Secrets of Sand Hill Road

by Scott Kupor

  That’s a lot of words, so let’s unpack it a bit.

  In general, most entrepreneurs at the early stages of their business raise new capital every twelve to twenty-four months. Those time frames are not sacrosanct, but they do reflect the general convention in the startup world and also reflect reasonable time periods during which meaningful business progress can be made.

  Thus, if you are raising your first round of financing (typically called the Series A round), you will want to raise an amount of money that gives you enough runway to get to the milestones you will need to hit to be able to successfully raise the next round of financing (the Series B) at (hopefully) a higher valuation than the A round.

  What are those milestones? Well, it varies significantly by the type of company, but for purposes of our example, let’s assume you are building an enterprise software application. The Series B investor is likely to want to see that at least the initial version of the product is built (not the beta version, but the first commercially available product, even though the feature set will of course be incomplete). They will want to see that you have some demonstrated proof in the form of customer engagement and contracts that companies are in fact willing to pay money for the product you have built. You probably don’t need to have $10 million in customer business, but something more like $3 million to $5 million is likely sufficient to get a Series B investor interested in providing new financing.

  If you posit that set of facts, then the decision you need to make at the A round is how much money you will need to raise to give yourself a realistic chance of hitting those milestones over the one-to-two-year period before you try to raise the B round. This, of course, is partly a spreadsheet exercise, but also includes a gut check from you as CEO to build in some cushion for things that just might not go according to plan (because nothing ever goes exactly to plan).

  A fair question to ask here is why not just raise all the money you need for the company, all at once, and forget this idea of staging out capital raises by round? Well, first, a successful enterprise software company that makes it to an IPO is probably going to raise at least $100 million (and, in some cases, a few multiples of that), so there aren’t too many VCs who are going to write that size check up front.

  More likely, even if you could raise that amount of money, the terms on which you would raise it—in particular, the valuation you would receive and thus the amount of the company you would need to sell—would be prohibitively expensive. Spreading out your capital raises allows you, as the entrepreneur, the ability to get the benefit of increases in the valuation of the company as you de-risk the opportunity, and provides the VC the ability to rightsize her total capital exposure to the business based on the achievement of these milestones.

  In other words, if you accomplish the objectives that you laid out at the time of your A round, your B round investor will pay you for that success in the form of a higher valuation. This means that you will have to sell less of the company per dollar of capital you raise. In that case, you and your employees are all better off—you have the capital you need to grow the business, and the cost of that capital is less than it would have been had you raised more money than needed at an earlier stage.

  The other consideration regarding the amount of capital to raise is the desire to maintain focus for the company by forcing real economic trade-offs during the most formative stages of company development. Scarcity is indeed the mother of invention. Believe it or not, having too much money can be the death knell for early-stage startups.

  As a CEO, you may be tempted to green-light projects that might be of marginal value to your company’s development, and explaining to your team members why they can’t build something, or hire that next person, when they know you don’t have financial constraints is harder than it may seem.

  Nobody is suggesting that everyone live on ramen and sleep on the floor, but having a finite amount of resources helps to refine what are in fact the critical milestones for a business and ensures that every investment gets weighed against its ultimate opportunity cost.

  . . . And at What Valuation?

  We’re going to talk a lot more about valuation when we get into the mechanics of the term sheet, but I’d be remiss if I didn’t touch on valuation in this section, because it’s a key part of the question: “How much money should I raise (and at what valuation)?” Of course, you might say, I should raise the money at the highest valuation at which I can get a VC to invest. But that’s not always the right answer.

  This might be what you’d expect a VC to say—after all, a venture capitalist benefits economically from paying a lower valuation—but bear with me, as there are important considerations here.

  Recall the discussion we just had—that the current round of financing should be driven by the milestones needed to achieve the next round of financing at a higher valuation that reflects the progress (and de-risking) of the business. If you allow yourself or a VC to overvalue the company at the current round, then you have just raised the stakes for what it will take to clear that valuation bar for the next round and get paid for the progress you have made. After all, you might be able to get away with overvaluation at one round (or possibly more than one), but at some point in time, your valuation needs to reflect the actual progress of the business.

  I’ve had the following conversation with many founders over the years: “I’ve more than doubled my business since the last fund-raising, but the valuation I am receiving in the current round is way less than double the last round valuation. What gives?”

  Well, what gives is that your next round valuation is not a function of your last round valuation. Rather, it reflects the current state of business as valued within the current state of the financing world.

  So a few things could have happened. First, the valuation metrics by which the business is being judged could have changed. For example, if the public stock markets have dropped since your last financing round and thus the public markets value a mature company using a lower valuation metric than before, your valuation may be affected as well. In other words, the market environment will undoubtedly have an impact on valuation for your startup.

  Second, although you may have doubled your business, the new investor may look at your last valuation and feel as though you had been given forward credit for that type of success. As a result, that new investor might decide that tripling is the new doubling; in other words, the new investor is not that impressed that you only doubled the business coming off of the previous round’s valuation and capital resources; they expected more.

  As a result, one very important thing to do as an entrepreneur—assuming you do decide to optimize for valuation—is to make sure that you raise a sufficient amount of money to give you plenty of time to achieve the now-higher expectations that the next round of investors may have. One big mistake we at a16z have seen entrepreneurs make is to raise too small an amount of money at an aggressive valuation, which is precisely the thing you don’t want to do. This establishes the high-watermark valuation, but without the financial resources to be able to achieve the business goals required to safely raise your next round well above the current round’s valuation.

  Third, competition drives valuation. Whether we like to admit it or not, valuation is more art than science, and “deal heat” can drive VCs to pay more than they might otherwise think is appropriate for a company at a particular stage. And a higher valuation hurdle from the last round may scare away competition. The potential B round investor might like the business but see what valuation you achieved at the last round and fear that she will not be able to match your expectations for the current round. Much of this unfortunately goes unsaid and is a result of people interpreting others’ expectations without engaging in a full dialogue, but this happens nonetheless.

  And, if you have enough investors who refuse to bid on your B round because they are afraid to offend you by not being able
to match your business progress with a commensurate increase in valuation, you will fail to generate competition for the round. That is generally not a good place to be.

  An obvious objection to what I’m saying—if you aren’t already objecting to my arguments against stretching too much on valuation as being self-serving—is that all of this is interesting, but it doesn’t matter. That is, if I get the benefit of overvaluation in one round and then I pay the price for that in the next round by getting undervalued, am I not still better off?

  When you raise money from a VC, the transaction goes as follows: the VC gives you cold hard cash, and you issue her an amount of equity that corresponds to whatever valuation terms the two of you agreed upon. For example, if the VC agreed to invest $5 million in the company in exchange for owning 20 percent of the equity, she would give the company the $5 million, and the company would issue her shares equal to 20 percent of the total equity. Thus, when we talk about dilution, in this example, you, your employees, and any other existing shareholders in the company are being “diluted” by 20 percent; that is, if you owned 10 percent of the company before this financing round, you will own 8 percent after this round.

  In most cases, of course, companies go on to raise subsequent rounds of financing, often with increasingly larger amounts of capital being raised and (hopefully) at materially higher valuations. So if you were to later raise $20 million in exchange for 10 percent of the company’s equity, everyone would have their ownership diluted by an additional 10 percent. Your 8 percent stake is now about 7.2 percent.

  So the logical objection to my above comments regarding valuation is: If I overvalue the company at the first financing and thus get diluted by less than 20 percent, who cares if I have to pay the piper with an undervalued price at the second financing, as long as I still end up with 7.2 percent in either case?

  Let’s concede for a second that in the theoretical sense your math is right; there’s something deeper at work that is critical. Employee expectations and sentiment matter a lot to a company’s development. Great employees who have lots of job opportunities want to work for great companies where they can achieve their personal growth goals. When a company is doing well in all respects—employee hiring and development, customer goals, product goals, financing goals—it’s easy to retain and motivate employees. After all, who doesn’t love being on a winning team where the growth of the company can translate into personal career growth for the employees?

  However, if the company is in fact on track to achieve its goals but then faces a disappointment in fund-raising, things can get tougher. In particular, the company’s valuation is the one highly visible external benchmark that every employee often seizes on (whether you want them to or not) as a measure of interim success. Momentum can appear to be stalling and employees may start to wonder whether everything you have told them as CEO about how much progress the company is making is in fact true. At a minimum, you now have to explain why your financing partners value your progress differently than do you or the others in your company.

  I’ve been there. When I joined LoudCloud in 2000, things couldn’t have been any rosier. We were in the height of what turned out to be the dot-com mania, and the business was on fire. We were hiring employees quickly, growing our customer base, expanding our office footprint—everything was exceeding plan.

  My first job when I started was to raise more capital to allow us to continue on our growth path. Working with the other members of the executive team, we were able to raise $120 million at an $820 million valuation in June 2000. This, by the way, was for a company that was nine months old! Our prior round of financing in September 1999 was $21 million at a $66 million valuation. We were feeling pretty good about this as our CEO (Ben Horowitz) and I were preparing to host an all-hands meeting to discuss the results of the raise.

  But rather than ride off into the sunset to a standing ovation, the first question we got was: “How come you didn’t get a $1 billion valuation?” It turned out that a company in our same cohort of startups (StorageNetworks) had raised money a month before at a $1 billion valuation. So the heart of the question was “If you’re so smart, how come you aren’t as rich as the next guy?”

  Now, keep in mind, none of us had set the expectation that we would be able to raise at a $1 billion valuation. But it didn’t matter. Our employees had a data point that caused at least some of them to think that we had fallen short of what defined world-class in this financing environment.

  We recovered from this—and granted, the dot-com bubble was a crazy time—but nonetheless it served to remind us of three very important lessons. First, employees do often judge the success of the business at least in part on the external measure of valuation in a financing round. Second, even if that valuation looks great in the absolute sense (or in the relative sense, compared with your previous round of financing), employees are likely to compare it to other companies that have raised money recently, in many cases independent of whether those companies are relevant benchmarks. Third, never underestimate the value of always maintaining momentum in the business, one measure of which may be a successful financing round. And, in the LoudCloud case, we were not even talking about a lower valuation than the prior round, nor a modest step-up in valuation; those things can be debilitating for companies and often hard to recover from.

  Ultimately, the best story for you as a CEO is to be able to point to the proverbial “up and to the right” valuation graph. If your financing valuation is inconsistent with the success story you’ve been telling about the company, you’ve likely got some explaining to do. And even if the explanation is honest and truthful, it’s far better to never have to explain it in the first place.

  We’ve been talking so far about suboptimal, but still reasonable, situations whereby you are raising capital at a higher price than the last round, just less so than you or others might have anticipated. Where the wheels can really come off of the bus is either if you end up not being able to raise money at all or if you have to raise at a valuation below the last round’s valuation. We’ll talk more about the implications of that when we cover the economics of the term sheet. I keep punting on this because we have a lot to cover, but it’s coming up soon. When you see chapters 9 and 10 you’ll know what I mean. (Grab your coffee in advance!)

  CHAPTER 8

  The Art of the Pitch

  For many entrepreneurs, the act of pitching their business to a venture capitalist can be a harrowing experience. After all, you are at your most vulnerable place in your professional career. You’ve probably just quit a job that provided a steady income and had to convince your spouse or significant other that all of this would eventually work out in the form of greater financial security for your family. But, in the meantime (i.e., the next ten or more years), you are going to live cheaply, take no vacations, work longer hours that you ever have before, sleep fitfully (my partner Ben remarked in his book about his experience as a startup CEO that he slept like a baby every night—waking up every few hours crying), and, on top of all that, beg VCs to finance this glamorous lifestyle. Sounds like fun, right?

  I’m assuming that since you’ve read this far, you’re all in, so here we go.

  Foot in the Door

  Let’s start by talking about how you get the opportunity to pitch. Most VCs have websites that provide an email address for you to contact if you have a business idea. But, as with a lot of businesses, that’s not the recommended path to get in front of a decision-maker.

  Unlike regular jobs that have job listings and application processes, VCs don’t have such a formal structure. But there are informal structures that provide a similar function.

  Angel or seed investors are often an important source of referrals for VCs. It helps that they are upstream from the VCs in that they are typically investing at an earlier stage in the company’s development than might a traditional VC. As a result, many VCs develop relationships wi
th angel and seed investors, with whom they live in a symbiotic relationship in the venture world. Angel and seed investors have a direct interest in seeing the companies in which they have invested raise additional (and usually bigger) capital downstream from VCs, and the VCs are interested in a curated pipeline of interesting opportunities in which to invest.

  Law firms also tend to be important avenues into venture firms. As we talked about earlier, often the first stop along the entrepreneurial journey is at your lawyer’s office to form the company itself. Thus, as with seed and angel investors, lawyers are often upstream of the VCs and in a position to see opportunities at their most nascent state. Lawyers, too, are motivated to introduce their best startup clients to VCs, as more institutional funding for these clients means that they can become long-term business clients of the law firm.

  If neither of these routes is available to you, get crafty. (Please also consider the difference between crafty and invasive.) You should be industrious enough to find someone who knows some-one who has some relation to a VC. While I recognize in some cases this can be challenging, it’s a great test of your mettle as a startup CEO. If you can’t find a creative way to get to a VC, then, for example, how are you going to find a way to get to the senior executive at a potential customer prospect of yours?

  Your ability to find a warm introduction to a VC, while not a requirement, is often a screening heuristic that VCs use as a gauge on your grit, creativity, and determination, each of which might be an important characteristic of a successful founder.

  It’s important to note here that there are hundreds of fantastic blog posts, books, podcasts, and conferences about networking, being generous, enchanting people, and getting your foot in the door. It’s part likability, networking, hustle, showing up, following up, persistence, salesmanship, confidence, experience, storytelling, and yes—sheer dumb luck.