Bruce Hallett — Miramar Digital Ventures

Wednesday, May 25, 2022

Bruce’s new $100M fund, Miramar Digital Ventures II, invests early in software and data.  He explains why many VCs have gone back to preferring notes over SAFEs, and other insights on deal preferences and construction.

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Bruce Hallett is a partner and one of the founders of Miramar Digital Ventures. Miramar is a seed and early stage venture fund focused on the future of data.

Miramar has about twenty five companies in their portfolio and about two thirds of those are Southern California based companies, many in L.A. But Miramar itself is based in Orange County. Bruce has been doing venture for a couple of decades and I am excited for what I’m going to learn from him today. Thanks for being on the show. Oh, it’s my pleasure.

Minnie. Great, well, I guess the first question is, did I get the introduction right? And can you share a little bit more about Miramar?

Yeah, I’d be glad to. We have a history kind of through two different series of venture funds. And I go back, we can talk about this later because that’s part of our connectivity with TenOneTen and Gil and Eytan Elbaz is that back in the late 90s when I was a lawyer at Brobeck, I was their counsel.

I was also running a venture investment fund with some other partners at Brobeck. So we were investors in Applied Semantics and a number of other companies. So that’s kind of how I got started in and really got the bug for investing. And then one of my other clients was Broadcom. I had taken them public and they almost wore me out doing lots of M&A nineteen ninety nine two thousand timeframe and then this decade partnered up with Sherman Atkinson, who had come out of his company, originally acquired by Buy.com, one of the early e-commerce companies based here in Orange County.

And then he went to L.A. to help with the turnaround at Intermix Media, which owned MySpace successfully did that and sold that to News Corp. 

So you went from from helping companies like applied semantics to kind of doing corporate venture in a sense at Broadcom. Right, right. Right. And then and then when was when did you when did Miramar come into existence?

Well, Miramar Digital Ventures, which Sherman, I, Sherman and I formed in kind of 2014 time frame we launched and that was about a twenty five million dollar fund and we were focused on data mobile data Iot. And then just earlier this year we closed on our second fund, Miramar Digital Ventures II, which is a good deal larger thankfully. And we hope to by the time we’re we’re done, have about one hundred million dollars under management in the second fund.

And so that enables us to invest not just at the seed stage in series, but to kind of keep up with some of the companies that have been successful in the portfolio, including crossover investments in companies where our first investments were in Miramar Digital one. But we’ve kind of reached our concentration limits, which you understand. That means it’s usually about 10 percent of your fund can go into a single company. And so in this case, with the larger fund, we’re able to continue into some of the same companies from Fund one and try to maintain some semblance of our original percentage in these companies.

So if so, with this larger fund, I imagine you’ll be will you be the leading seed rounds? Is that kind of a sweet spot?

As far as leading, we’re happy to co-lead, we’re happy to go in on convertible notes. We can do SAFEs if we have to. We can talk a little bit about that later. We kind of prefer convertible notes, but but, yeah, we’re we’re really looking for great teams who have high proficiency in AI and data science and are using it to transform existing industries.

Do you have certain trends that you’re following or on companies that are a good fit for you? Well, we first of all, there’s no such thing for us is too early. We are very happy to kind of go in even alongside angels and start out putting a couple of hundred thousand in maybe two hundred to five hundred as our sweet spot as far as the point of entry.

And then we have the capability of putting millions in in subsequent rounds. So we we love that.

And so how do entrepreneurs think about when they, you know, why go to Miramar versus someone else? I would say we’re we’re very quick, we’re very certain about what we do and don’t do, so we’re not there’s not a lot of mission creep with us where we go. We might do that. Let us spend some time and due diligence the nice thing about a bigger fund, is that we can expand the team and we’re looking to add some team members this time around. And and one of the areas we’ve added is Stuart McClure, who is the founder of Cylance, the cybersecurity company here in Orange County that was acquired by BlackBerry last year.

How do you think venture has changed and will change? 

Well, that’s a great question. It’s it has changed a lot. I mean, the big funds, you know, especially in the early 90s when I started working with, you know, Brentwood, Redpoint, Enterprise, Crosspoint, all those funds were sort of in the, you know, 50 to maybe one hundred million dollar size.

And that was pretty typical. There were a few funds and Silicon Valley that were bigger. But even the big funds in Silicon Valley might have been more like, you know, two hundred million.

And then, of course, the other factor is these just mega funds. I mean, these funds that are billion dollars billion plus and come in mid to late stage, but a lot of funds, a lot of those funds are going earlier.

It seems like I don’t know if Andriessen or who’s the best example, but a lot of them are now running their seed programs or something. And so I wonder what that what does that mean for for the for the those of us who are in the sub hundred million dollar category?

I think it means we better we better be there early and we better be there with conviction. And we also better be prepared that we’re going to have co-investors maybe from a series seed or series A who are mega funds and have that kind of tension or dynamic between, you know, we may, as smaller funds want to see more capital efficient. See, and hitting milestones and proof points and the bigger funds, if they’re starting to commit serious dollars, know part of their part of their model is to put as much money to work for serious ownership positions as possible.

A lot of times they’re not too sensitive on valuation. But sometimes, I mean, I’ve seen this. You probably have to where they they can kind of swamp a company with too much money and too high expectations. 

Yeah, no, I think it’s experience that, too. Oh yeah.

Unfortunately, a little like close to home for sure. Before being, before doing like I was a founder and we, we took it, we took a lot of money.

So I think, you know, from the venture point of view though, one question is, you know, in you’re a former lawyer who’s worked on deal structure. You know, are there things you can do on the deal structure to avoid getting smushed by the by the larger funds that can pour money in later? Well, there’s. Ultimately, the answer is probably no. But but but there are on the margin, there are ways maybe we could protect ourselves or steer things into what we think is a more prudent direction.

One of the way, there was kind of a mindset of early stage investors that there was a lot of times, you know, kind of an inclination to in addition to preferences on the preferred stock having participating preferred.

And so what that what that means is, you know, is that the preference just says, hey, you get your money back. You know, if there’s a if there’s a liquidity event before the common does, but the participation says you get your money back and then it’s like you convert to common and you participate with common. So in that situation, the investors with the participation get paid at least twice on their early investment. It’s kind of tantamount to at least a 2x preference instead of a 1x preference and sometimes can be much more.

So what what has happened is that as these rounds have gotten larger, like in the 90s, a company did an IPO or an acquisition at a two hundred to three hundred million dollar market cap. Well, now that’s just like a series B or C for most companies.

And if they hit that milestone, they’re on their way to being a unicorn. Mm hmm.

But the longer you can defer and maybe it’s permanently, perpetually you can defer having participation rights on the preferred stock the better, because as an early investor, you’re later going to get swamped by the big investors. If the company is successful, one of those big investors just have the same simple preference that you do, like a one X preference. It’s going to be a lot better for us and the founders not to have a huge stack of preferences that get paid and then participation again when the company goes public or gets.

So you’ve been doing this longer than I have and you have more background here.

So I just legitimately how often do you see the participating preferred and when does it come in that? I don’t feel like I would see it much at the seed stage right now. And I think liquidation multiples are usually come in later as well. But is that true and how common is it? I think it is.

I think it is true. And what I what I’m saying, though, is that in the 90s and even early, two thousands, VCs from the get go, the series seed or series A, investors would want the the preference and the participation. At this point, I think we’ve all figured it out as early stage investors. And the status quo is not to have a participation and just a one X preference, which means that if the company exits over that one X, everybody’s going to flip over and convert to common anyway.

Right. And everyone converts to common. I’m just learning this. You convert to common when you IPO and when you SPAC it turns out I believe that’s what I’m going through.

Yes. Yeah. That we haven’t had anybody that’s SPAC’d yet, but that is my understanding.

And what did you say at the beginning, I think you said you prefer notes over SAFEs. Did you say that? I did, yeah, I’m in safes, we’re kind of all the rage when they got launched out of the Combinator in twenty thirteen or so, the idea was that they were going to just sort of streamline the whole process by not having an interest rate, not being considered debt, going on the cap table instead of showing up as debt on the balance sheet.

And I think what’s happened over time is that, you know, from an investor standpoint, a lot of us have come back around and in. I have a preference for convertible notes, it’s not it’s not that we won’t do a SAFE, I mean, particularly if we’re the last investor in and everybody else did the safe and the terms are OK. I mean, one of the things the other things that got popular five or six years ago was not having any interest rate paid or discount rate or cap on safes and so on.

From an investor’s standpoint, it’s like, well, why not just wait until the company does a round of financing and get the same pricing, making a lot less risk? And the founders have to realize that for the risk your earliest investors take, there’s got to be some benefit. It shouldn’t be overreaching, but to have a 15 or 20 percent discount to the next round price is a good thing. Having some type of cap.

And then the other thing on a convertible note that we like is, you know, even if it’s a notional interest rate like five percent and we always want to convert that into the into the final, whatever the round is, it kind of gives you a little bump, a little benefit if it takes a while. So all those things contribute to our preference for a no versus safe.

And then the other thing is that and don’t hold me to this because I’m I’m not a tax lawyer or anything like that, but I believe there’s a benefit. If something goes off the rails, the company doesn’t work out. If it fails and you have a convertible note, you can deduct that as business debt versus a safe. I think you just it’s a capital a long term capital loss. 

Why is it sounds very basic, why do entrepreneurs still get in trouble with this in the sense of I sort of thought maybe you can tell me who are the best law firms? Aren’t there?

Doesn’t everyone sort of work with, like a Willson Sonsini, Gunderson or a Fenwick?

Or maybe I have the names wrong, but I’m curious, who do you who do you recommend entrepreneurs to work with? And shouldn’t that just cover them? I think for the most part, and all those firms are should be on the short list. I mean, Cooley, KNL Gates. There’s a lot of other ones to that and even smaller firms where there’s kind of spin offs from from the big firms and they’re very efficient. But yeah, it’s usually not a law firm thing.

It’s usually something where maybe the law firm isn’t even involved and the founder just got to a safe off the Internet and they just want to use that. And sometimes you’re kind of stuck with it because if they’ve raised too much money on the safe side, I mean, you’re not going to change it. So you just have to make the decision. Well, will I take the suboptimal document and go with it and be part of this round? Or do we need to reconsider the whole thing?

And of course, if we reconsider it and of course the company wants or would need to agree with this, we’d usually just sort of change the terms for everybody, you know, who signed the safe at the beginning. And we want to put something in place that is a little bit more formal and investor friendly.

Yeah, but I mean, it seems like we’re founders get in trouble. Also is is the layered notes right now as well, which is their thing.

Again, layered, layered notes from the standpoint of they’ll do one round round of notes for a two or three million dollars worth and then they’ll do another set that’s converts into the next round too. 

I was thinking, you know, I haven’t seen as much as you, but sort of a, oh we have a note with a three million cap and then a note with a five million cap and net with a seven million cap. And then the the round gets priced at eleven. And the person with the three million, you know, the founder doesn’t realize how much ownership they’ve given away.

Oh, yeah. Yeah. And and sometimes that’s not only, you know, kind of a showstopper from the founders standpoint, but if you’re a later investor, it is to or if you’re the person leading the round and you find out, oh, there’s a I’m leading around it 12 million dollars, but there’s a person with a three million dollar cap. I you know, I want the prior investors to be treated fairly for their risk, but I’m really betting on the founders and the founders aren’t going to end up with enough of the company that.

Mm hmm. And this is just the series seed array. So God knows what’s going to happen later. So you don’t want to see that happen.

And then how do you think about your own ownership getting diluted? That’s a great question. It’s probably going to be the end of the 10 year term before those deals see liquidity. But that’s also one of the reasons we’re in modeling this next fund.

We’re figuring that somewhere between 40 and 50 percent of the capital, this fund is going to get invested in later stage opportunities, most of which we developed in the first fund and are now in Series B, C, D and D. And so those are closer to liquidity. And we may even have some that are within 18 months or two years of liquidity, but they’re not going to be the, you know, fifteen to one hundred X that we’re hoping for and the winners at the seed stage.

But, you know, by getting some quick, you know, five X’s from the later stage deals that are dressed and closer to liquidity, it’ll kind of keep the keep the flywheel going as far as capital back to our investors and, you know, keeps everybody happy. Yeah.

And if you weren’t reinvesting into a round, like, how do you either for your fund or for your founders, tell them to think about the dilution they should expect in a series A, series B and and later rounds.

Yeah, I mean, it’s it it does hopefully stepped down as the valuation goes up, but there’s also a tendency to raise bigger rounds, so. It’s it’s the sort of thing where, you know, if a company’s had two billion dollar valuation and they decide, you know, they’re raising two hundred million, then it’s around a 10 percent dilution.

But, you know, it can be considerably more if they raise more money. And there’s a lot of there’s a lot of pressure to do that. And so, again, you know, it’s at that stage where it’s not venture debt, but company at that point where they’re you know, they’ve got the revenues to drive that kind of valuation. I think they ought to be looking at debt facilities and working with sophisticated lenders to use debt for acquisitions and other strategic initiatives versus necessarily just, you know, just kind of adding to big rounds of equity.

Yeah.

So before I get into the personal question section of this interview and tell me, is there other are there other things about Miramar or other thoughts you have for entrepreneurs that we should really cover?

I would just say that we’re we’re big fans of entrepreneurs. I mean, I think and and I would say this is true of most Southern California VCs, is that we see ourselves as supporting entrepreneurs, not telling them what to do. I’ve noticed that. In some parts of the country, there seems to be more of a mindset of, you know, we’re, you know, this fund, we’re masters of the universe. So when you get you get you know, we’ll give you instructions on how to run your company.

And I mean, some of them do real well with that. But I think we see ourselves and we love to converse with people who kind of see it as, look, it’s a journey we’re all taken together. 

OK, I really appreciate that. And first personal question is, is there a wetsuit hanging on the door behind you?

There is. And it’s it’s not mine, which probably makes it even more interesting. Sherman, who now spends most of his time in Park City, is a big surfer when he’s not skiing or doing VC So that’s Sherman’s wetsuit. And, you know, this is his.

So it’s basically just storing it in the office here. 

And do you have any advice that you really like either giving or advice you’ve received? Oh, boy, I guess, you know, it’s it’s just kind of fundamentally, you know, treat everyone with respect. I have appreciation for the job that everybody is doing, and I think people always, you know, show their best in that situation.

So that’s not a very articulate way of saying it. But that’s that’s what I believe. I believe that, too.

But it’s good to be reminded of these things. My mother says repetition doesn’t ruin the prayer. I like that. Well, thank you so much.

I think that’s all I’ve got for you today. And I really appreciate you coming on on the L.A. Venture podcast.

Oh, it’s it’s my pleasure.