How Venture Capital Works

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In a 3-part video series the highly knowledgeable Scott Kupor, Managing Partner of Andreessen Horowitz aka a16z (private American venture capital firm founded in 2009 by Marc Andreessen and Ben Horowitz), shares concrete, easy-to-digest and actionable fundraising advice based on his experience of seeing thousands of startup pitches and working on all of a16z’s investments.

In the first episode, Scott covers how venture capital works: how the money flows, what limited partners are looking for, what differentiates the top investors, and what all of this means for an entrepreneur raising money.

Key Points

• Capital flows into venture capital funds from pension funds, university endowments, foundations, finance companies, and high-net-worth individuals. Such investors in venture funds are called limited partners (LPs). “Limited” in this context refers to their passive role with, say, a fund’s operational activities.
  
• Venture capital funds often have a negative return in the early years of the fund’s life as it is expected that 50-60% of the fund’s seed and early-stage investments may not return capital. As the fund ages, the fund’s return increases. This is phenomenon known as the ”J-Curve”. A few additional reasons:
  • Fund organizational expenses
  • Management fees
  • Fund expenses

• Moving forwards, the competitive dynamics among VCs (and sources of capital) are going to be even more challenging because money is no longer a scarce resource, and other means are required for differentiation (such as e.g. strong advisory, domain experts).
  
• Looking ahead, the trend of companies staying private much longer is going to continue. It used to be 6 – 6,5 years (on average) until a company went public after they were started, now it is 10-12 years. Some companies are even deciding to go for direct listing, omitting the traditional IPO approach (such as Airbnb and Slack | info as of 2019).
  
• We will continue to see a blend of the private and the public market, which makes this look more like a continuum. There will probably be a more active secondary market/re-sale market for private stock. This may have some elements of regulation that we have typically seen in the public market.

What to do After Having Decided that Raising Venture Capital is the Best Fundraising Strategy for Your Startup

In the second episode, Scott covers what to do after having decided that raising venture capital is the best fundraising strategy for your startup.

Key Points

• Raise as much money as you need to accomplish the objectives you need in order to raise money in the next round. Thus, if you are raising money for your series A round today, you should be thinking about what is the pitch I am going to give to the series B investors. Then work backwards. For the series B investors to be compelled to what I am doing, what milestones, what objectives will they need to see? Therefore how much money and time will I need to reach that level? You should tell the VCs what you want, and you should be able to articulate that for X amount of dollars, this is what I can do. Then add, by the way if you gave me X + 50% then I would be able to do this much more. Part of the exercise is along with the VC to discuss what is the right amount of money that does not dilute us too much today, but gives us enough degrees of freedom that when we go for that next round of financing, then someone will come and put more money in at a higher price then what was done in this round.
  
  
• A priced equity round is an offering and sale of newly-created stock in your company at an agreed-upon per share price. Once stock is sold, investors are part owners of your company.
  
  
• Convertible note is a loan from the investors, that ultimately converts into equity at some yet-to-be-determined price at a time in the future. Quite good as they are simple, low cost and the paper work is very easy. The drawback of doing a lot of convertible notes when raising money, is that the founders may lose track of how much equity their giving away. This could lead to a surprise when all of it is converted into equity further down the road.
  
  
• Full ratchet is an anti-dilution provision that, applies the lowest sale price as being the adjusted option price or conversion ratio for existing shareholders. E.g. an investor who paid $2 pr share for a 10% stake would be able to double his shares in order to maintain his stake if a subsequent round of financing were to come through at $1 pr share.
  
  
• Liquidation preferences: when the company is sold, who get the money and in which order. Typically the VC’s money is given out first, then the common shares that belongs to the founders, and then the remaining parties (if any). The most entrepreneur-friendly liquidation preference is the 1x non-participating, which means the VC gets 1-time the money they put in, and not the corresponding percentage that they hold in the company also from the proceeds.
  
• As a founder be careful of how much structure you put into a deal and how much benefits you bake in when raising money in the early days, as you set the precedence. Typically each new investor that comes along will read through these clauses and will want to have the same or better terms.
  
• Thus, when raising for the series A round, the founders should really think ahead on how the terms and setup will affect the next rounds (series B, series C, series D, etc.). Keep the economic side of the term sheets simple.
  
• When getting close to going public, it makes sense to consider having dual class shares (higher and lower voting rights), in order to hedge against short term investors who may not agree with e.g. your product strategy. Thus, you can use your higher voting power to go ahead none-the-less, if you believe that your product enhancements will lead to a higher valuation of the company further on, while we may see some downturns in the short term.
  
  
• The first board members will typically be the founders and early investors. As the board expands to 4-5 members it generally makes sense to add an independent board member. This would typically be an industry expert within the domain that you are in or someone with expertise in an area (e.g. Sales, Marketing) that the company really need at the stage their in.
  
  
• A pro rata clause in an investment agreement gives the investor a right (but not the obligation) to participate in one or more future financing rounds to maintain their percentage stake in the company. It is advisable to have the conversation with the first VC to understand if their planning to exercise their pro rata right in the following rounds of raising capital. This info can then be used to e.g. set the right expectations when new investors come in.
  
  
• As an entrepreneur, if you have got a very employee-friendly stock policy, then you would extend the period after they leave for them to exercise their stock options.

If you want to get into these topics in more depth, then consider the book “Secrets of Sand Hill Road: Venture Capital and How to Get It” by Scott Kupor.

YouTube video, episode 2 in a 3-part video series with Scott Kupor (Managing Partner of Andreessen Horowitz aka a16z) on what to do after having decided that raising venture capital is the best fundraising strategy for your startup.