26 July 2019
Secrets of Sand Hill Road, Venture Capital and How to Get It – Scott Kupor
Chapter 2: So Really, What Is Venture Capital?
If you are a founder of a company, assuming you had a choice between debt and equity, which would you choose? Well, the answer is that it really depends on the type of business you are seeking to build, and how you want to think about the constraints that different forms of capital entail. If you think you can generate near-term cash flow, or at least are willing to reduce investment in some areas of the business to make available cash to pay interest (and ultimately principal) on debt, then bank lending may be your best source of capital. After all, using debt means you don’t have to sell any of the equity in your company to others.
Equity-based financing is often the better choice for businesses that (1) are not generating (or expecting to generate) near-term cash flow; (2) are very risky (banks don’t like to lend to businesses where there is real risk of the business failing, because they don’t like losing the principal balance of their loans); and (3) have long illiquidity periods (again, banks structure their loans to be time limited – often three to five years in length – to increase the likelihood of getting their principal back).
Many early-stage investors – we call them angels or seed investors – often invest in companies via notes, but they have a distinguishing characteristic that makes them look more like equity: they are convertible notes. What does that mean? The initial investment looks like debt – it has an interest rate (most of the time) and a date by which the principal amount of the debt is expected to be repaid. That looks and smells like the bank debt we were talking about earlier. But the debt also has a conversion feature – that is, a mechanism by which, in lieu of getting the principal back, the investor converts its debt into equity. Thus, the conversion feature turns nonpermanent capital into permanent capital.
This is oversimplified, but there are basically three types of people involved in VC. There’s an investor (institutional, “limited partners” – I promise we’ll unpack these definitions soon) who invests in a venture firm’s fund. Then the venture capitalist, usually a general partner at the firm, takes that money to invest in (hopefully) upward-bound startups. And the entrepreneur uses that money to grow her company. Those are the three: the investor, the VC, and the entrepreneur.
VC returns do not follow a normal distribution.
Instead, VC firm results tend to follow more of a power-law curve. That is, the distribution of returns is not normal, but rather heavily skewed, such that a small percentage of firms capture a large percentage of the returns to the industry.
First, signaling matters. Venture firms develop a reputation for backing successful startup companies, and that positive brand signaling enables those firms to continue to attract the best new entrepreneurs.
We can also have false negatives, when we underfit on the curve and thus eliminate great candidates without having fully evaluated their skill sets. In the venture context, as we’ll see when we discuss incentives, underfitting is the far more serious mistake.
The other special characteristic of venture investing is that it is restricted to what are known as “ accredited” investors only. Accredited investors are basically people who have achieved some level of financial success (the current rules require that you have a $1 million net worth or have earned for the last two years, and have an ongoing prospect of earning, at least $200,000 annually).
Qualified – an even higher form of wealth, generally in excess of $5 million of net worth – investors.
You will not be invited to make an investment in a VC fund unless you meet at least the accredited investor definition; many VC funds restrict their investors to the even higher, qualified investor standard.
What are the implications of all this for investing in venture capital? First, diversification is a bad strategy for investing in VC firms. If you are an institutional investor who is lucky enough to have built a roster of successful firms whose returns are not the median but in the high-return section of the power-law curve, you don’t want to diversify.
Probably further exacerbates that power-law distribution of returns. And that brings us to the second implication – it’s very hard for new firms to break into the industry and be successful.
Not only does the performance of VC firms follow the power-law curve, but so does the distribution of deals within a given fund. Over time, funds that generate two and a half to three times net returns to their investors will be in the good portion of the power-law curve distribution and continue to have access to institutional capital. We’ll talk about fees later, but to achieve two and a half to three times net returns (after all fees), VCs probably need to generate three to four times gross returns.
In VC, all we really care about is the at bats per home run. That is, the frequency with which the VC gets a return of more than ten times her investment.
Using the 1974 data cutoff, 42 percent of public companies are venture backed, representing 63 percent of total market capitalization. These companies account for 35 percent of total employment and 85 percent of total research and development spend. That’s pretty good for an industry that invests about 0.4 percent of the US GDP!
Chapter 3: How Do Early-Stage VCs Decide Where to Invest?
There are qualitative and high-level quantitative heuristics that VCs use to evaluate the prospects for an investment. And they generally fall into three categories: people, product, and market.
For early-stage investing, likely the most important evaluation criterion. When the “business” is nothing more than a very small collection of individuals – in some cases only one or two founders – with an idea, much of the VCs’ evaluation will focus on the team.
Among the cardinal sins of venture capital is getting the category right (meaning that you correctly anticipated that a big company could be built in a particular space) but getting the company wrong (meaning that you picked the wrong horse to back).
First, what is the unique skill set, background, or experience that led this founding team to pursue this idea?
In the product-first company, the founder identified or experienced some particular problem that led her to develop a product to solve that problem, which ultimately compelled her to build a company as the vehicle by which to bring that product to the market. A company-first company is one in which the founder first decides that she wants to start a company and then brainstorms products that might be interesting around which to build one.
The product-first company really speaks to the organic nature of company formation. A real-world problem experienced by the founder becomes the inspiration to build a product (and ultimately a company); this organic pull is often very attractive to VCs.
Consumer “delight” and repeat purchasing are the classic hallmarks of product-market fit.
The third big area of team investigation for VCs focuses on the founder’s leadership abilities.
Determine whether this founder will be able to create a compelling story around the company mission in order to attract great engineers, executives, sales and marketing people, etc. In the same vein, the founder has to be able to attract customers to buy the product, partners to help distribute the product, and, eventually, other VCs.
Most ideas are not proprietary, nor likely to determine success or failure in startup companies. Execution ultimately matters, and execution derives from a team’s members being able to work in concert with one another toward a clearly articulated vision.
Will this product solve a fundamental need in the market (whether or not that need is known currently to customers) such that customers will pay real money to purchase it?
Only through iterative testing with real customers will the company get the feedback needed to build a truly breakthrough product. Thus, much of what an early VC is evaluating at this stage is the founder’s idea maze: How did she get to the current product idea, incorporating which insights and market data to help inform her opinions? Assuming that the product will in fact change many times over the course of discerning product-market fit, it’s the process of the idea maze that is the better predictor of the founder’s success.
You’ll often hear VCs say that they like founders who have strong opinions but ones that are weakly held, that is, the ability to incorporate compelling market data and allow it to evolve your product thinking.
Max Planck, the German scientist who is credited with inventing modern quantum physics, said it most eloquently: Science advances one funeral at a time. Simply put, it’s hard to get people to adopt new technologies. So new products won’t succeed if they are marginal improvements against the existing state of the art. They need to be ten times better or ten times cheaper than current best in class.
“Market” is the third leg of the stool that VCs use to evaluate early-stage investment opportunities. It turns out that what matters most to VCs is the ultimate size of the market opportunity a founder is going after.
Often it’s unknowable at the time of investment how big a market actually is.
Chapter 4: What Are LPs and Why Should You Care?
There is a story that Queen Isabella of Spain was the first true VC. She “backed” an entrepreneur (Christopher Columbus) with capital (money, ships, supplies, crew) to do something that most people at the time thought was insane and certain to fail (a voyage) in exchange for a portion of the to-be-earned profits of the voyage that, while probabilistically unlikely, had an asymmetric payoff compared to her at-risk capital.
Similar early VC-like tale here in the States in the 1800s – the whaling industry. Financing a whaling venture was expensive and fraught with risk but, when successful, highly profitable.
There are many categories of LPs, but most tend to fall into the following buckets:
- University endowments (e.g., Stanford, Yale, Princeton, MIT) – Nearly every university solicits donations from its alumni. Those donated funds need to earn a return on investment. Those returns are used to fund operating expenses and scholarships for the schools and, in some cases, to help fund capital expenditures, such as new buildings.
- Foundations (e.g., Ford Foundation, Hewlett Foundation) – Foundations are bequeathed money by their benefactors and are expected to exist in perpetuity on these funds. Foundations need to earn a return on their funds to make charitable grants. In the US, to maintain their tax-free status, foundations are required to pay out 5 percent of their funds each year in support of their mission. Thus, over the long term, real returns from venture capital and other investments need to exceed this 5 percent payout level to ensure a foundation’s perpetual existence.
- Corporate and state pension funds (e.g., IBM pension, California State Teachers’ Retirement System) – Some corporations (although many fewer these days), most states, and many countries provide pensions for their retirees, funded mostly by contributions from their current employees. Inflation (particularly in health-care costs) and demographics (more retirees than current employees) eat away at the value of these pensions, absent the ability to generate real investment returns.
- Family offices (e.g., U.S. Trust, myCFO) – These are investment managers who are investing on behalf of very-high-net-worth families. Their goals are set by the individual families but often include multigenerational wealth preservation and/or funding large charitable efforts. There are single-family offices (as the name suggests, they are managing the assets of a single family and its heirs) and multifamily offices (essentially, sophisticated money managers who aggregate the assets of multiple families and invest them across various asset classes).
- Sovereign wealth funds (e.g., Temasek, Korea Investment Corporation, Saudi Arabia’s PIF) – These are organizations that manage the economic reserves of a country (often resulting from things that we US citizens know nothing about – government surpluses) to benefit current or future generations of their citizens. In the specific case of many Middle Eastern countries, the sovereign wealth funds are taking profits from today’s oil business and reinvesting in other non-oil assets, to protect against long-term financial reliance on a finite asset.
- Insurance companies (e.g., MetLife, Nippon Life) – Insurance companies earn premiums from their policyholders and invest those premiums (known as “float”) for when they are required to pay out future benefits. The monies they earn from investing these premiums are then available to pay out the insurance policies as they mature.
- Funds of funds (e.g., HarbourVest, Horsley Bridge) – These are private firms that raise money from their own LPs and then invest in venture capital or other financial managers. LPs of fund of funds are typically smaller instances of direct venture LPs and thus find it difficult or economically inefficient to invest directly in VCs.
One of the best examples of modern asset allocation is the Yale University endowment. (...) over the last ten years, the Yale endowment has returned more than 8 percent net from its investment allocation, ranking it among the very top educational institutions. (...) In 2016, the endowment contributed $1.15 billion to the university, accounting for one-third of the institution’s revenue. Maybe surprisingly (it was to me), tuition and room and board that Yale’s student population paid amounted to only about $333 million. (...) Because Yale has a lot of its assets tied up in illiquid categories such as venture capital, it does ultimately care a lot about eventually achieving liquidity. In other words, Yale wants to be able to realize its 18 percent annual return in VC by tying up its money for longer periods of time, but in order to keep funding the university and reinvesting in its venture managers, it needs to eventually get liquidity from its earlier venture investments. And, again, that drives corresponding behavior among the VC firms – they need to either sell or take the companies in their portfolio public at some point in time in order to realize cash to provide back to Yale.
At some point in your company’s life cycle, the VCs will push for an exit to generate this type of liquidity. When that happens is a function of not only how the company is doing but also where a firm might be in its fund life cycle and how the rest of the companies in the fund are performing. To this end, one thing for you as an entrepreneur to consider is how old the fund is from which you are receiving your investment.
First, you should ask about the specific fund from which the VC is proposing to invest in your company – most funds are serially numbered with Roman numerals. You can then check the initiation of that fund to determine its age. As you’ll see later, funds tend to be ten years in life and often can get extended for a few years beyond that.
VCs are generally limited in how late into the fund they can make new investments (often only through years five or six).
The later in a fund cycle your investment occurs, the greater the likelihood that the VC may also not have sufficient reserves to set aside for subsequent financing rounds.
VCs can and often do invest in the same portfolio company in a subsequent fund, particularly if they run out of reserve capacity in the original fund that made the investment. However, this is not as easy as investing reserves out of the same fund as the original investment, in part because the mix of LPs could be different from one fund to the next and thus create potential conflicts between the funds.
Chapter 5: The “Limited” Edition: How LPs Team Up with VCs
The LPs in fact have a “limited” role in the affairs of the fund in two important ways. First, they have limited governance over the affairs of the fund. In the main, this means that LPs have no say over the investments that the fund chooses to make. As long as the fund invests in the set of things that are prescribed by the fund parameters, the LP is essentially investing in what’s often called a blind pool – blind, that is, to the LP itself, which has no ability to weigh in on investment decisions. Similarly, the LP has limited ability to influence the decision to exit an investment and determine the manner and timing of whether to distribute the proceeds of that investment.
Second, as a result of their limited governance, LPs enjoy the protection of limited liability from a legal perspective if something goes wrong. For example, if a portfolio company or other investor sues the venture fund for some action it may have taken (or failed to take) to protect the interests of shareholders, the LPs are basically immune from any potential liability.
The limited partnership agreement (or LPA) is the legal document that formally lays out the rules of the road – the economic relationship between the LP and the GP and the governance relationship between the LP and the GP.
Typical VC firms charge 2 percent annually, although some firms are able to charge as much as 3 percent.
So even though the GP is not investing (and thus not calling) all of the $100 million up front, the GP is able to take a 2 percent management fee, or $2 million per year, on the full amount of the committed capital.
As the fund ages and more of the GP’s activity shifts to managing existing investments (versus finding new ones), many funds start to have a step-down in the fee.
Perhaps, for example, the company grants the GP some equity or cash incentive for being on the board of directors. The question then becomes: What does the GP do with that compensation? In most modern LPAs, the GP can keep the compensation if she wants, but she needs to credit that fee against the management fees otherwise being charged the LPs. In other words, no double-dipping; if you get paid by the company, you deduct that compensation from what you charge the LPs so that the GP ultimately has the same amount of disposable fee income in either case.
Carried interest in the VC context refers to the portion of the profits that the GP generates on her investments and that she is entitled to keep. (...) It often ranges between 20 and 30 percent of the profits.
Unfortunately for our GP, she overdistributed profits to herself and is now subject to what’s called a clawback – the money needs to be returned by the GP to the LPs.
Most LPAs have a provision that allows the GP to reinvest, or recycle, some portion of her interim winnings into other companies.
In reality, the GP also has to have some skin in the game; the more the better (from the LP’s perspective).
Most GPs contribute 1 percent of the fund’s capital, and many times they will contribute 2–5 percent of the capital.
Instead of investing in a VC fund, an LP could choose to invest in the S&P 500 or some other asset class. To account for this, some LPAs introduce the concept of a “hurdle rate” into the profits calculations. A hurdle rate says that unless the fund generates a return in excess of the hurdle rate (this is a negotiated number, but often around 8 percent), the GP is not entitled to take her carried interest on the profits. If the fund exceeds the hurdle rate, then the GP can start collecting her carried interest as if the hurdle rate didn’t exist.
How the fund is doing may also influence your GP’s willingness to invest additional money in your startup or her desire to seek an exit.
If your company is the lone shining star in an otherwise poor portfolio and you receive an acquisition offer that would meaningfully help the GP to get cash back to her LPs (and therefore increase the likelihood of her being able to raise a next fund), she might be more inclined to push you to take that deal, even if you think there is still more upside to come from running the business.
Chapter 6: Forming Your Startup
At a minimum, most founders vest their shares over a four-year period. But given the much longer runway most private companies will have before they get to their public market debut, founders should think about whether four years is enough time.
Consider at the time of founding the company how you and your cofounders will govern such situations.
Chapter 7: Raising Money from a VC
How much money should you raise? The answer is to raise as much money as you can that enables you to safely achieve the key milestones you will need for the next fund-raising .
If you accomplish the objectives that you laid out at the time of your A round, your B round investor will pay you for that success in the form of a higher valuation. This means that you will have to sell less of the company per dollar of capital you raise.
If you allow yourself or a VC to overvalue the company at the current round, then you have just raised the stakes for what it will take to clear that valuation bar for the next round and get paid for the progress you have made.
One big mistake we at a16z have seen entrepreneurs make is to raise too small an amount of money at an aggressive valuation, which is precisely the thing you don’t want to do. This establishes the high-watermark valuation, but without the financial resources to be able to achieve the business goals required to safely raise your next round well above the current round’s valuation.
Never underestimate the value of always maintaining momentum in the business, one measure of which may be a successful financing round.
Chapter 8: The Art of the Pitch
Pitch Essential #1: Market Sizing
Pitch Essential #2: Team
- Once you’ve established that the market opportunity is in fact big, the real question for a VC now becomes “Why you?” That is, “Why do I want to back this set of entrepreneurs versus waiting for the next set that might walk into my office tomorrow tackling the same idea?” After all, ideas are a dime a dozen; execution is what sets the winners apart.
Pitch Essential #3: Product
- They are evaluating the process by which you came to your initial product plan. VCs are fascinated to learn how your brain works.
- What data have you incorporated from the market; how is it more aspirin than vitamin; how is this product ten times better or cheaper than existing alternatives?
Pitch Essential #4: Go-to-Market
- How will you acquire customers, and does the business model support customer acquisition profitably?
- You do need to demonstrate to the VCs that you are the master of the domain you are proposing to attack and that you have thought about every important detail of your business in a way that shows depth of preparation and conviction.
Pitch Essential #5: Planning for the Next Round of Fund-Raising
- In general you want to aim toward a valuation that is roughly double your prior round.