Commodity Capital Quarterly LP Letter Q2 '23

Welcome, Jacob Helberg as Venture Partner / Advisor

Jacob Helberg is one of the preeminent minds on bridging the gap between startups and the US government. He currently runs the Hill and Valley Forum, designed to put America’s best New Industrial Base startups in the same room as our country’s leaders across Congress, the Armed Services, and other branches of the US government.

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Among his long list of accomplishments:

Author of the best selling book The Wires of War: Technology and the Global Struggle for Power
Commissioner for the U.S. - China Economic and Security Review
Senior Adjunct Fellow at the Center for a New American Security
Senior Advisor for the Center of Geopolitics and Technology at Stanford

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Portfolio Company Updates

New Investment: Senra (Invested at Pre-seed)

Description: Automating wire harnessing and reducing time to delivery by 50%

What is a wire harness? “An assembly of electrical cables or wires which transmit signals or electrical power. The cables are bound together by a durable material such as rubber, vinyl, electrical tape, conduit, a weave of extruded string, or a combination thereof.”

Highlights:

Co-founders, Jordan Black and Ben Shanahan, met and recently worked at SpaceX overseeing manufacturing and building internal software tools
Wire harnessing is the largest market most people have never heard of ($58B by 2030)
Early customer traction is strong across aerospace and defense
Co-investor Founders Fund, Caffeinated Capital, and Countdown Capital

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Update: Varda (Invested at Seed)

Description: Microgravity platform and reentry logistics

First launch and reentry (coming soon): Varda had their first launch on June 12th and everything went off without a hitch - thanks SpaceX. This first mission will be manufacturing Ritonavir, an HIV/AIDS drug, in orbit and then attempting reentry in late July. Reentry is the most critical part of the mission - so fingers crossed.

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This is the first NGO to manufacture drugs in orbit

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Launch day for Varda: Me, Eric Lasker (Head of Business Development at Varda), and Delian Asparouhov (Co-founder and President at Varda)

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Update: Hadrian (Invested at Seed)

Description: A series of highly automated precision component factories across the US to enable Space & Defense manufacturers to get parts 10x faster and halve the cost of making Rockets, Satellites, Jets & Drones.

Anduril Industries and Hadrian Announce Strategic Partnership: “Through the Anduril-Hadrian strategic partnership, Anduril will accelerate its production of key components and precision parts at scale, leveraging Hadrian’s proprietary design excellence and manufacturing competencies to reduce cost and lead time.”

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Vertical Integration: Venture Scale Returns, Moats, and IP

The playbook for building a New Industrial Base startups goes something like this:

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Build a top-tier technical team.

Achieve your technical milestones.

Generate the appropriate level of BD and sales interest in what you’re building.

Not Boring, Varda: The Space Drug Company, June 12, 2023

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There’s one more step I’d add to that, vertically integrate as much as possible ESPECIALLY when it comes to software. Given the cost curve of developing software going down, the sophistication of developer tools, and the ability to simplify/customize your architecture it’s the best way to capture the most amount value. Not to mention achieve venture scale returns, build moats, and develop intellectual property.

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Screenshot from Tesla shareholder meeting showing the breadth of tools developed in house.

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Finally, one critical piece that was mentioned above that should not go without reiterating is that vertical integration not only simplifies your architecture but also the procurement process. Friend of the firm, Chris Mintle (Investment Banking Director at Lazard for Aerospace and Defense), says in his annual New Space Ecosystem & Investment Overview:

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“Space companies pursue vertical integration to lower costs and bypass traditional procurement approaches

Allows companies to control their supply chain and efficiently manage development of their spacecraft

Avoid procurement complexities with in-house manufacturing”

New Space Ecosystem & Investment Overview, Winter 2023

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Unlock Venture Scale Returns in Historically Non Venture Scale Businesses

Companies like Hadrian are able to create venture scale returns in historically non venture scale businesses because of vertical integration. We can see what this business profile looks like at scale by comparing it to Tesla and their operating model/system.

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For this example we’ll compare Tesla to a preeminent SaaS company, Snowflake. Snowflake is a fantastic representation of what has historically been thought of as a venture scale business compared to a company that would not have been considered venture scale.

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Yes the gross margins of Snowflake greatly outweigh that of Tesla. But if we go a little further down to the EBITDA margins of both companies that tells us a very different story and even poses the question - what is “venture scale” and does it even matter?

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New Industrial Base Startups are Creating Moats

Building a moat or even moats around your business are critical to long term success. For New Industrial Base startups vertical integration allows you to develop a superior solution/product compared to your incumbents. Unfortunately, switching costs tend to be high when selling against incumbents, especially for the average New Industrial Base market. But, once those customers have been won they tend to reap the same rewards of having high switching costs.

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Building a vertically integrated company is immensely harder but allows you to beat incumbents because of the flexibility and efficiency that comes along with it. In one of Albedo’s most recent investor updates they can be quoted as saying:

“Verticalization is key to commercializing VLEO and maintaining our moat”

Albedo Q2 ‘23 Investor Update

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New Industrial Base startups require patient capital but that capital will be returned many times over with long term sustainable value creation.

“Nothing defensible grows that fast”

Ryan Peterson, Founder at Flexport

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IP is Created at the Intersection of Software and Hardware

The average SaaS or AI company is not creating intellectual property; they're either spending it on CAPEX or sales and marketing. That doesn’t mean returns can’t be generated by investing in SaaS or AI companies, it's just that there's little intellectual property to show for those investment dollars. Intellectual property is important to building long term sustainable companies that change the world and that’s where I want to invest.

We’ll refer back to the table above comparing Tesla and Snowflake. Tesla allocates ~43% of their expenses on research and development while Snowflake is ~36%. I’d argue that Tesla has created more IP than Snowflake and the dollars allocated to research and development are directly correlated to that.

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VC Market Update

Slow Q2 for Financings and a Hot Forecasted Second Half of ‘23

Commodity Capital saw a very slow Q2 when it came to new investments. Last year the pace was roughly 1 new deal a month and last quarter only 1 deal was completed. There is no rush to deploy capital unless a company is compelling and the number of compelling companies went down in Q2. This is more a function of the current fundraising narrative and founders wanting to time the market rather than a function of quality deal flow. Globally, venture funding still fell 18% in Q2 quarter over quarter to $65 billion according to Crunchbase.

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An opportunity for Q3 and Q4 might present in Seed stage companies who have gotten lean and have good traction but have misaligned expectations on their ability to raise $10M - $15M series A’s at $60M - $80M valuations. These companies have the metrics but the market isn’t prepared to invest those amounts and pay those prices. The opportunity to invest in Seed 2’s should allow for increased ownership at reasonable prices. The bar for companies in that situation is much much higher than that of a normal Seed round because sometimes stuff is on sale for a reason.

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Late Stage Concerns Still Present

There are two concerns when it comes to late stage financing and New Industrial Base startups

Valuation
Who will write the check?

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Valuation

Broadly speaking there’s been a significant drop in growth-stage valuations as seen below:

“The median valuation for growth-stage startups fell to $90 million in the first quarter, a 75% drop from 2021, according to research firm PitchBook.”

The Information, Startup Valuations Are in Free Fall, June 4, 2023

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With that being said, New Industrial Base Startups have largely been saved from the current late-stage crunch but will still be impacted. Anecdotally, a handful of Commodity Capital portfolio companies are in the market at elevated valuations compared to their last round, albeit not the insane step up in valuations we saw two years ago but increased valuations nonetheless. There are two major themes supporting valuations in this vertical; first, contracts are large, long dated, and the US Gov always pays their bills. Second, most New Industrial Base startups are generating real revenue and that’s attractive.

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Who will write the check?

A bigger concern than valuation for New Industrial Base startups; who will write that check at Series B and beyond? Unlike enterprise SaaS, there are only a few late stage $1B+ funds who have publicly announced their willingness to invest in the space and they include; Lightspeed, General Catalyst, and Coatue. I’m sure there’s plenty missing from that very short list but it is a real concern.

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In order to fill the gap, what I expect to see are syndicated deals including the above-mentioned funds, corporate venture arms, and family offices. We’re in uncharted territory for New Industrial Base startups and with that, periods of uncertainty - but this is where the returns are.

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Where does AI Fit in the Portfolio?

My position on AI remains that startups building at “the metal” or the ones that use it to enhance an existing solution will succeed. Paul Graham puts it perfectly with this Tweet below:

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Twitter, @paulg, May 14, 2023

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I believe the at “the metal” companies who are building foundational models or the ones that allow you to train on new data will succeed. Conversely the infrastructure layer for implementing AI into an existing application is not much different than implementing any other API and since there have been billions of dollars invested in lowering the barrier to implementing API’s there’s no need to dig in here. Across the Commodity Capital portfolio there’s been some movement to injecting AI into existing applications but nothing too significant.

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Ultimately, it seems like at “the metal” investments happened 2-3 years ago and given current price appreciation for anything that has AI in the name I’ll be holding off on making any investments for the time being.

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Macro Update

Reshoring Continues to be a Major Theme

Advancing, or just rebuilding, the industrial and manufacturing base can even be seen in the chart below. This is a striking increase in the amount of construction dedicated to building factories and manufacturing facilities from chip fabs to pharmaceutical drugs. There is no coincidence that this spike coincides with our continued Cold War with China as well as the brittle supply chain that was made quite obvious due to the pandemic.

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FRED St. Louis Fed, Total Construction Spending: Manufacturing in the United States, June 28,2023

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Not only are we seeing construction for manufacturing going up, but anecdotally the government wants to work with more startups that are filling the gaps in our industrial base - this is coming through a handful of interactions with a handful of Congressmen who are extremely excited by a few of the companies in the Commodity Capital portfolio.

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I don’t see a slow down in the chart above or the narrative radically shifting. Especially with the national security threat coming from China and the continued modernization of our industrial base.

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Slow Down in Rate Hikes… for Now

We saw a pause in rate hikes in June but don’t expect the increase in rates to stop, notwithstanding some large shock to the system.

What we are seeing though is a slowdown in consumer spending, reduced consumer savings, and inflation slowing but not to the point we need to start decreasing rates. If anything, the Fed has shown us that they aren’t afraid to go higher with rates.

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Brace for a Recession?

Although the economy is still running quite hot, the potential for a soft landing might actually be in the cards. The most simple explanation is that the Fed has been able to successfully, at this point, continue to raise rates so that when we do have a slow down there’s room for rates to drop. The next major question is when? I’m a big fan of Macro Alf who has a fantastic track record as a bond trader and macro strategist. In his most recent letter he says:

“Every time real yields were sitting above equilibrium, something broke in the economy and in markets (2001 recession, 2008 GFC, 2018 stock market). To the contrary, periods when real yields were below equilibrium were generally good for growth and markets (2004-2007, 2012-2017).”

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As you can see in the chart below, we’re well above equilibrium. So keep an eye out for a potential slow down in the medium term.

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Macro Alf, June 2023

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The reason it’s important to stay on top of the macro as a Seed / Pre-seed stage fund is because both VC’s and startups are impacted by the type of macro environment we’re in - so it’s always best to be prepared for the downside and be ready to take advantage of the upside. Macro trends impact everything from fundraising, to customers, to suppliers.

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We’ve seen this with the best positioned companies that took the hard medicine 12-24 months ago who cut headcount/expenses ahead of massive rate increases that have greatly impacted the funding environment that then allowed them to weather the current storm.