Summary

Kupor (a16z COO) provides a practical guide to VC mechanics from both sides of the table. VC invests just 0.4% of US GDP but accounts for 42% of IPOs, 63% of new market cap, 85% of R&D spend, and basically all net new jobs since 1977. The book demystifies fund structure (LPs, GPs, carry, hurdle rates), term sheets, and what VCs actually look for.

Key thesis: VC follows a power law distribution – it's not a good asset class in aggregate, but the best funds generate outlier returns. A good VC batting average is .500. Goal: generate 2.5-3x net returns, which requires 3-4x gross returns. For founders, the pitch objective is convincing VCs your company has the chance to be a 100x+ outlier, not just a solid business.

Key Takeaways

Notes

Introduction

• 42% of all US IPOs were venture backed
• 63% of new market cap
• 85% of R&D spend
• Basically all of net new jobs since ‘77
• Invests only 0.4% of US GDP, for all of ↑

1: Born in the bubble

• Dot com bubble
  • 900 IPOs
  • Avg 4y to public, now 10+
  • PE ratio of 175+
  • Dropped 80%+
• Loudcloud LBO vs IPO
• ↑ to Opsware → HP acquisition
• 1970s was start of VC
• Capital was scarce, dominated by a few players
• Big changes:
  1. Cloud computing slashed startup cost
  2. YC 2005:
     • Educated
     • Cracked open VC black box
     • Created community
• a16z: capital becoming commodity, need to provide value
  • Conviction in product-Eng CEOs
  • ↑ lack other skills
  • So build a network of institutions

2: So really, what is VC?

• Useful when loans don’t work
• ↑ no ownership, must be paid back
• VC takes “permanent capital” (equity)
• Better choice when:
  • Not expecting to generate near-term cash flow
  • Are very risky
  • Have long illiquidity periods
• Convertible debt: non-permanent into permanent
• VC is not a good asset class
  • Illiquidity
• VC is a power law distribution
• VC positive signal flywheel
  • Shorthand for informing judgement
• VC is largely zero-sum
• Accredited + qualified investor gate-keep
• Good VC batting average .500
  • Better measure: at bats per home run
• Goal: generate 2.5-3x net returns → need to generate 3-4x gross returns

3: How early stage VCs decide

• People and team
  • Motivations: product-first vs company-first company
  • Founder-market fit
  • Need to be able to sell / tell a story
  • Egomaniacal: have to be party delusional
• Product
  • Testing product fitness in market
  • Evaluating “idea maze”
  • Strong opinions weakly held
  • Vitamins vs aspirin
• Market size
  • Is the “so what” question - doesn’t matter unless market is big
  • Hard to estimate (eg. Airbnb growing the market)

4: What are LPs?

• Original VC industry: whaling
• LPs generally expect 5-8% extra IRR from VC vs S&P500 due to illiquidity
  • Eg. Yale 18% vs 8%
• Types of LPs
• FoFs have LPs too
• Yale endowment is the benchmark model now (Swenson post-‘85)
  • Usually 4-6.5% given to school/yr
  • 20% domestic public equity
  • 15% foreign public equity
  • 10% hedge funds
  • 51% Illiquid assets (less efficient markets)
    • 15% buyout funds (PE)
    • 16% VC (77% IRR)
    • 20% hedge against unexpected inflation
      • 7.5% oil and timber commodity
      • 12.5% real estate
  • 7.2% hedge against deflation
    • 4.9% bonds (5% IRR)
    • 2% cash
• Know the timeline of the fund investing (10y)

5: How LPs team up with VCs

• “Limited” partner / role: (passive)
  • Limited governance:
    • No say in investments, “blind pool”
    • Limited say on exit, return of capital
  • Limited liability
• General partner: assume all risk
• Pass through entity: no corporate (double) taxing
• LPA: LP agreement
  • Fees
  • Capital calls
• LP cash flow J curve
• Methods for valuing companies
  • Last round waterfall
  • Comparable company analysis
    • Public company with revenue multiple + DLOM
  • Option pricing model (OPM)
    • Set of call options with strike prices
• Clawback when over-distributing to self
• Recycling: past wins re-invested
• GP commitment
• Hurdle rate: can’t take carry unless return is above this # (eg. 8%)
  • Preferred returns: carry only after above the hurdle rate
• Careful of misaligned incentives: eg. quick exit to clear hurdle rate
• Additional LPA terms:
  • Investment domain (eg. industry, geography, round, asset class)
    • Primarily to prevent style drift
  • GP co-investment
    • Avoids cherry-picking
  • Substantially all efforts
    • Suspension → divorce if not met
    • Applies to key men
• EPA: equity partners agreement
  • Ownership and governance
  • Vesting
  • Indemnification

6: Forming your startup

• C corp vs pass through (eg VCs)
• VCs typically avoid investing in pass through corps
• C corps: equity, shareholder classes
• Equity = long-term incentive
• Vesting
• Blanket transfer restriction: prevent sell equity without company consent
  • More often ROFR for company
• Employee option pools
  • Option + exercise price
  • Incentive stock options (ISOs) vs non-qualified options
• IPOs down by 50%, now often 10 yrs
  • Causes:
    1. Higher cost due to regulation → more revenue to amortize
    2. Efficiency rules disproportionately effect smaller companies (liquidity)
    3. Mutual funds are bigger, and thus like bigger companies (5x since 2000)
    4. There are alternative forms of private financing
    5. There’s too much public company pressure (eg. hostile takeovers)

7: Raising money from a VC

• Know what you want, how much, and why
• Benchmark market size: $xxxM business in the next 7-10 years
  • Though some small VCs target acquisition exits → go smaller
• Are you ready to play by the rules?
• Raise enough money to meet milestones to raise the next round (12-24 mo)
  • Eg. $3-5M ARR for series B
• Too much $$ → risk of lack of focus
• Higher valuation → higher risk of flat or down round
• Need to create competition for round
  • Too high valuation risks ↑
• Employee morale + momentum

8: The art of the pitch

• Warm intros from angels, legal
• ↑ acts as screening criteria
• Objective: convince the VC that your company has the chance to be a 100x+ outlier
• Paint the market size picture
  • Market vision
  • Network effects
• Team: why you?
  • Experience / learning (vs failure)
  • CEO skills
  • Storytelling
• Product
  • Idea maze
• GTM
  • Channel, ACV
• Show that you’re the master of your domain: conviction (don’t cave to VC suggestions)
• Milestones for next round

9: Term sheets: economics

• Aggregate proceeds: debt must often convert to equity
  • Uncapped note
• Valuation
  • Comparable company analysis
  • Discounted cash flow analysis
    • Beware of fund cycle and VC’s ability to follow on (show of faith)
• VC valuation
  • “What do I need to believe?” analysis
• Capitalization: forecast hiring requirements
• Dividends
• Liquidation preference: who gets their money back during certain circumstances
  • Helps to align interests across rounds
  • Participating: get X back, then convert to common stock to participate in proceeds
  • Preference order: seniority vs pari passu
• Redemption
• Conversion / auto-conversion:
  • Can have 2-3+ classes, but risky splitting incentives
• Anti-dilution: safety from down rounds
  • Broad-based weighted average
  • Full ratchet
• Voting rights
  • Voting proxy

2: Term sheets: governance

• Board of directors:
  • Hire / fire CEO
    • Ruling from the grave / dead hand control: CEO removed but still on board
  • First 3 should be CEO, VC (representing preferred shareholders), independent
• Protective provision:
  • Delaware chosen because it has the most developed set of provisions and governance rights
  • Protection against economic value of investment
• Registration rights: IPO stuff
• Pro rata: generally above ownership threshold
• Stock restriction
  • ROFR: can control who owns shares
  • Co-sale: right of all owners to sell at that price on a pro rata basis
    • Prevents founder sales
• Drag along: prevents tyranny of the minority in sales
• D&O insurance
• Vesting:
  • Standard 4y with 1y cliff
  • Post-termination exercise period 90d
  • Double trigger acceleration: acquisition + acquirer end of employment
• Employee and consultant agreement
• No-shop: 30d tie-up, even though two-way non-binding
• Takeaway: be forward-thinking and align long-term incentives

11: Which deal is better?

• Cap table
• Tradeoff between current known dilution and future round dilution
• Maintain momentum
• Must consider both economic and governance terms

12: Board members

• AVC’s have dual fiduciary responsibility
• CEO vs board info gap (full-time vs advisory)
• If the board is getting too hands on, ask why (eg. losing faith in your abilities)
• Pre-flight major decisions with individual board members early
• 409(a) valuation
• Should never overreach and influence product strategy (not enough context)
  • Gentle nudge back on task
• Set expectations up front (1-1s)

13: In Trados we trust

• Duty of confidentiality quagmire: on two boards with competing products - must leave, reassign, or recuse
• Business judgement rule (BJR): courts are loathed to second guess a board decision as long as duty of care
  • Keep good meeting minutes
• Entire fairness: opposite of ↑, majority not disinterested → burden of proof on the board
• ↑ determined by assessing conflict of interest
• Lesson: if you have liquidation preference during an acquisition you’re probably conflicted, so beware
• Assume most VC board members are conflicted
• Most importantly, need to recognize risk of potential CoI clearly and take action

14: Difficult financings

• “We are where we are, and something needs to change”
• Reducing liquidation preferences:
  • Pull up: carry forward some of LQP
  • Reverse split
• Insider rounds
• Management incentive plan (MIP)
  • Short-term incentive
• Warren notice: must give 60d notice of shutting down business
  • Faltering company exception: if fundraising and would degrade ability

15: Exits

• Get to know potential acquirers early
• Make sure you have multiple suitors
• Aspects of deal
  • Acquisition price
  • Cash vs stock
  • Vesting acceleration
  • Additional grants to key employees
• Generally want 90%+ of votes in favor of the acquisition
• Escrow (10-15%), term (12-18 mo)
• Indemnification
• Exclusivity period (usually 30-60d)
• Revlon duty: must explore all options to get the best price
• How will the acquired company be incorporated?
• Why IPO?
  • Raising capital
  • Branding
  • Selling stock
  • Customer credibility
  • M&A currency
• The IPO process

Conclusion: the world is flat

• Capital is more abundant now
• Lower cost to start a company
• More seed-stage funds
• It’s easier for startups to win
• 2 important financing trends;
  1. All-stage VCs
  2. More non-traditional sources of growth capital (non-IPO)
• Private > public returns
• The end of VC?
  • Crowd funding
  • ICOs
• ↑ democratization