Secrets of Sand Hill Road

by Scott Kupor

  Once the banks are picked (and, by the way, there tends to be a lead underwriter and several co-underwriters on the overall team), the company will often host a kickoff meeting with the banks. The meeting’s purpose is exactly as the name suggests—to kick off the process by presenting the company’s products, strategy, go-to-market, and financial information. The idea is to help educate the bankers on the nuances of the business so they can both advise the company and begin to think about how they will market the company during the IPO.

  The biggest labor component of an IPO tends to be the process of drafting the prospectus. This is a highly formalistic legal document that is mostly intended to provide all the relevant disclosures required by prospective investors. It provides some narrative about the company, but most of the pages are filled with detailed financial disclosures and a litany of all the risks that investors are taking on should they elect to buy the stock. It’s not intended to be a marketing document but is really designed to disclose information and risks and, ultimately, to provide legal protection for the company and its board should something go awry once the company is public. In that case, you hope that the prospectus highlighted the risk that ultimately befalls the company! If not, expect to be on the receiving end of a class action lawsuit from those investors who purchased the stock in reliance on the prospectus.

  Congress passed the JOBS Act in 2012 to try to streamline both the information requirements of the prospectus and other components of the process of going public. To qualify for filing an IPO under the JOBS Act, a company needs to be an “emerging growth company, or EGC.” An EGC is a company that has less than $1 billion in revenue in its most recent fiscal year. As a result, most venture-backed startups qualify as EGCs.

  The benefits of being an EGC are numerous.

  Testing the waters—An EGC is allowed to meet with potential investors (as long as the investors meet certain asset size requirements) as a mechanism to get feedback and to build the relationship ahead of the IPO. This is really valuable since, in the absence of doing this, companies get to spend typically one hour only with an institutional investor during the course of the sales meetings surrounding the IPO itself. The full set of IPO-related sales meetings is called the road show, as it is usually entails a seven-to-ten-day set of meetings with investors in various locations across the US and sometimes Europe. Testing the waters helps both parties have more time to evaluate the opportunity and takes some of the pressure off of the more constrained road-show meetings.

  Confidential filings—An EGC is allowed to file its initial prospectus with the SEC confidentially, versus the past practice of having the filings be public. The reason this matters is that it takes time once a company files its prospectus for the SEC to review it and provide comments and, in this interim period, the company is restricted in some of its external communications. Violations of these restrictions—called “gun jumping”—can cause the SEC to delay the company’s IPO until the market has cooled off from the communications. Ultimately, the SEC is worried about companies trying to hype their stock before the offering and thus potentially causing investors to make investment decisions without fully considering all the risks. In the absence of a confidential filing, the communications restriction means that all the company’s financial information is sitting in the public domain for competitors and reporters to take apart, yet without the company’s ability to meaningfully respond. Thus the confidential filing ensures that the company is not a sitting duck in the period during which the SEC is completing its review. By the way, confidential filings started with EGCs, but as of the end of 2017, the SEC changed its own filing rules to extend confidential filing privileges to all IPOs, even if the company is not an EGC.

  Financial and regulatory disclosures—EGCs enjoy lighter regulatory and disclosure requirements both in the prospectus and post-IPO. For example, an EGC is required to provide only two years of historical financials in its prospectus and is not subject to a requirement that its auditors opine on the company’s internal controls. Essentially, the JOBS Act scaled down the regulatory costs of becoming a public company.

  Once an EGC has mostly completed its back-and-forth with the SEC on its prospectus, it will make the prospectus publicly available (i.e., take the covers off of the confidential filing) and begin the formal marketing phase of the deal. It is also at this time that the underwriters will provide an initial filing price range and offering size for the transaction, with the understanding that these numbers may move up or down during the course of marketing based upon investor feedback. As noted above, the marketing process is called a road show, and entails exactly that: traveling around the country (and sometimes Europe) to do a seemingly endless number of one-hour pitch meetings to institutional investors.

  During the road show, the underwriters are doing what’s called “building the book.” That is, they are talking with the various institutional investors and trying to get a sense of how much demand there is for the offering at different prices (in relation to the initial filing price range the underwriters had set). Once the marketing period has finished, the underwriters and the company will assess the strength of the book and make a decision on how many shares to ultimately sell and at what price. At this point, the SEC needs to weigh in one final time to declare the prospectus effective, permitting the underwriters to distribute the shares to investors and start the public trading of the stock.

  Pricing an IPO is one of the more challenging aspects of the process, and undoubtedly leaves at least one of the parties unhappy. Here’s the challenge: the underwriters are repeat players in the IPO process (as are the institutional investors who purchase IPO shares), whereas the company by definition likely only ever goes public once. Thus, the incentives for the underwriters are to price the IPO appropriately so that it trades well in the aftermarket; as I’ve said many times in this book already, the world is a much happier place when things go steadily up and to the right, and stock prices are no exception. The incentive for the company going public is of course to achieve a good long-term stock trajectory but also to raise as much money as possible with the least amount of dilution possible. After all, the company gets the proceeds from selling the IPO shares, but it does not benefit directly in the form of cash on its balance sheet with the subsequent appreciation of the stock price.

  Estimating the right selling price for the stock, however, is more art than science. If the underwriters price it too high, then the stock is at risk of trading below this price on the first day of trading. This is called “breaking issue price” and can be a very bad place for a company to be, in part because so much of how a stock trades is based on sentiment, and negative sentiment can become a self-fulfilling prophecy.

  Recall what happened to Facebook on its first few days as a public company. Granted, we won’t ever be able to disentangle the effects of the trading glitch in the Nasdaq market that day from the underwriters’ decision to set the initial price at $38 per share, but both may have contributed to the sell-off in the stock. Facebook stock fell all the way to $14 per share before eventually recovering and is now trading at nearly four times its IPO price.

  On the flip side, if the underwriters set the initial price too low and the stock trades way up in the aftermarket, the institutional investors may be happy because of the appreciation, but the company will feel as though it left a lot of money on the table or unnecessarily suffered dilution. Interestingly, when I was a banker at Credit Suisse First Boston in the dot-com bubble, we held the record for the largest one-day IPO increase in a stock price. The company was VA Linux, and the stock, which was priced at $30 per share in the IPO, traded immediately (on the opening trade) to $300 per share and then closed on the first day of trading at $242.38, an 8x increase in one day. Funny enough, at that time, we actually celebrated and marketed this as our brilliance in leading the IPO; in retrospect, that was a pretty sure sign that we completely misjudged the r
eal market price for the stock!

  After this initial pricing dance, in the first thirty days post-IPO, the underwriters are allowed to stabilize the trading price of the stock. The primary mechanism by which they do this is through what’s called the “green shoe” (named after the first company, Green Shoe Manufacturing Company, for which this technique was deployed).

  The green shoe allows the underwriters to sell to the market up to an additional 15 percent of stock at the time of the IPO; essentially it oversells the IPO but retains the right to purchase those shares back within thirty days from the company at the IPO price. So if the stock price goes up, then the underwriter exercises the green shoe by buying the shares back and distributing them to the institutional investors to whom the overallotted shares were sold. If the stock price goes down below the original sale price, the underwriters can just go in the market and buy shares back at the lower market price and thus they do not end up exercising the green shoe.

  We started this section by talking about liquidity being one of the reasons to go public, but so far we’ve said nothing about liquidity. For investors, liquidity is still a ways off, since they are generally required to execute a lockup agreement that restricts their ability to sell stock for the first six months post-IPO. The reason for this is price stabilization as well; we worry that if the VCs (or founders and executives who own a lot of stock) dump all their stock immediately, it could have a big impact on the trading price. Even once the lockup expires, VCs may still be restricted depending on whether they remain on the board of directors (and might be subject to the company’s trading policy, which restricts the time intervals during which officers and directors can trade) or on how much stock they own (there are sometimes volume limitations associated with large holders).

  Employees and executives, too, are usually subject to the lockup agreement. After that, other than for executives, who may have restrictions based on the company’s trading policy, employees are generally free to trade their shares.

  Finally, that long journey from startup to liquidity is in sight. But how do venture capital firms ultimately achieve liquidity for their LPs, and when do they decide to seek liquidity? The decision to seek liquidity varies among firms, so it is important for you as an entrepreneur to have this discussion with your particular firms, assuming you are lucky enough to get to an IPO.

  Recall that when we talked about LPs and the Yale endowment we mentioned that VC is but one asset class to which most institutional investors allocate capital—public equities, real estate, debt, etc., being among the other classes. As a result, most venture LPs take the view that, once a portfolio company goes public, the default should be that the VC exits its position in the stock by returning cash or stock back to its LPs. The reasoning behind this is that LPs pay VCs to invest in and manage private company exposure, but generally have separate fund managers on whom they rely for managing public stocks. If an LP wants to own Facebook shares, she has a public manager who is skilled in that area; she doesn’t need her VC to do that for her.

  That doesn’t mean that VCs are required to exit public shares immediately. Remember that a function of being a limited partner is that you are in fact at the mercy of the GP’s decision to exit or not. But in practice, many VCs will take the position that they will seek to exit public shares in some reasonable proximity to an IPO, unless they still have a thesis such that there is material upside still available in the stock. The definition of “material” varies by VC, but most would probably agree that if the stock is likely to go up at the same general rate as the overall market, that doesn’t qualify. So the bar to continue holding for a longer period of time usually requires a stronger conviction in the remaining upside in the stock.

  The decision to exit can also be affected by whether the VC is remaining on the board of directors of the company post-IPO or by whether they remain a significant shareholder (typically meaning that they hold a position in excess of 10 percent of the stock). Either of these conditions can impose restrictions on the VC’s ability to exit the stock, by limiting either the windows in which they can exit (e.g., a board member will often be prohibited by the company’s insider trading policy from exiting in a closed window, which typically occurs within certain times of an earnings release) or the volume of shares they may sell at any given time.

  Once a VC makes the decision to exit its position in whole or in part, the VC can do so either by selling the shares in the open market and returning the cash proceeds to its LPs or by distributing the shares themselves directly to the LPs. As with other aspects of the GP-LP relationship, this is a GP-only decision. There are a number of considerations in this decision, including the overall trading liquidity of the stock, and the VC’s opinion as to whether doing a mass sale or distribution could materially weaken the stock price, as well as the desire (or not) to trigger taxes to the LPs and the GP (a sale of stock for cash is a taxable event, whereas the distribution of shares defers taxes until the recipient herself decides to sell the shares).

  As an entrepreneur, you will want to be mindful of the VC’s deliberations around sales or distributions, as they may have an impact on the stock. In particular, if a stock is thinly traded (meaning there is not a lot of regular trading volume in the stock), a meaningful sale or distribution could cause a material decline in the stock price. Similarly, the signaling of a large VC exiting the stock alone might have an impact on the trading sentiment of the stock.

  As a result, sometimes the company’s board will seek to mitigate the potential deleterious effects of VC exits by organizing what’s called a secondary offering of shares. Just as in an IPO, this is an offering coordinated by the company and its underwriters in which the company seeks to orchestrate a sale of shares to oftentimes existing institutional investors who want to add to their holdings in the stock. As distinct from an IPO, however, the shares being sold are secondary, meaning they are owned by someone else, rather than being newly issued by the company. These shares are often those owned by executives or VCs who may have not already exited their holdings. Thus, the proceeds of such a stock sale do not go to the company but rather to the holders of the shares who are selling into the market. The main benefit of this process in lieu of having VCs simply distribute shares independently to their LPs or sell on their own is to give the company an opportunity to place the shares in friendly institutional hands and thus minimize the negative price pressure on the stock.

  However accomplished, the sale or distribution of shares by a VC completes the often ten-or-more-year cycle of having invested in a startup and seeing it through to a successful exit. And the circle of life for the participating VC begins anew: looking for the next potential IPO candidate.

  While an IPO may ultimately be an exit for the VCs—and provide broader liquidity for you and your employees—it also reflects a new chapter for you as CEO. You’ve now got a new set of co-owners in the company—namely, public institutions that will be able to grade your performance daily in the form of the stock price. And of course a new set of governance rules by which to live.

  Most importantly, however, you also need to think about how you keep your key employees focused on delivering on all the promises that you outlined to your investors during the course of the road show. This can be a real challenge, particularly given that the liquidity that many early employees will have achieved via the IPO may change their go-forward financial incentives. In addition, the daily reminder of apparent success (or failure) that the stock price represents can become a distraction from keeping people’s eyes focused on the long-term prize of executing your product plan.

  These are of course first-class problems to have, given that you have achieved what a very small minority of venture-backed entrepreneurs ever do: getting your company from founding to a successful IPO. And thus a new day begins.

  CONCLUSION

  The World Is Flat

  If you made it this far, congratulations to
you, and might I suggest that you find some hobbies?

  Seriously, though, I hope I have been able to give you a better perspective on how the venture industry works and how startup companies can best navigate their way through their interactions with venture capital firms.

  As I mentioned at the outset, this book isn’t intended to be the VC bible. But I do hope this book is like your own Alohomora incantation from Harry Potter—the spell you need to unlock some fairly heavy, opaque doors, behind which are the inner workings, incentives, and decision-making processes of VCs. In short, I want to shine a light on what makes VCs tick, what the VC life cycle is, and why all this matters to you as a startup founder, employee, or partner.

  The decision to raise capital from a venture firm is a huge one, and my personal motto about most things is Better to be informed.

  The Evolution of VC

  When Marc Andreessen and Ben Horowitz started Andreessen Horowitz, they were contemplating building a different type of venture firm from those already in the market. In particular, we decided to hire a lot of noninvestment, nonfinancial personnel to work closely with our startups to help them achieve their goals of building large, self-sustaining companies. Today, in fact, a16z employs about 150 people, and two-thirds of the employees are focused on post-investment engagement with our portfolio companies.

  We thought at the time, and continue to think today, that this was part of a broader evolution in the VC industry through which money alone would no longer be the primary source of competitive differentiation.

  The thesis was that money had been the scarce resource through much of the industry’s first thirty to forty years, and, because the VCs controlled access to money, they had the power as a result. Over the more recent ten or so years, money is no longer a scarce commodity—there are plenty of VC firms with lots of capital and many more non-VC firms that provide significant amounts of particularly later-stage capital into the venture ecosystem—and thus something other than money will serve as the source of competitive differentiation in the marketplace. For a16z, investing in a team of post-investment resources is one way in which the firm hopes to compete among a group of other very successful and competitive venture firms. There are of course other ways to achieve that differentiation in the marketplace, and no doubt new models will continue to emerge.