A few highlights from Zack Schildhorn:
On the current market: "It's an ebullient time with plenty of cash in the ecosystem, rising valuations and – importantly – a huge wave of liquidity."
On the future: "It feels like a gold rush mentality amongst investors right now, who are willing to fund pretty much anything that moves. What matters is how long that lasts, and it certainly can't last forever."
On Lux's strategy: "Our preference is to invest in areas where we can maintain some price discipline. This means pursuing ideas that may be unpopular or outside others' domains or, in some cases, ideating and funding companies at inception."
On the proliferation of venture capital: "It's not just a great time to be an entrepreneur, but a great time to be a new GP, in that you're seeing thousands of new firms get started with individual partners from larger organizations branching off on their own or angel investors starting to institutionalize."
Does the data you have seen from Cooley's report reflect your experience at Lux in Q1?
Yes, aside from a small pullback in total number of deals and total dollars, which may be reflective of the public market correction we saw in Q4, everything is up and to the right. In effect, 90-something percent of rounds are up rounds, with incredibly favorable terms for companies across the board. But at some point, this breaks down. If we know that up to 90% of startups fail, it doesn't make sense that 90% of companies continue to be able to raise money at increasing valuations.
Do you make anything of the pre-money valuation decline (it was slight in my view)?
It's hard to say if that's noise or signal. If you look at the time frame and scale of that data, it's likely insignificant. It could be some small correlation to stage of deals reviewed or skewed by one mega deal getting done or not in a particular time period.
Do you see this continuing through 2019? Do you expect anything different?
I think so. There's always the risk of some exogenous shock to the system. One could also imagine a situation where a high-flying public tech company suddenly faces a liquidity or fraud situation and starts to resemble Icarus more than a unicorn. I think that could be a big yellow flag for the ecosystem and start to cause a correction.
Of course, all sorts of macroeconomic factors could play a role, but short of a war, it's hard to pick that catalyst. Politically, we shouldn't expect any major changes this year, and it looks like we're going to have to wait for a new election. There's no major change to interest rates expected, and generally, dollars keep flowing into market index funds. I don't see anything on the immediate horizon that will cause a change, but that doesn't mean there won't be one, right? If you could predict the future, then we'd all have a much easier job! But you never know what's going to happen, and I don't see anything that would lead me to believe that 2019 is going to be any different. It's an ebullient time with plenty of cash in the ecosystem, rising valuations and – importantly – a huge wave of liquidity. It feels like a gold rush mentality amongst investors right now, who are willing to fund pretty much anything that moves. What matters is how long that lasts, and it certainly can't last forever. I don't know when it will change, and I don't know exactly how it will change, but it will change.
I know that Lux invests in early-stage companies, but do you have any opinion about trends in early-stage deals versus later-stage deals?
There's a belief that's been promulgated throughout our industry that there are only a few companies that actually matter, and so long as you're in those companies, whatever price you pay doesn't really matter. It may be true that there are just a few companies, but of course picking those companies is the hard part. Price does matter, because across a portfolio, if your price is averaging up, your expected returns will average down. What we've seen as a result of this notion is escalating prices across the board and a lack of price discipline, which is dangerous. At the early stages, you've seen behavior where many, many ideas get funded with the hope of those early-stage ventures becoming one of those chosen companies. We refer to these different strategies as "spray and pray" and "wait and pay," and we intentionally try to avoid both.
Our preference is to invest in areas where we can maintain some price discipline. This means pursuing ideas that may be unpopular or outside others' domains or, in some cases, ideating and funding companies at inception. From Lux's beginnings, our goal has been to invest in companies at the boundaries of what's possible. Oftentimes that leads us to areas that aren't as popular amongst other investors, where there's less supply of capital and, as a result, lower prices. We also pursue special situations, whether these be secondary opportunities, recaps or taking companies private. These days we're starting quite a few companies from scratch to secure early ownership and ball control.
Do you see any changes in Lux's sector preference as you look to the future?
Not for Lux. We've stayed true to focusing on the outermost edges of what's possible – ideas that many may feel are impossible, but we know to be inevitable. We're very much focused on technology companies at this frontier, and we're going to stick to that.
We have seen other investors also start to pay attention to these sectors, which means we need to stay aggressive and competitive and, in some cases, change tactics.
There's a specific example of a company, the name of which I'll keep confidential, that's emblematic of this reality. The company is in the medtech space, with some very talented founders and a big idea we wanted to back. It was still very early stage, with important proof of concept work still incomplete, and the company wanted to raise a large round. We were OK with that, but wanted to tranche the financing subject to technical milestones. Another investor was willing to do the whole round at once. Despite this investor having some well-known reputational risk, the founders wanted to take more money upfront. This is a reflection of today's environment; investors are willing to put a lot of dollars behind anything that they think could become an important company, sometimes without taking into account all of the risk that comes along with those decisions.
I want to open it up to you on any other trends you want to discuss.
It's not just a great time to be an entrepreneur, but a great time to be a new GP in that you're seeing thousands of new firms get started with individual partners from larger organizations branching off on their own. Entrepreneurs are forming funds, and you have thousands of these sub $50 – $100 million dollar funds that are forming and raising capital. The venture landscape is like the "minnows and the megas." All of these smaller funds are the minnows. At the opposite end are the SoftBanks and the Sequoias of the world, raising billions of dollars to fund later-stage businesses and make sure that they can continue to fund companies throughout their life cycles. LPs are supportive and are continuing to pour money into the sector. Of course, the higher supply of capital, the lower the expected returns, and at some point this cycle breaks down. But as we know, venture is a long time frame business and funds are measured over many years, so it will take time for that capital to flush through the system. It will be interesting to see if there is a correction – or, rather, when there is a correction – how that plays out with all of the latent capital that's been and is being raised. The data here on companies and deals is a lagging indicator – the leading indicator, of course, is funds getting formed and raising capital.
About Zack Schildhorn
Zack partners with entrepreneurs who use science and technology to erase the lines that divide the digital and physical worlds. Zack led the firm's investment in Latch, Shapeways, SOLS Systems, Moment and Scatter; he sourced Lux's investment in Matterport, and he has also worked with Auris, Transphorm and Kurion.
Prior to joining Lux, Zack worked as an expedition photographer on the Colorado plateau. He created his own curriculum at Cornell University, which combined materials science and entrepreneurship. He graduated in five years with a BS in engineering and an MBA. He is a contributing editor at Forbes and has been a guest speaker at Cornell University, Drexel University, New York University and the University of Pennsylvania.
About Lux Capital
Lux Capital is based in New York City and Silicon Valley, with $1.4 billion assets under management.
Lux invests in seed and early-stage ventures across multiple sectors, including 3D printing, machine learning, artificial intelligence, flying robots, surgical robots, synthetic biology, genomics, satellites, space, drones, computational imaging and recognition, new materials, holograms, "fixers" for the future, the internet of things, connected hardware, the smart home and virtual reality.
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