Should I Raise VC Money? With Investor Jensen Warnock

Podcast Transcript 

Bart: Thanks for joining us today, Jensen. 

Jensen: Absolutely. Thanks for having me. 

Bart: Built to Stay, as you know, is all about creating businesses that will outlast the competition and be in it for the long haul. As an investor, I’m sure you’ve had a variety of businesses come through your doors. But before we get to talking about all of that, Jensen can you just give us a little background? How did you get into investing? You know, what’s your story? 

Jensen: Yeah, absolutely.  I actually started out in computer science. That was my degree at university. And after that, I went down to Texas to work at a large tech firm. I wanted to sort of see how one worked, see the ins and outs of you know recruiting at scale and career management, those types of things. And it was a great experience. I learned what I wanted to learn and some of those things were I thought they did a fantastic job about creating a company culture and capturing knowledge and passing that on to new employees. But the other thing that I learned, probably the most important thing for my career, is that I don’t make a great employee.

I actually . . . The politics and that side of things didn’t go well. With me, I needed to be able to write my own destiny. So that career path was relatively short-lived.

And 

Bart: you had an idea of that before you even went down it sounds like.

Jensen: Yeah, entrepreneurship was always in the back of my mind.

It’s always something I wanted to do. I grew up in a household that was very entrepreneurial, and my father had started a variety of companies and done investing. And so I had lived in that world and seeing that world and had been relatively brainwashed in that world. And so the idea of going down to Texas was just to get a sense for what a larger tech company runs like so that I could better prepare myself to do my own thing.

Bart: That makes a lot of sense.

Jensen: So then when I came back, I decided I didn’t want to have a job with anybody and actually did some freelance development while I was trying to figure out what the next game plan was. And while I was going through that timeframe, one of the things that I realized from that is that it was important to try to separate your time from your money, the money that you’re making. But you’re not working for an hourly wage.

Bart: So the freelance development you didn’t like that kind of hourly wage aspect.

Jensen: Right. That’s  sort of caps out what your ability is to make money and also restrains you to have to always be at your desk when you’re making money. You always have to be working on that thing. You can never make money while you’re sleeping unless you dream and code and something crazy is going on.

So I didn’t see that as a long-term alternative and then came across an opportunity. Actually, my dad forwarded me an article on a new financing concept called revenue-based financing. Yeah, and that intrigued me and I learned that there was a conference of angel investors that was being held back down in Austin, which is where I lived.

And so I went down there and learned everything I could about revenue- based financing and decided that I was going to work on starting a revenue-based financing fund, and my brother got excited about it. And so we sort of joined forces and found a couple companies that were interested in doing revenue-based financing and then found a couple people that I had met that were doing revenue-based financing and tried to syndicate some deals to see how the diligence worked and how the dynamics were different from early stage investing that we had done in the past. We learned a little bit about that and then ended up doing another, you know, eight or nine deals over the next few years, and it was a lot of fun.

We were raising capital from a small network of high net worth individuals and just deploying that capital in these revenue-based financing loans, which it’s just an alternative financing structure. Instead of having a loan where you’re paying back the same monthly payment each month, you’re giving the company a loan, and they’re paying you back a percentage of the money they made that month. 

So it’s flexible for a startup and an earlier company. If they made more one month, they can make a bigger payment. If they made less, they’re not required to make a big payment that would eat up all of their cash reserves for growth or something like that. So it was an interesting new model, and one of the things that I learned there is that the structuring of a deal can make all of the difference. Like it from a company side or from an investor side, how you structure the financing can do wonders. It can change everything, make it better for the company, better for the investor, downside risk, all of that.

So it was a really interesting model and I enjoyed my time doing it. 

Bart: But it sounds like it was short-lived. 

Jensen: Yeah, there were some competitors that came into the space. We probably did it for four or five years. And at first, the returns were really attractive for the risk profile of the investment. And after a while, the returns sort of started to normalize towards a more consistent risk/reward profile.

And so we decided to go back to the equity investing side of things so that it was something we knew a little bit more. And since the returns were diminishing in the revenue-based financing side, we decided to go back to the equity world. And the next thing that we did was pulled together again some investors money and made sort of a small micro VC and did a few investments through that really early stage. And what we learned from those first few investments was that the equity investing can take a really long time.

Yeah, I mean that was years ago, and we’re still holding those Investments.

Bart: Especially really early stage. 

Jensen: Yeah. 

Bart: It takes a while to grow a company. 

Jensen: Longer than you would ever imagine turns out. You know, I was anticipating or thinking in my head for five years and here we are probably seven or eight years later, and there’s no end in sight.

They’re just interesting but they’re fantastic companies. It just takes longer than you imagine when you’re making those investments. After that, some of the partners that we were working with on those early stage deals had come to us and said that they had done an analysis of their investing history, and they really liked the performance.

They were seeing in a type of investing called secondaries and suggested maybe we work together to do some secondary investments. If we see some, we will let them join our deals. And if they see some, they’ll let us join some. 

Bart: And can you explain what those are? 

Jensen: Yeah. So a secondary investment is you can think of it sort of like the stock market where in the stock market people are buying and selling shares and none of that money is ever going to the company. Once they’ve had their initial public offering, they’ve raised their capital, and now people are trading those shares based on what they think the company is worth right now.

That’s a secondary market. So traditional VC and privately held companies, private equity, is money that the investors are giving to a company, and that money is going on the balance sheet. The company has been able to use it for growth capital.

Bart: But that’s not what this was. 

Jensen: No. In secondaries, what we’re doing is we’re going to early investors, departed co-founders, maybe current CEOs and co-founders who are building this huge asset, and they have maybe a large net worth but it’s all tied into one company.

 And they might be having net worth on paper, but they actually have no liquid cash in their life at the moment. And so they might want to take some off the table or an early investor might have invested like we said, you know, five, seven years ago and the company has grown exponentially in that timeframe. But there’s still another five-year hold, and they would like to get some of that capital back out. So they might be looking for someone to buy. But since these are all privately held companies, there’s no liquid market place like the stock market facilitates for publicly traded companies that allows them to sell those shares. So they have to go find an accredited investor who’s willing to buy those shares,and that’s the niche that we fill. We are a fund that’s dedicated to providing liquidity for these shareholders of privately held companies.

Bart: So let’s say I start a company with a friend. We’re a few years in. I kind of want to cash out at least some of my stock. My friend doesn’t. There’s not like an acquisition or something that we want to do, and so I come to you and I say, “Hey, are you guys interested in buying some of my stock?”

Jensen: Yeah. So we’ll talk about it, we’ll negotiate a price, and then we’ll give you the cash. You’ll write over the shares to us on your cap table and then we’ll wait it out till the end. 

Bart: Very cool. And are you still doing those secondary investments? 

Jensen: We are still doing it. So if you know of anybody who’s had a great high- growth company and wants to sell some shares, please reach out.

Bart: Alright, you heard that builders. So let’s go back to your story. So is that the main thing you’re doing now or is there more? 

Jensen: Yeah, so I spend a good part of my time focused on those secondary transactions, finding those opportunities and working through the mechanics of those investments.

And then I also spend some time consulting with Mercado Partners. They are a growth-stage fund. So I’ve sort of been involved in investing in many different aspects. I mean we’ve done debt with revenue-based financing, done seed-stage very early. We’ve done the secondary transactions, and then I’m also working with Mercado on sort of growth stage, so companies that are ten plus million in revenue, maybe five million. If you’re a SAS company and high growth, we will provide growth capital to pour some fuel on the fire so that you can grow through to a harvest 

Bart: Very cool. So I want get back to our builders. It sounds like you have a lot of great perspective; you’ve done a lot of different types of equity investment.

In what situation should our builders consider equity investment as opposed to financing or as opposed to not raising any investment? 

Jensen: Yeah, that’s a great question, and it’s becoming more and more possible to grow a legitimate full-scale business without financing. The efficiencies that are available to entrepreneurs today are unprecedented.

So it’s a question that I think everybody should be asking. I’m glad you asked it to me. The best time to raise capital is when you’re aligned with an equity investor, and the only time really that I see you’re aligned perfectly with an equity investor is once everything in the company is figured out and dialed, and you’re just trying to scale it to an acquisition or an IPO.

That’s the time frame when everything really makes sense because as soon as you take money from an equity investor, you’re answering to another master.  And you’ve started a time clock. And in order for the investor to be happy with his investment and be pleased and get a return for his limited partners . . . Because he’s that venture capitalist, he or she is also answering to limited partners that they have raised capital from, right?

They’re collecting this big pool of capital, and there’s a mandate and requirement for them to invest that capital–

Bart:And a time period.

Jensen: –and a time period. They’re usually like a 10-year fund. So there’s a time period for them to get that money back to those limited partners that they’ve made, you know, some promises to and who were making a bet on them.

So making sure that once you take that capital, you understand that you’re in high-growth mode towards some sort of activity or harvest or event where you can get that capital back to them. That’s the most important thing to understand, that dynamic that’s at play.

 So growth stage, marching towards some harvest event, that’s an ideal time, and you not only get the capital you need to grow through that high growth phase but you also are then aligning yourself with an individual that has hopefully had a lot of experience with that acquisition side of the table 

You as an entrepreneur, this may be your first or second or maybe even third company that you’ve worked on, and you might have had some experience in selling or taking a company public, but the VCs likely have had many more experiences. 

Bart: That’s what they do. 

Jensen: That’s all they do. Yeah. Every company that they invest in is going to end somehow.

Bart: Yeah. They have to get their money back. 

Jensen:] Yeah, so taking capital from someone at that stage makes a lot of sense. Everything’s aligned and you’re bringing some expertise for the next stage, that stage specific expertise for your company that will really help get you the best return possible, which is exactly what they’re interested in.

I also think that it makes sense to take equity early on or while you’re growing. And you might not have everything figured out if it’s the last alternative. There’s a lot of different capital needs out there. But if you see an opportunity that requires capital that’s beyond your ability to raise it through debt or friends or capitalize it yourself or bootstrap, if you really need to capture this opportunity, then raising equity makes sense there.

 Also, you might not be perfectly aligned. There might be times that you butt heads with your investor . . . like they’re coming up on the end of their fund life and need to get their capital back out, or you had to pivot the business a little bit and it’s not exactly what they signed up for originally.

But it’s still better than the alternative which is absolutely missing the opportunity. 

Bart: Yeah, doing nothing. Interesting. So, it sounds like when you say growth stage, where you’ve kind of figured things out, does that mean your product is perfect? Does that mean you just figured out the business model, but you’re continuing to kind of build the plane while you’re in flight? What exactly does that mean? 

Jensen: Yeah, so I would say you created a transaction where you’re providing a service or a product. Someone is paying you money, and everybody on that transaction is happy and they would be willing to refer their friends.

Everybody believes they’re receiving more value than they gave. Right? So you’ve nailed that sort of fit, and then your company is also at a point where you would like to start building for an exit. So some of that might be you as a builder or a CEO. It may be that you figured out the product market fit, but there’s a couple other things you want to do with your business or company that you still want to work through, other pieces that you want to plug on. Or maybe you just really like what you’re doing, and you don’t want to be put on a time clock yet. 

Bart: You have a long-term vision. 

Jensen: Maybe you want to grow this company for another 10 years. You really are enjoying what you’re doing.

And if you bring on an investor who has six years left in their fund your artificially putting a time clock on that when you don’t necessarily feel as though you’re ready to start marching towards some sort of an end goal. 

Bart: Is there any way to get out of that if you have taken on investment and you realize, hang on, I actually want this to be long term.

Jensen: You can call a secondary buyer. No, I mean there are ways to work through it. There are typically conditions and clauses in a VC’s agreement with their limited partners where they can extend the fund for a year or two. They also are thinking about these things, so they might go try to sell on a secondary market, or they might try to recapitalize the company through debt or something else.

There are creative mechanisms that you can use, but it’s definitely not easy or straightforward. There’s always going to be tough conversations when you get to that point. 

Bart: Yeah, this is interesting because we had an earlier episode with someone from National Business Capital and Services, Joe Camberato.

He talked about with financing a business on the kind of loan alternative types of debt side, they really look for growth. Like, you know, you’ve kind of figure things out, and you’re ready to grow. And you’re saying the same thing: that really the best time to raise capital, whether it’s equity investment or whether it’s financing, is when you’ve kind of figured things out.

So a lot of it has to be done ideally. A lot of that figuring things out needs to be done on your own time, your own money, and the most efficient use of capital, whether from equity investment or debt financing, is when you’ve already done that kind of exploration and kind of figuring things out and you’re ready to just scale it.

Is that consistent with what you’re thinking? 

Jensen: I think that that is true when you say it’s the most efficient use of capital. 

Bart: But it’s not the only situation. 

Jensen: Yeah, it’s not the only situation. It’s most efficient, if you think about it, because everybody, every dollar that’s being spent is growing towards something bigger for everybody. Right? 

Bart:Yeah.

Jensen: If you think about experimentation and early on when the company still might be pivoting and trying to find the right product, you might spend a million dollars headed down one direction only to realize that that direction is not going to work for anybody and then you have to raise the same million dollars to finance that first step again in a new direction.

And so that first million that you brought on, those investors are going to see a delayed time period and the progress that wasn’t made during their time frame. And you as a founder also got diluted with an equity investment in a direction that nothing happened. So those dollars were sort of wasted.

That’s why it’s less efficient. And that’s why you start to see head-butting because it diluted the returns for everybody. Once you put that capital to work and you’re marching in a direction that ends up not being the direction you end up doing, you might learn some stuff, you might be able to be more efficient in your pivot and being able to dress that final solution more effectively than you could have if you started in that direction originally. But it’s still a waste of some level of capital where everybody got diluted, and everybody’s returns were eroded a little bit. So the more you can figure out with less capital the better off everybody is.

Bart: And the bigger the opportunity in the long run the more willing people might be to burn a little capital upfront. 

Jensen: True 

Bart: Interesting.

So, if you were going to raise money Jensen, what are some of the things that you’ve learned as an investor that our builders should be thinking about or might not know because they haven’t been on that investor side?

Jensen: You know, one of the things that I’ve talked with entrepreneurs about and builders about is that the fund size determines a lot. And they don’t think about that very much.

But if you go and you’re raising capital from a fund that’s a 50-million- dollar fund that’s got a couple directors, they might say that they’re a seed-stage fund or a Series A fund or something like that. They might invest in companies. They might say, “We invest a million dollars into companies, and we look for companies that are just starting to produce revenue,” or something like that. 

Bart: Yeah 

Jensen: And then if you go . . . but that might be the high end of what they invest. Their biggest check size might be a million dollars for an initial investment or two million dollars or something like that.

And then you go talk to a fund that’s 150 million dollars, and they might say, “We also are able to write checks that are one to two million dollars, but that’s sort of the smallest check that we can write.”

If the same company goes and talks to both of those investors and they’re both interested, the dynamics of the funds themselves are going to influence the conversation around evaluation, for example. 

So the smaller fund, it has to deploy so much capital, and it has to have so many investments in its portfolio to be diversified. But it’s also limited by the amount of employees, the amount of members of that fund that are available to sit on board seats or manage deals, right?

And so that determines an artificial number of companies that need to come in and check sizes that need to be written. And those check sizes, and their ability to do follow on capital or whatever it is, will determine what sort of percentage of each company they’re looking to do in those first investments.

And if you’re at a larger firm, they might be saying, “Well, we can do 20 deals in 150 million dollars, and so we need to deploy so much into each company.” So that’s why they have a minimum check size of one to two million, and they’re going to want to deploy that capital and then put more Capital into that business along the way. And they can’t take a majority stake in those companies.

Bart: Right.

Jensen: Venture capitalists need to have, you know, a sort of a 15 to 25% stake to make everything work right . . . and so . . . because the fund is larger. But they can only manage so many companies. They have to put more cash into each company. And putting more cash into each company and having sort of a target about how much they want to own in each company artificially inflates the value of that company. So it doesn’t happen in every circumstance, and everybody’s trying to approach these things objectively. But in reality, it’s small things like that that are influencing a valuation of a company.

That has nothing to do with the company. It has nothing to do with their performance. It has nothing to do with their future vision. They just found a company that they like, and then because of the dynamics that are inside their fund, they have to artificially try to push that so that it fits a little bit more.

Bart: So is there an arbitrage opportunity for companies then? What’s the sweet spot? If I’m a company and I want to raise, which fund do I go for? 

Jensen: Well, I think that if you are a company looking to raise capital, if you’re raising capital from a venture capital fund where the check size you’re looking for and the valuations you’re looking for is on the smaller end of what that fund is willing to invest in, then you’re going to see a bump.

 If you are taking investment from a small fund, and that fund due to concentration limits can only put five million into a company and you raised three million, they only have two million left to really put it to work in that company. And if you went to a company or went to a venture capital firm that is looking to put 15 to 20 million dollars to work in every company that they have in their portfolio, and you originally raised four or five million, there’s a lot of excess capacity that they’re going to put into future rounds and participation because of the deployment they’re looking to do in each company. That gives you more opportunity in the future to make sure that you’re secured with financing should things happen down the road or you need more growth capital.

Bart: Are there any advantages to the smaller company, the smaller fund?  

Jensen: I think some advantages might be that you’ll probably get a more personal experience, and it’s likely that you’ll get the ear of somebody who is higher up in the firm, right? If you’re talking to firms that are billion dollar firms, they have a huge team of people. And there are all different levels that are talking to these companies .The likelihood that you’re going to get one of the founders of the firm or a managing director that has a ton of experience behind them is less likely if you’re going to one of those firms. You do have more resources and whatnot that may be important to you. But you also just might be someone lost in the numbers. Where if you have a small, more boutique firm that you’re working with, it’s more likely that you’ll get one-on-one attention and will really be important to that venture capitalist. So everything has got pros and cons, and I would say that the intangibles of a venture capitalists are just as important as the tangibles. The cash itself is pretty easy to come by.

Bart: Currently especially.

Jensen: I mean relatively. It’s still difficult, right? There are still thousands and thousands of companies that go raise capital and a small portion of that that actually get funded. But relatively speaking, there’s a lot of dry powder.

There’s a lot of capital out in the world right now looking for investment into private equity, and it’s a good time to be on that side of the table raising money. So it’s probably more important now than ever to not raise capital just for the money but really think about the intangibles that come along with it–the support, the help, the expertise, those things that you’ll be getting when you raise money from a venture capital firm.

Bart: Yeah, interesting. So, are there other dynamics? You sounded like you had multiple secrets that you were going to share. 

Jensen: You know, another one that might be interesting for people to think about is not just about which fund you’re raising capital from but when you raise capital from that fund. So as I mentioned before, every venture capitalist that is out there investing capital has raised money from a set of limited partners.

And when they went out to talk to those limited partners, they were describing what it is they’re going to do, what types of companies they’re going to target, what sectors, what sizes, how they’re going to deploy the capital, you know, the check sizes. 

And so the venture capital firm has some leeway inside that mandate that they can invest in, but there’s also some restrictions there. And if you go raise capital and you’re the first investment out of that new fund, you probably have to fit that mandate relatively closely. If the firm has invested in four or five companies that are all performing really well, the limited partners will probably give them a little bit more flexibility to do something that’s a little bit outside their lanes. 

If you’re receiving investment from a fund that’s in year one or year two, it’s likely a 10-year fund with maybe one or two years of extension allowed, and you’ve given yourself that sort of time window before you need to produce a harvest or liquidation event for the venture capital firm. If you’re taking investment at year five in that 10-year fund, then you have sort of a shortened window, and they might be producing or putting more pressure on you around year five to get that capital back somehow. When nowadays, maybe that’s not long enough for you. companies are staying private longer. There’s more capital available at the the high end of the range, so people are delaying IPOs and raising 100 million dollar rounds and 200 million dollar rounds at billion dollar valuations, which didn’t used to happen.

 And if you’ve raised capital at the end of somebody’s investment life cycle, which is usually five years, then you might have more pressure from that investor to get them liquidity before you’re ready.

Bart: It’s interesting to think about that kind of time period that investors are under, you know, five to 10 years.

This podcast focuses on discovering the keys to building businesses for long-term success, and I’m wondering Jensen if you can kind of take a crack at how does equity investment play into that? 

Jensen: Yeah, that’s a good question.  So there’s probably a few ways. One is when it comes to taking advantage of an opportunity.

It’s very likely that it will require capital. In order to adequately capture that opportunity, one of the things that I’ve learned is that every idea you have someone else has too. There are probably five to ten businesses that are all doing the same thing who all believe they’re the only ones who are doing that business.

Bart: Absolutely. 

Jensen: And in order to increase your odds of success, you’re going to need to move faster. You’re going to need to be more aggressive. You’re going to need to capture some market share and develop more quickly, fail faster, and succeed faster than these competitors. It’s often times, especially with a marketplace or a really big idea, oftentimes it’s the first one or two that succeed and the rest sort of fall by the wayside. So, it really does require capital in order to grow quickly enough and capture those opportunities. On the other side, I also believe that the expertise, the network, the connections, all of those are things that can increase your chances of success.

So, I do believe that. The best companies that are being created are ones that are being created to last, not being created to seize a quick opportunity and flip it. Because if you’re doing that, the person who is also potentially acquiring that or the public markets when you go for an IPO, they’ll sense the short-term nature of what you’ve built and they won’t be able to pay up for that themselves. 

 Also, if you’re starting a company, if you’re building a business, what you’re trying to do in most circumstances is increase your odds for success. You’re looking for the decisions that you can make and the connections you can make and the choices and decisions that will help you be more successful or improve your odds of success. And I think that you can be successful by yourself, one single employee building something and scaling it up. And there’s a chance that you could raise a billion dollar business.

It’s a very small chance, but there’s a chance. That being said, the more connections you have the more capital you have at your disposal. All of those things will make it easier, and they’ll increase the odds of being able to capitalize on an opportunity.

 So, in order to increase your chances of success, having capital available, having a plan and a way to position and pivot your company, having more connections, stronger networks will get you better employees, more people that see you get to your opportunity and your solution in front of more faces. And all of those things, they increase your chances of success.  We can’t be someone we’re not. It’s hard to be passionate about and grind day in, day out for something that you don’t care about at all. And so oftentimes, all the time, entrepreneurs are pouring themselves into what they’re building. That’s blood, sweat, and tears. And as you do that, partnering up with some people that can provide capital, that can make connections and help your vision succeed, it’s very fulfilling and gratifying. 

Bart: I think that’s a great summary, and your perspective is super valuable to me and to our builders. Thank you so much for coming on the show today.

Jensen: It’s my pleasure. Thanks for having me.