Secrets of Sand Hill Road
Why Am I Interested In This Book?
Given that I have lived and worked for a VC-backed firm, it seems wise to actually understand how this entire game works. Sure, so far, I have just been that one employee who gets a very small piece of the equity, but it’s possible that in the future I would become an entrepreneur myself, so this is a good time to understand how the game works.
One big realization that I took away from the book is that, at the end of the day, all these money exchanges are driven by incentive structures — who has the money, who is accountable for what, and I think understanding this in a very holistic way could have good implications on things like equity, when the company is going public, etc. Knowing the big picture will help me to not have tunnel vision and focus on minuscule things.
Working with VCs usually lasts 8-12 years, which is actually longer than an average marriage in the U.S., so it’s important you know who these people are.
What This Book Is About
For many entrepreneurs, the world of venture capital can seem mysterious at best, adversarial at worst. And yet, understanding how venture capital works and how VCs make decisions is often critical to the success of many startups. Whether trying to get a new company off the ground or scale an existing business to the next level, founders need to know just what makes VCs tick.
In Secrets of Sand Hill Road, Andreessen Horowitz’s managing partner (and former entrepreneur himself) Scott Kupor demystifies the role of venture capital in all stages of the startup lifecycle. He explains exactly how VCs decide where and how much to invest, and how entrepreneurs can get the best possible deal and make the most of their relationships with VCs.
Part 1: How to Understand and Choose a Venture Investor
Why Venture Investing?
Why the world needs venture (risk) capital. Stanford research shows that venture capital-backed companies founded since 1979 account for 43% of all US public companies, 57% of public company market capitalization, and 82% of the country’s total R&D budget. The world needs this risk-seeking asset class. And indeed you see every region around the globe trying to nurture their own Silicon Valley-like ecosystem.
VC financing’s purpose is to fund risky businesses in the form of permanent capital. These types of funding are in contrast to banks, which are more conservative and expect the borrower to return that money. What they do is that they invest in the hope that the venture will get big and they can make good returns.
Where Does the Money Come From?
VCs typically get money from Limited Partners, the easiest example being a university endowment. LPs have specific goals to use finance vehicles to fund their objective — to subsidize higher education. LPs typically have a portfolio of investments, of which venture capital is one component. But VC is an important component because that’s the only high risk, high return category. Essentially, VCs are General Partners, and are accountable to LPs.
University endowments (LPs) usually have the benefit of time — the goal is for Yale to stay in perpetuity, and they have 30B+ dollars which they want to invest so they can cover expenses for universities. So what they have is time — they can afford to invest in ventures that have abnormal returns in time. “Prudent man rules” opens up the opportunity for LPs to give money to GPs to invest in risky ventures.
- Limited Partners (LPs) are so named because in the VC fund, they are legally “limited” partners — they do not have any decision-making authority in investments the fund makes and thus have no liability if things go awry.
- General Partners (GPs) are the legal decision-makers in the fund and also bear the full brunt of liability. GPs are fiduciaries to the LPs, meaning that they have a legal responsibility to act in the best interests of the LPs. (One clue that things are getting serious in a startup board meeting is when a VC declares “I’m a fiduciary!”)
How to Choose a VC Fund?
Why venture investors only fund companies with large market sizes. VCs are dealing with long tails. A lot of their investments basically are “impaired investments”, where they will not get any returns. This means that they need a very small number of investments to give 20-100x returns. Essentially, a very small number of investments makes up the majority of the return. This means that for VCs, they want to invest in companies that eventually can take on a very large market size. As an example, the VCs will not be happy if you build a company and sell it to Google for 30-40 million. This might be life changing for founders, but not so much for VCs.
When fund raising, does it matter how old a fund is? The J curve — in the early years of a fund, the VCs have negative cashflow, because they are investing money, and if they fill all the investments, they might not have enough capital to make subsequent investments.
As an entrepreneur, you should know where the VC is at — are they at the beginning of the J curve, where they still have a lot of capital to invest, or are they at the end of the cycle where they don’t have much left to continue to invest.
Should you care how much money a specific General Partner has invested in a fund? GPs usually have 3-5% invested as their stake in the game. LPs usually care a lot more about this, because they want to make sure GPs are not just playing with other people’s money, less so entrepreneurs. But generally it’s good to have skin in the game.
On governance, generally it’s important for you to understand how, in a fund, general partners process deals and make deal decisions. Understanding this will help you understand who you are working with, how much budget they have, and how much they are willing to invest. If you understand the decision process, you have a better chance to secure a deal.
How do corporate venture investors have similar and different incentives from pure financial investors? Google Ventures is an example of corporate VC, Google is their only LP, so they don’t have to raise money. Oftentimes, they are different from pure financial investors. Their angles are usually for the mother company to diversify or create a channel for M&As. Usually, the ordering is to first find financial VCs, and after that you could work with corporate VCs.
Because corporate VCs don’t have to raise fund by fund, and usually get money from the mother company, the incentive system of a pure financial investor is different from that of a corporate VC.
Future of Venture Capital?
Can’t entrepreneurs just crowdsource both funds, advice and connections? “Are VCs the last dinosaurs?” In the old world, VCs are the only people who have the money, but this is no longer the case. In modern day, there are plenty of opportunities to find money, and so the added value a VC provides is something other than capital. In fact, for A16Z, they believe that capital alone is not a differentiator.
What are 3 ways venture investing and entrepreneurship evolve over the next 10 years? In the last 10 years, the biggest change was the introduction of the “seed” round, with angel investors like Ron Conway who write checks. Going forward, companies are going to stay private longer than before. In the future, there will be more of a blending of private & public. In the future, there is going to be more of a continuum, like secondary markets.
Part 2: How to Raise Money from a Venture Investor
Starting A Company
Why is it easiest for venture investors to fund Delaware C Corps? There is a lot of legal precedent in Delaware and things are well set up. C Corp allows you to have a lot of shareholders, and it allows you to have different classes of shareholders. It’s a seamless way to get to where you ultimately want to get to, the trails have been laid out.
What should you do if you’re planning to start a company but are still employed? The thing you have to be careful about is intellectual property — VCs don’t want to fund a company where the technology is taken from an existing large corporation. If you have a great idea, don’t use your company laptop — have some physical separation. If things are becoming real, try to create a separation.
Raising Money
How much money should you raise? The simple answer is — how much money would you need to raise this round in order to achieve the objective to go to the next round. If you are raising your series-A, you should think about what’s the pitch for your series-B, and then think back what is the money you need for completing what you can show during your series-B. You do it one step at a time. You don’t want to over-finance, because that will introduce dilution. The important thing is that you are making steady progress.
What do you need to be careful of when raising a convertible note? A convertible note is a form of short-term debt that converts into equity, typically in conjunction with a future financing round; in effect, the investor would be loaning money to a startup and instead of a return in the form of principal plus interest, the investor would receive equity in the company.
Typically, a convertible note is easier to set up, and because it’s easier, sometimes founders end up taking on too much convertible note and eventually give up too much of the company. They are convenient, but would cause problems down the line if you give up too much ownership.
Is there such a thing as too high a valuation? As an entrepreneur, you want to avoid the situation where everyone is working super hard, and hitting all the goals, and yet, because you have too high of a valuation last round, now people have an even higher expectation which you fail to realistically achieve.
There’s always a tension between entrepreneurs and VCs: entrepreneurs want to give up as small a stake in the company (percentage of the company) as possible while getting as much money as possible. VCs want the opposite.
Economics of the Term Sheet
Liquidation Preference. Liquidation preference is the order in which money comes out from the company (in exits, either a sale or IPO). Typically VCs would have liquidation preference over the common shareholder, so it means that in the case of a sale, VCs will first get back the money, before common shareholders.
Participating vs. Non-participating. What’s the most entrepreneur-friendly liquidation preference? 1x non-participating liquidation preference is the best one for founders.
- 1x: means that you get back one times the original money you put in
- non-participating: no double-dipping. An example: a company is sold for 20M where a VC invested 10M for a 25% stake. Then “participating” means that not only will the VC get back the original 10M, they can also get 25% of the remaining 10M, which is generally quite unfair for the founders.
Anti-Dilution Clause. If we later in the future raise money in a lower valuation, then VC is allowed to keep their share of the company. Weighted average anti-dilution is fairly common, and there is a very egregious one called a ratchet.
These are all related to the “structure” of the term sheet. Generally, the simpler, the better. Clean deals are better. Complicated structure means that you create a precedent for exceptions, so it’s likely that future investors would want the same thing. So you should think carefully about what exceptions you are making. It’s not just about the current round, but also later rounds as well. Project as much foresight as possible upfront.
Corporate Governance
Dual-class voting structure. This means different classes of shares have different voting rights. They exist because sometimes the company and the public market might have different short-term v.s. long-term perspectives.
Sometimes, founders want to have more votes so they can invest in longer-term investments that might not be in the appetite of the public shareholders. It’s again to counter balance incentives.
Independent Board Member. It used to be the case that VCs would outnumber the common shareholders (employee-led shareholders), and CEOs are typically worried about this because they can be replaced. In recent years, there are more common shareholders than VC shareholders. The idea for an independent shareholder is to have someone who is an industry expert in a domain where they need help to drive the company.
Pro-rata Right. It’s the right to invest additional dollars in the next round of financing in order to preserve the percentage ownership of the company. This is very good for VCs working with a growing company so they can invest in future rounds of financing.
This is something that as a CEO, you have to deal with the dynamics among investors from different rounds. Investors from new rounds obviously want more stake and wouldn’t like the previous investors to have too large of a stake, but the old ones don’t want to be diluted, so they are incentivized to use their Pro-rata right.
Stock Transfer Restrictions. Often investors will have restrictions on how they can sell their shares. Similarly, you might want to have something on employees as well. This is something that the CEO needs to balance — you want to give people some flexibility, but you also want to make sure those shares won’t take up demand from people who might invest and grow the business. Usually, the company would add guardrails on how much and what time employees can sell.
Vesting Schedule. There are different kinds of vesting schedules. 4 years is the typical one. The big change for options is that in the past, if you leave the company, you have to exercise them in 90 days. Because companies are staying private longer, more companies are lifting those restrictions.
Part 3: How to Get the Most from Your Board
Building a Board
What do you want from a board? They are a good coach, a mentor, and good company governance. You want value from the board so you can accelerate the growth of the business.
The fundamental power of the board is that they can control whether to hire or fire the CEO. However, this generally requires consensus from the board, so it’s not as easy, it requires votes. Still, in a healthy relationship, CEOs should share enough information with the board so the board can help them address issues and make the company better. There are definitely some power dynamics there though.
Power Dynamics of the Board
How do you handle situations in which the economic interests of your board members diverge? Given that VC is a fiduciary, there are legal constraints on how much they can do to only benefit themselves. This is why it’s important to find board members who can exercise duty of care and not put their interests above the company. When a company is sold at around liquidation preference, this is where problems tend to occur. You need to understand the incentives and timeline of each person on the board.
Different Scenarios of Outcomes
Re-capitalization & Wind Down. The important thing here is to have the conversation and figure out how to ramp down responsibly and take care of the employees. Alternatively, there could be a case that the team needs to re-cap or re-start, cleaning up liquidation preference, and reset. This is possible, but requires commitments from both VCs and the founders.
Successful Acquisition By a Bigger Company. A lot of things to think about:
- What is the economic interest? Are you getting cash, or stock of the acquiring company? Sometimes there’s “management carveout” to incentivize managers and important leadership in the company to stay longer.
- What is the go-forward business going to look like? Are you going to be the GM of a new division, and leverage the company’s resources? Or is it just acquisition-hire, and keep the engineers, but lay off the marketing / sales org?
Initial Public Offering. You need to understand the incentives of your investment banker: Goldman Sachs, Morgan Stanley, etc. They typically help you to shepherd the process and bring your company public. They typically have two clients, and there’s tension:
- You (the company): you want the price to be as high as possible, so you can raise a lot of money with less dilution
- Institutional investors: they want to buy as cheap as possible
Once the company is public, the board also starts to shift their roles to governance rather than forward-looking growing the business.
Sometimes, investment bankers would prefer the institutional investors, because they are repeat players, but you have to use your judgement here.