In Secrets of Sand Hill Road, Scott Kupor provides a well-needed and clear view of the venture capital (VC) phenomenon, from both entrepreneurs’ perspective and VC providers’ perspectives. Kupor successfully demystifies the phenomenon by providing a new framework to analyze the relationship between a start-up and its investors, guiding readers from an often uneasy alliance full of friction to a positive “win–win” relationship.
The author is managing partner at well-known Silicon Valley VC firm Andreessen Horowitz and has a broad background from business and law studies at Stanford. He previously worked for Lehmann Brothers, Hewlett-Packard, First Boston, Credit Suisse, and a start-up. His insights do not limit themselves to technology investing only, but provide useful take-aways for venture capital investing in general.
Kupor’s present position as the head of a well-known VC firm drives the book’s emphasis on the VC side of things – above all, where to invest, how to evaluate an entrepreneur’s business picks, and how to cope with the many legal and financial details, including how to establish processes for good governance.
Significantly, the author stresses the extent to which his firm, generally, has a very high commitment to each firm it has invested in and does whatever it can to help these companies succeed. Identifying key persons and even suggesting specific sites where such start-ups might try out their products (beta testing) often seem particularly value-enhancing for the start-ups.
According to Kupor’s data, the typical time from initial VC funding to some sort of exit – such as an initial public offering – can typically be around 10 years, much longer than one had expected. VC investing is typically quite risky: around half of such investments will yield less than satisfactory returns, another quarter will be outright failures, and only the last quarter will yield good results.
More recently, two factors have changed the process of starting new businesses to favor the entrepreneur. First, capital availability is an increasingly less significant constraint. Less capital is needed to start a new firm, while capital is becoming more abundant. Second, start-up schools for entrepreneurs have been established, the most famous being the so-called Y-Combinator school in Silicon Valley. Many important new ventures have been tested out in such incubators, thus significantly contributing to a higher degree of success for new ventures.
Kupor later discusses how the “batting average” of investing may be improved. However, he readily admits that there are typically many failures, with only 10–20% of these investments leading to true success. Kupor identifies classes of factors that may significantly improve the likelihood of ultimate success:
People and team. He distinguishes between a “product first” team versus a “company first” team. The former, which he prefers, is based on a concrete product idea, while the latter merely reflects the team’s drive to develop a new company.
Product. Here, it seems essential to judge the extent to which this particular product idea may be good enough to meet a true need in the market. Are customers ready to pay real money for it?
Market size. Is the intended market big enough? It is all about market size!
The author then discusses the various types of investors that tend to provide funding through venture firms. Common to all of these are perfectly rational considerations such as assessing if the VC´s profile matches their industry preferences, the risk-adjusted return and robustness, the payback time, possibilities for co-investment, access to management, and portfolio balance. Kupor later discusses how investment firms, i.e. the providers of VC, line up with VC firms. The limited partnership agreement between these two sides must be clear and must detail how to regulate the relationship between these entities, including in cases of unexpected developments. This agreement must cover what is understood to be the investment domain and spell out that the “best ideas” belong to the partnership and that the VC firm is incentivized to work hard for the money. A management fee of, say, 2% to the venture firm seems normal. On top of this remuneration, the venture firm typically also gets a carried interest of 20–30% of an investment’s profit.
The last two-thirds of the book function as a sort of how-to manual for getting a start-up off the ground. When forming a start-up, spelling out the vesting process for the founders is key, to encourage key management to stay committed to the company and not leave the scene! When a senior manager leaves, however, clear rules must be established for purchasing this person’s stock.
According to Kupor, start-ups typically go around four years before entering a new phase, which usually consists of going for an IPO or selling out. But the author warns of the many regulations that typically must be adhered to when going public. Staying private and staying motivated may be better!
Of course, raising money from a VC firm for a new venture is a crucial aspect of starting up. This communication must be realistic and credible! Setting a relatively modest valuation helps. The author discusses five aspects of what may be an effective pitch:
Market sizing (as we have already discussed)
The team
The product
The process of going to market
Planning for the next financing round
A detailed discussion on how to develop a meaningful term sheet thus follows, emphasizing both economics and governance. Further, a detailed example of a term sheet is provided as an appendix. A key economic issue is the use of convertible debt, initially a loan that later may be converted into equity. And, two economic “no-no’s” for new ventures: no dividends and no redemption. The capital should remain in the firm and continue to be put to work there. Anti-dilution provisions should also be spelled out in the term sheet.
The key to good governance is a strong board, which should support the firm but not run it! The CEO must thus manage the relationship with his or her board. An effective board must play the following roles:
Hire/fire the CEO (not an easy task)
Provide guidance regarding the business’s long-term strategic direction
Approve various corporate actions, such as increased funding, going for an IPO, and acquisitions
Maintain compliance, such as by filing tax returns, issuing audited reports, and adhering to public stock regulations
Open up the business to specific VC inputs, such as introductions to key contacts, financing sources, and marketing outlets
However, the board should not run the company or dictate strategy (above all, not interfere in product strategy). These tasks belong to the CEO. As a general rule, simplicity seems key to developing an effective term sheet.
The book discusses potentially difficult financing situations stemming from unforeseen adverse circumstances. Bad management may not be given a second chance. But, legitimate adversarial effects in the marketplace might deserve additional funding. Being realistic about whether to stop additional funding is, of course, often difficult.
The final part of the book discusses the exit stage, including preparing for an IPO. Most countries have specific regulations on prior filing regarding one’s intentions to initiate an IPO. This preparation can be tedious and require specialized competencies. Therefore, boutique consultancy firms or investment banks are typically involved in such IPO processes.
I find this book to be very helpful and to have an abundance of practical advice. This may be particularly useful for many members of the Lorange Network, particularly those who are utilizing Lorange Network’s Deal Wall.
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