My views on the market, tech, and everything else

Secrets of Sand Hill Road (Venture Capital and How to Get It) — Know Venture Capital Before You Get Married to a Venture Capitalist

Scott Kupor’s new book Secrets of Sand Hill Road is a bottom-to-top explanation of venture capital and other aspects of growing a business intended for founders, board members, employees, investors, venture capitalists and people who are curious about this investing approach. Writing a book that is interesting to an expert, but informative for a novice, is not an easy task. I think about this challenge every time I write a blog post or book. Kuper has struck an admirable balance in writing a book that appeals to many types of people with different levels of expertise.

Secrets of Sand Hill Road is the outcome of a tremendous amount of work by Kupor. Why would an extremely successful person like the author devote the time and energy necessary to do this? Aside from wanting to help people learn more, Kupor knows from experience that dealing with better educated and informed individuals and organizations will create fewer problems and produce better outcomes. Risk is created not only from not knowing what you are doing, but also from dealing with other people who don’t know what they are doing. One of the reasons I enjoy watching skilled and experienced professionals interact is that they avoid time and energy wasting behavior. They tend to avoid pointless posturing and counter productive negotiating styles. This informed professionalism makes the process more fun and you can learn more. If you have a choice between dealing with an idiot or a professional, dealing with the professional is the better option.

Venture capital can seem confusing at first, especially to an entrepreneur who has never started a business before, but it is simpler than it seems. Any business has a range of specialized terms and jargon and Kupor does an admirable job of explaining them in a way that is not boring. One thing I liked about the book is that Kupor sometimes uses colorful language in the book (e.g., “schmuck insurance”) to keep his readers entertained. Humor helps the learning process if the material is a bit dry. Readers of this book will learn about the meaning and purpose of terms like “dead hand control,” “ROFR”, “drag along,” “full rachet,” “no shop,” “D&O,” ‘MIP,” ‘BJR,” ‘WARN,” “green shoe, ”“piggybacks” and “down round.” Kupor marches the reader clearly and swiftly though term sheets, sample cap tables and term sheets.  He provides readers of the book with a sound introduction to the implications of legal decisions like Trados, Bloodhound and Revlon in a way that is not too technical and not too basic (i.e., “just right” as Goldilocks said in the famous story). 

Every entrepreneur I know would rather build products than learn about finance, but taking the time to learn the important concepts can pay big dividends over time. The actor Tina Fey wisely said once about learning about business even though your dominant interest is in other areas: “Today, as much as it makes me super sleepy, I have to pay a lot of attention when my business manager talks to me about money. He talks to me about taxes, and I get really, really sleepy. But I listen.” The topics Kupor covers in the book are not always exciting to read about, but they can be exciting to actually encounter in the real world. You may only encounter a situation once in your life, but when you do it will be important. Reading and thinking about these issues in advance can pay big dividends. As an example, Kupor has a chapter in which he discusses corporate governance which he starts by saying “let’s eat our broccoli together,” meaning you may not necessarily like it, but it will be good for you.

Kupor digs into hard and complex issues like down rounds and option pools with advice and examples that are useful even for a person with a lot of venture capital experience. As an example, he explains why an investor might want to use a “pull up” in a recap (no, a pull up is not a diaper product for toddlers). As another example, he also explains why a new investor might want a larger option pool. Kupor also has some very useful material in the book on the roles of directors and potential pitfalls in situations like acquisitions. The material is in effect a travelogue through many aspects of important processes. The author can’t discuss everything in a book of this length, but what he does discuss is important. Experts can also learn how Kupor explains complex topics simply to people who are encountering them for the first time.      

Kupor identifies early in his book why entrepreneurs will benefit from understanding the motivations of venture capitalists:

“Entrepreneurs need to understand their own goals and objectives and see whether they align with those of the funding sources they want to tap. To determine that calculus, entrepreneurs would be wise to understand how the VC business works, what makes VCs tick, and what ultimately motivates (and constrains) them.” (Page 5) “If you are going to raise money from VCs or join a company that has venture money, the only way to know if that is a good idea is to understand why VCs do the things that they do.’ (Page 7)

In short, since nothing is more powerful as a motivator in life as someone’s interests, it is wise to spend time and effort making sure these interests are aligned between all participants.  There is a balance that works best when it comes to entrepreneurs and founders and finding that balance is very valuable. Experienced participants in this process know this and when they are on all sides of a transaction things just go more smoothly and the result is inevitably better.   

Kupor points out that there are also several reasons why venture capital might be a good choice for a business, including:  

“…equity-based financing is often the better choice for businesses that (1) are not generating (or expecting to generate) near-term cash flow; (2) are very risky (banks don’t like to lend to businesses where there is real risk of the business failing— because they don’t like losing the principal balance of their loans); and (3) have long illiquidity periods (again, banks structure their loans to be time limited—often three to five years in length—to increase the likelihood of getting their principal back).  (Page 28)

Kupor also raises another reason why someone might not want to raise venture capital:

“Even if your business is appropriate for VC (because of the ultimate market size opportunity and other factors), you still need to decide whether you want to play by the rules of the road that venture capital entails. That means sharing equity ownership with a VC, sharing board control and governance, and ultimately entering into a marriage that is likely to last for about the same time as the average “real” marriage. (It turns out that eight to ten years is about the average length of real marriages in the US . . . make of that what you will.)” (Page 115)

Raising outside money from a venture capitalist involves real tradeoffs. But if you want to scale a business quickly, which in some cases is essential to capture an opportunity, venture capital can be the very best alternative.

Of course, some entrepreneurs will not be able to raise money from a venture capital firm, even if they want to. Kupor writes:

“Rules of thumb are overgeneralizations and crude ways to simplify complex topics, I admit. But, as a general rule of thumb, you should be able to credibly convince yourself (and your potential VC partners) that the market opportunity for your business is sufficiently large to be able to generate a profitable, high growth, several-hundred-million-dollar-revenue business over a seven-to-ten-year period.”  (Page 113)

One important point being made here is that not being able to raise venture capital is not a tragedy. There are other ways to fund the creation of a business.

The book informs readers that the venture capital industry is small but punches above it weight in terms of impact.  Venture capital firms know the distribution of financial returns of all the portfolio companies in their fund will inevitably reflect a power law. The statistics Kupor provides are quite interesting:

“… what matters most ‘[in venture capital] is your “at bats per home run.” In baseball, at bats per home run is the quotient obtained from dividing the number of times a player comes to bat by the total number of home runs achieved. …That is, the frequency with which the VC gets a return of more than ten times her investment—which we consider a home run. If you do the math, you’ll see that VCs can get a lot of things wrong. Their overall batting average can be even less than 50 percent, as long as their at bats per home run are 10–20 percent… For most VCs, the distribution of at bats looks something like this:

50% of the investments are “impaired,” which is a very polite way of saying they lose some or all of their investment.

20–30% of the investments are—to continue with the baseball analogy—“singles” or “doubles.” You didn’t lose all the money (congratulations on that), but instead you made a return of a few times your investment.

10–20% of investments are our home runs. “These are the investments where the VC is expecting to return ten to one hundred times her money.”

Of course, in the last category above there are home runs, grand slams and tape measure grand slams. As an example, Kleiner IX was famous for having just the one tape measure grand slam named Google. The top down math limits the number of tape measure home runs. That year investing in Google $100 million pre money valuation was the only decision that mattered in venture capital.

A common source of tension between the venture capital firm and the entrepreneur springs from this reality. Kupor’s partner Chris Dixon describes the tension that this can cause: VCs have a portfolio, and they want to have big wins. They’d rather have a few more lottery tickets.. while for the entrepreneurs, it’s their whole life, and let’s say you raised five million bucks, and you have a fifty-million-dollar offer, and the entrepreneurs are like, “Look, I make whatever millions of dollars. I’ll be able to start another company.”

Kupor’s book travels through so many phases and aspects of a entrepreneur-venture capitalist relationship that I can’t cover all of them. I nevertheless decided to drill down into just one topic to illustrate how informative and useful the book is:   

“Now, assuming you made the decision to raise venture capital in the first place, how much money should you raise? The answer is to raise as much money as you can that enables you to safely achieve the key milestones you will need for the next fund-raising. In other words, the advice we often give to entrepreneurs is to think about your next round of financing when you are raising the current round of financing. What will you need to demonstrate to the next round investor that shows how you have sufficiently de-risked the business, such that that investor is willing to put new money into the company at a price that appropriately reflects the progress you have made since your last round of financing?”

(Page 115)

“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.” (Page 116)

What Kupor just described seems simple, but is not always intuitive to everyone and there are nuances, important concepts, and useful skill to learn.  

“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 start-ups. 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.” (Page 117)

These points made by Kupor above get to the issue of why businesses so often die of indigestion rather than starvation. Too much money raised too soon by a startup can be inversely proportional with innovation. Is often the lack of money that drives people to innovate.  

“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.” (Page 118)

Having a margin of safety is also important in raising capital.

“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.” (page 119)

Writing a book review can create a temptation to reveal all the book’s secrets, especially if the book is as good as Secrets of Sand Hill Road. The good news is that I have revealed little of what he has written between the book’s covers. I won’t write much more in this review other than to recommend that you buy and read Kupor’s book.

My book “A Dozen Lessons for Entrepreneurs” (Columbia Business School Publishing) which was published in November of 2017, covers some of the topics in Kupor’s book, but Kupor’s book deal with scores of issues my book doesn’t mention. Secrets of Sand Hill Road and my book actually make a nice pairing. Adding in Elad Gill’s book, which I write about here, makes for an excellent trilogy. Add in Scott Belsky’s book, which I review here, you have crossed four bases (i.e., home run).

People asked me sometimes why I so often convey ideas by writing about the views of famous people. The answer is that people like to read about people. My book about Charlie Munger is my most popular book of the seven books I have written because he is famous and interesting. Readers are not as likely to want to dig into some of the more technical aspects of an issue like how to run a compensation committee as a company board member than they are to read a story about a famous person dealing with a hard compensation issue as a board member. One close friend of mine likes to remind me: “don’t tell people how to do something, show them with a story.” Are there people who want to learn more technical material and don’t need to hear it in a story format? Sure. But that approach is not a mass market.

If you ever do write a book, especially one that is technical, do it for yourself and/or because you love to help other people learn more. Selling a book is hard work (my post about that process is at the previous link) and few people do it well. Writing for me is relatively easy. Getting people to read what you write is hard. Few people will read this blog post, but writing it was enjoyable.

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