Written by Scott Kupor, employee #1 at Andreessen Horowitz (a16z), this book reads like an unbiased presentation of facts rather than advice or personal opinion. Depending on your familiarity with venture funding and term sheets, this summary might seem to omit some important information, or it might be completely obvious to you.
A Brief History of Venture Capital (VC)
The VC industry started in the 1970s and up till the 2000s, it consisted of a few successful firms which controlled access to capital. Capital was the scarce resource that entrepreneurs were competing for. In the early 2000s, the amount of capital needed to start a company declined. In parallel, the formation of Y Combinator allowed entrepreneurs to better understand the process of startup formation and capital raising. As a result, capital flew into the VC sector and VC firms started competing for the right to fund entrepreneurs by increasing their offering to more than just capital.
a16z, for example, was built on the premise of forming a network that would improve the prospects for founding product CEOs to become world-class CEOs. Today, two thirds of their employees are focused on growing the businesses they invest in.
Irrespective of the changing dynamics of the VC market, Kupor emphasizes that entrepreneurs and investors are on the same side - as both share a desire to create businesses that improve the world.
Introduction to VC Investing
Venture funds follow the power law, where a small percentage of firms capture a large percentage of returns to the industry. This results in positive signaling, which further compounds the notion of spoils going to the same set of winners over time.
For most VCs, their returns follows this distribution:
Because of this distribution, we don’t want to look at the average number of successes in a portfolio, but rather the number of home runs (i.e. >10x returns).
When it comes to putting dollars in the ground, early stage VCs use three qualitative heuristics to decide where to invest:
Because VC is zero-sum (owing to the winner take all notion), the best investors are those who invest in good ideas that look like bad ideas.
There are 2 primary stakeholders for VCs: their limited partners (LPs) and the entrepreneurs.
LPs give VCs money to invest, and include endowments, pension funds, family offices and sovereign wealth funds.
The average VC fund life is ~10 years. For entrepreneurs, it is important to consider where in a fund’s lifecycle the VC is, because at some point they will need to generate liquidity in order to return capital to their LPs. This might pressure your business into generating an exit.
LPs receive quarterly reporting on the value of the fund, which is prepared using the follow mark to market techniques:
Considerations for Founders
For entrepreneurs raising early stage venture capital, Kupor provides a list of considerations that should be taken into account.
Startup Formation: Most startups are C-corps, because they are a good vehicle for companies that want to build long term equity value, rather than distribute profits to shareholders. C-corps also allow for different classes of shareholders with different rights.
Stock: Founder stock typically has a 4 year vesting schedule, but founders may want to consider having a longer time period than 4 years for the sake of better aligned incentives. For the employee option pool, there are 2 option types:
Intellectual Property: Founders should sign an invention and assignment agreement. Basically, the founder assigns to the company the creations she has invented, other than an enumerated list of prior inventions that the founder claims for her own.
Is VC Right for Your Company? Equity financing is a better choice for businesses that are not generating near-term cash flow. If you want to raise VC, you should believe that the market opportunity for your business is sufficiently large enough to generate a profitable, high growth, several hundred million dollar revenue business over a 7 to 10 year period.
How Much to Raise: You should raise enough so that you can safely achieve the key milestones you will for the next fundraising round. Raise enough such that you have plenty of time to achieve the higher expectations that your next round of investors will have. Keep in mind that employees will judge the success of the business on the external measure of valuation.
Pitching VCs: Your ability to find a warm intro to a VC is often a screening heuristic that VCs will use to gauge your grit, creativity, and determination. Pitch essentials include:
Economics of the Term Sheet
Security Type: VCs invest using preferred shares. These shares have preferred economic and governance rights relative to common stock.
Valuation: There are two primary types - pre-money and post-money valuation. Post-money just refers to the value of the company once the capital has been invested, i.e pre-money + investment = post-money.
There are multiple ways to value startups, including a comps analysis and DCF. For early stage companies, these are impractical. The more common alternative is a “What You Need to Believe” analysis.
Liquidation Preference: This outlines who gets their money back under certain circumstances, i.e. a liquidation event. “1x” is the predominant form for early stage financings. There are 2 flavours:
Conversion / Auto Conversion: This details the terms for converting preferred stock to common stock. Auto-converts can happen during IPOs for example. Voluntary conversion is rare, and generally only happens when a company goes south and effectively needs to restart / pivot. If the VC believes in the go-forward prospects for the company, she might volunteer to give up her liquidation preference to provide the company a fresh start.
Antidilution Provisions: These are included for the purpose of providing a safety net for VCs in the event of a down round. They set the value per share for the VCs ownership at some level between the original price, and the lower price from the down round. There are a few methods for calculating the new price, including the broad based weighted average and full ratchet method.
Board: The board composition in a startup will evolve and is a negotiation. At the early stages, it may include a CEO, the lead investor, and an independent member.
Protective Provisions: These clauses give the preferred shareholders the right to vote on a number of things including authorizations of new classes of stock, corporate actions, liquidation, recapitalizations, or an increase in the employee option pool.
Pro-Rata Investments: These give VCs the right, but not the obligation to purchase their pro-rata amount of future financing rounds, to avoid dilution.
Stock Restrictions: This includes what is known as a Right of First Refusal (ROFR), which means that before an owner in the company sells their shares to a 3rd party, they must give the company and then investors the right to purchase the stock at the same price. A go-sale is an inverse ROFR, meaning that if you offer to sell your shares, all other investors also get the right to sell their pro-rata portion of shares to that buyer at the same price.
D&O Insurance: Protects board members and officers against legal liability.
No-Shop Provision: Most term sheets are non-binding, so VCs will ask for a 30-day period (or more/less) where the company is prevented from being able to disclose the term sheet to other parties, or pursue another deal.
Role of the Board
The Board has a few primary responsibilities. These include hiring/firing the CEO, providing guidance on long term strategic direction, approving various corporate actions, and maintaining compliance / corporate governance. VCs sitting on the Board will also typically attempt to add value, by “coaching” the CEO, and opening up their network to help with finding employees / customers. From a legal standpoint, there are few specific responsibilities, including but not limited to:
Entrepreneurs should remember that the presence of preferred and common shares can create challenges when making decisions about the company. This is because VCs are dual fiduciaries, meaning they have a duty to both common shareholders in the company, and their LPs.
The two most common types of exits are acquisitions and IPOs.
Acquisitions: There are many considerations, including price, form of consideration (cash or stock), what happens to employees, voting approvals and exclusivity periods. In these scenarios, the Board has no obligation to sell the company but if it does, it must seek to maximize the value of the common stock.
Going Public: In recent years, many companies have been staying private for longer. Reasons for this include:
But there are also many reasons to go public, including: