Kindergarten Ventures’ Vanta investment, and building a new Strategy for Venture (with Thomas McGannon)

Transcript: (disclaimer: may contain unintentionally confusing, inaccurate and/or amusing transcription errors)

Ben: Hello, Acquired LPs. Welcome to another installment of the LP Show. This is an episode where it was actually recorded for a different podcast, one of David's LPs in Kindergarten Ventures, Thomas McGannon, has a great podcast called The Unlimited Partners Show that he started earlier this year. Thomas is a dear friend of both of ours and it was very fun for me to get to listen to this episode and not participate at all.

David: But you're doing such a great job with the intro, Ben.

Ben: Thank you. David, what did you talk about with Thomas?

David: Thomas pinged me about doing this and asked if we could talk about our recent Vanta investment. We did a SPV with close friends of the show, Vanta, together and Thomas participated in that. I said sure. We spent a bunch of time talking about Vanta, but we also talked all about Kindergarten, about how Kindergarten intersects with Acquired, and this sort of new form of venture capital that I'm experimenting with now. The non-professional venture capital is what I'm calling it.  

Ben: It's this rare opportunity to get to hear a GP and an LP talk about an investment thesis together. That's what I thought was the most interesting. You get to talk about all the very firsthand knowledge that you have from the company from talking with Christina from all the stuff we've done with Vanta. Then Thomas comes in as the appropriately skeptical investor and talks about how he did diligence and where there were open questions and how to rationalize price. It was great. Listeners, you're in for a treat.

With that, our thanks to the Solana Foundation for sponsoring all of the limited partner episodes this season.

David: Indeed. Solana, as probably all of you by now know, is a global state machine and the world's most performant blockchain. That means that developers can build applications on Solana with super, super low transaction fees compared to pretty much every other Web3 infrastructure layer out there and all with low latency and without compromising composability.

It is truly a technical marvel. We've had CEO Anatoly Yakovenko on the show before to talk about his time as a systems engineer at Qualcomm and how CDMA Technology influenced Solana.

Ben: Yeah, and one thing to point out is while we may be in a crypto winter right now, having a little bit of insight on what many members of the team at Solana have been up to, they're not slowing the pace of building at all. I would say it is just as good a time as any, if you have a great idea for something to build on the Solana platform, to build it now.

I think it's a trope, but my God is it a really good time to put your head down and make something that actually creates value for end users and customers. I know they would be happy to chat. You can learn more at solana.com/developers.

David: We also have some very, very fun news. We are going to Solana Breakpoint.

Ben: We are, live show.

David: It's a live show at Solana's Developer Conference in Lisbon, in Portugal at the beginning of November. We are super excited. It'll be a great time. We hope to see many of you there.

Ben: Indeed. Before we get into the interview, We have something to ask of you. We just launched Acquired's 2022 survey. Our audience has grown a lot since the last time we launched one of these so we would be eternally grateful to all of you if you would take the three minutes, I timed it when I went through, to participate. It's mostly check boxes. One lucky winner will get a second generation AirPods Pro, as usual, and 10 other winners will get Acquired t-shirts from our fancy new merch store.

David: Dude, I just picked up the new AirPods Pro 2 and they fit my ears for the first time. The extra small tips finally fit my ears. I've been rocking the original AirPods for like five years because the Pros didn't fit.

Ben: That's awesome.

David: So excited.

Ben: Be like David, get some AirPods Pro 2 for your tiny ears. Win them by participating in our survey at acquired.fm/survey or clicking the link in the show notes. With that, none of this is financial advice as always, and without further ado onto the interview.

David: When you reached out at that moment, I was just doing angel investing. I had gone full-time on Acquired and was running that. Fortunately, one of the great unexpected true blessings of my life was, which it's always funny to say but I don't know how else to say it. Acquired, which I love doing and doing with one of my best friends in the whole world, kind of unintentionally became a real business. That had kind of just recently happened and I was just angel investing in stuff that mostly came from Acquired writ large.

Either relationships through guests on the show or what have you, but also the community and the Slack community specifically. There are a number of companies I angel invested in that I just met the founders because they DMed me in Slack. Then you DMed me and that started this relationship, which was super cool because you were not the only input, certainly my partner in Kindergarten was a big input to it too, but you're a huge input in us deciding to raise a fund around this.

You were our first major LP to commit to that first sort of experiment fund and then a large LP now in our second larger more real, I don't know how you define real, but longer term fund, let's call it that. I'm just so appreciative to you for being part of the Kindergarten Acquired investing journey and now Vanta. It's been great.

Thomas: I didn't know that. I appreciate hearing the dribble that comes out of my mouth sometimes has a real-world decision tree impact. The decision to go in the direction of using podcasts as a tool for making investments and building partnerships, it just made all the sense in the world to me.

When you go and you find the smartest, most creative, hardest working people speaking in real time and you can reach in, ask questions, and build relationships, it was a very obvious decision to me. I'm glad that what was obvious to me has built itself into a real business and a real partnership.

You've spent a long time as a venture investor. When you stepped out into running Kindergarten, what were some of the experiences that you had that you wanted to replicate? What were some of the things that you thought that you could do better than what your prior iterations of venture investing?

Basically, what did you see that might suck out there that you guys could help? Even though Kindergarten might be a small fund—I guess all businesses start as small businesses and I think that it's a reflection of the evolution of the capital formation. What were some of the thoughts that you had when you guys set it up?

David: There are a number of threads we can pull on here. The first thing I would say is that with Kindergarten, we weren't really thinking about doing things better than at least how I had done venture in the past and the traditional way of doing venture, but we were very intentionally thinking about doing things differently.

My goal and I think we are very much a coexisting player in the ecosystem. Life is long and you can never predict what will happen. I would be very, very surprised if what we're doing ends up disrupting traditional ventures in a major sense. I think it's very much a coexisting, a complimentary aspect to capital formation and traditional ventures.

My set of experiences at the firms I'd worked at and then also observed close to, I do think one thing that's universal in an investing partnership is the partnership is super important. We talked about this a lot in partners in our last episode we did together, the first Unlimited Partners episode.

That was like a very very kind of intentional focus of partnering with Nat, starting slow, having this be an informal thing, and see where it goes. I'm glad we went that direction. The partnership has been going great so far.

In terms of the different versus traditional venture, there's just a number of elements that kind of were all coming together right around that moment that I saw. One and certainly very critical was the kind of enabling technology, if you could call it that, the enabling platform of AngelList and AngelList funds.

The first Kindergarten fund, as you know, ended up being $2.8 million total in the fund. Our intention that we set out was to raise $1 million. We wanted to create a $1 million fund, which just would've been completely impossible. There's no way that would've worked in any way, shape, or form before the AngelList fund administrative platform which had really only matured enough.

It's existed for a few years, but it was only like getting to a point where I felt comfortable as a former "professional VC fund manager" being like okay, there are some compromises that we're going to make by doing this. Everything is a trade-off, but it's viable that we could run a fund on this platform, especially a small fund. That was certainly one like okay, this is possible.

Then two, this dynamic existed for a while, but I was seeing it more and more in my angel investing and around Acquired that I felt like there was room in the venture ecosystem for, like you said, complimentary capital to the big traditional venture fund players. One of the hardest parts, probably the hardest part, reflecting on my career in "traditional venture" is at the end of the day, every round is a zero-sum game. If you're a sizable fund, you really need to lead rounds. I did plenty of partnering, splitting rounds, and all that, and that can happen on the margins.

Really truly, if you want to be a great fund manager and a great fund, you need to lead rounds in the best companies. The best companies tend to be very competitive. It ultimately boils down to answering a very simple question, which is why is an entrepreneur going to take your money over instead of Sequoias, Andreessen, Benchmarks, founders funds, or what have you?

Frankly, most people don't have a good answer to that question. A lot of people have answers to the question, but they're not good answers. For pretty much my whole career in venture, I don't think I had a good answer to that question.

What angel investing and stepping outside of that dynamic opened my eyes to was there's this whole different world where it's not instead of, it's not a zero-sum game, it's not take my money instead of Andreessen's money. It's take Andreessen's money and take my money. That is really a core component of what we're doing with Kindergarten.

Thomas: With a million-dollar fund, I mean, you're not doing this for the economics of the business. How do you think about the time that you put into Kindergarten, the relationships that it can build with companies and with other capital partners? I think that there's something really strategic in my mind about the way that you are building Kindergarten and I'd love to hear you riff on some of that.

David: That first fund, there's only so much in any dimension you can accomplish with a million-dollar fund. That was very much intended to be an experiment of let's just see if some of these hypotheses we have like is the AngelList platform viable? Can we do this while Nat and I both have very consuming full-time jobs and not think of this as like our hobby on the side, but as an integrated part of all of that in our ecosystem, which I think is your question that we'll get into in a second?

That experiment went well. It's now, as you know, our current fund is $12 million plus with a few SPVs, including this Vanta investment. We're going to have significantly more capital under management.

What I was seeing through angel investing and what Nat was seeing as kind of a leading founder in InsureTech in a specific space, was we had all of these opportunities to have relationships with other founders and other companies that were great companies that were raising great rounds from the best venture investors, and we had opportunities to invest capital, but also, just as important, have business and personal relationships with those companies.

The easiest to illustrate on the Acquired side are guests we would have on the show and our sponsors on the show. We would have venture capitalists on the show and they would be doing rounds. They would want to invite us along. Say a GP at XYZ firm, I'm bleeding around at this company. Of course, I'm going to do 70% or 80% of the dollars into the round, but we leave some open for value-added angels and other folks. You have this great platform with Acquired, with the podcast, and with the community. We'd love to have you as part of it.

We were seeing literally the VCs invite us into deals. That was a very different experience than the zero-sum game of before. But the companies too, our sponsors and our guests want to have deeper relationships with us. They'd ping us and say hey, we're raising around. Would you be interested in being a part of it? We'd love to have you.

Sometimes we were getting folks who are founders saying you're seeing such a great deal flow. Let me know when you're doing deals. I angel invest as well. I'd love to come in and be part of it too. We were kind of thinking man, Kindergarten could be a way to just tie all of this together and do it at a much bigger scale than we could do with our own personal balance sheets.

Thomas: When you and Nat are building the top of the funnel and sorting through what's going to make an interesting investment for Kindergarten, what does that process look like? What do you guys usually use as your way of communicating? How do you articulate a priority stack so that the other person really gets what's most important, what's kind of nice to have in an opportunity?

David: I can tell you what we don't do, which is what traditional VC firms do and what I used to do. We don't have Monday meetings. We don't sit together. One of the firms—I won't out them— I worked at in my career. I actually love this. This is great. They ran the whole firm on a whiteboard. They had a whiteboard in the conference room and the Monday meetings would happen in that conference room.

There were doors on the whiteboard, so the rest of the week the doors would stay closed so other people didn't see it. Literally the whole firm, the portfolio company, the active portfolio companies, the pipeline of deals that the firm was prosecuting and ranked order, it was all just there on the whiteboard and got together. It was just funny that they did it on a whiteboard.

Every firm does a version of this. You talk about the portfolio, what the needs are, and who's raising. You talk about all the deals that every partner is interested in and what are the highest priority and you align.

That is not what we do, not what we do at all very intentionally. I don't want to claim yet. We don't have real performance on the board. We're still very early so I don't want to claim that this is going to work necessarily.

When we meet and interact with companies, it's not in the context of they're raising a round, they're coming to pitch us, and they're presenting their deck and they're trying to raise money. We get to know these companies and these founders in a very, very different context.

To speak to my side, I get to know sponsors on Acquired and guests on Acquired. I see and I interact with them. I interview them on the podcast so I know them in that way. Then I get to see how the Acquired community, how does our listener base react to these companies for our sponsors. What are the click-through rates or I guess how many people ping me after the episode and say gosh, that was amazing. I would love to connect or I can help with XYZ. How many VCs ping me and say that was awesome. Can you introduce me to the founder? I want to lead the next round.

I just kind of have a natural sense. For the sponsors too, I have a business relationship with these companies. I know how they are to work with. It's just pretty obvious to me which are the ones that we want to put money behind.

Thomas: I turned my camera off, but I'm smiling really big right now because the data that you are pulling together through that process I think it's so differentiated. I think in many ways you're getting to see what it looks like when people don't think they're being watched. You get to see into a business' communication funnel in a way that I don't think is even possible in a traditional fundraising route.

David: No because it's performative.

Thomas: Precisely. Having the opportunity to build that authentic and what authentic means is it's not performative. It's something that is spur of the moment. It's truly like what these people and what these companies are, and it being like hard data. If you're talking about how much everyone loves you and then through the process of working with founders, having them as customers, seeing the way that your community relates.

If you're seeing that that's not true, then I think that you have a very special way of making the exhaust of your business with the podcast kind of manifest itself into what I think is really interesting capital formation circulatory system stuff.

David: Let's take Vanta. Let's get into Vanta as an example. It's the foremost example in our portfolio. It's such a beautiful case study of this.

Thomas: When did you meet Vanta? When was that time zero?

David: I'll take you through the whole thing. Ben and I knew of Vanta and knew Christina Cacioppo, the founder, for a long, long time. She had worked as an analyst at Union Square Ventures back in the day. This was right after I left New York. I think she joined USV and I joined Madrona. Never actually connected with her but she blogged, USV is so public, and of course, I heard about her.

Then when she left USV and went to start something in NYC, we tracked her and she's still a prolific blogger, but we never actually met. Ben and I are both very familiar with her and her work.

Then one day, Patrick O'Shaughnessy from Invest Like the Best, who all of us here are friends with, sent Ben and me an email and he said hey, I invested in Vanta and Christina. She's pretty awesome. She wants to meet you guys and she loves Acquired. Maybe on Twitter, we'd had some interactions. I knew that she was a fan. She loves Acquired and she wanted to talk to you guys about sponsoring.

That was how we first directly connected with her. We love all of our sponsors, and many of them are like this, but she was just a dream to work with. We interacted directly with her and we met other people in the company too. She was so clear about what the Vanta business is, why it's compelling for founders and companies to use Vanta, and why our audience of primarily founders is a great fit. She was just wonderful to do business with as was the company. It was very smooth and easy. That was the sponsorship process.

Then shortly thereafter, the company was raising the round, she sent Ben and me an email. This was right as Kindergarten was getting going. She said hey, we're raising this round. I love you guys. I'd love to have you be part of it if you'd be interested. No pressure. Obviously, at this stage, you'd be small checks, no big deal.

Kindergarten invested $100,000 out of the fund in that round. I think that was what happened next. Then we just got to know her better through the sponsorship. She invited us to a Vanta all-hands meeting. This would've been, if I remember my timelines—

Thomas: In the spring of this year. I remember listening to it. I was in Singapore. It was like 100 degrees, I was on a long jog, and I was listening. It was an all-hands for you guys.

David: It was right before you decided to start the podcast.

Thomas: It was, yeah. Just a couple of days actually.

David: She invited Ben and me. Ben was in town. It was when we did the Altimeter episode with Brad. That's right. We had told Christina that Ben was going to be in town. We'd love to get together. She was like actually, we're doing all-hands. Why don't you come by?

We'll do a little fireside chat. I'll interview you guys. We ended up releasing it as an LP episode, but she didn't ask for that. That wasn't the intention. We just thought it was so good. We were like, great, we'll bring the microphones and we'll record it if it ends up being good.

We got to meet the whole team in person in the office, and just had a great time. We were so impressed with everybody. We got to meet Matt Spitz, the Head of Engineering. For our arena show that happened a couple months later in May, we invited Christina to come up and do the interview portion on stage. She couldn't make it because they were doing what we did in March, I guess it was the regular, weekly, or biweekly all hands at the office. They did their annual offsite down in Palm Springs. The whole company flew in from all over the world and obviously they were leading down there.

Matt, who we'd met at the all hands did a turn and burn. He flew up from the offsite in Palm Springs up to Seattle to come to the show and then flew out that night to go back to Palm Springs. Anyway, I say all this just to illustrate the depth of the relationship and how none of this in my career as a professional venture investor would've been any part of the equation.

Then when Vanta was raising this addition to the Series B, the round that we invested out of the fund, Sequoia led the series A, Craft and David Sacks led the series B in the end of April, beginning of May of this year in 2022. We talked with Christina on our sponsor slots this season. It was literally I think the best round that any company has raised in 2022 so far.

It was a $110 million series B and a $1.6 billion valuation. Christina pinged us late this summer and said hey, we're going to do a second close of that round because a bunch of LPs and the VCs are interested in putting in more money. If you have any interest, would you all be open to putting in more money?

I was like, probably not out of the fund because we're small. It's not our strategy, but let me ping our LPs and see if we could have interest in putting an SPV together. Hence, Thomas, why don't you take the story from here.

Thomas: I'll be honest. When the update came across that you guys were doing an SPV here, I was going to let it go by. I was busy with other things. We would not be talking if you hadn't reached out and said hey, Thomas, I think that this suits you guys really well. I think you should take a look. I had definitely been familiar with Vanta through your relationship as them being a customer.

It's the same with a lot of podcasts. And again, just referring to the network that gets built and the kind of liquidity that that facilitates amongst talent, customers, and capital was something that you did a really nice job helping me get focused on.

It came at a really good time because a lot of the conversations that I've been having with my clients, the families that I work with, they're asking for cybersecurity investments. They see the breaches, they see the compounding nature of the problem and the value that is encapsulated in a secure digital estate and want to invest in that.

Personally, I've struggled a lot with cybersecurity investments. There aren't that many high quality generational companies built here. A lot of times it's because people try to build force fields, and building a force field, it's just an ephemeral advantage that you could potentially build.

The nature of the investment started to look really attractive because it was something that I knew I was being asked for. As I started to do my due diligence across my network, reaching out to general partners that have lots of insight into their customer subset, fast-growing, a lot of YC-backed companies that are just getting to that point where they're winning customers and this is table stakes. This is an expectation.

Hearing some of those founders say, oh my gosh, Vanta is a verb. All of our portfolio is using it. It really started to wet my enthusiasm because I thought that you could build what initially today is a product company with SOC 2 compliance, but eventually, I think it can evolve into a platform company.

David: We're 30 or 40 minutes in yet and we haven't even talked about what Vanta is as a company.

Thomas: Yes, we should probably do that.

David: This is what got me so excited. Way back when I was at Madrona in Seattle, I had done some cybersecurity investing. Gosh, that was like 2014 or 2015 and I felt the same pain as an investor that you're describing, Thomas, which is clearly, this is a massive market. A huge need for any person, any company needs cyber security. It's so obvious, the need.

Thomas: It's perfectly ubiquitous. Everyone needs it.

David: Yes, but the problem with the industry that I found in investing and I think has mostly still been true to this day is that it's all fud. It's all like building force fields, as you say. It's teams coming out of the NSA or the IDF in Israel and these companies end up either looking like services companies or they build the latest and greatest force field that works until something else comes along that's better.

It's just this very difficult space to build actual durable products and moats in, and then here along comes Vanta. Vanta is explicitly, and Christina will be the first person to tell you, that we are not a security company. We're not from the NSA. We're not building force fields here.

They are a security monitoring company. I had this aha moment for me in getting to know them and the product, seeing the uptake in our community, the rapidity of clicks on the links in the show notes, the customer adoption, and they're adding hundreds of customers every quarter. It's very much like a Datadog-type situation. They're not building the force fields, they're monitoring the force fields and everybody needs that.

Thomas: The topic of observability was one that really dominated the last year that I spent as a public hedge fund manager. These are companies like Datadog, Splunk, New Relic, and AppDynamics. Having visibility into a digital estate, knowing that metadata that speaks about the software that you're working with, that speaks about the process that is being run. I think about the internet as this vast trove of data, and you need some kind of process of synthesizing and curating and that's why I think podcasts are so cool.

In a similar way, monitoring observability, seeing how your software components, especially in an increasingly fragmented services-based is a very ephemeral way that we build and run software. The importance of having monitoring instruments throughout your organization and the fact that this is getting to a scale where human hand drawn, whiteboard, Excel, processes, screenshots, it just doesn't work. It's breaking at an accelerating rate. It really gets me excited.

I mentioned earlier how I became so in love with software was hearing the Salesforce journey, the way that the CRM has been stood up as a pillar of data insight action, and believing that as software eats the world, you're going to have multiple other forms grow and evolve. Their point of view for how this problem gets solved and where to insert themselves, I found it really compelling.

David: It has to be software at this point. I mean, by the time this episode comes out, our Acquired episode on AWS will be out, part two of the Amazon saga, part two of I'm sure many to come over the years, but the story of AWS.

At this point, AWS is just one cloud provider. It's just the infrastructure layer, the base layer for building, I say a technology product, but really anything. Everything runs on AWS these days. There are other cloud providers out there too and lots of businesses of any scale use multi-cloud.

AWS has hundreds of different services and that's just the infrastructure layer. Understanding are all of those services, do you have them configured correctly? Are the right access protocols on there? Who has access to the data? That's the infrastructure layer.

Now layer on the vast diaspora of application and software middle layer products between your infrastructure and then your end product. You've got hundreds to thousands, literally thousands of different software products that have access to data, that have security vulnerabilities that weave together to comprise the products and services of every industry in the world right now. There's no way that a team of humans can keep track of that.

Thomas: No. I think that one of the pieces of this investment thesis, which is to say investing in compliance automation broadly, that I really like is, as I look at some of the notable breaches, I was listening to Okta earnings call yesterday. There's a lot of conversation about some of the customer breaches that they've had to deal with.

It's not Okta software that we're principally talking about. We're talking about software that is in their supply chain. When you come home from school and be like, mom, I was doing this, but the other kids were doing that, you're responsible for what those other kids are doing in your cloud software estate. What expectations can you put in place to ensure that the cloud services that you're bringing in are being run in a compliant, defensible, and also in an organization where they have a culture of compliance?

I think one of the things I really enjoy doing with an investment thesis is talking to consultants, like the Capgeminis or Deloittes that have seen dozens of implementations of security programs and can talk about, as a people process technology, what works and what doesn't? The thing that I realized in doing these calls through Tegus was that—

David: Another great friend of Acquired and Unlimited Partners.

Thomas: Mike and Tom, they're so cool and the acquisition of Canalyst, I really think that that's the generational financial service provider technology layer. It's going to be very, very cool what they're building. But in any case, in talking to these experts that Tegus sets up, you really come to appreciate that the best that you can hope for when it comes to cybersecurity is to have a culture of compliance.

That is something that gets not a snapshot in time once a year, it's something that is continuous. It's something that is part of the DNA of the way that you build the ways that you communicate. By adopting something like Vanta, and there are other competitors, that's something that as an investor I take very seriously. But I think that this layer could eventually be a very large pillar in the digital estate.

David: One thing I've learned in the past several years, I catch myself whenever I'm about to say something is inevitable or I can't imagine any future where this doesn't exist. I'm like, oh, well, none of us know anything. Strange outlier events can come to pass, as we all know now. But I think it is very, very likely in the future that this is a very large category of software because it's very hard for me to imagine—again, never say never—that you're not going to use software to do this.

Thomas: Yes. I don't think there's any question about whether this is an automated instrumented solution. I think for me, at the foundational layer, when I make an investment, I like to think about it, like Geoffrey Moore has his stack of what a business is. At the low level, it's the infrastructure. What are the first principal inputs that go into the world that your business is executing against?

Here, the infrastructure layer is the software eating the world and the cloud-dominated software estate. What sits on top of that is a business model. What are the products that you're building to serve to your customer base? How does that draft on the wave of what's occurring at the infrastructure layer? And then on top of that, is the operating model. How are you going to market? How are you communicating, pricing, creating, and capturing value?

At the low level, the infrastructure of what compliance automation executes against, I don't have any real concern there. Where I start to ask questions is, this opportunity will exist. This is a when not if. But is this going to be a compliance automation company that captures this kind of ingest and process communication layer, or is it going to be something else? Is it going to come from a monitoring-type solution like a Datadog?

Is this tool something that can be built and appended into a ServiceNow, perhaps? Because right now, what Vanta is, it's a tool, it's a product. I think that there's a really exciting future where it does mature into a platform and then it has a lot of value that I'd love to—maybe we can talk about grading this towards the end. But whether Vanta or one of its competitors owns this opportunity, they created the category, but they are not guaranteed to win it.

I think that when you look at the depth of integration, the sophistication of the data, and the flows and the processes, that other businesses in orthogonal parts of the data journey have, there is a real question in my mind whether this is an opportunity that's captured by the players that are creating this category.

David: People who are familiar with fans are probably wondering why we haven't brought this up yet, the SOC 2 and compliance. Probably, these days if you hear Vanta on an Acquired episode, an Invest Like the Best episode, out there in the world, or if you use Vanta, your company, which if you don't, you should, you are probably using it to get SOC 2 compliant. That's a really interesting aspect of how this market has developed and what the go-to-market that Vanta pioneered.

There are the security compliance standards of which SOC 2 is the broadest and most well-known that most businesses are going to want to have. The way—before Vanta and its competitors, but Vanta was the first to do this—a business got SOC 2 compliant was you hired some auditors, either independent auditors, Deloitte, Accenture, or somebody to come if you're a bigger business, to come in and audit your security, infrastructure, protocols, and all your software supply chain.

Then they would issue a compliance report and say, okay, you are now SOC 2 compliant. The same thing for HIPAA and healthcare or GDPR in Europe for data practices.

What Vanta said is we can actually use that as our go-to-market channel. We will be the software product that won't actually do. You still have an auditor that we partner with or you bring in, come in, and do the certification to get the compliance certificate.

Rather than having a team from Deloitte come parachute into your company for a couple of weeks and rummage around, do all of the work via software and automate it, and then the compliance gets much, much easier, at least a burden of compliance for you as a company, especially ongoing in the future years when you renew. That's been the go-to-market strategy.

I think this is super cool because eventually, we want to and I think Vanta, the whole industry and its competitors, can evolve into that big vision we were talking about a minute ago of security monitoring, continuous security monitoring, the "Datadog for security". But I don't think Datadog, ServiceNow, or whomever certainly over the past several years haven't been willing to say like, oh, we're going to go get into the compliance certification business. We're going to go do SOC 2 audits. It's been this cool little insulating bubble that they've been able to build the business up within.

Now, will all of that change now as Vanta and its competitors have gotten clearly, this is a fairly big market. They've gotten quite big. I'm sure those larger companies that you mentioned that we've been talking about are paying attention to the space. But it was a really elegant way to start the company.

Thomas: Yes. I think that initially when I started my research and I heard people say, these are investors that had invested earlier in the company and had been observing it for a while, they said, gosh, we really would like for this whole process to be automated. What Vanta does is they'll automate up to 90% of your processes. But at the end of the day, SOC 2 compliance is an AICPA certification. These are auditors that are crafting the rules.

I spoke with somebody that does security audits. He talked about how people are looking for the answer. An auditor will always tell you that there's no way that you can bring me the answer when I first sit down. The answer is found through the process of examining what kind of a business that you have and how you're approaching your compliance frameworks.

As I look out at potential competition from other incumbents, I do think that the fact that this isn't completely automated, the fact that this is an auditor and chief risk officer focused sale and not as much like the developer bottoms up prototype this and run with it.

David: She made a very smart decision that none of the other early competitors to Vanta did, which was that she in the early days of Vanta as a company, they partnered with the auditors. The Vanta value prop is not we're going to take all of these human auditors and we're going to turn all this into software. The early competitors, this is what they were saying. All these audit firms are gone like you're going to click buttons and then you're going to get your audit.

What Vanta said is we're going to turn into software the plumbing, the monitoring, the work, and the tools, and then we'll partner with auditors and audit firms. They will do the audit because as you said, the audit is a human opinion. That was the way the industry worked.

What that did was two things. It didn't piss off the auditors because it would threaten their business the way that other early competitors were a threat to their business. But also, like you said, it's actually not the right way to do things with the audits themselves to make that totally software. The auditors had a very good point on that.

The other thing it did though, it's funny you're talking about the go-to-market, it enabled, especially for SOC 2, all of these younger companies, startups or younger and smaller companies. Using Vanta enabled them to go get SOC 2 audits in a way that they couldn't before. If you're going to start, you're going to bring in Deloitte or even an individual solo practitioner.

You're going to bring them into your company for weeks and weeks and have them audit your security practices. No, of course, you're not going to do that for cost reasons, if nothing else. But with Vanta, you can say like, oh, no, all the actual work, the tool, we just do that with software now. We can just buy Vanta, then have an auditor come in, and we can be a seed stage Series A stage startup.

Thomas: How do you think that Vanta will perform in the current environment and the weather conditions that we're all managing through?

David: Yes. So far, it's been good. They've been hitting a plan through 2022, which is great, or even slightly exceeding, which is great. Once you start getting compliance certifications, especially SOC 2, you're not going to stop. It's very hard for me to imagine. Unless a business pivots significantly where you're like, well, I have been getting SOC 2 compliance. I don't think I'm going to do that in the future.

If you work with any customers or partners of any scale, especially in anything financial services related, which is pretty much every product and service in some way, shape, or form these days, you're going to need this.

Certainly, you're not going to take it away. Your partners and customers would be very unhappy about that. The risk to your revenue is huge if you were to take it away. I think it's a very sticky product.

I think the risk in this weather climate, as you say, to Vanta is if a bunch of their customers go out of business or pivot to something else, which I'm sure will happen. Unless things completely stabilize or turn back up in the coming months, which could happen. But if that doesn't happen, if we continue into sort of a protracted, challenging weather conditions for the economy and for startups, for sure, that will start to happen, I think. How do you think about it?

Thomas: This was a big piece of how I thought about making the investment. I think that by working with companies who need SOC 2 compliance as a way to earn their revenue, like this is a revenue-enabling product or service for their customers to purchase, I like that a lot. As I've been listening to public earnings calls, there's a lot of focus on rationalizing the existing footprint.

If you're a usage-based model, something like a Datadog, a Snowflake. MongoDB, talked about how in their cloud native or digital native customer group, they were seeing some slowdown, just the rationalization of that footprint. But the binary nature of, do you have SOC compliance, do you not, and is it a critical piece to whether you can generate revenue, I really love that mission-critical nature.

I think one thing that Vanta does really well that I would love to see them continue to perfect is finding ways of standing up SOC 2 compliance certification as an announceable event for their customers, like celebrating that and also affixing the name Vanta to that achievement. Making Vanta a verb that states we take this seriously, this is part of our compliance culture, I think that that is a way that they can help drive customer success, but also deepen the commitment at that organization to Vanta.

One of the individuals that I spoke with through Tegus used to work for one of their competitors. He's now the director of compliance for a publicly traded learning company. I think what's important to remember here is this is somebody who has built a career building the processes, practices, and manuals for how this works. What's easy and achievable to this individual might be very, very difficult for others that haven't been so focused.

His opinion was, what Vanta is right now is a system of record. You go to Vanta to see that your compliance processes are functioning the way that they ought to, but that is something that, with the right kind of skill and focus, can be taken in-house. Once you have a successful SOC 2 compliance program put into place, it's not rocket science to internalize some of the products that Vanta builds.

Where it becomes impossible to pull out is if it can graduate to a system of engagement where through automation, through dashboarding, and really robust integrations, the organization throughout has Vanta on their screens where it becomes something that as a methodology of maybe not daily, but weekly, monthly use that people are spending more time in Vanta. Which is just going to be a very necessary piece for them to build on to graduate to platform. But I think that for me, the real determinant of success for Vanta and for the investment is going to be whether they can make that transition.

David: I agree 100%. I suspect Christina and the company would also agree 100% with that. I think that's true of probably any software platform. If you want to become a platform, you need to, like you said, go from a system of record is great, but you need to go to a system of engagement. That's what Salesforce is, right?

Thomas: Right, exactly. Most businesses, it's really hard to build a platform out of the gate. If you say platform and V1 of your businesses, you probably are not going to find success. You do have to go through this process of nailing a specific use case, really understanding your customer base and what their key mission-critical pain points are.

I think that in terms of discovery and identifying what kind of a business that you're building, that is such a key low level piece that's so necessary. Then as you're spinning this up, being aware of what's my next act, my second, third, fourth act going to be here? I loved you, Andrew, and Howard Marks talked about as the innovation cycles shorten, the durability of existing competitive advantage narrows significantly. Historically, having a system of record business would have entered you to a decade of owning a specific use case, things are just moving too quickly.

David: Yeah, not anymore. That's 100% why I say I think Christina and the company would agree with you. The product focus now is on building out Vanta trust reports, which is exactly that. Datadog for security was a good shortcut analogy, but what does it look like to have a system of engagement for this space? It looks like both internally at the company for monitoring, but also externally, for your partners, for your customers.

Here's the Vanta power dashboard, a trust report from Vanta that shows you in real time, what are the security practices, what's the data access, red, green, and yellow. What's the state of all of my services internally? What's the state of my software supply chain? And to sharing that and being open.

Thomas: You mentioned earlier that you've had Christina on to talk about the fundraising process. People have talked a good deal about her skill as a leader. What for you makes Christina somebody that earns this like, ah, she's a special designation?

David: I don't think you can ever underrate someone who you want to be around, do business with. Every time I interact with Christina, I come away, this is a classic thing that VCs say. I think they say it as this shortcut because you can't really put your finger on what are the components of it, but she's the classic founder. If I were ever to go work for somebody, she's one of the few people. I would be very happy to work for Christina.

I think that that is certainly one element of it. I think the other element is I'm very impressed with her as a founder. She went and pioneered this space. Vanta was the first company. She was the first person to see this in a very, very non-obvious way.

She was on a very traditional Silicon Valley path. She went to Stanford and then she went to work at Union Square Ventures, which is in New York, not Silicon Valley, but a very Silicon Valley firm, even though it's in New York, this hallowed position. Then she went to work for Dropbox. She left USV to tinker with some products, then went to work for Dropbox in Dropbox's heyday. Then she goes and starts this security compliance monitoring company with no security background and doing SOC 2 audits.

I remember at the time, to the extent that I saw what she was doing and focused on it, I felt this way a little bit, but I didn't even focus on it. I'm sure most people were like, Christina, what the hell are you doing? You should go be working at Uber, Airbnb, or something, or starting some God knows what. It is just so not obvious that this space was going to be big, that there was defensible value to be built here.

She did Y Combinator. The company di Y Combinator and they raised a little bit of money. I believe Pear led the seed out of Y Combinator. Great, great folks. I love the people at Pear. I've known Mar for a long time. We were on a board together back when I was at Madrona.

Anyway, and then they just went and operated for years, and everybody forgot about them. In the meantime, they were just executing. During the phase when so many companies were raising so much money without having product market fit or anything, she stayed so lean. Didn't raise any more money after YC got to over $10 million. I believe she got to 13 million in ARR for the company before she raised another dollar, which was that first big round from Sequoia last year.

When that happened it was like, holy crap. To the extent that we were wrong about Christina and wrong about Vanta, like boy, were we wrong. I just love that. It's not often you see the combination of somebody who is genuinely great, I would love to work for you. And you can be so contrarian and be willing to do all the correct but non-obvious things that great founders need to do.

Thomas: Right now, there's a lot of conversation about durable growth and what constitutes durable growth. I think that as I try and ask myself, what are the companies with the people and the products that are best suited to really understand, internalize, and practice the inputs that go into achieving durable growth? For me, it's hard to do that without having been built on a notion of scarcity, so my favorite companies.

Like Tony Xu at DoorDash, the notion of 1% improvements, or CloudFlare thinking about the scalability and that they would need to achieve for their business to kind of achieve its full vision, and what that required from a network speed and security perspective.

Vanta having been a functionally bootstrapped business from zero to $13 million in ARR, I think for me, that is a really critical component to answer for myself as an investor. They're raising now a growth round. They're going to be receiving north of $110 million of capital, that's many multiples. How much did they raise in their Series A? Was it 50?

David: Yeah. Within a year and a half, they'll raise $200 million.

Thomas: Exactly. That's the point, that they're going from very cash constrained to upwards of $200 million of total capital coming into the business. Knowing that they have the ground level of appreciation for the value of a dollar, and I think in the most recent interview that you did with Christina talking about this round, just how they're taking really a scientific approach to building their sales reps and the efficiency.

David: Weekly cash reports.

Thomas: Precisely.

David: I don't know too many companies in 2021 that were raising the kind of money, which was a lot of companies, that were doing weekly cash reports.

Thomas: You win races in the turns, not in the straightaways. 2021 was a straightaway. No one was winning a race last year. But this year, when things get more challenging and when communicating that value to your customers really has such a higher bar. You just hear everywhere the discussion about elongating sales cycles, which is really people spending a lot more time asking themselves, is this product or service really worth it?

I think that in order to communicate that to your customers, I think that it's something that you have to practice inside your organization. It does give me a lot of confidence that pouring in this amount of growth capital and that being a couple of times the inflow of investment arsenal that competitors are raising, I think that that does really portend getting ahead in this turn in the market.

David: We're both now very biased to love Vanta and want to talk it up and everything. That's great as we should be. But to be grounded in data for a little bit, opinions are opinions. I love it. Sequoia used to have this great saying about, they're so good at changing their minds about things when the data is there. They meet companies early and they're like, I don't know, is this durable, can this be a big thing or whatever?

I think this is a Leone line. At a certain point in time, the data doesn't lie. If the revenue keeps coming in and keeps growing, you got to go with this. In Q2 of 2022, that's the current weather climate and arguably even worse than here in Q3 2022. Vanta's customer growth accelerated. They added over 300 customers in Q2 2022. What more can you say?

Thomas: The metric that I cared the most about here is—I think the first question I asked you—what's Q2 going to do and how does that compare with the Q4 to Q1 sequential growth? You're absolutely right. This is data that's coming in real-time and seeing how that rubber is meeting the road, the numbers don't lie.

I don't know what the future is going to hold from a market perspective, from a product perspective, or from a customer expectation perspective. But having a team that is data-driven and has, again, that principle of scarcity woven into its culture I think is really important.

You're right. This has been a conversation about why it is that we're enthusiastic to invest in Vanta. I've listened to interviews that some of the founders of competing businesses have given some of the reasons for being their background, the credibility they have as founders. It is not a foregone conclusion at all that Vanta runs away with this segment.

There are other businesses that are growing very quickly. I think that just because you create a category, it does not mean that you own it. It's going to be really fascinating to watch. Were there any dynamics with this round, the participation?

Maybe the way that I'd asked it is when you come in and you look at a business and the round that they're raising, what are some of the questions that you ask? What's being accomplished here? What are we bringing to the company that we didn't have before? What might be worth talking about that here?

David: Coming back to the beginning of our conversation here about Kindergarten. If it's interesting later, we can talk about Nat. You should have Nat on the show to talk about how he operates within it. For me and through Acquired, it's really like I said, intentionally from the very beginning, both for personal reasons, just personal preference reasons and that I thought there was an opportunity. I don't want Kindergarten to look like, be, or feel like operate like a traditional VC. I've done that.

That's silly, it gets great. You can make a lot of money. They serve a great role in the ecosystem, and the great ones are truly, truly great. But this line of thinking, and not that I think this is where you're going with this specifically, but the deal dynamics. I genuinely don't care about deal dynamics anymore. It's one of the things I hated about being a traditional VC. Especially, while I loved the firms I worked with and they're a great partner, we were always fighting Sequoia.

I said that question with Sequoia or Andreesen. You always had that question, this nagging always there was like, why is a great founder going to take my money, our money over name your top tier firm? And then the question that you ask yourself is, okay, if I'm competing with them, why would the founder take my money? But the other really even more insidious question, truly more insidious that you end up asking all the time is, are they taking my money because the great VC is past? I just hated all that [...].

Thomas: I think about the Groucho Marx line every day of I don't want to be a member of any club that would have me. I think that investing with you, working with your network, and kind of the supportive nature that a lot of what you bring to bear represents, it helps me answer that question in a way that I don't get to very often. Which is to say, I am joining the club that wouldn't have me. I'm just going on the shoulders of someone else.

I think that that's why I thought that partnering with you as I built out this practice of working with family offices would be a really high value, like a node in our network to build out, and it definitely has.

David: Because that dynamic is so baked into the traditional venture ecosystem. It's kind of like the fish asking, what's water?

Thomas: Oh, yeah, the David Foster Wallace. I always love a David Foster Wallace reference.

David: Totally, right? Me yanking myself out of that, it's really [...]. Anyway, the way I think about all this, I truly don't care. For better or worse, I do not care about deal dynamics. When I want to invest in companies, it's because I met them through Acquired, they're great partners, I like what they're doing, all those other reasons we talked about at the top of the show.

Here in this Vanta situation, the deal dynamics are Craft and David Sacks. One of the greatest SaaS investors of all time led this round in the depths of the Q2 crash of 2022. They didn't say the name Vanta, but they talked about this deal several times on All-In episodes at the time. Sacks reference did a bunch. I don't know why he didn't say the name.

Thomas: Anytime that somebody talks about their book, it's just an open flank for one of the—

David: Actually, you know what, you're right. I feel like especially on All-In, I love those guys, one of the things that's so great about that podcast is the dynamics and the tension between all of them. But you're right, they don't talk about their book there because they pillar each other when they do.

Thomas: I love that they do the podcast, but that to me kind of highlights what I don't think is present in most partnerships. Whoever it is that we're doing business with, any interview that I do, any investment, any introduction that I take, I genuinely want the very best for every person that I'm coming across.

I want to find ways of, oh, you've got a sundae, let's put some whipped cream and cherries on top of that. When you have e a weekly commitment to something that is fundamentally imbued with friction and competition at a layer that I don't think is a positive sum creating, it's just like, I love the instruction and the conversation that comes through it, but I'm going to build my business and frankly, my life a little bit different.

David: Obviously, it works for the besties on All-In like, oh, my gosh. The show has been successful, each of their firms have been successful. Anyway, all that aside. Sacks led the deal. The way all this kind of came about, it was always written to the docks.

They were thinking about it, there's LP interest, but then as the summer went on and 2022, I don't want to quote her, but I had a bunch of conversations with her about this. She just decided, like you said, there are competitors out there in this space, this great round is happening, and I think just kind of came to the conclusion.

She was like, you know what, let's get as much capital in as possible right now. Let's just fill up the war chest, not in a 2021 way of, oh, a hot company may or may not even have product market fit yet. Let's just do to raise money to raise money. But no, hey, this is a new climate. There's competition out there growing fast, this is a great valuation and great round, it got great folks around the table. Now's the time to actually fill up the war chest with as much money as possible to go out and work like hell, execute, and be the winner, be the system of engagement of record in the space. That's kind of how this all came together.

Thomas: When you see Craft lead a deal, I don't know if you've done business with them or participated in a lower level.

David: We've done a few early days deals with them.

Thomas: Yeah. Can you characterize what involvement the Craft has? What does a Craft investment look like? I've never worked with them before.

David: I could speculate. It would be pure speculation, especially with Kindergarten. It's not like I sit on boards with these companies. Another non-obvious thing that when I yanked myself out of the professional—I use professionals just to the term for the traditional way, but traditional is better—venture ecosystem of board seats.

I had a conversation with a really great older generation investor who is just a wonderful, great investor, well-known, all the things during that period. He said to me, board seats are one of the paradoxical, anti secrets of these. There's all this ego and status wrapped up in who's on your board? I want to join the board of this company or lead this round, blah, blah, blah. And it's like, there's no upside to being on the board in every dimension.

There's no upside for you as personally being on the board. You're exposing yourself to a lot of risks, but there's no upside with the founder relationship either. You create this quasi, not adversarial, but it complicates the relationship. He's like, I found in my career, I have much more influence on the company, I can be much more involved, happier, all the dynamics not being on boards. I was like, ah, yes, you're right. Why did I ever want to be on all these boards?

Thomas: Because of credentialing.

David: Yeah, credentialing, exactly.

Thomas: Which is a totally normal thing to want, but I completely agree with you. If I were to sit down and say, hey, David, let's have a really nice conversation. We'll share a lot about each other and our hopes and fears. Oh, by the way, I have a loaded gun that I just set on the table here that I not only have the opportunity to potentially use, but in many ways, have the responsibility, which is to say being a board member means that you are responsible. You have a duty to ensure that a business is performing to what you think is the highest and best use. That's a really difficult responsibility set to execute.

David: It really changes the dynamic of the relationship.

Thomas: It absolutely does. I think that that's something that I am learning and really appreciating the difference between—I'm on the board of one company. I have a great relationship with that founder. I think it helps that maybe also by investing at the seed stage when you're working with these companies, joining the board might be a little bit different because you know that their well-being supporting the founder is the job to be done by the board. But once you get to $50, $60, $100, or $500 million of revenue, that relationship gets a lot more complex.

David: Or heaven forbid, a public company.

Thomas: Absolutely.

David: Of course, I had great board relationships with many of the founders that I was on their boards. But the point that this investor was making to me that just totally hit home, you're right. There is a time in your career or a time in a company, there are situations where it makes sense. That investor, he takes board seats. It's not like he doesn't.

In general, if the situation doesn't require it, it's generally better not to be. Anyway, your question was about Craft. All of this is from afar, arm's length. But I think what they are certainly what they market themselves in, but they're quick, they're just really plugged in on what the attributes of great SaaS companies are, particularly around investing, valuations, multiples, and all that. They're very data-driven on that stuff.

I've never actually studied all of the data. It'd be interesting to do so. But the common belief that I generally think is true in B2B and SaaS products, that works pretty well. The consumer is different, more hit-driven, and more unexpected things can happen. But yeah, I think Craft is just really good at that, as our other folks like Emergence too.

I love Emergence. We're super close with them too on Acquired. They're a little more qualitative. They're a little more liberal arts to Craft's engineering approach to SaaS investing, and that's okay. That works great for them too, but that's what I think of when I think of Craft.

Thomas: It's really helpful in my situation where I'm bringing investments. I am not a professional investor in the way that Craft is. I'm not a professional investor in the way that a real estate manager or a private equity fund is. I have to operate by way of proxy.

In this environment where I'm getting asked for cybersecurity investments, I have some beliefs on what good businesses might look like here, and what lower quality businesses have historically been. And then when I think about the people running the business and the investors getting on the cap table, I really have to lean on years of experience. Past performance doesn't indicate future returns. That's total bullshit. Winners keep winning.

David: At least in venture. In venture, past performance is definitely a predictor of the future returns.

Thomas: I think it's increasingly a predictor of future returns, just as the benefits of scale become more and more pronounced. I really do believe that businesses in an internet age, particularly, skew to perfect commodities or perfect monopolies. I think that that's a very long-term fullness of time observation. But nonetheless, for us to be able to co-invest with some of the longest-tenured, most rigorous B2B focused SaaS investors.

It's a really great opportunity that you've given me to come in and step in and make this investment because it's really the product that I had hoped that I would be able to deliver when I started this journey when I reached out to you and said, hey, I've got this thesis on podcast networks as a way of building an investment program.

David: Maybe it's worth spending a little time on that. The deal dynamics of the Kindergarten's SPV here, maybe without getting into specific numbers, but for me and Nat, it gets going back to sort everything I've been saying all along here a little bit on our first episode and the LP episode that Nat and I did with Ben where we talked about things about Kindergarten a little bit. Mostly about Kettle, but a little bit about Kindergarten.

Hopefully, it's clear that it's genuine. I'm not saying this as a faint. We're genuinely not trying to build a traditional venture firm, genuinely, genuinely. I want to do Acquired, Nat wants to do Kettle. Those are the things. Kindergarten is the part of that ecosystem flywheel, whatever you want to call it. We're not interested in scaling assets, under management to scale assets, under management and scaling management fees to scale management fees, and building a team in charging premium carry, which is what I was going to get into here.

Hopefully, we can provide a great investment product to LPs like you. What clicked for me in this process, I'd sort of maybe intuited this ultimately than chatting with you and hearing it. I think it was valuable to you, we don't want to raise large core funds. The Kindergarten fund two now is just about $12 million. We might take it a little bigger, but that's the scale that makes sense, I think.

This SPV vehicle will end up doing it. I think when all is said and done here, we're just wrapping up some loose ends, it'll be roughly about the same size as the whole fund. Double-digit millions are close to it that we're investing in Vanta here.

I don't need to charge a management fee on that. We don't need to charge 30% carry on that. We don't even need to charge 20% carry on that for our large LPs. I hope to you that that's compelling and different.

Thomas: It's compelling at a lot of different layers. I think about your business and your motivations when we are partnering with you. When I see that Kindergarten is, it's really play for you what is work for others, which is another way of you saying your margin, your fee structure is my opportunity.

You've mentioned a couple of times that you're not a professional investor in the traditional sense. That's core to my thesis, which is the service that you are providing here connecting me as an LP to Vanta as a company that I get to invest in, as I put myself in your seat and I see how you're interacting with Vanta, the way that you are growing the surface area in Acquired for them to really get the full benefit of a partnership with you guys.

When we start to talk about, okay, they opened their round, which this is maybe another thing I should have mentioned earlier. As I've been asking people, hey, what do you think of Vanta, we have an opportunity to invest. People have said, oh my gosh, that's a really tight, highly sought after. How did you get into Vanta? And then I say, oh, it's through David Rosenthal, and then everyone's like, oh, yeah, that's right. Everybody loves David.

I think, yes, that is the business that I want to invest in. I understand why it is that Christina opens the door for you to lead an SPV. When you and I are talking about what I need to do my job well, which is bringing thoughtful investments that fit specific needs that meet criteria, whereby I can point and say, here's where we're adding value. For you to be so flexible on fees the way that you have, it really helps me feel like I'm doing my job as an institutional investor.

I think that, really, a lot of the lessons that I feel like I learned now on the allocator side of the table came from our mutual friends over at MITIMCo, especially Nate Chesley and Nav Harikumar, they focus a lot on fees because over the fullness of time, fees really do matter.

David: Yeah, both management fee and carry. They both matter. We carry more than, but over a number of years, if you're charging 3% management fee for 10 years, that's 30% of the fund.

Thomas: Yes. For me then to be able to go and articulate this investment to others, we're not paying a management fee. We're paying probably half of the carry. I don't know what conservative is, but hopefully, we can do better than a 20% gross return here.

Let's just, for math's sake, say 20% gross return. If I'm invested in a 2 and 20 fund structure, then my take home is going to be about 14%. In the way that you and I and Nat have set this up, our take home here is going to be 18%. Four hundred basis points of differential performance in the context of co-investing with a fund like Craft, Sequoia, and YC.

David: Maybe to hopefully tie it all together a little more, this is why I'm so excited about the opportunity that we hazily saw for Kindergarten and coming together, but also why I was so passionate. Once Acquired became a real business, I was like, oh, wow, I love doing this, it's just amazing. This can be my livelihood, and I don't need to play the same game anymore.

When you're in the traditional venture firm world structure, certainly I won't deny, there's an element of greed that goes into the high management fees, carry, building assets under management, and all that. Undeniably, there is greed associated with that writ large. I'm not saying any individual people in VC are greedy, but it's just in aggregate, incentives drive behavior.

There's another reason why all this happens, which is when you're trying to build a firm to compete in the zero-sum game of being one of the best firms to lead the rounds, have the opportunity to lead rounds in the best founders and best companies out there, which is a zero-sum game and you have to beat the other people, there's all this artifice building that goes into it. Of which your terms with your LPs are actually part of it.

Being able to say to yourself, to your LPs, to founders, to others having it known in the ecosystem of, we charge premium carry because we're that good, of which all the top firms do. Those are the elements of the firm building there too. The management fees are part of that, the full offices, the big staff, and all that. Again, there's nothing wrong with that. That's the way the traditional ecosystem works. I think that's fine driving. I don't think we're going to disrupt it.

We're going to be complimentary for sure. Having done all that, I just didn't want to do it anymore. I was like, no, I do not want that in my life anymore. It's just so cool to be able to do this in a different way.

Thomas: Yeah. The other thing I wanted to mention here is, this is the first time that I've invested in my career, which I'd say over the last year. This is the first time where I've had liquidation preferences as a feature for investments.

When you have a software business that can grow very efficiently to several million dollars of recurring revenue, when you're investing as this round is put together in the preferred equity, you have a liquidation preference so that as long as the company sells for north of the money raised, you get a full return of capital.

David: The total dollars raised? Yeah.

Thomas: Yes. I was a public hedge fund manager for 11 years. Every stock that I ever bought absolutely had the potential that it would go down the very next day.

David: Right. Imagine if you had that feature in the public markets where you could invest in XYZ security and be like, I'm only playing for the upside. Ninety-nine percent probability, my basis is not going to go below 100% in this investment.

Thomas: It's very liberating for me as an investor that can go out. I think a lot about my job as being something of a bartender or a butcher. My job is to deliver the best product for the right solution. I'm helping other people achieve their goals, so I need to be considerate of what their risk tolerances are, what their sophistication might be, and having the liquidation preference in this spot where I can help.

A lot of the families I work with are more legacy in nature. This will end up being some of the first software technology exposure that they have. I care very much that this is a good experience and having the ability to say, all right, this company is being priced at 10, 20, 30 times revenue. I think that we can earn a nice return on that. But in the event that the forecast doesn't pan out the way that we're hoping, the downside is really, really limited.

Again, that's something that's, I think, very unique to software businesses where when they're successful, they are so economically successful that the amount of money, the total dollars raised, is such a small amount relative to the intrinsic value of 80% recurring revenue business. It's really then, for me, as I've been trying to think about ways to navigate a private investing program, I think that a) this is a feature that I will continue to seek out, but b) it really distorts pricing.

Yes, we have had a bit of a reset from a fund flows perspective. But the secular trend, as more institutional dollars come into the theme of software eating the world, and as these liquidation preferences are in place, the price, the way that like you said, if this was a public investment, how would you price the can't lose money and then what's the upside? It really gets distorted. It doesn't seem like something that's fully taken into consideration in the market.

David: It's fun. Let's jam on this little bit. This is one of those secrets hiding in plain sight that I don't think it's talked about enough. I'd hoped that we might go there in the interview we did with Howard and Andrew Marks that came out a little bit ago on Acquired. When I asked Howard about the differences between public market investing, which is a highly efficient market and all that in private market investing, I was hoping we would touch on this feature of at least venture private market investing.

You're absolutely right. The concept of preferred equity is, to my mind, a huge reason why there are outsized returns to be had in private market investing versus public market investing. Now, access is a bigger one for sure, privileged information, rights. All of that is true, but this is certainly a piece of the puzzle for me.

For me personally, in my own activities and you as an LP, why do I feel good about committing large portions of my net worth, my time, and energy to investing in private market technology companies versus public market technology companies, which many of the same features of still in cases be plenty of upsides left, infinite liquidity, and all of that? This is one of the features that is a big feather in the cap for private market investing.

Thomas: It definitely is. It's been peculiar to me that it hasn't been talked about as a distorting factor in valuations. I've been digging into this more recently. I was going down a Twitter rabbit hole just searching liquidation preference and other similar terms to see how people are talking about this.

A lot of the secondary platforms like Forge, pricing, common, and preferred equity, they end up trading way closer in price to one another than I would expect. When companies go public, there almost always is, as going public, the preferred converts into common. I understand that that point of convergence does exist.

David: Depending on the scenario. On paper, the benefits of this, the investors are larger than they actually are because it only applies to an M&A scenario. If a company were to go public, then the preference gets wiped away.

Actually, I've seen this way back in the early days of my venture career. You can get a management team and an investor base at strong odds of incentives here where if a management team thinks that they can take up—say, they've raised money at a valuation that is no longer reasonable, the intrinsic valuation of the company should be much lower.

If the management team thinks that they could actually get an IPO through, get public, and get liquid, their strong incentive is to do that versus to sell the company, even at the equivalent price, especially at the equivalent price because if you sell the company, the investors get a much larger share of the proceeds because of the preference. You go public, the preference gets wiped and everybody shares equally.

Thomas: Yeah. I think that that's something that you certainly have to express the view here. Vanta has raised the $1.6 billion valuation. If they go public and the price is less than that, then you don't have the protections of that liquidation preference.

As an investor, I'm asking myself, what are the series of next best alternatives that Christina might have? Does this company go public in a variety of worlds where they are under a $1.6 billion valuation, which is basically just at the end of the day, is there enough gas in this tank that I'm pretty confident that we can get within the next couple of years to that threshold? I very much believe that they will.

I think that as more capital comes into earlier stage, technology-enabled assets, and I look at myself as a Sherpa kind of fostering those flows, having the liquidation preference is really helpful. What are downsides of having liquidation preferences? Does this end up operating something like debt in an organization?

David: I don't think functionally. We should talk about ratchets in a sec here. I think for a standard liquidation preference like this, like I said, I've seen it in my career where you couldn't get a company in management. Common shareholders at odds with preferred shareholders over companies viable, but not as viable as thought. In that case, it was a very capital-intensive company that had raised a lot of money.

Again, never say never. I'm sure this will happen in cases and has happened. But in a software company, it's pretty hard because it's not the valuation that matters with the liquidation preference. It's the amount of capital raised.

Let's take Vanta here. Round numbers, let's say it all and be about $200 million that they've raised. That's the preference stack. Whether the valuation was $500 million or $1.6 billion as it actually is in this round, $3 billion, $5 billion, or whatever, that doesn't matter. It's getting the dollars back to the investors.

For argument's sake, let's say Vanta had raised at a $5 billion valuation, but only had $500 million that it had raised for company X. The $5 billion valuation had raised $500 million total of capital. If the company had an opportunity to exit for $1 billion, that's obviously way lower than the valuation in an M&A exit, but the investors would get their $500 million of capital back. For software companies that scale so efficiently, as you say, it's not like that big a deal.

Ratchets are what's interesting. I wonder if we'll start to see this coming back. This had happened in the mid 20-teens era where people were unsure about economic inflation a little bit back then. Square is the most famous example.

Their last one or two private rounds at Square had raised these dynamics we're talking about, but the extra feature of a ratchet—and what a ratchet is it's basically saying this dynamic applies both in an IPO and in M&A. Liquidation preference is usually just M&A. If you go public, the preference gets wiped out. But a ratchet says no, no, it stays. If you were to go public at a lower valuation than this round, investors essentially get their money back through a variety of mechanisms.

Thomas: Interesting. Yeah, I think that that's what I'm probably most looking forward to about this ongoing and continuing phase of the capital formation cycle, just as a practitioner, learning about the features that come and go over time and increasingly kind of using those as tools and as ways of also charting where we are in this capital cycle. I think it's going to be really interesting.

David: It's interesting, the ratchets got a really bad rap in that era, and I'm not exactly sure why. If you think through it as objectively as possible, early stage investors hated them, which I think is why they got a bad rap. Because if you're an early stage investor in a company like this, let's take Square, for example, that ratchet can really hurt you. It can cause you to suffer a lot more dilution at the IPO, which you're already probably not happy about dilution of the IPO, but you'll suffer even more because of a ratchet.

I think a lot of early stage investors got very vocal about hating them back then. But like anything, it's a term, it's a feature. You're providing further downside protection to a new investor in exchange for a combination of a higher valuation and more importantly, more concretely, probably more capital getting put into the business. I'm not sure it's actually that bad. The management team kind of sits somewhere in the middle. If you want to go deeper, we can discuss their motivations too.

Thomas: It just depends on the circumstances. The specifics matter in terms of where the business is, what that marginal dollar might accomplish if raised. I think one of the things I really like here is, and I've heard this from some investors that have partnered with Vanta where they like to be involved because they think that Christina isn't going to be a founder that has multiple acts in her, which I don't know whether that has basis or not. But the point being that her next best alternatives, I think a lot about next best alternatives.

What does that look like for her? It's going to be a very high bar that she has to continue to put her life's work into Vanta. I feel like when it gets to a point that she might think that doing something else is more attractive, getting the highest value, and having that be a data-informed decision that happens earlier rather than later, I think is something that when I go into thinking about who the people are that are involved, their next best alternative is a really key input for what I think that they might do in the future.

David: Yup, great.

Thomas: Do you want to move on to grading?

David: Oh, yeah. How do you want to grade this?

Thomas: I think it needs to be forward-looking. What does really bad look like? An F is that this category that Vanta—

David: Everything we were just talking about actually becomes irrelevant, which I really think is unlikely.

Thomas: I think that it is as well, but I want to do this for posterity's sake. As a professional hedge fund manager for a long time, my pre-mortems and post-mortems looked like translating Hebrew to Chinese. The unknown unknowns were so often the dominant fundamental factor that I should have been paying attention to. I think for me, there's some posterity value in doing this.

What does really bad look like from here? Maybe we'll go back to the Geoffrey Moore mindset. At an infrastructure level, I have a hard time manufacturing risks at a software eating the world level. Where the risks start to manifest is creating the category doesn't mean that you continue to own it. In fact, it attracts a lot of competitors. Some of the competitors are very strong. Also, there are large behemoths that control a lot of data and workflow adjacent to Vanta.

There are scenarios where growth slows dramatically. It ends up being a public comp kind of valuation of something and the four to six times revenue multiple. I think that fortunately for Vanta, a slower growth environment would likely result in the company having pretty good cash flow margins. There is downside, absolutely, to that $1.6 billion valuation. Is there a downside to the 200, 250? No, I think that that's hard to get there.

David: To your point though, also about that little bit of a sidebar, but I just learned something the other day that blew my mind, which is that, to your point about large incumbent software companies that might want to enter a space, I learned about a new software, a new product, cloud software, application software product from Microsoft that they launched 18 months ago that is now doing $1.5 billion dollars in annualized revenue.

I was just like, holy crap, that's so crazy impressive that Microsoft can still do that and does that. Man, it's so awesome. Microsoft probably wasn't doing that. Yes, of course, it's distribution that does that.

Thomas: Their ability to see, it's like the Eye of Sauron in Lord of the Rings. To see that opportunity and be like mine, $1.5 of ARR, no time flat. It is a very challenging part of investing in an ecosystem-driven internet services world. I was very bullish on Slack.

Actually, I think, one of the few private investments that we made at the fund where I worked, we're users, and we loved it so much. It transformed talking about a system of engagement. But holy hell, Microsoft's ability to pour water on the Slack fire was really remarkable. I think that's a piece here that I feel a little bit more comfortable just given the nature of this being an aggregation layer.

Very few companies are mono cloud. As long as that digital estate has a lot of heterogeneity, as long as you have Azure, AWS, GCP, a suite of cloud services that go into building your infrastructure, I think that this is relatively insulated from the big scary platform competitors. What does a middling outcome look like? I think they continue to grow north of 100% rate for the next year or so, but then that stair steps down to maybe 50% or so in two years.

David: I don't think we actually said that. I won't say the actual numbers, but the revenue growth rate in the air, our growth rate for Vanta is unbelievably impressive. Truly, truly top tier, one of the best I've seen in my whole career, which is awesome. That's another feather in the company's cap.

Thomas: It is. As businesses grow so quickly, the bar for exceptional growth, I think it just has to go up. As you think about continuing to refine your investment thesis for the environment that you're operating in—I remember when I first got into software, a rule of 40 company was really good. Rule of 40 means recurring revenue growth plus the cash flow margin that they're able to earn. Vanta is rule of well into the triple digits.

David: Well into the triple digits, yes.

Thomas: Which is exciting. I think that having that be a durably high number and that really being a function of a data-informed decision, that is making those return-oriented investments into the business and having a forced rank way of prioritizing capital. This is really a capital allocation exercise that Christina and team are working towards.

In any case, for a middling outcome, I think that they continue to dominate in SOC 2. They find ways of appending the SOC 2 product with some PCI compliance, maybe some HIPAA, Sarbanes-Oxley. I think that piece for me is going to be really important. Right now, their net retention rate is good, but I want to see it improve over the coming quarters.

David: They don't have a good expansion product flow. It's like, you buy Vanta, the expansion is you add more compliance certificates. It's not a usage-based expansion right now, which as you say, can be a double-edged sword in a tough environment. But generally, usage-based expansion is great.

Thomas: Yeah. I think that the middling situation is where they kind of stay in the system of record world. They have some expansion, but not a lot. In three years, it's $200 million something. You probably get to that $1.6 billion valuation. Maybe you can get kind of a 15%, 20% return from here, and it's a fine investment.

What I would say also though is something challenging right now. When you have dislocation in the market, there are lots of purchase decisions you can make right now that might look like exceptional investments. The bar is pretty high on a relative basis. Again, bringing in that liquidation preference really does kind of help justify the investment, even in the case where it's something of a middling outcome.

What does an A look like here? An A looks like standing up compliance automation as a major pillar within the digital estate. So something like a CRM or service management like what ServiceNow has built, or even observability like Datadog is in the process of building out. In that scenario, you end up ingesting upstream processes, creating a visualization and engagement layer that really hones in on the core risk profile of a business.

I want to add one thing that really could get me super excited for that A+. When I think about what's the information that exists in a business that could really tell me something about its DNA, about its culture, about its likelihood to execute and win large markets, it does have to do with the insight that Vanta captures.

If they can find ways of translating the data that they're ingesting into something of a communication to the outside world about what that company is, kind of almost along the lines of like what an S&P or a Moody's do for assessing financial stability. If Vanta can become a way of communicating operational stability and excellence, I think that there is a sundry of ways of creating and capturing value. A $100 billion dollar company. That world is not out of the question. That's the thing that when I'm daydreaming, which I do sometimes, is how—

David: I love the way you phrased it earlier. I think, really, a great way to capture what you're talking about is, can Vanta cross the chasm from a system of record to a system of engagement? If they can do that, yes, the system of engagement around security compliance and data security monitoring is going to be an enormous market. Again, with the usual caveat of, I can't be sure about anything anymore, but I'm pretty sure that that's going to be an enormous market.

Thomas: Yes.

Ben: All right, listeners, thank you for joining us on this episode. Our huge thanks to the Solana Foundation. Come hang out with us in Lisbon at Solana Breakpoint. Dave and I will both be there on stage doing a live show. We're very excited about that.

Lastly, please take the Acquired 2022 Annual Survey. We ask delightful questions like what do you do for a living? How big is your company? And other fan favorites, such as, did you become a customer of any of our wonderful sponsors all year? We would really appreciate you helping us out by filling that out and win some sweet prizes. All right, listeners, we'll see you next time.

David: We'll see you next time.

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