by Scott Kupor
Start by Asking the Right Questions
Have you ever seen those Charles Schwab commercials about how to talk to your financial advisor? Unless you watch a lot of golf on TV or actually pay attention to YouTube ads, you probably haven’t. Here’s the premise.
Your average middle-aged couple goes through a series of life events. They ask their home contractor to explain why she recommends cedar versus synthetic wood for a remodel. They meticulously debate the merits of a particular school for one of their kids. They grill the car salesman on whether the 467- or 423-horsepower car is more appropriate. But then, in the final vignette of the commercial, the couple sits across a large mahogany desk from a well-dressed financial advisor who tells them, “I think we should move you into our new fund.” The couple glance blankly at each other for about a second—pregnant pause—and then immediately accede to the request. No questions asked.
The commercial’s narrator benignly reminds the viewers: “You ask a lot of good questions . . . but are you asking enough about how your wealth is managed?” The implication, of course, is that we all feel empowered to dig deep into many important life decisions, but for some reason we give a free pass to others if it’s a topic we don’t understand or feel intimidated by, no matter how important the decision.
This book is not about how to solve that underlying problem—we’ll all need to search in the psychology book section on Amazon for answers to that issue.
But this book is about helping you to ask the right questions about one of the most important life events for entrepreneurs—your startup and your career—so that you can make an informed decision about how best to proceed.
Why?
Because if you are going to raise money from VCs or join a company that has venture money, the only way to know if that is a good idea is to understand why VCs do the things that they do. In other words, know your partner before you get married.
Having a deep understanding of a prospective partner’s motivations will help you anticipate their moves and (hopefully) interpret them correctly when they happen. More importantly, it will help you determine whether entering into the partnership is the right path to pursue in the first place.
The VC Life Cycle
This book follows the VC life cycle as it relates to and informs entrepreneurs. The first section of the book deals with the formation of a VC firm—who are the players who fund them, what incentives (and constraints) do they provide for the firms, and how do the partners within a firm interact with each other. To understand how VCs choose to invest in certain companies and how they might act once involved with a company, we also need to look upstream to understand the motivations of the funders of such firms. For if VC firms fail to satisfy the needs of their masters, there will be no more money with which to invest in new startups.
Next, we’ll explore startup company formation. We’ll look at all the things that founders need to think about when deciding to start a company—from dividing up founder equity, to deciding who sits on the board of directors, to how to incent employees, and much more. A lot of the ultimate decision about whether to seek VC financing will be influenced by decisions that founders make at the time of company formation.
We’ll spend a big chunk of time on the VC financing process itself—in particular, the term sheet. This is the Magna Carta of the industry, as it ultimately defines the economic and governance rules under which the startup and the VCs will operate.
Then, with funding in hand, founders will need to be able to operate within the economic and governance constraints that they agreed to. Thus, we’ll talk about the role of the board of directors and how it influences the path of the startup and potentially the ability of the founder to keep steering the ship. Boards, including the founder, also have to operate under various well-defined legal constraints that can materially affect the degrees of freedom of a company.
In the last section, we’ll complete the circle of life. In the beginning, money comes into the VC firm through the investors in the fund. That money in turn goes into startup companies. Finally, the money comes back (or not) to the investors in the fund in the form of initial public offerings or acquisitions. If enough money doesn’t make it through the full cycle, then life, at least as we know it in VC land, ceases to exist. The financing spigot dries up, which can have downstream effects on the rate of funding for new startup ideas. Hopefully, everyone in the ecosystem does her part to avoid that.
Of course, not all VCs are the same, and, as I mentioned earlier, what I write about here is heavily influenced by my experiences at Andreessen Horowitz. So your mileage may indeed vary. That said, I’ve tried to broaden the conversation to make this book more general for the overall venture industry.
This book may not answer all the questions you have and is not intended to be a comprehensive source on the topic. There are plenty of academics who teach semester-long classes on VC, and of course there are lots of VCs and others in the venture capital ecosystem—entrepreneurs, lawyers, accountants, and other service providers—who spend their professional lives learning and perfecting their craft.
Nonetheless, I hope this book shines a light on how VC works and why, in order to create more and better company-building opportunities.
CHAPTER 1
Born in the Bubble
In the interest of unlocking the somewhat opaque doors of venture capital, behind which are the inner workings, incentives, and decision-making processes of VCs, let me start by more properly introducing myself.
The first thing to know about me is that if I weren’t a venture capitalist, I would sing country music in Nashville. But lucky for everyone who is a real country music fan—and for my ability to support my family financially—I somehow found my way into the VC business! I live in Silicon Valley, not Tennessee, so the best I can do is wear cowboy boots to work and play the guitar in my spare time. Both of which I do, as often as possible.
Let me give you a little bit of context about what the tech and investment world was like when I was getting started in in the 1990s.
Some of the big tech names back then were E.piphany, NetIQ, VA Linux, Commerce One, Razorfish, and Ask.com. It’s possible you haven’t heard of any of these companies, but they—like me—were products of the 1999–2000 tech bubble that produced roughly nine hundred initial public offerings of venture-backed tech companies. It was a great time to be starting out in the tech industry, as there seemed to be no end to the promise of technology and to the amount of wealth creation that was available to everyone involved.
Netscape had gone public in 1995, a mere eighteen months after its founding, receiving a huge amount of media attention and heralding the beginning of the dot-com boom. Google wouldn’t be founded until 1998, but Silicon Valley was already fired up with dot-com fever. New internet startups were appearing daily. The tech world was abuzz.
Venture capitalists (VCs) were investing in new companies at an unprecedented pace relative to historical norms. About $36 billion went into new startups in 1999, which was approximately double what had been invested the prior year (although that’s now less than half of what was invested in 2017). Additionally, limited partners committed more than $100 billion of new capital to the venture capital industry in 2000, a record that hasn’t come close to being broken since! By comparison, limited partners committed about $33 billion in funding in 2017.
Startups were also getting to an IPO faster than ever during the dot-com bubble. On average, it was taking companies about four years from founding to go public, which was a huge acceleration of the historical trend of taking six and a half to seven years to IPO. Today, that time period often exceeds ten years, for reasons we’ll get into later in this book.
In addition to a record number of IPOs, the public markets were also exuberant. On March 10, 2000, the Nasdaq index, the barometer for technology stocks, peaked just above 5,000. More interesting, the price-to-earnings
ratio (P/E ratio) of the companies listed in the Nasdaq index stood at 175. This means that stock market investors were valuing one dollar’s worth of a company’s earnings at $175.
While it’s generally the case that investors value a dollar of earnings today at some multiple greater than one because a company’s stock price is intended to reflect the present value of the cumulative cash flows of a business into the future, a 175 multiple is a historical anomaly. For comparison, the Nasdaq P/E ratio today is under 20, which is generally in line with the long-term historical trends for the index.
At the time, Cisco was anticipated by many to become the first $1 trillion market capitalization company. Alas, Cisco’s market cap peaked at about $555 billion in March 2000; today it stands around $200 billion. Early in 2018, Amazon became the first $1 trillion market cap company, albeit for a brief time, and as of this writing, sits at around $800 billion. (Fun fact: In March 2000, Amazon’s market cap was a mere $30 billion).
What Could Possibly Go Wrong?
So, back in 2000, everyone was on a collective sugar high to end all sugar highs. What could possibly go wrong? As it turns out, a lot.
The Nasdaq index began a precipitous decline from its March 2000 peak, falling all the way to its nadir of just above 1,300 in August 2002. While there is much Monday-morning quarterbacking about the impetus for the decline, many market analysts point to the Federal Reserve’s aggressive interest rate tightening in early 2000, which created a big debate as to the sustainability of heavy borrowing that many technology infrastructure companies had undertaken. Regardless of the ultimate cause, in about two and a half years, the index lost nearly 80 percent of its value, tech companies laid off record numbers of employees, VCs stopped investing in new companies, and the few companies that had sufficient cash to sustain themselves were focused purely on self-preservation at the expense of everything else.
That’s why you probably don’t remember most of the companies I mentioned before. Yet this was the environment in which I began my professional career.
Despite graduating from Stanford University in 1993 and Stanford Law School in 1996, sitting right at the epicenter of the tech boom the whole time, I was largely oblivious to what was happening around me. So, after graduating from law school, I left Silicon Valley to spend a year in my hometown of Houston, Texas, clerking for the Court of Appeals for the Fifth Circuit. This was an incredible learning experience and a fun way to spend a year, but, as it would turn out, it had zero relevance to my longer-term career.
I moved back to Silicon Valley to work for Lehman Brothers. Lehman, of course, was later a victim of the global financial crisis, suffering an ignominious bankruptcy in September 2008. My job at the time, in addition to being an all-around grunt, was to help life sciences companies raise capital, go public, and make acquisitions. Those were noble things to do, but for the fact that despite the raging bull market in technology in Silicon Valley, the investor appetite for life sciences was largely dormant.
Lucky for me, a friend had just taken a job at Credit Suisse First Boston, a scrappy investment bank that had brought on Frank Quattrone to build out their technology banking practice. Frank is a legend in the technology banking world, having started his career at Morgan Stanley, where he led IPOs for companies such as Apple and Cisco and advised on a huge range of important mergers and acquisitions. He is still a dominant figure in the technology space, having founded in March 2008 a leading mergers and acquisitions advisory firm named Qatalyst.
So I joined Credit Suisse First Boston and drank from the fire hose of the developing tech bubble. A few years into my job, on the eve of finishing an IPO for E.piphany, one of the marketing executives I had worked with to help them prepare for the IPO told me he was leaving to join a new startup called LoudCloud. Cofounded by Marc Andreessen, the already revered cofounder of Netscape, LoudCloud was trying to create a compute utility (much like Amazon Web Services has now created). Among the other cofounders was Ben Horowitz.
This was the fall of 1999, and the dot-com excitement was in full swing. I had finally opened my eyes to what was happening around me, and I wanted to be a part of it. When my friend at E.piphany offered me the chance to meet Marc Andreessen and Ben Horowitz and see what they were doing, it was too much to pass up. My wife, who was about five months pregnant at the time with our first child and who was busy closing on the first house we were buying together, didn’t see it quite the same way. She had a pretty good argument, to be honest. Why quit a great job with Credit Suisse First Boston where the business was going gangbusters, meaning the chance for both financial and professional success was palpable, in order to join a startup where I’d get paid next to nothing in salary for the promise of some equity appreciation in the future from stock options? She did, however, ultimately acquiesce, likely against her better judgment at the time.
I’ll never forget my interview with Marc. Although I had never met him before, like everyone in the tech industry I knew of his accomplishments and media fame. So when he asked me to meet him at a little Denny’s restaurant in Sunnyvale for my interview, I was a bit surprised.
But it didn’t take long to get excited about the LoudCloud market opportunity. Marc took a napkin from the table and began drawing some barely decipherable sketch of how LoudCloud was going to take over the computing world. Only now, with the benefit of more than eighteen years of working with Marc, have I come to learn that doodling in all its glory is among his many skills.
The idea of LoudCloud was elegant in its simplicity; it turned out that the execution of the business was anything but. In basic terms, Loudcloud sought to turn computing power into a utility. Just as when you plug your phone charger into the wall socket you don’t need to know (or care) about how the electricity got there, you just use it, LoudCloud’s mission was to do the same for computing capacity. As an engineer, you should be able to develop your custom application and then just “plug it in” to the compute utility that could run the application seamlessly for you. You shouldn’t have to worry about what kind of database, networking equipment, application servers, etc., underlie the utility; it should simply work. It was a great idea—one that Amazon Web Services has built into a multibillion-dollar business today.
LoudCloud was probably about ten years ahead of its time, an oft-repeated lesson, by the way, in the startup world. Though timing isn’t everything, timing is definitely something—it’s a big reason why we now see many ideas that failed in the dot-com bubble being reincarnated as successful businesses two decades later. As market conditions change—in the case of the dot-com businesses, the market size of available customers was simply too small relative to the cost of acquiring those customers—business models that previously failed can become viable. Marc likes to remind us that when he was building Netscape, the total size of the internet population was about 50 million people, nearly all of whom were accessing the internet on clunky dial-up connections. Thus, no matter how much utility the browser provided, the end-user market simply wasn’t that big. Contrast that to today, where we have about 2.5 billion smartphone users with ubiquitous connectivity to the internet and the potential for that number to double over the next ten years. All of a sudden, businesses that couldn’t work profitably at 50 million users take on a very different look when they can appeal to a mass-market audience.
After meeting with Marc, I also interviewed with a number of other members of the team, including cofounder Ben Horowitz. The setting for that interview was more normal, as we met on a Saturday at the company’s offices. But I remember being surprised by Ben’s attire—he was fully decked out in Oakland Raiders garb, including T-shirt, watch, and baseball hat. I now know, after many years of working side by side with Ben, that his attire was completely in character. In fact, to this day, Ben keeps a life-size dummy of a fully outfitted Oakland Raiders football player in his office. For the uninitiated, that can be quite a surprise!
LoudCloud’s
Atypical Success
I got the job as a business development manager at LoudCloud. This title was the euphemistic way of saying, “You were an investment banker in your previous job and might have some skills to add to the company, but we’re not quite sure yet exactly what those will be.” (Over my seven-year tenure at LoudCloud, I had the opportunity to take on a number of different roles, including running financial planning and investor relations, corporate development, some engineering teams, customer support, and field operations, which included support, professional services, and pre-sales engineering.)
I was in, I was thrilled (my wife was less so), and we at LoudCloud set out to build the first compute utility, flush with what we thought was plenty of cash. In its first few months, the company had raised nearly $60 million of debt and equity. But then again it was early 2000 and we were all living the dot-com dream. VC money was raining from the rafters.
We naturally decided to raise more money—$120 million, to be exact. In some respects the money was free (as the valuation at which we were able to raise was over $800 million—this for a less-than-one-year-old company!). But it was not in fact free, for with it came the expectations of growth for which the VCs had provided the money.
And grow we did. We topped six hundred employees before the company was even two years old. We decided to go public in March 2001, which was definitely not the greatest timing, right in the wake of the dot-com meltdown. In fact, LoudCloud was one of only a very small number of tech companies to go public that year (fewer than twenty tech IPOs happened in 2001, versus nearly five hundred in the prior year). The portfolio managers with whom we met during the IPO road show of back-to-back meetings could not have been more shell-shocked about the decimation they were seeing in their portfolios. They looked at us as if we had three heads when we dutifully gave the LoudCloud IPO pitch. Recall that Nasdaq was at about 2,000 at this time, down significantly from its roughly 5,000 peak a year prior, but still not at the bottom it would reach in August 2001.