Alexander Niehenke of Scale Venture Partners joins Nick to discuss The Future of AI is Vertical, Why Vertical TAMs are Getting Exponentially Larger, and Lessons from the Sector Giants that Lead to Dominance. In this episode we cover:
- Historical Reasons for Horizontal SaaS Success
- Shift Towards Vertical SaaS Solutions
- Unfair Advantages of Vertical AI Solutions
- Lessons for Modern Founders
- Expansion Strategies for Vertical Startups
- Talent Dilution and Competitive Moats
- VC Diligence and Founder Evaluation
- Regulatory Risk and Investment Decisions
- Motivation and Future of Venture Capital
Guest Links:
The host of The Full Ratchet is Nick Moran of New Stack Ventures, a venture capital firm committed to investing in founders outside of the Bay Area.
Want to keep up to date with The Full Ratchet? Follow us on social.
You can learn more about New Stack Ventures by visiting our LinkedIn and Twitter.
Are you a founder looking for your next investor? Visit our free tool VC-Rank and we’ll send a list of potential investors right to your inbox!
0:17
Alex Niehenke joins us today from San Francisco. He’s a Partner at Scale Venture Partners, where he invests in early-revenue companies across vertical SaaS, fintech, insuretech, AEC, supply chain & logistics.
Alex has backed notable companies including Monto, Sixfold, Motive, Scout RFP, and Root Insurance. Before Scale, he was an investor at Crosslink and worked in investment banking with a focus on high-growth technology and media companies.
Alex, welcome to the show!
0:41
Absolutely
0:45
thanks for having me. It’s a pleasure. It’s
0:48
a pleasure to have you. I’ve been such a fan of your writing, and specifically this article, I think the future of AI is vertical. I think you could but anyway, before we get to that, can you just tee up your background, kind of two minute summary of your path to venture,
1:01
in some ways, it’s as non linear as everybody else. I grew up in an entrepreneurial family. I was born in Europe, Germany. My dad was a serial entrepreneur of the bootstrap kind. Moved to the US when I was a little kid in elementary school. You know, how to learn how to speak English on the playground. And my parents, they’re the kind of the bootstrap kind of entrepreneurs. Like, I’m not sure my dad has a high school degree, so I went to college. He was like, Hey, you can be a doctor, not a good idea. I don’t like blood. You can be a lawyer. Actually thought about that. I got a degree in Legal Studies, but, you know, I don’t know, going to school for a couple more years seemed really daunting. Or you can go do business, right? That was the language, love language of my dad. And so I came out of school, started working at a merchant bank. But I remember having like, a stock account in like, middle school, you know, my dad was, like, doing like, Schwab trades and the tech boom with me and and, you know, I was the first kid that was CD burner. So I was swinging, you know, burnt music, CDs and video games at school. And
1:45
so, do you remember, do you remember your first stock? Alex, I don’t remember my
1:49
first stock, but I remember trading a whole lot of, like, pretty terrible stocks that all became penny stocks. It was all like, you know, communications equipment and so forth. I don’t think my dad had the brilliance to buy me, like eBay or Amazon, it was, it was always like something, something else that was like a good, rich, quick stream. And I remember looking at my portfolio in like, 2002 and like, like, the aggregate portfolio, my deal was only, like 500 bucks, but like, it was worth, like, $3 right? Like, all the thoughts that just got away so, no, I came out of college and joined a merchant bank that was actually venture backed and was pretty entrepreneurial in its own right. It’s called Montgomery company, and I have unusual runs, like I did some investment banking, there did some capital raising, but we started investing off that platform as well. And I just like the intellectual challenge of it, right? I figured out the investment banking piece. It was like, Can I get somebody to invest in this company? And that was an interesting question. But then we started investing, and I was like, do I want to invest in this company? And that seemed like an infinitely harder question to answer, and I just kind of got hooked on that 20 years ago. And, you know, along the way, a lot of people told me, Go do something else, and I just keep ignoring them and showing up for the job day
2:48
after day. Love it. Love it. So tell us a bit about the thesis at scale. Scales been
2:52
around for, gosh, I don’t know, this point, probably plus 25 years. I joined in 2012 we’re on our eighth fund. It’s a $900 million fund, and we focus on early stage B to B software, business software. We do it both at the infrastructure layer. So I have some colleagues that cover that at the application layer, that’s where I spend a little bit more of my time. I think that we are very thematically driven, market driven, so we pride ourselves almost like a hedge fund and doing this heavy tops down research project where we where we try to understand what’s changing within technology and what are the markets that are going to get impacted by that? And then building relationships with those individual entrepreneurs that are running those companies, sometimes at the earliest Inception stages, until we get a chance in order to invest with those companies. And because of that stage where we invest, if you take a step back, you know, there’s, there’s kind of seed investing, does the product work? Does it not binomial outcomes? And then after us, there’s growth investing, which is like, you know, market risk, valuation risk, that’s really what we’re underwriting at our stage. It’s execution risk. And so we talk a lot about taking that founder and helping them take a CEO, founder, let go to market, making it scale more reputable. And so we both underwrite that risk. We really try to understand that. And then we built all of our resources around the way that we support our portfolio companies and helping companies along that journey. Because these are very, very frequently, people that have never built out a good market machine, and so they’re super excited to get to get some resources
4:05
there, good, excited to dig in and got some go to market questions to throw your way a little later. But you know, let’s start out with some background. So as we think about sort of the history of software and verticalized solutions, what would you say are the primary historical reasons why horizontal SaaS has performed better than vertical SaaS, and also, why is now the time for vertical solutions to thrive? Yeah.
4:29
I mean, I think, look, you can kind of take a look at when I joined, I remember joining scale in 2012 and time just moved so quickly. People were like, Ooh, you’re joining the SAS firm, right? Like, that’s a big bet. That’s like a, that’s like a bold career move. Like, is that going to be a thing? And I remember sitting in board meetings in 2014 and arguing with CTOs about whether we should maintain our own infrastructure. We should move into AWS, into the cloud. No company today, no investor today, even five years ago, would debate the proliferation of cloud assess software. But when you take a look at the first places where people can. For the most part, SaaS software. It was places like marketing and sales, right? You think about Omniture, you think about Salesforce. Eventually that migrated into into HR. You look at like a workday, into the it regions, into finance, NetSuite. But in the vertical markets, those solutions have they had a challenge moving over there, and the challenges were twofold. I actually think a lot of the times vertical software buyers are early adopters. That’s a that’s a very, very controversial statement, but if you go to, like, the insurance or the financial services industry, they have huge data problems when you fly right? Like, why do airlines have those old, like, blue screen computers? Right? Like, when you’re like, something’s going wrong and you’re looking over the counter, you’re like, What do you type around? You’re like, Oh, that looks ugly. It’s because cookie clack for five, yeah. It’s because these industries, in the 70s, 80s, 90s, actually adopted technology. They were early adopters, and they’re within vertical industries, so the software needs to be very considerate of the problems that they have in the regulations with those industries. And so a lot of what I’ve seen over the last 15 years is somewhat of a naivety of people going in those industries, either presuming like, hey, these companies, they’re not early adopters. It’s like, no, no, they just have old software problems, and you’re not solving those problems for them. And replacing or ripping out those old systems is quite complex, and you don’t appreciate that. And then the second thing is you don’t understand the regulatory frameworks or the environments that they work in. I remember talking to a prolific, large life insurance company that has Snoopy as a mascot, and the CEO is telling me, like, do people think I’m an idiot? Of course, we want to get off of our old COVID Old cobalt systems, but it’s cheaper for us to wait until these people actually physically die, because it’s a life insurance company, and that’s how we’re going to sunset our software systems. Then for us to port these systems over because of the regulatory risk associated with something going wrong in that port. So I think about those problems a lot, and the laggards that it caused them, I can talk about why that’s changing now. I think you were leading there. Yeah, please. So the other thing that kind of like ended up happening in this is because of those things, venture investors just shied away from it. It’s like, it’s like venture investors also used to shy away from from S and P software. It’s because a lot of investors, a are kind of lazy in the way that they do market sizing, and they’re pretty Elementary in the way that they do market sizing. They basically take a look at number of customers and they multiply it by price per customer, and Yep. Well, you know, when you go vertical, usually that number of customers is smaller. Isn’t always the case. Sometimes people aren’t really good at doing that discovery work, and the price point might be the same as a horizontal solution, but you have a smaller number than you do in the horizontal markets. The thing that’s been intriguing to me in these vertical markets is the dollar capture seems to be shifting. And this is an early hypothesis that I’m not exclusive on. I think a lot of people are thinking through this, but take a look at Salesforce. They charge, what, 1000 2000 bucks per user. So if you’re hiring a sales professional for your organization, maybe they make 60 100, $150,000, a year. You’re thinking about spending Salesforce a couple other licenses, maybe 5000 bucks, 10,000 bucks on software for them, so 5% of their cost. What’s really interesting in some of these AI markets, we’ve seen like, take a look at legal instead of the CRM that that law firm uses for that lawyer, attaching that like a 5% rate, we’ve seen software solutions that are charging 4050, 60k, because that solution is, in fact, replacing a whole bunch of work that that human was doing, or multiplying the work that a human is doing with such volume that you have the ability to totally extract a different amount of dollars.
8:07
And I think it’s a different budgetary line item. It’s labor. It’s
8:11
totally different, right? Yeah, labor, that’s a very good way. I like that description and and so I think a lot of people, in the early days, we don’t know how this will pan out, but they’re saying, wait a minute if that’s the case, if you’re attacking that labor budget line item, there are all of these markets where, historically, the quality of the software has been low, because there’s been less capital invested, less entrepreneurial activity. Some of the things that I talked about these old, latest systems. What if we came in with really big dollars, with really good entrepreneurial skill set? Could we just blow up these markets and create really big companies. And, you know, to my dismay, my little cottage industry of vertical software, where it was like me and 10 other VCs that you know, were jamming on this, I suddenly have the who’s who of venture capitalists in the industry writing blog posts about how they’re investing in vertical software. So in some ways, I’m, like, very excited, enthusiastic that this, this market that I love, that people are all jamming out on it. On the other end, I’ve taken a couple licks lately where, like, a deal that I thought I had a good relationship with the entrepreneur, and other people are chasing those deals real heavily as well, and so smuggling up my waters a little bit too.
9:07
It’s gotten hot, and it’s staggering to me. If you look at penetration of software across vertical applications, yeah, cloud based software is still like, I think, less than 25% so 75% of vertical software is kind of what you’re talking about here. It’s like airlines and healthcare with epic and all this. It’s like these legacy on prem systems that, I hate to admit it, Alex, but the first language I learned to code in was COBOL. You know, I’m no spring chicken. So like, yeah,
9:34
yeah. It’s you go to talk to any insurance company. They’re drooling at the lips of, like, guide wire, right? Like guide wire. And I have a huge crush on guidewire, but like, let’s call it state of state. Guidewire was an on premise software company that ported itself into the cloud about 1015, years ago, and here in 2024 you go talk to any carrier, and they’re like, Oh, we’re putting our new stuff on guidewire. And you’re like, it’s not exactly modern, modern software, but there is no insurance company that doesn’t have a ton of software because you. Run an insurance carrier, you can’t keep all of that information in like an Excel spreadsheet. It just doesn’t work. It’s that they deployed systems in the 80s and 90s, and getting the data out of those systems and switching over is real freaking hard for them. And so in some ways, you know, the question we’re still wrestling with as a partnership is like, is there another 10 years of just moving stuff into the cloud, left within vertical or are they just going to leapfrog and go straight in the AI stuff. And I think a lot of people are saying, well, maybe we’re gonna we’re gonna have this whole like leapfrogging generation, which that’d be pretty cool. You saw that in other markets. You didn’t even have on premise software. They just went straight to the cloud. So
10:31
your latest piece is called the future of AI is vertical. And this is a popular piece that’s been sent around between a number of venture capitalists. It’s fantastic. I encourage everyone listening to check it out. You know, you talk about a number of things in the article, one of which is the unfair advantages that vertical solutions have. I’m seeing a tie as you kind of articulated some of the weaknesses of the historical platforms. But the three that you you lay out in the article are unstructured data domain specificity and regulations, can you just kind of give us a high level of these unfair advantages that vertical AI solutions are going to have going forward?
11:07
I know my limitations. Unlike you, I never, I never programmed in cobalt. And, you know, HTML was probably the extent and a little bit of visual basic of where my coding skills went. And, you know, then I study, study finance. Here I am, but data is really, really important when it comes to training models and understanding the specificity of that model, and what really is compelling, and what I see in my vertical companies is having deep domain knowledge around the definitions The meanings of those models. So it’s really compelling, in my mind, to have people who are experts within these industries that can then take foundational models, apply those to those industries, and take them to the proprietary data sets those organizations have, and I think it creates potentially very compelling outcomes. Whereas, when you’re training something on the breadth and and depth of like, let’s say, the whole internet, sometimes that creates really cool outcomes, but other times it creates kind of like, weird, you know, answers or hallucinations, because it’s convoluting different ideas and moving on to that, that second point around kind of regulatory environment, you know, in certain environments, you cannot have a black box experience, so you can’t, for example, underwrite. In most industries, underwriting has has discrimination laws. You have to explain why you underwrote something like that. And that’s like, that’s like, an interesting technological question when it comes to, like, large language models, because we don’t always know why they answered things the way that they do. And so we’ve seen a whole string of entrepreneurs who are doing really, really interesting things in order to create the trails of audibility, or the trails of transparency that regulation, regulation drives. And then the last piece is, like, You got to be able to integrate in all these like systems that are specific to these industries, and you got to be able to get all of that data in and out of those systems. And so again, I think that that leads to players that are willing to do the work within these verticals. And so it’s both understanding the nature of where the data sits, what that data is, and what you’re allowed to do with that data. So
12:46
when we’re talking about data, I had a bit of a debate the other day with another investor about llms. Do you are you partial to open source versus closed at all? I
12:56
don’t think I’m at the technical proficiency to have a, you know, nuanced point of view on that. I I have colleagues here who have sat in these debates, and I listen, and I have portfolio CEOs of and I I defer to people who are more technically expertise on that
13:10
I see. And then, you know, as we think about lessons that modern, modern founders can learn from, you know, the vertical giants of our past, you had some, like, catchy takeaways on that, like, get in on the ground floor and hunt, hunt the white whale. Can you walk through some of these? You know, just kind of crystallize. What are these lessons that founders should really understand about success in vertical applications?
13:33
I have this like crazy point of view that great products by themselves are pretty fricking useless, and great sales without great products is just multi level marketing, or like, a scam, right? Like, like and, and the marriage of those two is the absence or the void that just, you know, lacks in so many great businesses, which is the most compelling businesses that I see, seem to have innovation around the product, and then they marry some innovation around the distribution to go exactly at the problems that we kind of discussed earlier in this phone call, which is, is, you know, these people are all everybody’s always desperate for better solutions. And I use solutions that software very, very intentionally in that, you know, they want their employees, they want their customers to have better experiences. And so the question is, just like, like, sometimes it’s more obvious what the product is, and sometimes it’s more obvious what the distribution is. But I think, you know, one of the things that I’ve tried to do is I’ve tried to look back at these companies that, you know, we all in some way, interface with at some point in time in our lives, but often don’t know that they exist in the background, and try to understand how they came to be the way that they are. And you really do see all the time the marriage of these two factors, which is, they built a distinct product, they had a point of view, and at some point in time, there was a go to market, unlock. And you know, the first thing that that’s really been profound as I’ve been doing this work, and we’re continuing to publish these on our scale.vp.co, protocols website, and hoping that you eventually have 3040, 50 of these is and maybe it’s not surprising, but sometimes you got to do this. We’ve done like, 1012, of these. And like, I’d say, I say 75 plus percent have some sort of light network effects that eventually come to fruition. And by the way, sometimes the network effects don’t exist for the first 10 or two. 20 years of existence, right? Today I was tweeting about epic. Everybody thinks that epic, like, lobbied Obamacare, and I think she was involved with, with writing some of the regulation around the act, right? But like that, business got started in 79 and they did two really interesting things. The first is, they went after the biggest of the biggest. You sometimes see these in the verticals, the courage to go after the largest companies, not starting at the SMB or working your way up, right? That’s kind of the traditional like horizontal, but saying, Hey, we’re gonna go tackle Kaiser day one. Or last week, I was looking at check for you, which is the bill payment solution that most of us use in our consumer they went after Bank of America day one. So you do that, and you go get that giant and then you suddenly, slowly start unlocking these, these, these, like very subtle network of freaks. And so in the case of epic, what ended up happening was they wrote this regulation. All the hospitals suddenly needed to upgrade their emhr, and they have EHRs. And they kind of looked around, they said, Oh, Kaiser is using epic, all right, I can’t get in trouble for buying IBM. It seems to work with them. So buys and then, oh, both my doctors and my patients sometimes move in between other hospital systems. And what epic did really well was they went to large healthcare systems, and they allowed all the different practices within those systems to be interoperable. And because they had that interoperability core into the system, they also allowed them to be interoperable with other hospitals. So if I’m going from Stanford over to UCSF, I can send my files over, and there’s an epic API somewhere on the back end that does all of that. And those network effects are subtle, but they were meaningful enough in order to cause them to be able to sell $4 billion worth of that software over the last 20 years. In the case of check free, it was like, Ooh, they were, they were physically mailing out checks, and they nailed Bank of America, but then they went to all the bill payments people, and they were like, Hey, do we do we need a physically mailing checks, or can we do some sort of ACH wire situation? And then they went to the next bank, and they’re like, Well, we already have 20% of the vendors, and that was 30 and 40 and 50, because with each bank that they just had more density, right? And so it’s these, like subtle network effects that come over time. So those are two of the innovations. Like, another interesting one that I always love to talk about is there’s two or three companies that you see this in the legal space. You see this in that kind of AC space, getting into the colleges and actually educating people in your software. Because these are like, hard systems to use, right? Like AutoCAD. My wife’s an architect, like, you know, she always, she’s like, Oh, I’d love to move over to Revit, but it’s like a two year journey to move from AutoCAD to Revit. She’s like, I’m still willing to learn. I learned AutoCAD in school. They taught it to us for three years, and that’s what you stick with. And you see the same thing in, like in the legal profession, around the research tools and so forth, and so you just like you see these interesting go to market methods that I think inspire me when I talk to new entrepreneurs that we invest in.
17:13
I love that. I love that, if you I talked to, I used to talk to my team years ago about this, but it’s this, get in on the ground floor concept, if, if you think about the customer journey, and instead of looking at just the narrow spectrum, if you continue to go further and further back in the customer journey to figure out the first inception point of when they start on the path, and you get involved in that point, you can capture incredible amounts of value across the entire chain over time. You know, you drive with the customer.
17:40
That’s, right, yeah, that’s, that’s the story software in some ways, right? We’re perpetually unbundling and unbundling zone and, like, why is Microsoft so great? Because they capture you with one product, and then they just fucking sell you. Well, I’m sorry, cursing. Then they just sell you everything. Right? In verticals, it’s almost even more powerful than that, right? These people just don’t have a lot of options on vendors, and so you just sell more. Like motive, my portfolio is doing a tremendous job of just buying more and more products into their customers. Well,
18:03
once you’ve built that trust with customers, they will give you more. They almost want to give you more. Like, it’s all a trust thing. Like, yeah, you know, can you they’ll start asking, Can you do this over here as well? Like, I love it, which, you know, it’s perfect. TF, for our next question. So many of these successful vertical startups start niche, you know, they dominate the niche, or the wedge, or whatever we want to call it killer app, and then they start to expand, you know, horizontally, in some cases, you know, across different channel partners or even vertically. But how do you know when the right time is for a startup to expand beyond the initial vertical and when does the strategy backfire?
18:40
I tend to think that nine out of 10 times the best strategy is to sell more to your existing customers. So to add a second and a third and a fourth product, there’s less examples of vertical software companies saying, Hey, I’m going to expand my market by now finding a new customer set and selling more to them. There are examples of it, but they usually aren’t as successful as what we were just talking about four, which is like, hey, we found a third and a fourth and a 10th product in order to sell these people. And so I took my my customer that used to spend $25,000 with me, and they now spend $125,000 with me. But I think the timing of that, look, it depends on the market and the company. And I’m not trying to be opaque about that answer. And I think the great entrepreneurs, what I always test for when I’m engaging with entrepreneurs is I ask them to walk me through their product roadmap, and to do it on like, a multi year basis, and to hear how they’re thinking about that sequencing. Because I think that in itself is, like, really revealing, because if you do it too early, you don’t have focus, and if you do it too late, well, then eventually your growth is slowing down, and you can’t get the capital in order to build that third, that fourth, that fifth product, and so so you have to internalize it. It’s probably going to take you one to two years to get that new product off the ground, because it actually doesn’t tend to happen faster, right? Like if your first product took you two or three years to find product market fit, maybe you can shave off 10 20% the history of like, building good products inside of bigger businesses is not more successful than building products not inside of big businesses. And so you kind of have to have two or three years of. Of leeway, and you kind of have to have a founder that is really thinking about things in a multi year pattern. And so if you’re a 25 or $50 million and you’re still doubling like, like, if you start now, you’re probably not gonna be selling out a psych product until you’re at $100 million and maybe that’s the right time. Maybe that’s too late. But you know, you kind of got to think about where you need those incremental growth lifts, because eventually your growth will slow down. Number of customers typing price point, saturate your customers at some point.
20:22
So another thing that we’ve thought about a lot is talent dilution. So when you think within the startup confines, teams like you don’t want your teams focused on too many things, and so when the capital structure in the business suggests you can hire a new tiger team to focus on something else, then you can, you can justify the ROI much better, and you know that somebody’s not going to lose focus on what matters.
20:44
If you got this figured out, please, like, like, trying to build new products inside of companies, and trying to allocate resources between multiple products is exceptionally, exceptionally difficult, and it’s very, very, very obvious how quickly fiefdoms get established and preferences and favoritisms, and then, even if you got the products built, like, commission structures in order to get sales. Like, you know what sales people do? And they sell whatever sells easiest, right? When you have this, like, the board level, you’re like, we’re gonna sell all three of these things together, and it’s gonna leverage the customer, blah, blah, you know, the sales guy here’s longer sales cycle. Heck no. Like, I’m gonna take whatever product the customer says they want, and then I’m gonna kick it over to somebody else in customer success to maybe do an upsell. And then it’s like, you commission upsells do not like it all just gets it gets very complex, super quick, does
21:23
it? Does? Alex, you know, with the decrease in cost of hardware and the commoditization of these foundation models across the AI landscape, what do you think will be the defining, sort of competitive moat for AI first companies in the next five years?
21:36
Well, I mean, maybe, maybe I’ll start by what I don’t think like. I’m seeing a whole lot of stuff that like, if we go back to like the like on premise software worlds, you kind of have these like, ISVs or ISOs, independent selling organizations. What would they do? They would take a piece of software and they would go and they would sell that to enterprises, and then they would slap on some services in a relationship, right? And that’s really what they did. And those organizations weren’t all that valuable. They had a purpose in the world. They had an existence, and they were good, bootstrapped founder owned businesses, but they weren’t venture backable, nor scalable, and the margins never reflected that. I do have some fear that we’re seeing that wave within the AI markets. That is that there is a a wave of companies that are just rappers, in some regards, on top of some of the mainstay, you know, whether open source or not open source for your earlier question, but some of the mainstay foundational models and that the value is, it’s just that open AI doesn’t have a team that’s willing to go and integrate and sell to the airlines, right? Like, I don’t know that I would want to own that business long term. So I think you do really have to have a depth of proprietary knowledge around those industries, and you need to have some sort of proprietary data source or information in order to incremental value, so you’re something more than that. That’s where probably the differentiation comes out. But I also think that is one of those areas where, like, I put my opinions at medium confidence, because I think we’re all going to figure those out collectively over the next three years, where we find out that some of these companies just get disrupted overnight and end up not being that valuable, and then others that we thought were were maybe not that valuable. End up being really, really valuable. But I think it’s, it’s finding those, those those ounces of defensibility, because it is fascinating how quick some of this stuff is being built. And generally the answer is, when stuff is being built really quickly, is there a that strong a barrier? I always am somewhat dismissive. When entrepreneurs are like, Oh, it’s just the brilliance of our team that got this product to market in six months, right? It’s like, No, you guys, just like, we’re really good at assembling really good building blocks,
23:23
100% so Alex, many founders assume that VC diligence is this numbers game with checklists, metrics, growth rates, financial projections, etc. You know, what are the non obvious things that you look for in a founder or a market? You know that you’re not going to get in the spreadsheet?
23:39
Yeah. I mean, look, I, I’m trying to measure how they manage their team, how they manage their customers, how they manage their company, and I think the way that they engage and act with me, and it goes two ways. What always gets messed missed intelligence, in my opinion, is it’s a little bit like, like dating any any time in life, right? Like, the way that people engage in those encounters is probably indicative of how they are going to engage later. And so, you know, if a founder is very well prepared, they’re very thoughtful. They’ve maybe reached out in advance and said, Hey, is there anything that you’d like to cover, anything you want me to get prepared for? They do a really nice follow up afterwards. You know, they’re kind. Those are things that I say to myself, Oh, man, this is somebody that I would like to do business with, right? And I presume that they’re going to do the exact same thing with their customers. And I think in the long run, those types run, those types of things matter, and they influence it. And I think if they’re that way, they’re going to hire people that are that way, and they’re going to be less tolerable to people that are arrogant or rude or mean or those types of things. And so I think those soft signals are things that we’re all checking for as we go along in diligence. And then frankly, you know, the other thing that I check for is, do they have the desire, like, we ought to write really big businesses at scale, Venture Partners and so, like, do they have the desire and the willingness to go out and build something that’s that’s really substantial and really big? And I think that that driving force generally, isn’t, Hey, I saw some sort of innovation opportunity in the market, or, Hey, I wanted to make some money. Like, usually there’s something else that’s motivating them. People are motivated by different things. And we all have that person that was successful. Have made 10, $50 million early in their life. For the last 10 years, they have, they have worked. I don’t want to back that person, right? I want to back the person who, on paper, is worth 100 $500 million and they’re still yelling at me as a board member that I need to give them more leads and I need to go do more work for them, because they want to take the company from five to ten billion they are motivated by something else, and that’s how greatness gets
25:19
built. What are some of the non obvious red flags you know that you’ve come across that would cause you to pass.
25:24
First and foremost, for me, what we’re talking past each other. I’m very intentional about how I ask my questions and how I sequence things, and when people answer different questions, don’t answer those or don’t understand where I’m going. I find that all subsequent conversations are probably going to be difficult as well. That is, we just communicate differently. We’re operating at different IQ or EQ wavelengths. And so those are, you know, those are red flags for me, the classic one that is super noticeable is if there’s an ounce of tension between the team, right? If they’re cutting each other off, or if they’re disagreeing with each other so forth, that’s always the tip of the iceberg. And you always know it’s actually much, much worse underneath. And then I tend to think when things are slightly misrepresented, right? Like, if in the pitch deck, everything is like, perfect, we’re going through this today, like this founder was raving about his growth rates, and then we looked at the numbers, the spreadsheet, the spreadsheet, things weren’t quite that good. It might be an interesting business, but there was just a disconnect there. And I was like, oh gosh, if I’m on the board of this, do I just have to now go do like, a weekly or monthly call with a CEO where it tells me everything’s great, and then I gotta go download the spreadsheet make my own decision like that. Feels exhausting.
26:29
It’s good though. These are nuanced. They’re not obvious. They’re nuanced, and it’s really helpful and very accurate. You know, for being honest with ourselves, what what do you think CEOs miss when it comes to how VCs conduct diligence,
26:42
I always tell CEOs like, if you like this interaction with me during diligence, that is, if you find that the questions that I’m asking are interesting or thoughtful, if you think that I’m prepared, if you think that I’m intellectually challenging you and doing it for my place of trying to find intellectual honesty and challenging you in a way that you find stimulating and not insulting, then I think that you’re going to have that same experience when I am on your board of directors and we engage. And if you find that in these conversations, you’re walking away and saying, oh, man, you Alex, you’re just not really getting what I’m building. Man, every time you open your mouth, I’m just annoyed because I find your questions are too obtuse or too pie in the sky or whatever they are. This relationship probably isn’t going to get better after three or five years. And so I encourage my CEOs, if you’re excited about potentially working with me, just as much as I’m trying to find touch points to interact with you find touch points to interact with me, right? Look forward to that diligence, because you want to have three, four or five conversations where we’re both pushing each other and feeling each other out to discover whether that relationship feels very comfortable with each other. Because company building is not for the faint of heart. Like there’s going to be tough moments. We’re going to yell at each other at some point in time, we’re going to disagree at some point. And how we recover from those moments is usually is discoverable pretty, pretty early on. And then, you know, don’t hesitate to ask for a couple references at some point in time. Or, more importantly, just go on my LinkedIn and reach out to the people if you can’t get a hold of the people, and they don’t respond if you’re referencing me, and if you write like my name on the subject, and they don’t respond, I should concern you. That’s good point.
28:04
Now Alex, the venture landscape is still adjusting to higher interest rates, tighter capital markets, constricted, supply side of capital. What’s your blunt advice to founders raising a Series A or B today? Are there specific things they should be prioritizing to stand out? I
28:19
think once you move from the C rounds to the and the B rounds, metrics start mattering. So implement. It’s a little bit like we have a phrase inside of scale. It’s, I took a couple flying lessons, but I’m a no means a pilot. If you, if you fly in a little Cessna, you fly by line of sight, right? You’re looking out the window, and you’re making sure that. But then, as you get like a jet plane, and you start flying at higher altitude, and maybe you look at the other few passages on your board, right? The difference between 10 employees and 50 employees, you got to fly by instrumentation, and so you got to get your dashboards, your metrics, all that information, lined up. And I still see a lot of A B pitch decks where people are, like, unwilling to share financials. They’re like, Oh, I’ll send that in a data room later. And then, like, to me, like, speaking back to red flags, I’m like, oh, that’s important. That’s like, a piece. Have it at the risk. Yeah, if you don’t, if you don’t want to have in your core 10 slides, that’s fine. Throw in the appendix. But like, the fact that you’re like, No, no, I don’t want to engage in that. In this conversation, you should be running your business like that. That’s how you should be engaging your management team. That should be how you’re engaging your board, and that’s how you should be engaging new investors. And so I think that, you know, in any environment where capital is more constrained, I would encourage people to be more buttoned up around that. I always think that like the further you go down the food chain, or maybe up, I don’t know which way, but public investors are really, really broad, right? Whereas, like seed investors are very narrow, like you go to a growth focused fund, they’re not going to be as spoken. So you got to keep dumbing down your pitch, because when you’re raising a seed round, that person may be the expert in non relational databases. By the time you get to the A and B, maybe I know what a non relational database is, but the more you’re able to explain it to me in very simple layman word, because maybe you’ve gone and pitched and pitched to a few friends, or you figured out a way to tell the narrative that is a simple fashion. I think that also is just like, is like, something that you kind of got to nail. And then, look, I, I’m always a fan of just build pipeline. I there’s, there seems to be these two thoughts of fundraising. The first is, like, the shotgun approach, go talk to 10 people, create FOMO, and, like, run the whole thing. And. Or two weeks. I love that process. It is so low taxing, it creates great outcomes, but it’s also the one where you fall flat on your face if it doesn’t freaking work. And so, like, my life has never been that fortunate, and I’ve never been quite that confident. So I just build pipeline. I’m like, All right, here are the 50 people who would be right for me. Let me start building relationships with them over 1218, month period. Let me check in, let me give them a pattern, and eventually let me create a process around that, coalescing around a date, and then, you know, close the freaking thing that’s fundraising like, and maybe it’s not 50, maybe it’s 150
30:27
perfect. Alex, you know, one of the biggest forces shaping investment decisions right now is policy risk, whether it’s FinTech regulation, AI oversight, global supply chain shifts, there’s a lot going on. How do you factor regulatory risk into your diligence, in your investment process, and where do you see the biggest opportunities emerging from this uncertainty? I think
30:46
that’s a great question. I feel like we should do a whole podcast on it. I’m gonna, I’m gonna, I’m gonna give you an antidote that’s not gonna answer your question. But I did this dinner about a year, year and a half ago, maybe two years ago, and I actually brought up this topic. I sat on these boards and regulatory risk. Is not regulatory, but, like, political, socio economic risk hadn’t been a thing. And then suddenly Ukraine was being attacked, and I developers there in certain countries suddenly, like, you couldn’t send data to and like, I was dealing with these, these problems of board level. And I was like, I don’t know how to deal with these. I’d like, nobody prepared me for this. My mentors never talked to me about this. And the gentleman that was the CEO before, before, Elon at Twitter in between, but after Jack, I’m blanking on his on his name, but really, really sharp, quiet guy. He’d been at the dinner the whole time. I hadn’t said much, and he just, like, lit up. And he was like, Oh my gosh. When I was running Twitter, all we did at the board was talk about non revenue companies and geopolitical risk associated with us operating in those places. And so he’s like, it used to not be that way. And so I think we’re coming into an age where the last 20 years, the world was incredibly peaceful, incredibly peaceful, incredibly stable, and I just don’t think the next 20 years are going to be that way. And I think that the private markets and the private boards are incredibly poorly set up for assessing, managing and thinking through that risk. And put me at the top of the list of people that are in that corrupt bucket as well. I hope at least in my transparency around my naivety around those things, I’m stimulating the conversation so that we can all talk about it. But I don’t have the answers for you. I think it’s tricky as
32:02
we think about different forces, exogenous factors, or drivers of change and opportunity. In my previous career at Danaher, we’d talk about market forces, technology for forces, we talk about regulatory and we talk about consumer behavior, or general market behavior. Technology feels like it can be durable. Persistent. Have longevity to it, and the regulatory stuff, it’s always a challenge for me, because it feels a little temporal. It feels a little administration specific in some cases. Is that a factor? You know, if you find a really compelling startup that’s benefiting from an opportunity that’s based on a regulatory driver, does that factor into, kind of the durability of that long term. Well, I think you got it
32:44
like, like, when I invest in motive, right? They had about $50 million they went one to 50 in about 12 months after I invested, maybe nine months crazy growth trajectory. And at the time that I invested, there was this ELD mandate, so it was regulatory driven, which is every, every truck had to, had to have a compliance solution on board an ELD electronic blogging device. And I think most VCs, if not all VCs, pass because they took a look at it and they said, Oh, this is very regulatory driven, the exact concern that you have. And and I had the benefit of having, you know, looked at that industry for a longer period of time, and I’d understood that there was a strong push in the industry towards towards telematics, towards towards visibility, but there had been a catalyst to force people to purchase it. And so when I was doing my reference calls, I asked specifically around this, and it was, it was right around the first or either Trump had just become president, or it was he was about to come president. And I remember talking to somebody who was really mad about this mandate. By the way, it’s a bipartisan mandate. Or was back in 2014 2015 so I knew it wasn’t going anywhere. But I was like, well, Trump’s gonna be president. I was asking this customer, right? I’m like, he’s probably gonna get rid of this, right? You’ve 10 trucks, and you had to go buy this. You’re angry about it, and like, Trump’s gonna, he’s gonna roll this back, and you’re gonna rip this out. And he paused, and this, I thought this was such an interesting anecdote. And he’s like, Well, he’s like, now that I know where all my trucks are, it’s actually been really helpful. And I was like, What do you mean by that? And he’s like, Well, I had this one truck. And he’s like, think about a truck. It’s 100 $150,000 truck. I got a half a million dollar load. I almost got a million dollars worth of value in each of these trucks. And my driver just would on the walkie talkie, go unresponsive on me. Sometimes I’d call him a couple hours, you totally disappear. And he’s like, Well, I was able to discover the telematics solution. I need a gambling habit. He would stop at Indian casinos across the country when he was driving across the way, and he’s like, I didn’t love it, but it made me feel a lot better, right? He wasn’t doing drugs, he wasn’t drinking. He wasn’t doing something else, just like, stop and play craps for a couple hours. He’s like, honestly, it’s kind of worth the price of the software. And so sometimes, sometimes regulation can be a catalyst for something else, and you have to understand what that something else is. And I think that in the case of that ELD mandate there, for example, yes, I invested around a a regulatory catalyst. But really what I understood and what I saw was that visibility was going to be the driving force in the transportation industry and in the trucking industry, and it just needed something for that push. And so, like, solar would be another example, right? There’s been a lot of subsidies that have pushed that. But like, I think we are all going towards electrification, and seeing that happen in other areas that the regulatory pushes are totally bananas and idiotic. And I would never. Us behind them. So you got to understand both sides of the coin. It’s
35:03
like, once that genies out of the bottle, it’s hard to put it back.
35:06
Technology doesn’t generally like to roll back if it’s useful. Alex, what
35:10
motivates you and has your motivation changed from when you started in venture? Yeah,
35:14
I mean, look, how’s my motivation? I’m sure that it’s like, like, I think my motivation at some point in time was just to become a VC, and then it was to become, like a senior associate, and then it was to become a vice president, then it was become a partner, and and then I sat there at 34 and had like a mini life crisis, and I was like, Well, what do I do now? What motivates me? Look, I, I love partnering with entrepreneurs, but, like, I hear a lot of VCs say, and I, for me, it’s something slightly different, which is, like, I get, like, the court side seats at the basketball game, right? Like I’m not in that game. I’m not even coaching that game. But like, anybody who’s ever had a chance to sit really close to I love basketball, to like, sit really close to the court, or sit court side, like it is a different experience, and you gotta go home and you get to tell people about it, and you see, like, a different level that game. And for somebody whose religion is business, and that is the religion that I was raised in, like it’s just like the most thrilling experience of life. And so when you combine that with intellectual challenge of trying to understand where technology is and where it’s going, I mean, I think it’s even the smartest people are humbled by it, and they get it wrong, and they invest in the wrong companies and the wrong trends. But when you get it right, you feel like you’re on top of the world. You’re like, Ooh, I knew the whole industry was going to work that way. I knew that company was going to do it. And not only did I know that, but I put my money where my mouth was, and then I got to watch it, right. Like, that company that we now call like a giant, or a vertical giant or whatever, like, I know when they were in that dinky, smelly office with 20 people, right? Like, I have that memory, it just feels so cool. So you
36:37
mentioned the basketball analogy, I have to ask you this Luca train. How does that happen in this environment? I
36:45
mean, I don’t, I don’t. I don’t have any of the conspiracy theories that you know are any more proprietary than what what Twitter is putting out. But like, as a Laker fan, like, I freaking love it, I love COVID, I love pow, I love Shaq. I love the old Lakers. I always struggle like, I’m not a LeBron hater, but he always felt weird to me in a Laker Jersey still feels weird to me. And I look at Luca and I’m super pumped. Look, there is something that is magnetic about the Lakers. People want to play there. The NBA wants them to win. I think it’s good for everybody that the Lakers are doing well. And, you know, I think that that’s like, something that a lot of people get annoyed about. But then you also like, look at the NBA, and even like, small market teams continue teams continue to win all the time. And so I think everybody always has a chance in the NBA, because, you know, like, you just need, like, a few good players, but yeah, certain franchises are going to be more dominant consistently for a long time. Because success begets success, right? It’s great companies have the ability to attract more great employees, which begets more success and more great employees. And it’s the same thing in venture like when we sit down and say, how do we market scale Venture Partners? Like when we get back to first derivatives, the best marketing tool that we have is investing in great companies, right? Like, it’s just, it’s like, so simple. And so I think the Lakers do have that advantage. You sometimes are a little suspicious of what’s going on in the background, but I’m here for it. Success
37:59
does beget success, but that has not worked for my Chicago Bulls so well. But like,
38:04
it will come back around. I mean, I think, you know, you guys have done some good picking and just had some, like, real bad luck with injuries and so forth. And, I mean, look at like Boston. Boston kind of was, like, in a drought for a very long time. And now you look at the combination of a couple players that they have, and like, I despise Boston sports. Deeply despise it. I’m a cow guy. Maybe that helps. But, like, I look at that Celtics team these days, I’m like, Ooh, that’s a team you can get behind. They’re pretty fun to watch. That’s true. That’s true.
38:30
Alex, if we could feature anyone here on the show, who do you think we should interview and what topic would you like to hear them speak about?
38:37
Oh, gosh. I mean, you know, you probably, don’t want to hear me refer my colleagues, but you know, my partner, Rory O’Driscoll, is always a talking sound bite, and I think he’s, you know, invested in five companies, so $5 million that have gone public. And he’s so freaking humble that he just doesn’t hate he’s hearing about these statistics, but he’s just like a wealth of knowledge of like sitting on boards and going through those journeys. So I’m always a huge fan of his, if I might highlight one of my
39:04
partners, Alex, what book, article or video would you recommend the listeners the book that
39:08
I find myself kind of resonating back to again and again in my life, and maybe I’d like to share something about but like, I love the book catch 22 because it just talks about like the contradictions in life and the ironies, and does it all and puts a smile on your face. Like, I think it’s important. To laugh, and I think it’s important to be light hearted, and I think it’s important to understand that we’re all within this big system. And like, things happen, and sometimes you can’t change them, and sometimes there’s a catch 22 within those things. So, yeah, awesome. I like that book a
39:35
lot. Alex, you have any habits, tactics or behaviors that are a force multiplier?
39:39
I mean, I think the best therapy that you can find for your mind is exercise, and I think that that is undervalued. I think that we talk a lot about maintaining our bodies, and we talk too little about maintaining our heads. And so I’m a fan of therapy, I’m a fan of coaching, and I’m a fan of whatever is required in order for you to intellectually, be in the right state of mind. Go back to my earlier. Comment around focus. And so exercise has been a function in my life. I’m really bad at working out by myself and holding myself to my own goals. And so there is a endless list of friends in my life, former, current, future, who I have exercise like commitments with. And I just say, like, we’ll see you at the gym Saturday at 8am or we’ll go swimming Sunday at 10pm and if they’re showing up, I show up. And if I don’t make that commitment somebody else, I make that commitment to myself, I tend to not show up. And so I like that because, because exercise has just been this, like super power unlock in the networks and the friends and the mental health and the physical health,
40:34
two for one, exercise and accountability partners love it. Yeah. And then finally, here, Alex, what’s the best way for listeners to connect with you and follow along with
40:41
scale. Yeah, totally so scale. Vp.com, is our website. My email is Alex at scale. VP, I have a very hard last name to spell a knee. He can find me on Twitter, where I’m mostly snarky and cynical and sometimes grumpy, and for more productive conversations, you can find me on LinkedIn. I’m pretty accessible across all those mediums. And try to, you know, really try to be responsive. I think the job of us in the venture capital industry, we’re service providers, is to be accessible and to be approachable. And so do reach out. I love that perfect.
41:09
Well, I’m going to butcher the pronunciation, but he is Alex knee Henke, the firm is scale. And the article which you should really check out is the future of AI is vertical. Alex, thanks so much for doing this today. I really want to go out and appreciate the time Awesome.
41:29
All right, that’ll wrap up today’s interview. If you enjoyed the episode or a previous one, let the guests know about it. Share your thoughts on social or shoot them an email. Let them know what particularly resonated with you. I can’t tell you how much I appreciate that some of the smartest folks in venture are willing to take the time and share their insights with us. If you feel the same, a compliment goes a long way. Okay, that’s a wrap for today. Until next time, remember to over, prepare, choose carefully and invest confidently. Thanks so much for listening.
