Secrets of Sand Hill Road
Page 4
But even if banks are in a lending mood—which they luckily have been for the last few years—loans are not always the best form of financing for all companies. That is because loans are not part of the permanent capital structure of a company. In layperson’s terms, this means they actually have to be paid back at some point (and often with interest along the way). Thus, loans are best suited for businesses that are likely going to be generating near-term positive cash flow sufficient to pay interest and, ultimately, the principal amount of the loan.
However, equity—in the form of a financial investment in exchange for an ownership interest in the company—doesn’t suffer from this limitation. It is in fact permanent capital—meaning that there is no defined time period or mechanism by which the company has to return that capital to its investors. A company that is generating excess cash flow may wish to return capital to its equity holders in the form of a dividend or a buyback of shares, but there’s no requirement to do this (at least not in the vast majority of VC equity financings). Rather, the equity holder is making an implicit bet at the time of the investment that the value of the equity will grow commensurate with the financial progress of the business, and the most likely method by which the equity holder will realize that value is by selling that equity at some future date.
Debt or Equity, Which Would You Choose?
So 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, and thus you retain complete control of the business. Of course, bank loans do exert some control in the form of covenants—often financial metrics that you need to maintain to avoid being in default on the loan—but the bank itself is not a board member or voting shareholder of the company.
But if you think you are going to need to invest all your cash into the expenses of the business and don’t see a near-term ability to generate cash flow (or don’t want to be constrained by the fact that you have nonpermanent capital in your business), equity financing may be the better bet.
Now, of course, equity financing doesn’t come for free—you are at a minimum going to have to give up an ownership position in the company to your equity holders. And if you decide to take equity from VCs—as we’ll see in this book—you are going to have to live with their involvement in certain decisions of the company and, in many cases, as part of the board of directors of the company.
Nonetheless, 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).
We should go back to our definition of “VC” and clarify that it is not just any form of financing for businesses that may not be good candidates for traditional bank financing; it is equity financing specifically. And it is equity financing that the investors are willing to hold on to for a long time (that’s what we mean when we say “long illiquidity periods”), but only on the assumption that they will ultimately get paid for the risk they are taking in the form of significant appreciation of the equity value.
You may have heard that some VCs invest in companies through notes. Isn’t that really debt?
Yes and no. It is true that 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. The conversion is often tied to equity-based financing for the company. In most of the cases we are concerned about in this book, the debt will in fact get converted into equity, so for the time being we are going to lump it into our discussion of equity. We will return to a broader discussion of convertible notes in chapter 9.
Before we dive deeper, let’s spend a few minutes discussing some high-level themes about venture 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.
Now that we’ve got that out of the way, let’s look at how investors consider VC funds to put their money into.
Venture Capital as a (Not-Very-Good) Asset Class for Investors
In simple terms, an “asset class” is a category of investments to which investors make an allocation. For example, bonds are an asset class, as are public market equities; that is, investors often choose—as part of a balanced portfolio—to invest some portion of their monies into bonds or stocks of publicly traded companies. Hedge funds, VC funds, and buyout funds, among others, are also examples of asset classes.
Institutional investors (i.e., professionals who manage large pools of capital) often have a defined asset allocation policy by which they invest. They might for example choose to invest 20 percent of their assets in bonds, 40 percent in publicly traded equities, 25 percent in hedge funds, 10 percent in buyout funds, and 5 percent in VC funds. There are numerous other asset classes for consideration and x-number of percentage allocations between the assets classes that institutional investors might pursue. As we’ll see when we talk about the Yale University endowment, the objectives of the particular investor will determine the asset allocation strategy.
So, if we agree that VC is an asset class, why is it not a “good” one? Simply because the median returns are not worth the risk or the illiquidity that the average VC investor has to put up with.
In fact, as recently as 2017, the median ten-year returns in VC were 160 basis points below those of Nasdaq. A “basis point” is just a fancy way of saying 1/100th of a percentage point—so 200 basis points means 2 percentage points.
What does that mean? Unfortunately, it means that if you invested in the median returning VC firm, you would have tied up your money for a long time and have generated worse investment results than if you had just stuck your money in a Nasdaq or S&P 500 index fund. And you could have bought or sold your index holdings on any given day if you decided you needed to use that money—whereas had you needed to get your money out of the VC fund, good luck!
What explains this? Well, there are a few things at work here. Most significantly, VC returns do not follow a normal distribution.
You’re probably familiar with the concept of the bell curve, which says that the distribution of anything—in this case we are talking about investment returns—is symmetric (meaning that half of the points are to the left of the median and half are to the right) and with defined s
tandard deviations from the median (for example, in a normal distribution, 68 percent of the points fall within one standard deviation of the median).
If VC returns followed a bell curve, then you would have lots of firms—specifically, 68 percent of them—that were clustered within one standard deviation of the median. That is, most institutional investors could choose a manager to invest in and have a high expectation that that manager’s returns would fall within that 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.
BELL CURVE
POWER-LAW CURVE
So if you are an institutional investor in this paradigm, the likelihood of your investing in one of the few firms that generates excess returns is small. And if you invest in the median firm, the results generated by that firm are likely to be in the long tail of returns that are subpar.
On top of that, academic research on VC returns shows that the top firms are likely to persist across fund cycles. Thus, the firms that generate excess returns in one fund are more likely to continue to generate excess returns in subsequent funds. In other words, there is not a pattern of different firms winning from one fund to the next; the spoils tend to go to the same set of winners over time.
What explains this distribution of venture fund returns?
The Matter of Positive Signaling
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.
Think about it: if ABC Ventures (I am using pseudonyms to protect the innocent) has invested in wildly successful companies—Facebook, Amazon, Alibaba—then the entrepreneur who thinks she is starting the “next Facebook” might believe that taking an investment from ABC Ventures will increase her likelihood of success. And if she thinks that, then what about the engineers whom she is competing with fifty other companies to hire? Won’t they also think that the brand imprimatur of ABC Ventures might increase the likelihood of success, and therefore choose to work there? And what about the Fortune 500 company that is a sales prospect for this new startup? Perhaps the positive signaling of ABC Ventures’ investment means that the risk to the Fortune 500 company of investing in the company’s product is mitigated.
The bottom line is that—whether rightly or wrongly—all the players in the ecosystem are doing a simple calculus: Those ABC Ventures folks must be smart. After all, they’ve invested in Facebook, Amazon, and Alibaba, to name a few—so by the transitive property, the entrepreneur building the next Facebook must be smart, and thus the risk of failure is lower for this company. Hence, past success begets future success.
Before you dismiss this as crazy, it’s no different than any other signaling mechanisms people use throughout society. Why do lots of companies recruit heavily from Ivy League universities, even though we know there are lots of smart students who graduate from non–Ivy League schools? Well, because they’ve had success before with hiring Ivy League graduates and believe that the university itself has done a good job in the admissions process of screening the student for high intellect and good character.
Essentially, we often use signaling as a shorthand way of informing judgments. And as with all forms of generalization, sometimes we have false positives. This happens when we overfit on the curve and ascribe success to individuals or companies that might in fact not be as good as we have presumed them to be. 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. If you invest in a company that turns out to be worse than you anticipated (false positives), the worst that you can do is lose all your invested capital. For people investing their life’s savings, this is a very disheartening outcome. But as we’ll see, for VCs this is simply part of their day job. But failing to invest in a winner means that you forfeit all the asymmetric upside that comes along with that investment. Missing the next Facebook or Google is no doubt painful, and depending on the rest of your portfolio, can be career ending for a VC.
VC Investing Is a Zero-Sum Game
Another reason that success in venture capital seems to cluster is that VC investing is largely a zero-sum game. Let me explain this by analogy to public market investing.
If you and I both think that Apple is a great stock to buy, we can both decide to buy it. Of course, if one of us is a really big buyer, the act of buying it might move the price such that my price might be different from yours (depending on which of us gets there first). But regardless, the general investment opportunity of buying Apple stock is available to each of us, independent of what the other does. The stock market is a democratic institution open to anyone who has money and a brokerage account.
Contrast that with VC investing. In most cases, when a company raises VC money, there is one “winner” (or maybe two) and a lot of losers. I put “winner” in quotes because we all think that we’ve won when we are able to invest in what looks like a very promising startup. But we often learn later that in some cases it can be more appropriately described as the “winner’s curse”—a phenomenon whereby buyers in auctions get emotionally attached to the buying process or have imperfect information, such that they value the asset more than it’s actually worth. In a VC deal, competition can certainly drive what we call “deal heat,” a sometimes irrational response that causes investors to overpay for an asset. And no doubt information is nearly always imperfect in the evaluation process of an early-stage company.
Regardless of whether the asset is properly priced, there is often one VC firm that is the “lead” investor in the financing round and, as a result, invests the lion’s share of the money in the company for that particular round. Sometimes, there are other nonlead investors who might participate in smaller amounts in the same financing round, but in no case is the round made available on a public stock exchange for any random investor to participate.
Once that investment round is completed, in most cases that investment opportunity is gone forever. There will never be another first round of financing for Facebook. So whatever return is ultimately generated from that first round of investment accrues to a very small set of fortunate investors.
There are of course often subsequent financing rounds—e.g., the “B” round of financing for Facebook—but the valuation of the company presumably has increased by that time and thus the eventual return to that set of investors will trail that of the first round’s investors.
So if you couple the positive signaling we discussed earlier with this discontinuous nature of financing rounds and the winner-take-all notion, hopefully you can see how the overall returns in the industry often accrue to a limited (and often persistent) set of VC firms.
Investing in VC Is Restricted
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). The theory of accreditation is that wealth equates to investment sophistication; it’s an admittedly overbroad and underinclusive definition, but one in which the US securities laws seem to have much faith.
When a private company wishes to raise money to fund its operations, it must comply with US securities laws and thus needs to respect the accredited investor definition. Under the law, a company can sell securities only if it follows the registration requirements of securities offerings (whi
ch generally means that the company needs to be publicly registered) or it must have some exemption from the securities laws that allows it to sell securities without being a public company. That exemption generally comes in the form of agreeing not to sell securities broadly to unaccredited investors but rather to restrict the sale to accredited or qualified—an even higher form of wealth, generally in excess of $5 million of net worth—investors.
Investors in VC funds themselves also need to comply with these restrictions. Thus, 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.
There is an exception to these rules—the crowdfunding provisions that the US Congress created as part of the 2012 JOBS Act. Under these rules, companies are permitted to sell up to $1 million of stock annually to unaccredited investors. There are a number of other hoops that companies have to jump through to take advantage of these rules, including, for example, that the investment materials be posted on an investor portal. As a result, while this was intended to provide some level of democratization to the private fund-raising process, most companies that raise VC money do not avail themselves of the crowdfunding rules.
Thus, VC investing is undemocratic not only in the sense that the winners seem generally to just get richer, but also because a limited number of players are allowed to ultimately compete.