Commodity Capital Quarterly LP Letter Q1 '24

“To lose patience is to lose the battle” - Gandhi

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Industry

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Welcome, everyone: USV Announcing a Focus on Vertical Integration and YC Request for Startups

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USV Announcing a Focus on Vertical Integration

Since my first Letter to LPs I’ve discussed more investors entering the space but none have outright discussed vertical integration as a theme, it was discussed on the All In Pod a few times but never as clearly as USV has. Additionally, YC having a direct call for startups focused on the aerospace, defense, and manufacturing categories but more broadly the intersection of software and hardware.

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Source: @jaredhecht, X

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This is not a concern to me or Commodity Capital in the least bit, if anything it’s encouraged given the head start in a stellar portfolio, the learnings the founders have had, and the learnings I’ve gathered in the four years investing in not only the space but backing this larger platform shift - vertical integration.

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“Instead of selling software to industry incumbents, startups are increasingly deciding to use their technical know-how to compete head-on. We think this approach is especially important for companies in physical industries, and it fits our thesis of investing at the edge of large markets being transformed by technological and societal pressures.”

- Jared Hecht, USV: Vertically Integrated and AI-first

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YC Request for Startups

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Source: YC Request for Startups, Y Combinator

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In a welcome turn of events, YC has requested for startups outside of developer tools, enterprise software apps, and application layer AI companies. Specifically they outline the five categories below as focus areas for future cohorts:

Applying machine learning to robotics
Using machine learning to simulate the physical world
New defense technology
Bring manufacturing back to America
New space companies

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This most likely has a lot to do with two factors. The first being a shift in sentiment in expanding problem sets beyond the enterprise and the second is the hunt for returns.

On the return side Techcrunch has said, “the exit market for SaaS dried up in the second half of 2022, which saw the lowest exit activity since 2016. Meanwhile, venture investment was down 70% in Q4 2022 compared to Q4 2021.”

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So that would make sense since we’ve been seeing steady rapid appreciation in equity value for the categories mentioned above. My hope is that this unlocks more talent and creates more awareness as more firms begin to push the above categories.

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Note: Commodity Capital has two companies in the portfolio from YC that fall along this new call for startups, Albedo and Metalware.

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Vertical Integration is the Platform Shift

There’s been a lot of discussion of AI being the next platform shift that radically changes how business is done. From what I’m seeing what we’re getting are enhancements to existing products not new companies being created that radically change how a market operates. I do believe there will be a moment in time when this happens but not for several years.

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The real platform shift that we can invest in right now is vertical integration. Why I believe this is a platform shift is because we’re actually seeing a clear dichotomy of an old vs new way of doing business that radically changes market sizes and opportunities. I created the graphic below depicting why this is a platform shift and not an enhancement of existing solutions.

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Source: Commodity Capital

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We saw this very similar shift with on prem to cloud - you could argue on prem is coming back but with all of the enhancements created by cloud technologies. What we saw with the transition to cloud is rapid product iterations, massive cost reductions, and an always available access to your data. We’re seeing these same characteristics in vertically integrated companies - more on that in the next section (Real IP Creation; a Win for Customers and Shareholders).

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Real IP Creation; a Win for Customers and Shareholders

These companies are creating real IP compared to the last wave of enterprise SaaS. Chris Power outlines this by saying,

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Source: @2112power, X

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This is important not just for IP creation and technical moats but also the company’s ability to quick turn on customer/internal feedback, unlocking rapid product iterations and deployment. In turn, this makes customers happier because they can have a continuously improving product which in turn creates more business. Additionally, this translates into real IP creating deep moats making existing and prospective shareholders very happy.

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This is core to startups building complex vertically integrated monopolies as they seek to build more and more of their stack in house.

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VC Macro

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Early Stage Slow Down

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Source: Q1 2024 PitchBook-NVCA Venture Monitor

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Sometimes the data and the anecdotes align and that’s exactly what happened in Q1 with what we saw. Below are three reasons I suspect the slow down has been happening:

Pricing discipline: from what we saw it looks like pricing has started to outpace excitement when it came to early stage investing and a reversion to pricing discipline equating to a slow down in deals.
Talent crunch: what we saw in our part of the world another is a talent crunch in founding teams - since our category has started to pick up attention the number investable teams will go down for a time but should recovery once the founding teams that want to be in our space stick it out.
Cash management: LPs have been historically slow to commit which in turn slows deployment and ability for new funds to be raised forcing funds to think long and hard about every deal - on the whole this is a good thing.

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Late Stage Crunch but not for Us

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Source: Q1 2024 PitchBook-NVCA Venture Monitor

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The above chart would have you believe that late stage across the board is TOUGH. But if we look closer at just the Commodity Capital portfolio, which would be a good index for the manufacturing, automation, aerospace, and defense sectors, you would see no issues with raising large rounds at the lat stage. We’ve seen big rounds at elevated valuations for Armada, Albedo, Hadrian, and a few more that are currently in the works.

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My assumption is the above chart is more representative for AI focused companies that were able to quickly raise large amounts of money at the earliest stages but investors are realizing their ability to effectively commercialize is much harder. This is another reason I believe we’re still too early in the AI category to start making investments. The AI platform shift needs to figure out it’s place in the world first.

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IPOs are Coming

The tech IPO market is showing signs of revival in 2024 after a couple of rough years following the collapse of growth stage companies, valuations, and venture returns. I’d argue this uptick is largely fueled by renewed investor confidence and improved valuations.

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Another huge boost in confidence can be attributed to a move away from a growth at all costs mindset to one focused on sustainable growth, cash flow, and profitability. Combine this new found mindset with the ability to time market conditions using what’s called a “shadow backlog” (source: PwC) allowing companies to file confidentially while building their book 2024 should be a great year for IPOs. All of this combined with a more stable rate environment should set us up for a fantastic 2024 when it comes to IPOs.

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The issues that would dampen an onslaught of IPOs would most likely be related geopolitical issues and a worsening regulatory environment hurting fast growing tech companies in particular.

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Partial list of IPO ready tech companies:

Reddit - up 3% at the end of Q1
Astera
Telegram
Ibotta
DJT (IPO’d)
Stripe (IPO ready as long as public markets are kind with a large revenue multiple)
Shein (Controversial but IPO ready)
Zocdoc
Northvolt
Klarna
Zipline

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Secondaries heat up

Personally, I’ve received more emails from secondary marketplaces and brokers looking to offload shares so far in Q1 2024 than than I have since 2021. From what I gather this is a primarily from VCs and LPs looking to get liquidity since the public markets have been frozen.

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Historically, secondaries were meant for employees, as pointed out below, but have been a welcome exit for VCs and LPs.

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“Secondary markets have always been aimed at employees. What’s newer is that VC funds and LPs have begun to lean on them.”

Nat Leung, Sapphire Ventures

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Source: Industry Ventures - How Big is the Secondary Market for Venture Capital?

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With a hopefully high volume of IPOs in 2024 these should alleviate a massive build up in illiquidity we’ve seen over the last two years, making life much better for VCs, LPs, and employees.

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