Seed Investing Macrotrends: An Interview with Kelli Fontaine from Cendana Capital

By Steve Gotz, Silicon Foundry

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Recently, Silicon Foundry had the opportunity to sit down for a conversation with Kelli Fontaine from Cendana Capital, a $1B AUM fund-of-funds that exclusively focuses on investing in Pre-seed and Seed VC funds. Kelli spoke about the evolving nature of Seed investing and the various implications of the monumental shifts that are underway in Silicon Valley.

Cendana isn’t a household name, but its portfolio is impressive. It contains 1400 companies, which includes 38 unicorns and 150 companies valued at $100M or more. To put that into context, Y Combinator, which has been around for five more years has well over 2000+ companies, but only 21 unicorns and 102 companies valued at $100M or more.

Cendana’s fund managers (25 in total) operate at the bleeding edge of innovation across a variety of investment areas so they see what’s coming around the corner better than most. This is why we thought it might be interesting to have a conversation about the trends Cendana is seeing across the portfolio.

Below is a transcript of our full interview, with light edits for length and readability. If you don’t have time to read the whole interview, here are a few interesting takeaways:

Many managers are encouraging their startups to build outside of the Valley.

It won’t come as a surprise to anyone that Silicon Valley is an expensive place to build a startup, and while the region’s unique amalgamation of risk capital, entrepreneurial vigor and technical talent made it a seductive destination for the longest time, it appears to have reached a tipping point. Many of Cendana’s managers are now actively encouraging their companies to think about growth and expansion in places other than Silicon Valley for reasons discussed below.

Entrepreneurial apprenticeships with great Seed managers are in vogue.

During a Silicon Foundry dinner last year, Amir Mortazavi (CEO & Co-founder of Canopy) observed that “entrepreneurs are artists” in every sense of the definition. When you read biographies of history’s greatest artists, you often find that many of them credit much of their success to the mentorship they received from masters during intense apprenticeships. Entrepreneurship is no different. It’s quite difficult to learn to be a great entrepreneur during an eight-week accelerator program. It is possible though to learn to be a great entrepreneur by working with a hands-on Seed manager who has mastered the craft over an extended period. Cendana’s performance seems to support the assertion that a more engaged and hands-on Seed manager materially increases the chances of entrepreneurial success.

‘Regional platforms’ have the potential to catalyze new entrepreneurial clusters.

The implications of the shift out of Silicon Valley are potentially profound, especially for regional and state governments that are now in a position to think creatively about how they might be able to leverage local resources and capabilities to position themselves as attractive ‘regional platforms’ for the next generation of startups. The most forward-thinking regions such as Michigan and Arizona are starting to learn the lessons of Silicon Valley and are actively exploring how they can create ‘regional platforms’ that provide startups with accelerated access to data, infrastructure and resources. We expect this is something we’ll be talking more about in the coming years. In the meantime, we hope you enjoy reading the conversation.

Interview Transcript: Kelli Fontaine (Cendana Capital) <> Steve Gotz (Silicon Foundry)

Steve: Thanks for agreeing to sit down to discuss what you’re seeing among your managers, but first some scene setting. My understanding is you exclusively focus on investing in Seed funds, is that correct?

Kelli: Yes, we are Pre-seed and Seed only, so we don’t touch Series A and beyond. The thesis has always been that two things have happened in venture. It became much cheaper to start a company because you don’t have to buy servers and infrastructure. At the same time, all of the good funds started to raise much larger funds, which created a greater opportunity at the Seed stage.

Steve: When did you start deploying capital and do you have a regional focus?

Kelli: Cendana started fund raising in 2010, and our first vintage was from 2012. A big part of our thesis is that ecosystems matter. Obviously, you need entrepreneurs, plentiful co-investors in the region and most importantly access to follow-on capital. Honestly, follow-on capital is often the most difficult to find in an ecosystem. Traditionally, we have invested in new fund managers in San Francisco, New York, Boston and Los Angeles. Last year, we started investing out of the United States because we think there are more mature ecosystems coming online with their own follow-on capital.

Steve: Cendana has been around for a decade and I’ve heard you mention that when you started, Seed rounds were averaging $500K but today they’re closer to $3–4M. What do you think has driven that shift?

Kelli: Multiple things. Number one, it costs more in San Francisco to live and to recruit. If you’re trying to hire talent in the Bay Area you’re competing against Facebook, Salesforce, Apple and their extensive compensation packages. The other thing that’s happening is startups are much more mature when they’re raising Seed funding. Let’s say that an average Series A round is $12M. That means during the Seed round you have to be able to grow into the enterprise value where you can actually demand a $12M round. When our managers are looking at Seed deals today, they’re finding companies with $500K to $1M of ARR, which used to be the metrics required for a Series A.

A Pre-seed round today is what people probably think of as Seed: two people and a PowerPoint, no product and no customers. Currently, these rounds average $500K to $1M. It’s pretty amazing to think that today’s Seed companies have products, revenue and customers to diligence. At the same time, Series A rounds have increased in size. Across our portfolio the median A-round is $12M, whereas five years ago it was $5-$8M. Over ten years, the average amount raised doubled, which means the companies have to be that much farther along.

Steve: My understanding is that Cendana is also somewhat unique in preferring single GP structures. Why is that?

Kelli: Yes, we are unique in that many LPs avoid single GPs for a variety of reasons, but we don’t. Most of our Pre-seed managers are single GPs. We also have a few Seed managers who are single GPs, but they usually have teams around them. Team risk is the number one concern in startups and in venture firms. Solo GPs don’t have team risk. People worry that solo GPs will be in their own echo chamber, but we mitigate that by working closely with our managers.

Steve: It sounds like your Pre-seed and Seed managers are really hands-on with their portfolio companies.

Kelli: Absolutely, they’re very hands-on. One of our Pre-seed managers calls himself a “founder coach.” He’s really hands-on to the point of sharing an office with his companies and white-boarding at minimum one day a week with them. It’s admirable because he really takes it seriously; he’s there to help set the path of the company. Most of our managers (Pre-seed & Seed) will only do one deal per quarter because they’re so involved with their companies, and it’s really difficult to scale your bandwidth or time. Our managers tend to roll off the board at Series A and let the next VC come in and take over, though there are some companies where they stay involved longer.

This is an important quality we look for. When we were doing diligence on Kirsten Green at Forerunner Ventures, we spoke with the founder of Warby Parker who observed she was his first call for everything; it didn’t matter if it was 5:00 a.m. or midnight. He referred to her as the most helpful early investor, even though she wrote him the smallest check. Clearly our managers are super involved, but there’s also some variety in styles that is often tied to their skillset. However, across the board, the one common theme is they all love building companies with founders.

Steve: It almost seems like we’re witnessing a return to what venture was 30 or 40 years ago, when VCs viewed their job as less financial engineering and more working hands-on with visionary founders to solve really hard problems. Not to say that financial engineering is bad, but it certainly seems like there is a balance that we may have lost over the past decade.

Kelli: Board members contribute different things at later stages than they do at the early stages. Many of the startups our managers invest in are run by people who typically haven’t founded companies before, so they need all sorts of advice and support to build out a team, shape company culture and find product-market fit. That’s something many of these entrepreneurs have never done before, so having a wise mentor who can walk them through this process is often times one of the biggest factors that separates success from failure.

Steve: Have you seen any of the mega funds that have been able to go early-stage with their vehicles?

Kelli: Sure, there are larger funds that have developed Seed programs. The issue is the million-dollar check doesn’t mean anything to their funds. So they can easily write lots of small “option checks” into Seed-stage companies. Unfortunately, what many young entrepreneurs don’t realize is that it can end up killing the company because if the fund that wrote your Seed check decides not to lead your Series A, then often times other investors wonder why should we? So, it leads to significant signaling issues. Many entrepreneurs think “Well, that’s not going to happen to me. I want this money,” but it does happen. We have it in our portfolio right now, a large fund has decided not to lead the A, so all the investors are saying “If this fund isn’t leading why should we.”

With that said, we do see the larger funds being vocal about spending time and doing Seed-sized checks, and their pitch is very compelling. They have lots of capital, market development programs and sizable resources. However, the thing they don’t have lots of is time. Even if they do a big Seed round of $5M and they commit to spending as much time as needed, they’re certainly not going to be spending as much time as they are with a $20M check and a company on a different trajectory.

We really think it’s a different skill set for our managers — people who absolutely love rolling up their sleeves and building companies. Your fund size dictates your fund strategy, meaning it’s really hard to do early stage, write million-dollar checks and be super helpful out of $1B fund, $700M fund or $500M fund. But like I said earlier, we are seeing the big funds playing in the Seed area with a variety of strategies particularly over the last year, so it will be interesting to see how this plays out.

Right now, we’re hearing things like “Hey, we’re three guys from Uber and we got $5M committed to us in one week.” Our concern is that these are not necessarily proven founders, but because they come out of unicorns they’re able to command substantial sums. We have to fast forward that movie three to five years to see how it plays out. The last few years in Silicon Valley has provided us with ample examples of what happens when you don’t provide first-time founders with the right kinds of support and mentorship. We believe Seed managers are the backbone of Silicon Valley. These are people that have been founders. They have been in the trenches and know how to deal with the trials and tribulations of startup life, and that’s hard to scale.

Steve: How long does that kind of reckoning take?

Kelli: At the end of the day, I think we’re witnessing a SoftBank-effect at the early stages. SoftBank has proven that you cannot throw capital at a problem and scale. Entrepreneurship is really a process of discovery. When you start a company, you have an idea and you try something. Although it may not work along the way, you discover new information so you try again. It’s about pulling all the threads and seeing which way to go. This isn’t a magical process. But if you throw capital at it and keep doubling down on the thing that wasn’t working, you never have the discoveries that you should be having which is when things start going sideways. I feel like SoftBank has provided a great learning to us, namely you can’t give a company a war chest and expect they will succeed. Giving people too much capital at the early stages doesn’t allow them to figure out which direction the company should actually go. So if you fast forward, the same lessons from SoftBank will be learned by the mega funds around their early stage activities.

I don’t know how long this will take, but there are a lot of prudent founders out there who know they have to grow into their valuations, and rushing it isn’t necessarily a good thing. In the middle of all of this, we’re delighted to see that our managers are still capable of winning really good deals.

Steve: If we step back a bit and talk about the early stage dynamics, we’re seeing an explosion of venture studios and company builders. It seems like there are some parallels with your Seed investment thesis. Do you have any thoughts on that?

Kelli: So I can compare our ecosystem to Y Combinator and some of the other accelerators. We don’t invest in accelerators, incubators or studios. We think there’s some adverse selection there. Our portfolio contains 1400 companies. Again, we started our first ones in 2012, so we’ve reached that number in eight years. Over that time, our managers have backed 38 unicorns, and we have over 150 companies valued at $100M or more. Contrast that with Y Combinator that has well over 2000+ companies and has been around since 2005 (five more years of portfolio maturity). Last time I checked, they have 21 unicorns and 102 companies valued at $100M or more.

When you look at the stats, it’s hard to argue that percentage wise our managers are much better pickers. Don’t get me wrong, Y Combinator’s done an amazing job. They provide great support for companies, but our portfolio shows higher success rates which is largely driven by the unique qualities of our managers and their willingness to jump in and help an entrepreneur learn as they’re building.

There are interesting aspects of studios, but we haven’t done any yet. There are great examples of what can happen when you get the right people in the room and the right mindset and you can come up with some really great ideas. But that high ownership upfront can really hurt a company’s trajectory.

Steve: As you’re talking about how your managers operate, it sounds very much like an entrepreneurial apprenticeship. Most founders will admit that it’s really hard to learn to be an entrepreneur. You make a lot of mistakes, independent of having somebody who’s been down that path several times and can smooth out or accelerate the learning curve. It doesn’t seem that you get that, at least in the same way, from many of the accelerators.

Kelli: I think you’re right. But it also depends on the entrepreneur and their experience level. We have experienced CEOs who have told me they could have gotten better valuations elsewhere, but they took deals from our managers because they really wanted to work with them. It seems obvious to say but quality matters. I was recently doing a due diligence call with an older entrepreneur about his experiences working with a manager, and he observed that he didn’t need as much of the day-to-day handholding from his Seed investor, but he really valued his investor as a thought partner. For him, a great investor is as much about network as it is the person’s ability to support him though the inevitable ups and downs of the entrepreneurial journey. That pretty well encapsulates it for me. Our managers are very good at knowing who they want to work with and are relentless at going out there and finding the right matches.

Steve: Fantastic. I have one thing I wanted to come back to. You mentioned you are thinking of expanding the mandate outside of the U.S. You also mentioned that the costs to build and recruit in San Francisco are prohibitive right now. I’m curious, are your managers becoming more open to working with companies from outside of the Bay Area?

Kelli: Absolutely. Two years ago, our managers were talking to their portfolio companies about how to recruit in the Bay Area. Now the conversation has completely shifted. They’re not talking about building teams in San Francisco, they are talking about how to build teams remotely. One of our managers said it’s suicide to think about building a company exclusively in the Bay Area. It’s not in their term sheets, but they will not allow their companies to build out entirely in the Bay area. It’s a 180-degree shift.

Personally, I think capital and executives will always be located in Silicon Valley, but teams can be elsewhere, in places that are more conducive to the task at hand. I like the way one of our managers puts it, “In the not-too-distant future, startups will be generated in much the same way as Hollywood movies are generated. The U.S. film industry produces from Los Angeles, but in reality, movies are filmed all over the world.” In the case of startups, they’ll be produced in San Francisco, but all the heavy lifting will happen in specialized places around the world where you have unique communities of specialized talent and resources.

Fast forward three to five years and there are concentrated pockets of talent distributed across the globe that can start companies in a more efficient and hopefully sustainable manner. I don’t think there’s any question that this is going to give rise to more regional tech hubs.

Steve: Sounds like Silicon Valley is coming to Main Street…exciting times. Thanks Kelli!

Kelli: My pleasure.

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Silicon Foundry is an innovation advisory platform that builds bridges between leading multi-national corporations and global startup ecosystems.

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