Secrets of Sand Hill Road

by Scott Kupor

  How did we get to this point where capital ceased to be a scarce resource? We talked about this briefly in the introduction to this book, but a few things happened along the way. First, starting in the early 2000s, the costs required to start a new company began to fall precipitously.

  As cloud computing began to take off, the unit costs of all these hardware and software products began to fall. A variant of Moore’s law was sweeping through every segment of the technology stack. At the same time, software development systems also progressed, and engineering efficiency increased correspondingly. Today, developers can go to Amazon Web Services or competing providers and rent compute utility on demand, providing incremental pricing coupled with dramatically lowered input costs. Thus the costs required to start a company have fallen significantly, and therefore the amount of money that startups need to raise at an early stage has declined accordingly. This is a good thing overall in that it means there is a lot of new company experimentation that can be had with only small amounts of actual capital put at risk. This is why you have seen such an increase in the number of early-stage companies being funded.

  Commensurate with this decline in costs, a new form of early-stage financing developed. In the old days (roughly pre-2005), angel investors were individuals who invested small amounts of money in startups out of their own checkbooks. However, as the costs of starting a company fell, the institutional seed market began to develop. Over the past ten years, likely more than five hundred new seed firms have been formed, most of which have fund sizes less than $100 million, and many with fund sizes below $50 million. But unlike the angel investors of old who invested their own money, most of these firms are funded by the same types of institutional LPs who fund larger VC firms. The proliferation of these firms has also contributed to the increase in the number of seed-funded startup companies.

  Ironically (or maybe not), at the same time that it has become cheaper to start a company, it has become more expensive for companies to win. That’s because the world is flatter than ever before. Whereas the US once dominated the venture scene, funding as much as 90 percent of global venture capital investments just about twenty years ago, today the rest of the world is roughly on par with the US in terms of share of the venture capital funding pie. As a result, startups face competition in virtually every global market in which they seek to compete. The good news is that the end markets for successful companies are bigger than ever (we’ve never before seen a company achieve what Facebook has done—grow from zero to a $400-plus billion market cap company in fourteen years); the bad news is that winning those markets requires a lot of capital to simultaneously capture each one.

  And with this change has come two important financing trends.

  First, many of the traditional venture capital firms have increased their fund sizes to be able not only to fund startups in the very early stages, but also to be a source of growth capital throughout their life cycles. Second, as companies have elected to stay private longer, more nontraditional sources of growth capital have entered the financing market. Whereas public mutual funds, hedge funds, sovereign wealth funds, family offices, and other strategic sources of capital had traditionally waited for startups to go public before they would invest growth capital, nearly all these players have now made the decision to invest directly in later-stage startups while they remain in the private markets. This is the most viable way for such institutional investors to capture the appreciation attendant to startups; that appreciation has essentially shifted from post-IPO to largely pre-IPO.

  Consider the following example. Microsoft went public in 1986 at a $350 million market capitalization. Today, Microsoft has a market cap of approximately $800 billion. That’s more than a 2,200x increase in market cap as a public company. No doubt the venture investors in Microsoft did fine themselves in terms of return on their investment, but if a public market investor held Microsoft since its IPO, she would have made more than Accel made on its pre-IPO Facebook investment—talk about public venture returns!

  In contrast, Facebook went public at a $100 billion market cap and now trades around $400 billion. Absolutely nothing to sneeze at, particularly given that the company’s value has increased four times in about six years. Just to have some fun, though, for the public market investors to eventually earn the same multiple on their Facebook holdings as has been the case for their Microsoft holdings, Facebook would have to reach a market of more than $220 trillion. To put this into context, global domestic production—the sum of the entire economic value in the world—is about $80 trillion.

  Now, I realize these numbers are crazy and this comparison may not be apples-to-apples, but it illustrates a very important point in the overall capital markets. Companies are definitely staying private longer, resulting in more of the appreciation of startups going to those investors in the private markets, at the expense of those in the public markets. This means that normal retail investors, who rely on public stock price appreciation to fund their retirement accounts, may be losing out on a real portion of economic growth.

  Regardless of your policy views, private capital is becoming a commodity, and this is why access to capital alone no longer provides significant differentiation for most venture capital firms. And yet, despite our having tried something new to differentiate our service offering at a16z, my partner Marc likes to keep us ahead of the curve by often asking whether we are in fact simply the most advanced dinosaurs—the implication being that we may think we look differentiated relative to others, but we are always at risk of being the last generation in the evolutionary chain of traditional venture firms.

  What Might Be the End of Venture Capital as We Know It?

  Crowdfunding is one alternative—in 2017, roughly $1 billion was raised through crowdfunding efforts in the US, an increase of about 25 percent from the previous year. Obviously, this is much smaller than the more than $80 billion of venture capital financing that year, but nothing to dismiss.

  Initial coin offerings (or ICOs) for digital tokens is another potential candidate to replace venture capital. In 2017, roughly $4 billion was raised via ICOs, about 5 percent of the total US venture capital investments. Some have argued that ICOs are a mechanism for founders to raise both institutional capital and retail capital without having to rely on VCs to finance their growth.

  These funding sources ultimately represent two sides of the same coin—each is a way to democratize access to capital beyond the more centralized venture ecosystem that exists today. In that respect, they are part of the very same trend on which Andreessen Horowitz founded its business—capital is no longer a scarce resource, and thus returns will not accrue to those individuals or firms that provide access to capital only.

  This is, I think, the fundamental answer to whether crowdfunding, ICOs, or some other new financing mechanism that we can only dream of today will supplant venture capital. If money remains abundant, and value creation in startups (or digital coins) remains a function of being able to build large, self-sustaining businesses, then the firms that provide meaningful value to entrepreneurs beyond just being a source of capital likely have an ongoing role to play. It’s certainly possible that those firms may not be the traditional venture model that we see today, but could also include a whole new variety of organizations that combine capital availability with value-add aimed at helping entrepreneurs achieve their business goals.

  And this takes us right back to where we started this book. VCs and entrepreneurs working together to achieve wonderful things.

  Here’s What I Believe about Good VCs

  Good VCs help entrepreneurs achieve their business goals by providing guidance, support, a network of relationships, and coaching.

  Good VCs recognize the limitations of what they can do as board members and outside advisors as a result of the informational asymmetry they have with respect to founders and other executives who live and breathe the company every
day.

  Good VCs give advice in areas in which they have demonstrated expertise, and have the wisdom to avoid opining on topics for which they are not the appropriate experts.

  Good VCs appropriately balance their duties to the common shareholders with those they owe to their limited partners.

  Good VCs recognize that, ultimately, it is the entrepreneurs and the employees who build iconic companies, with hopefully a little bit of good advice and prodding sprinkled in along the way by their VC partners.

  If VCs remain good, they won’t become dinosaurs.

  The World Is Flat

  I am very privileged to be part of an incredibly dynamic industry that, while small in terms of relative capital, contributes an enormous amount to the technological development and the economic growth of the global economy. For many years, as noted earlier, the US has occupied a special place in venture capital. As a country, the US has benefited tremendously from the startup and VC communities, and we need to continue to encourage more people in the US and across the world to pursue careers in these industries. Eliminating the information asymmetry barriers between entrepreneurs and VCs is one step in helping to achieve this goal.

  The world is undeniably flat—and the global playing field has never been more open to startup opportunities. I hope at some small level that this book helps inspire more people to think about the role they can play in this increasingly important ecosystem to improve the growth prospects and financial well-being of people all across the globe.

  APPENDIX

  SAMPLE TERM SHEET

  [COMPANY XYZ, INC.]

  TERM SHEET FOR SERIES A PREFERRED STOCK FINANCING

  This term sheet dated as of January 17, 2018, summarizes the principal terms of the proposed Series A Preferred Stock financing of Company XYZ, Inc., a Delaware corporation (the “Company”), by Venture Capital Fund I (“VCF1”). This term sheet is for discussion purposes only, and except as expressly set forth below, there is no obligation on the part of any negotiating party until a definitive stock purchase agreement is signed by all parties and other conditions set forth herein are met. The transactions contemplated by this term sheet are subject to, among other things, the satisfactory completion of due diligence. This term sheet does not constitute either an offer to sell or an offer to purchase securities.

  OFFERING TERMS

  Security:

  Shares of Series A Preferred Stock of the Company (“Series A Preferred Stock”).

  Aggregate Proceeds:

  $10 million in new capital, all of which shall be from VCF1 (for at least 20% of the post-closing fully diluted capitalization of the Company) (the “Investor”).

  In addition to the new capital described above, to the extent the Company has any outstanding convertible notes and/or SAFE securities, such instruments shall convert into shares of capital stock (the “Note Conversion Shares”) pursuant to their terms.

  Price per Share:

  The per-share purchase price of the Series A Preferred Stock (the “Original Purchase Price”) shall be based upon a $50 million post-money fully diluted valuation (which includes all new capital described above, the Note Conversion Shares, the unallocated pool described below, and all other rights to acquire shares of the Company’s capital stock).

  Capitalization:

  The pre-money capitalization shall include an ungranted and unallocated employee option pool representing at least 15.0% of the fully diluted post-closing capitalization (after giving effect to the issuance of the Series A Preferred Stock, any Note Conversion Shares, and any other rights to acquire shares of the Company’s capital stock), exclusive of any shares of Common Stock or options to acquire shares of Common Stock that have been previously issued, granted, promised, or otherwise committed by the Company (verbally or in writing) prior to the closing of the Series A Preferred Stock financing (the “Closing”).

  Use of Proceeds:

  The proceeds shall be used for working capital and general corporate purposes.

  Dividends:

  The holders of any prior series of preferred stock, Series A Preferred Stock, and all future series of preferred stock (together, the “Preferred Stock”) shall receive an annual 6% per-share dividend on a pari passu basis, payable when and if declared by the Board of Directors (the “Board”), prior and in preference to any declaration or payment of dividends on the shares of the Company’s Common Stock (the “Common Stock”); dividends are not cumulative. For any other dividends or distributions, the Preferred Stock participates with Common Stock on an as-converted basis.

  Liquidation Preference:

  In the event of any liquidation or winding up of the Company, the holders of Preferred Stock shall be entitled to receive prior and in preference to the holders of Common Stock an amount equal to the applicable Original Purchase Price per share for such series of Preferred Stock (as adjusted for stock splits, stock dividends, recapitalizations, etc.), plus any declared but unpaid dividends on such shares (the “Liquidation Preference”). After the payment of the Liquidation Preference to the holders of Preferred Stock, the remaining assets shall be distributed ratably to the holders of the Common Stock.

  A merger, acquisition, sale of voting control, sale of substantially all of the assets of the Company, or any other transaction or series of transactions in which the stockholders of the Company do not own a majority of the outstanding shares of the surviving corporation (but excluding the issuance of stock pursuant to customary venture capital financings by the Company) shall be deemed to be a liquidation or winding up (a “Liquidation Event”) and shall entitle the holders of Preferred Stock to receive at the closing (and at each date after the closing on which additional amounts [such as earn-out payments, escrow amounts, and other contingent payments] are paid to stockholders of the Company) the greater of (1) the amount they are entitled to receive as holders of Preferred Stock above or (2) the amount they would be entitled to receive had such holder of Preferred Stock converted such shares into Common Stock prior to the closing. Subject to the Protective Provisions herein, treatment of any such transaction as a Liquidation Event may be waived only with the consent of the holders of a majority of the Preferred Stock, voting as a single-class on an as-converted basis.

  Redemption:

  No redemption.

  Conversion:

  The holders of Preferred Stock shall have the right to convert the Preferred Stock, at any time, into shares of Common Stock at an initial conversion price of 1:1, subject tortt adjustment as provided below.

  Automatic Conversion:

  The Preferred Stock shall be automatically converted into Common Stock, at the then-applicable conversion price (i) in the event that the holders of a majority of the outstanding Preferred Stock consent to such conversion or (ii) upon the closing of a firmly underwritten public offering of shares of Common Stock of the Company pursuant to a registration statement under the Securities Act of 1933 for a total offering of not less than $50 million (before deduction of underwriters’ commissions and expenses) (a “Qualified IPO”).

  Antidilution Provisions:

  Proportional antidilution protection for stock splits, stock dividends, recapitalizations, etc.

  Except as further described below, the conversion price of the Preferred Stock shall be subject to adjustment to prevent dilution on a broad-based weighted average basis in the event that the Company issues additional shares of Common Stock or securities convertible into or exercisable for Common Stock at a purchase price less than the then-effective conversion price; except, however, that without triggering antidilution adjustments, (1) Common Stock and/or options therefor may be sold, issued, granted, or reserved for issuance to employees, officers, or directors of the Company pursuant to stock purchase or stock option plans or agreements or other incentive stock arrangements approved by the Board, (2) shares of Common or Preferred Stock (or options or warrants
therefor) may be issued to leasing companies, landlords, company advisors, lenders, and other providers of goods and services to the Company, in each case approved by the Board (including at least one director elected by the Preferred Stock [a “Preferred Stock Director”]), (3) shares of Common or Preferred Stock (or options or warrants therefor) may be issued to entities in connection with joint ventures, acquisitions, or other strategic transactions, in each case approved by the Board (including a Preferred Stock Director), (4) securities may be issued pursuant to stock splits, stock dividends, or similar transactions, (5) Common Stock may be issued in a Qualified IPO, (6) securities may be issued pursuant to currently outstanding warrants, notes, or other rights to acquire securities of the Company (the foregoing issuances described in subsections [1] through [6] shall be referred to as the “Exempted Securities”), and (7) securities may be issued in any other transaction in which exemption from the antidilution provisions is approved by the affirmative vote of a majority of the then-outstanding Preferred Stock.

  Voting Rights:

  The Preferred Stock will vote together with Common Stock and not as a separate class except as otherwise provided herein for Preferred Stock or as otherwise required by law. Each share of Preferred Stock shall have a number of votes equal to the number of shares of Common Stock then issuable upon conversion of such share of Preferred Stock. For all votes of the Common Stock, each share shall have one vote.