these guys do and then just do a direct listing it's the cleanest most honest you know you're not uh you know playing any funny games and and then i think that combined with the scrutiny that the main arbitrage between a classic ipo and the spac boom was the ability to give forward guidance and so you have these companies you know and i won't name them but that are putting out basically renderings you know like elon has done with tesla and renderings of financials and renderings of products and none of those things exist and so there was a call which i think was a good call that you know if you're gonna put out those renderings management and insider should be locked up you know for that same period of time that seems like a good you know alignment of interest and a way to reduce conflict so um i think all of that will shake out rightly and there will be abuses but the other thing that i think is also interesting is it's very hard to bet against some of these companies because of the amount of cash that has been delivered to their balance sheets and i i think there's like three phases to this the first phase is just like the boom and spax and again applying sturgeon's law ninety percent of these facts i call craps you know they're going to go to the 10 will survive and thrive and deserve it and some portion of those 10 percent don't deserve it but they will still thrive and survive some portion of those 90 will trade far below their cash value and you will see activists come in and basically say liquidate and so what the macro give the macro can take it away and i think should and so you'll see some liquidation of these facts which i think will be quite interesting and it'll shake people um but the the people who are able to get a lot of cash and still maintain a high multiple of the ones that survive i predict that there's going to be an m a frenzy and the mna frenzy will be catalyzed by that multiple arbitrage so if you take um you know a company that's trading at uh that despacked and is trading at 25 or 30 times multiple and whatever right revenue or profit today doesn't matter and they find a target they want to consolidate and that's trading at and they buy it for 15. when the incumbent competitor is trading at 10 or something and the boardroom of that incumbent competitor is like we can never buy these guys we need to buy something at eight or nine that's creative on the downstroke and you know one time they seem disciplined two or three times where they miss a target to a higher multiple competitor they say wait a second like this could be existential like there's a lot of advantage that's accruing here we need to do something about it and then they lacks in their discipline and they lower their standards and they do bad acquisition and i think you'll see a bunch of people do these kinds of things they'll be in m a frenzy is my prediction for sort of the next wave of how this all shakes out and that will reach peak fever pitch culminate in like a january 6 2000 you know going back 20 years 21 years uh aol time warner like merger where high flying high multiple reasonably high growth but unprofitable business buys a declining secular but still cash flow positive business and um and that'll ring the bell and who that is or you know i've i have no idea but um but but that i think is sort of the way that this whole market evolves you

Channel: Real Vision Finance

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Keywords: Finance, Markets, Economy, Stock Market, Investing, Trading, Education, Financial Literacy, Recession, Interview, Conversation, Strategy, Insight, Analysis, Facts, Data, Fraud, Entertainment, Thesis, Short Seller, Real Vision, Equities, Short selling, Carson Block, Zeroes, Zeros, Frauds, Fakes, Fraudulent Companies, Shorting, Stocks, Learn How To Short, Josh Wolfe, Venture Capital, VCs, Misvalued Stocks, Overvalued Stocks, Short sale, to short a stock

Id: Afet6VPaa7A

Length: 34min 51sec (2091 seconds)

Published: Fri May 07 2021