Mike Fernandez -- B Capital

Mike Fernandez — B Capital

Wednesday, September 28, 2022

Why is a Series B pitch so much different than pitching a Series A company?  How do growth stage investors think about multiples today?  

Mike Fernandez talks about what he is seeing in growth rounds today and the sort of support that is needed for later stage companies.

Mike Fernandez is with me today. Mike is well known in LA as he has been at B Capital since the start over seven and a half years ago. Mike, I’m pretty interested to pick your brain on growth stage investing as I know Series B to pre-IPO is your focus today at B capital, but I know you’ve done it all from seed to pre IPO, and I’m looking forward to hearing all about it.

Let’s dive in and talk about the growth stage. I’m super curious about growth in 2022 versus 2021. And how you guys are thinking about the markets today. 

So, I primarily play in the infrastructure layers of enterprise software. And so when the market started to turn at the beginning of 2022, actually it took a while for some of that effect to filter down to the types of companies that I look at. 

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If you were to look at public market comps, software applications, e-commerce plays broader internet plays were the first to take the hit, uh, in terms of valuation, infrastructure in general held up better. And then even within infrastructure, there were cybersecurity sectors that held up the best in terms of overall multiples. And that continues to be the case today. You see companies like, , Sentinel one or cloud strike, or CloudFlare that we’re gonna have the best multiples.

Of most tech companies in the public markets.

 what are sort of multiples in the sectors that you cover and, you know, if you could gimme sort of a range or something, a sense of

Yeah. So in 2021, if you were to look at kind of top tier companies in public markets, you would see enterprise value to next 12 months projected revenue multiples for the best companies. North of 25 times for some outlying companies as high as 40 to 50 times today. Most of those have come down, but you’ll still see for the top dozen companies multiples, averaging about 15 times very, very few companies can achieve that. Multiple most companies in, SaaS markets have come down into kind of a seven to 10 times range, which is more of a long term historical norm. They’re for those sectors, they have more of an infrastructure Ben to them, and where you’re seeing still top tier growth rates, top tier net retension, some of those companies are still able to achieve the 15 times forward revenue.

Multiple.

And is that, you know, are you using those multiples and those forward. When you’re coming up with your models and valuations.

We are. So what we do in every deal, we look at. Is, forecast out several years of revenue based on when we think the company could realistically go public, then project forward what that valuation they could receive in the public markets based on comparable companies and use that to back into what’s a reasonable valuation to pay today based on our own returns, hurdles, and what we believe the risk in the company.

so one of the things that we saw in, 2020 and 2021, the big run up valuations. Is of course the constant you’re using to project. Those, future valuations are, quite inflated and the, the trouble is everyone knows that they’re inflated. They’ll probably return to some long term average over time.

 you know, certainly if you’re talking about five years or, you know, to an exit or something like that, you, don’t really want to expect, That elevated multiples will stay elevated. The trouble is someone will take that bet out there. And so I think that’s what we saw from a lot of the crossover hedge funds in the past few years.

Valuations that they were willing to pay for companies may have seemed high, but if you were doing the math and they assumed that a company would exit 20 times forward revenue, and they only needed to achieve something like an 18%, uh, internal rate of return, you could kind of back into how they, paid the valuations that they paid in 2021.

Obviously that’s all changed.

So now that the, the, public company multiples have changed, it sounds like most of the crossover investors are sort of gone. Like, how is that manifesting when you are doing your work and what you’re seeing in rounds?

Yeah. So it’s taken some time to trickle down. there were definitely a few months at the beginning of 2022, where people were talking about the market downturn and we weren’t seeing it yet. Certainly through Q1, we were still seeing a number of deals of what you would call 2021 valuations that were happening.

and then, you know, slowly, we started to see, either valuations come down slightly on new rounds started hearing a few rumors of, firms pulling term sheets or trying to renegotiate at the last minute. but I’d say it’s, it’s really only in the past few weeks that we’re feeling the full impact and, and seeing a noticeable decrease in the velocity of deals and, starting to see more rounds happening or, or at least founders contemplating flat valuations or in some cases, even down.

 does that manifest in. There’s just instead of having, you know, a hot company, instead of having 30 people banging down their door, it’s just, you know, it, it’s a little bit more sane.

I think, there’s a couple things that have happened at the same time. So one is that the really good companies all raised in 2021, or at least most of them. did and so there are a lot of companies out there with really strong balance sheets, that have three, four, even five years of runway.

 So part of it is that, there aren’t as many good companies raising at the moment. the other part of it is the competition dynamic between growth stage firms has definitely changed.

 generally speaking, the universe of companies that a growth stage firm is going to invest in is, gonna be smaller, than what an early stage firm would. And those companies tend to be more identifiable, a most basic level, everyone can look at what did the good early stage investors invest in and, and follow those companies.

It’s easier to do kind of outside in references, more people will be familiar with products and with markets and be able to give you a sense for who the market leader is, or which products are getting the most traction. And so one of the things that we saw in kind of the run up of the past few years was.

Lots of outside in work, being done by growth stage investors, leading to them, showing up to companies with term sheets, or at a minimum, having done a significant amount of work that they could move to an investment decision quite quickly. in some cases that would be 30 firms calling on the same company.

Now we’ve seen, you know, a bit of the slow down, manifest. Some of the crossover hedge funds, have either decided that they’re seeing more attractive opportunities today in the public markets, or they want to take a pause on their private market investing and, and wait and see how things shake out.

 so you’re not seeing quite as much of that frenzied activity that’s happening before you even meet a company anymore. when you think about extensions down rounds, rounds with structure, The world of structure is, you know, doesn’t happen a lot at the seed stage. is that something you guys will do?

Yeah, so, different people have different philosophies on this. Uh, my personal belief is I try to avoid structure when possible. you can definitely use structure to try and juice your returns, but in a lot of instances, structure can come by bite you. if, a company needs to raise an additional round.

Structure terms don’t tend to fall away. They tend to just carry into each new successive round. And so if you’ve gotten too aggressive with liquidation preferences or kind of the stacking of preferences, you know, you can find yourself buried underneath, those lick preps down the road.

What we are seeing increasingly in market is, the term we’ve seen come up the most is blocks on sale below a certain valuation. so for example, you know, if a new investor is coming in at evaluation of 500 million, they’ll set a term where they could get a block on an acquisition at evaluation of less than seven 50.

 I’d say 1.5 X tends to be. the most common number that we’re seeing there. So that’s, you know, not so much structure and the sense of dramatically changing the, the waterfall of proceeds in an exit, but more about, when Canon exit actually happen.

Mm-hmm um, and I should have said this at the top. I had Raj gulli from B capital on the podcast fairly recently. So if people want all the background on B capital, they can go listen to that because you’re really focused on the growth stage. , what. Raj said, I think was that for the growth stage, you guys can write 10 to a hundred million dollar check.

That’s right. Yeah. We, We will come into a company anywhere from series B all the way through that pre IPO round.

And so tell me more about the growth stage. So there’s so much written and talked about, about how to raise your first round of capital, your seed capital. Tell me more about like what entrepreneurs should know about their growth stage.

this is something I’ve always thought is quite interesting. There are so many resources for brand new founders trying to raise their seed round, trying to raise their series a round. And then the advice falls up pretty dramatically. and so, you know, I think there are tons of areas we could get into, but generally speaking, I think there’s, three things that founders need to keep in mind as they’re raising later and later rounds, and it’s all shifts in their business that need to be occurring.

So number one is, they need to be thinking about shifting the risk profile of their business over time. at the early stage, you’re thinking about a series, a company, the range of outcomes. Call it a two year window could be anywhere from 10 Xing revenue to shutting down and having zero as companies get later and later, they need to eventually look more like a public company where your range of outcomes in any given year is probably gonna be plus or minus, you know, 30, 40%, 50%, some cases in terms of revenue, but much more predictability and much less risk on what that growth profile’s gonna look like.

And so you think about all of the steps along the way, you need to be building that predictability into, your growth profile. And that’s, you know, something that I think founders to appreciate is, that the early days of, Hey, we’re gonna go really fast and we’ll just figure it out along the way, needs to eventually turn into we’re gonna grow by X amount.

And this is exactly how we’re gonna do that. And being able to communicate that to investors.

One question on that. Is that like showing you that look, I made these forecasts, I consistently have hit my forecast or is it like changing my business model so that I’m a much more predictable subscription sort of thing or, you know, how do you think about showing that change in risk profile?

So , it’s a little bit of both, , you know, in the early stages. You’re doing that experimentation around your business model, figuring out who are the right types of customers, figuring out how you can reach those customers in a repeatable way. As you continue to grow, the question becomes, how do we Institute that in process so that it’s not just, we happen to have one or two really fantastic reps and, they made our year for us in terms of new bookings, but you’re onboarding new sales reps or you’re onboarding new people across the go to market motion and they can do that and bring on that playbook and execute against.

And so part of it is figuring out your business model and really understanding the levers to your business and what you can pull on. And then being able to prove to investors that you have a handle on those levers and with the right types of investments. Moving levers X, Y, and Z are gonna reliably lead to our growth target of whatever it may be.

Interesting. Um, were there other things I, I think I interrupted you, you were talking about things that companies need to do in order to get a growth stage investment.

Yeah. So one say is, you know, understanding the changing risk profile of your business, and that ties exactly into, , what you were askingYou know, the second piece is, really about. Understanding that fundraising is changing from being story driven to more and more metrics driven over time.

So when you’re raising your seed round, a lot of times it can just be a founder with a vision, some early inklings of team or product and go from there. And the later and later that you get the more that you need to be able to have the metrics to prove that that story is correct. And so I think this is an area that we see a lot of founders struggle with.

I’d say particularly around series B is their expectation for what the fundraising process should look like, is informed by what they went through at their seed or series a. And when it was much more about story and vision, And a lot of founders end up a little bit behind the curve in terms of being able to tell that story through numbers and so there, a lot of founders have that shock moment where they realize like, oh, I actually, I need to really be on top of my numbers now. And this is a core part of due diligence. And I can’t just talk my way into an investment.

Hmm. sometimes I think it’s hard because like, you almost need to, it’s not just that you need to have a handle on your numbers, but you also almost need to memorize your numbers. That always seems hard to me is knowing off the top of my head when investors ask me these questions.

You know, it’s funny. There are founders that know every single member in their business. And when we have a conversation with them, almost mind blowing. Like how can you remember all this raw information? And on the complete opposite side, sometimes you talk to founders and they don’t even know where they’re at in terms of ARR today.

, I don’t necessarily expect everyone to have an encyclopedia in their head, but, you know, What are the key numbers that are driving your business on a day to day basis? You should have a pretty good understanding of those, , and not just where they are today, but where they’ve been and where you wanna take them.

And so when you B capital are talking to someone who’s sort of a hot founder, let’s say a hot company, what is the pitch? What’s the offering?

Right. So B capital we have, I’d say three main things that are unique about us, that are really what we try to offer founders. Uh, the first is our partnership with the Boston consulting group. we can really tap into. Market knowledge and operating expertise and relationships with the global 2000 to help our portfolio companies with. that’s all on top of a very extensive platform team that we built out internally, which is tailor made for the growth stage.

So there were a number of firms that had built phenomenal platforms focused on early stage companies, first round Andreen. and what we saw when we started building B capital in 2015, Was that same type of platform resource didn’t really exist for the growth stage and growth stage companies need different things.

I mean, to give you an example, something we call capital advisory, which is really about tapping into all of the non venture sources of capital in the world.

And that can be everything from helping portfolio companies find the right type of venture debt or the right credit facilities, to thinking about how to go through a spec or an IPO process, to thinking about how to do acquisitions. And then the third thing that’s unique to us is being a global firm from day one that acts fully integrated. And so a lot of firms kind of act as independent teams, or even explicitly have more of a franchise model where the, global teams and different geographies aren’t as coordinated. And we think that having that one team model really helps our portfolio companies

Then even for us as investors, it helps us take the learnings from one geography and apply them to the geographies when we’re looking at new investments.

 Let me ask about capital advisory. I’m very curious how you’ve worked with your portfolio companies or just what lessons you’ve learned on the capital advisory side of things.

Yeah. I think across capital advisory and all the functions that we include in that, what happens. On a lot of boards that I’ve seen is when it comes to raising venture debt or making an acquisition, or, you know, finding a letter for a credit facility, the range of options that a company considers is normally pretty small.

You know, when it’s time to raise venture debt, one board member says, Hey, call it my guy at SVB. Another board member says, Hey, call it my guy at square one. And those are the two options you put them side by side and you pick one in reality, there’s a number of different firms out there that offer venture debt that are gonna bring different terms, a different style of relationship.

 same thing with M and a, most companies until they get to be pretty late stages.

Don’t have a M and a muscle that’s been built out in their org, , and at a simple level, it can be, how do we hire the right investment bank? , or how do we structure a process to move through a set of target companies in a pipeline and find the company that we actually wanna acquire?

, and so just like with the venture debt example for a lot of companies, it’s somebody on the board says, oh, this is what we did and why one other company call this person, versus actually being strategic in finding the right fit for what you wanna do as a company.

, Okay. So you’re building something differentiated and helpful, but growth rounds are still inherently pretty competitive. And yet you also told me that you’d like to see more Sandhill road funds in LA. So help me understand that thinking.

so I should preface this. I’m an LA native born and raised here. , and. Before I got into venture in 2013, I was in business school and my reason for going to business school was to try and do venture in Los Angeles. And what I’d seen at that point in time was, Los Angeles had not quite recovered from the.com bus, the way that some other regions had.

you know, there were a number of great success stories in Southern California in the eighties and nineties. You know, in fact for most of the 20th century, you would’ve said. That Los Angeles was on par, if not, beating the bay area in terms of technical advances, primarily driven by the aerospace industry in the middle of the century.

And so when I was looking around Southern California in the early two thousands, I really wasn’t satisfied with the number of interesting companies that I was seeing or the amount of capital that was available. And so when I joined the world adventure in 2013, I had a hypothesis that LA was going to be the next big region.

 There were a number of industries, including aerospace, including transportation, logistics, where Los Angeles should be building the best companies in the country and really in the world.

, , what’s tricky about being a growth stage investor is. Because the universe of companies is smaller. You can’t be as focused, on a particular geography or in some cases, a particular sector. So, as a growth stage investor, I need to look at like, what are the best hundred companies anywhere in the world and pick from those.

So the number of investments that I’ve actually made in Los Angeles is a much smaller number than I would like. , Now, the reason that I like having more Sanho road firms coming down to Southern California is I do think there is a flywheel between capital availability and. The presence of founders starting new companies.

And so having more just presence of capital in the region helps make Los Angeles a more viable option for a founder that wants to start a new company. And I think we’re seeing this play out in a couple other spaces. I think capital availability helped, , New York grow. Significantly in the past five years, capital availability is definitely one of the driving forces behind Miami right now.

But like not to pick on Miami, but one of the things you said, which is very strikingly different about LA is the amount of industry that’s here. I mean, it’s a. $800 billion GDP economy just in LA. Right. And I know that’s one of your big focus areas. Let me ask a question about that. I think Raj said on my podcast, something like the industry of today is only one to 5% digitized how do you sort of quantify how much room there is to grow in these industries?

When you’re thinking about digitization?

 So I spend my time focused , in two different sectors. So one is I focus on horizontal enterprise software, primarily the infrastructure layers. So cloud infrastructure, cybersecurity, data science and engineering. developer tools in the applications layer. That’s the world that a lot of us are familiar with where you can walk into, , a CTO or a CIO or a CISO’s office with a brand new product. And, the willingness to try something new is, quite. The other area where I spend a portion of my time is a vertical that we call industrial transportation.

A lot of those industries are nowhere near, done with their digital transformation. In fact, many of them have barely started.

 I think about one of our portfolio companies was trying to sell software into a top 10 company in the transportation logistics space. This is maybe two years ago, the CIO said I’m still not sure about this cloud thing. And they had no SAS software in their. I mean, that’s, what we see in a lot of these more industrial sectors And so that’s, kind of, it’s a blessing and a curse, right? It’s a blessing because you know that there’s significant market opportunity there.

 These industrial sectors are, , you know, meaningful chunks of GDP and could be meaningful chunks of it. Spend

on the flip side, it means you have brutal sales cycles. Companies get stuck in proof of concept hell and can’t really convert over to a proper commercial contract. and it’s a.

in some ways like a war of attrition to get the sale. and so I think we’ll see more and more companies in those industrial sectors loosening up over time. And that’s a big opportunity for software companies to grow in those sectors. , let me ask another about another one of yours. , cyber, I think you were just in Vegas for black hat, right?

I was, I was,

I’ve never been, was it cool? What did you learn?

I love the cyber market. , I always joke. You know, cyber is, one of those spaces that companies will seemingly throw limitless amounts of money yet and never quite solve the problem, , which makes it of course a very interesting space for, founders to go after. , you know, I think what we’re seeing right now in cyber is.

Companies are still struggling with all of the cyber implications of that same digital transformation that we were talking about just a moment ago. , so companies are still in the midst of shifting to hybrid cloud and multi-cloud environments. They’re still in the midst of a shift to microservices architecture for their applications.

 So the concept of the perimeter is shifting for all of these companies, the concept of what a user looks like.

 No longer, just a person that. Desktop computer, but now mobile devices and other applications and connections via APIs, that’s all shifting as well. And what we’ve seen is just the cost of a breach is increasing day after day. And so you combine all of these market factors and it just means that there’s so much interest in new cyber technologies, and a willingness to spend.

When you, zoom out to the global level in cyber, , I mean, do you feel like we’re secure as a country? Do you think that there’s other countries far ahead? Is it different when you look at it? From the global perspective?

That’s a really good question. Um,

 my perception is. The us Europe and Israel function more as one cybersecurity market. I mean, we know such a huge percentage of successful cyber companies come out of Israel and they pretty early on in their life know that they need to target markets in the us and Europe.

And that’s where they’re gonna find customers. Those all operate more as an integrated market. My perception is that cyber. Tech adoption is lower in other parts of the world. Now, part of that is gonna be targets are not necessarily as attractive. The biggest companies in the world are always gonna be the biggest targets.

And for the most part, those are gonna be, in the us and Europe, as opposed to a place like Latin America or Africa, we’re just gonna have a lower number of targets to me. The interesting geography is. Asia where you do have a similar number of quite large attractive targets, but a bit lower adoption of the bleeding edge of cyber technologies.

And generally speaking, what we see is cyber companies engaging in more go to market partnerships in that region as opposed to selling directly. So okay. The more personal questions. So I also sometimes think that investing in cyber almost seems intimidating from a technology point of view. And I know you’ve gone through a journey of starting in consumer and now being comfortable talking about, you know, perimeter security in the cyber world.

How do you get up to speed fast enough that you feel like you can hang in that, sector?

So a bit of it is background and, and a bit of it is, process. , So his background, I was one of those kids that was teaching myself how to code when I was nine years old. Right. I’m in the library on the apple two, instead of out at recess, playing kickball or whatever. Now, luckily by the time I got to college, I realized I didn’t wanna be a software engineer as my full-time job.

Probably should have gotten the computer science degree anyways, just to, to check that box. but I think all of those years spent learning how to code and learning how, a lot of, infrastructure works that kind of mindset has still carried forward with me today.

Mm, I didn’t know that about your background.

Um, and B capital has grown a huge amount since you joined. I believe you now have over 6 billion AUM. How did you get connected with B capital?

Yeah. So I had been working with our founders, Raj Eduardo, uh, at another firm in 2013 through 2015. And so when BCAP was started in 2015, it was a very natural transition, , for me to go with them. , and so in 2015, it was. $0 and just a few people. And today, you know, 6.5 billion in AUM and 150 people really across the world.

so it’s been , a wild ride, tons of fun to build.

So let’s talk a little bit more about that journey. Is there an investment that you can point to that really shaped you? or that really stands out for you. so the first investment that I ever worked on. in 2013 was a consumer company, , in the e-cigarette space, which was a very interesting space. Back in 2013, there was. a number of new companies that had emerged that were trying to make pure cigarette replacements.

There was also this emerging kind of vaping culture with refillable, cartridges and flavors and all of these things. Not a space that I had any personal interest in, but What was actually really interesting at that point in time was some science emerging that vaping would be much healthier.

And if you could convert smokers to be vapes, that was probably gonna be a significant net positive , for overall public health. So we were looking at a company that was the market leader, had the best distribution inconvenience stores, , was. On a fast growth trajectory, talking to investment bankers, getting ready for the IPO.

We made an investment. and within a year, the market completely shifted out from underneath them. The e-cigarette market contracted significantly consumers shifted to the refillable vape pens. And this company went from IPO target to, bankruptcy within a couple of years. And that was the first deal that I ever worked on.

 So I think just was a really good reminder that markets can change, , You know, you can lose product market fit, , and things are never quite as secure as you think they are. there could always be looming problems out there, that, you know, you’re not gonna be aware of until they, smack you in the face.

so I think it was just a reminder that, , luck plays a bit of a role in this. , it was a reminder that you’re always gonna have some portfolio company that’s struggling. , it was a reminder that, you know, portfolio construction really matters.

Mm. Okay. Mike, I have to hit a couple, questions here at the end. First off, I like to ask all my guests, how would your friends describe you?

Yeah. how of my friends describe me, , a couple things. So, The main things that come top of mind. one is. Being quite loyal. So I have a number of friends that I’ve, maintained for. Decades. And, you know, I think it’s very easy when you’re in the tech world to live in your tech bubble, and all your friends become other founders or other VCs.

, but it’s important to me to keep a lot of those relationships outside of the tech world and keep you grounded a little bit. , I think a lot of people describe me as young at heart

Hmm

So I, I try to maintain a certain degree of, , I guess you would call it levity, I, I do remember one of my reviews once when I was a consultant that was living in London and my manager said, you know, I don’t know if this is a California thing or it’s just a you thing, but he said, you always seem very calm and levelheaded and.

If I didn’t know that all your work was coming in with really high quality, I would be a little concerned because you seem very unbothered by it.

I like that. I love that

 Well, I know you’re a surfer and I know that you will paddle out in big surf. And so sometimes I think that, that, you know, fear of drowning helps kind of keep everything else in perspective, cuz it’s like, ah, it’s just a PowerPoint.

Yeah. Yeah. I’m not, not gonna drown, not gonna get eaten by a shark, not gonna hit the rock. Totally. Well, Mike, it’s been really good to get to know you. Um, and I’m so glad that you and BCAP are here in LA.

Yeah, this was fantastic. And what I always say is , I wanna do more in LA. , so any companies that are in LA at the growth stage or any investors in LA that are looking for growth stage partners, I’m always happy to chat.

I love it. Well, fantastic. Thanks so much for coming on the podcast today.

Thank you, Manny. This is fantastic.