AI transcript
The content here is for informational purposes only, should not be taken as legal business
tax or investment advice or be used to evaluate any investment or security and is not directed
at any investors or potential investors in any A16Z fund.
For more details, please see A16Z.com/disclosures.
I’m Frank Chen.
Today I’m here with Scott Cooper and we are now in part three of three of our de-mystifying
Silicon Valley.
This part is all about living with your investor.
As Scott will point out, the average length of time that you will work with a venture
investor, 8, 10, 12 years, is longer than the average marriage, terrifying statistic.
And so you want to make sure that you understand how to work and pick with an investor that
you can live with over a long period of time.
And so we’re going to talk about ways that you can think about getting the most out of
your venture investor and board member and how to handle situations from the bad situations
where you have to wind down the company to the awesome situations where we hope you find
yourself, which is you’re doing an IPO for your company.
So let’s dig right into it.
Let’s talk a little bit about, fundamentally, what do I want from my investor?
And usually they’ll live basically as my board member.
Yeah.
Right?
Like what are the big things I’m looking for?
Yeah.
So look, I think, you know, certainly you want a board member and all the things that a board
member entails, which is hopefully they are a good coach, a good mentor, a good sounding
board for you, hopefully they’re good stewards of corporate governance and help you kind of
think through important strategic decisions for the company.
But then I think more importantly, you know, and this extends beyond often just the general
partner who’s sitting on your board, you want some value from them that allows you to help
you accelerate the growth of the business.
I mean, ultimately, you and the venture capitalists are along for the same ride, which is you’re
both trying to achieve an outcome that yields a very important, longstanding, hopefully independent
and publicly traded company.
And so, you know, whatever the venture capitalists can do to help you with that, whether it’s
making customer introductions or helping you understand, you know, how and when to add
a CFO or a head of sales or, you know, how best to kind of navigate, you know, the PR
and marketing world and who are the right press relationships to have.
All those things are, I think, fair game where, you know, kind of good VCs find ways in which
they can be valuable to entrepreneurs in that regard.
So one of the jobs of the board is that they can fire me as the CEO.
Yes.
Okay.
So now I’ve got this weird incentive, which is on the one hand, I want that partnership.
Yeah.
I want to get great advice.
And on the other hand, like if I share too much or like I, you know, too open about my
vulnerabilities or my shortcomings, like I could get fired.
And so how should I think about transparency, trust?
Exactly right.
It’s a little bit like the relationship, you know, probably your youngest has with you
as a parent, right?
Which is okay.
I want to be truthful.
Right.
I want to tell them what I’ve wrong, but I know there’s consequences for doing that, right?
So yeah, look, I think, so you’re absolutely right, which is, look, the fundamental power
the board does, of course, is to be able to hire a private CEO.
Now we talked about this in a different session.
It’s also changing these days, which is often the boards are not controlled by the venture
capitalist, but controlled by the CEO and, you know, kind of, you know, other common shareholders,
in which case the board really can’t, you know, the venture capitalist can’t, you don’t
really do anything.
They would have to actually really generate consensus with a much broader set of folks.
So I think some of those risks of kind of, you know, a VC being, you know, kind of random
or, you know, kind of, you know, not thinking through these things and, you know, and doing
that is much, that risk is much lessened today.
Technically they can’t out-vote me.
That’s exactly right.
Right.
They would have to kind of, you know, co-opt other members of your kind of, you know, constituents
to do so.
But that notwithstanding, I think even in the scenario where that’s not the case, I think
you’re right.
In some cases, look, you have to, you still have to build a relationship, though, where,
you know, you are willing to share enough information to, you know, to kind of, you know, get their
advice and get their help.
Yeah, in some cases, maybe that means you’re vulnerable, but I think in most cases, I think
most VCs would say, hey, look, if there’s, if you can tell us stuff and we can help you
fix it and help you address it, then, you know, there’s no reason, it doesn’t necessarily
mean that every time you do something wrong, you know, you get punished and you basically
find yourself out of a job.
So I think most people are pretty rational about this, but you’re right.
There is this kind of strange dichotomy of kind of, you know, having somebody who’s also
your boss essentially be your consigliary as well.
And then sort of as I build the company, I’m going to basically grow the board from, you
know, people who invest in money, right?
So I have a Series A investor who takes a board seat, then the B investor takes a board
seat.
So now I’ve got like a whole cat herding exercise to go through.
And there are situations in which the economic interest of my investors, A’s and B’s and
C’s, can diverge.
Absolutely.
Like I might get into a situation where somebody’s heading into a fundraise.
They need a liquidity event.
Yeah, yeah, yeah.
They need to put up some dollars and so like now they’re pressuring me to sell the company.
Yeah, yeah, yeah.
Right?
Whereas the A and B investors might be like, no, no, no, we’re like, let’s go for a bigger
outcome.
Yeah.
So how do I manage these situations?
Those are tough issues in managing, I think, again, as a CEO, it’s really important for
you to kind of understand exactly what those incentives are.
And you mentioned it, hey, maybe I, as the VC, need to go fundraise a new fund and so
I need to show my LPs that I’m smart and I’m making some money and we get an acquisition
offer for your company.
And for me, it’s a good outcome, but maybe it’s not a good outcome for you and others.
Now the good news is, as a board member, you are a fiduciary to those shareholders.
And so you do have legal constraints on your ability to be completely self-serving.
But still, even within that, you have to think about it.
And so this is, you know, oftentimes you’ll see, you may have heard of this term called
a waterfall analysis, which is oftentimes it’s a mechanism by which often the lawyers
will do it for you for the company and they’ll say, hey, look, if you sell the company at
this price, here’s what the A people will get, here’s what the B people get, here’s what
you and your employees get.
And it’s good in those situations to look at that because that will help you understand
if you do have this kind of divergence of interest among folks.
You know, again, I think, as with all things, look, the best thing you can do is hopefully
you’ve stacked your board with good people who are rational and who respect things like
fiduciary duties.
And you can have a meaningful conversation around that.
Yeah.
In theory, the board is supposed to be exercising duty of care.
In theory, they’re not supposed to put their own interests ahead of all of the, but there
are situations where you will get this sort of self-serving behavior.
Yeah, well, you kind of find this weird situation and is often times when company, we talked
about liquidation preference in one of our prior sessions, where a company is getting
sold for at or around the liquidation preference.
This is where you tend to kind of get these issues that come up, right?
Because the VCs are, you know, if they’ve got $30 million of liquidation preference,
they’re probably indifferent between a $30 million sale and a $35 million sale and a
$40 million sale because, you know, I’m just making up these numbers.
But let’s assume in those cases, they’re still going to get the same amount of their
liquidation preference because the price isn’t high enough to actually cause them to convert
and take their normal equity ownership.
And so you do get these weird scenarios.
Now, again, as I said, the good news is most of the time, you know, people still act rationally.
There are a couple cases, though, that we’ve seen where the courts have kind of said, “Hey,
we don’t like the behavior we’re seeing from the VCs because you kind of didn’t take
care of the common shareholders, which is really your main job here.”
And so, you know, I don’t want to put everybody to sleep on this webcast here, but, you know,
there’s a whole chapter on this in the book which kind of helps you understand how we
got there.
And then, importantly, what are the kinds of things that you can do to make sure that
you don’t run afoul of those problems?
So the take home message for me as the startup CEO is like, “I need to understand all of
the incentives and the timeframes of the people who are on my board so I can try to understand
why are you saying what you’re saying?”
That’s exactly right.
Yeah, and look, it goes, again, you know, it goes back to, you know, where we started
the conversation.
Our first session when we started talking was, you know, incentives drive behavior for
better or worse.
Right?
You know, you know, we, again, you and I spent time in the enterprise world where, look,
if you want to change the way you sell your product, the best thing to do is change the
quota structure for your sales reps, right?
And that’s not, you know, a denigrating statement.
It’s just the way that, look, incentives may have a matter and people respond to incentives.
And just like that, you know, venture capitalists are people, too.
And so, they respond to the incentive structure they have, and the more you understand that,
the more I think you can finally cut through and actually have a rational dialogue.
Great.
Now, I want to do some sort of play acting with you on three scenarios.
So scenario one is things aren’t going well, we’re going to have to do something tough
like raise a down round or a bridge, and then a scenario where, hey, yeah, we’re getting
acquired and, you know, we’re going to clear the liquidation preferences.
It’s going to be happy.
Yeah.
And then the super happy scenario where we’re going public.
All right.
So let’s, advice for each one of those.
All right.
Tough times.
Yeah.
It’s not going the way I expect.
I have to raise a bridge.
Yeah.
Maybe I have to raise a down round.
How should I think about this?
Yeah.
This is hard.
I talk about this in the book a lot, but I’d say the most important thing I think to think
about here is, and this is where I do think having good relationship with your VC is critically
important, is having a real open, honest discussion, right?
So sometimes, unfortunately, despite your best efforts and, you know, despite our best
efforts, hopefully to be supportive of you, maybe the market’s just not there or the product’s
not taking, you know, for whatever reason, you know, look, you gave it 110% and it’s
just not there.
And, you know, it’s interesting when I’ve had those conversations with entrepreneurs,
I was kind of, I was, you know, dreading going into that conversation because I was worried
that, you know, it was going to be a contentious discussion.
And more times than not, they actually come out and they say, you know what, I’m kind
of relieved because I was thinking the same thing you were, which is I was doing this
because I thought my job to you as the VC was to just run through walls no matter what.
And honestly, I don’t know that spending another three, four years doing this is likely to yield
a better outcome.
It doesn’t always happen that way, but more often than not, I’d say that happens.
And so I think in those cases, look, it’s perfectly respectable to say, hey, look, we
all gave it our best and it didn’t work.
And the right thing to do is let’s wind it down in a reasonable fashion so that we can
hopefully, you know, take care of our employees and take care of our vendors and do all the
things we can.
If you still feel like, you know, the alternative is true, which is, hey, yes, maybe we got
the product wrong or maybe the market’s developed more slowly, but you know what, like, I’m committed
as an entrepreneur and I really believe this market is still here in the survival business.
Then, you know, kind of, I talked about this in the book, but things like what you call
like a recapitalization, which is kind of almost a reset, right?
Which is we say, hey, look, we raised a bunch of money, we spent it, it didn’t yield what
we want, but we’re all still believing this thing and I want to go spend the next 10 years
of my life trying to do this.
Then let’s set the company up for success, right?
And it’s unpleasant, the word recap is obviously has such a negative connotation, but in that
respect, it’s actually a positive thing, which is we’re going to figure out, okay, how do
we kind of make the company attractive for potentially new investors to come back in
by cleaning up some of these things like liquidation preference we’ve talked about, resetting the
price to a point that actually reflects the progress of the business.
But importantly, and this is where I think entrepreneurs need to make sure they’re aligned
with their VCs, for you as an entrepreneur and your employees to also make sure that
you get reset as well, right?
So there’s no sense in any of us putting more money in the company if it turns out all of
your stock options are underwater and you’ve got no financial incentive and then tomorrow
everybody’s going to walk away from the business, right?
So this requires kind of give and take on both sides, which is, you know, the VCs will
give up a lot of the rights that they otherwise had.
But importantly, the give that the VCs, you know, need to do to make this successful is
to kind of re-insent the team as well and make sure that you all are, you know, shooting
for the same ultimate outcome.
So there’s a lot of emotional freedom, just sort of listening to you talk, right?
Because even if we have to wind it down, we can have the conversation and then realizing
that like half your portfolio is going to go belly up anyway, right?
I don’t have to feel like, oh my god, I’m like the world’s biggest failure, right?
Which is like you’re kind of expecting this.
I think that’s right.
Yeah.
But it’s, you know, it’s more, obviously look, it’s more emotional and more personal
for you as the entrepreneur, of course, right?
Because you’ve, you know, this has been your life’s dream.
But you’re right.
So you shouldn’t feel sorry for the VCs, right?
And I certainly never, would never suggest that you should feel sorry for the VCs because
you’re right.
We expect that that kind of risk is what’s inherent to the business.
The more important question is really, do you still believe in the market?
Do you still want to pursue this or also do you feel like, hey, it was a good idea, but
just for a variety of reasons, didn’t materialize in the way we thought and the more rational
thing to do is go do something else?
Got it.
Great.
Let’s move on to scenario two.
Right.
So we’re getting an acquired and an attractive price, yay, it’s not quite an IPO, but it’s
not a wind-down.
Yeah.
It’s not a recap.
So what are things that are important to think about as we’re going through this process?
So maybe let’s start with sort of how, you know, how are we getting value?
Is it cash or private stock or public stock?
Yeah.
Yeah.
So there’s lots of things to think about, right?
One is you’re right, which is look, what’s the economic interest we’re getting here?
And, you know, sometimes, as you said, that could be you might be getting paid in cash,
sometimes you might get stock of the other acquirer.
And so depending on the scenario, right, you may want to do some homework if you’re getting
stock to understand what do I think about that stock, what do I think about the prospects
of that company, because your economic future is now going to be tied to the success of
that business as well.
I think the most important thing, though, to think about, obviously price is important,
so I don’t want to belittle that.
But the next most important thing to think about is what is the go-forward business going
to look like, right?
Are you being acquired because they really love your product and love your vision and
now you’re going to go be the general manager of some new unit in the company and have the
ability to affect the vision that you had hoped you would affect as a standalone company,
but now inside of a bigger, you know, better resource, better capitalized company?
That’s wonderful.
Obviously if you’re signed up to do that and your employees are signed up for that, or
are they saying, hey, you know what, we really like those engineers, but all these sales guys,
all these product guys, you know, we don’t need them.
And so like we’re going to, you know, incent the engineers to stick around, but quite frankly,
we want you to lay off everybody else before you kind of, you know, come over.
So those are, I think those are the most important things, which is kind of, you know, what is
going to happen to the employees?
What does the go-forward business look like?
And you know, again, I know we all get excited and we like to talk about the price because
of course it’s a lot more fun and sexy to talk about money, but it’s, I think, I think,
you know, managers and CEOs make their reputations quite frankly in these types of situations
where, you know, they are thinking first and foremost about kind of the prospects for their
employees and their team members, you know, kind of, you know, not secondary to the actual,
you know, value of the company, right?
So who’s getting a job?
Who’s not getting a job?
That’s right.
What are the terms of the stock options?
That’s exactly right.
What’s the financial incentive look like, right?
Are they going to give you new stock options in the new company or are they just going
to take the ones you had and move them over?
Sometimes people do what are called retention bonuses, right, where they say, hey, you know
what, like, for the first two or three years of the deal on each of the one-year anniversaries
of the deal, if you’re still here, we’re going to give you maybe a cash bonus or we’re going
to give you a stock bonus.
So all those things that kind of allow you to kind of get a better sense of what is that
go-forward structure going to look like and is that something that you as a CEO believe
you can sell to your employees to say, hey, look, you know, we gave it a shot, we did well,
and now here’s an opportunity for you to both enjoy financial reward as well as feel like
you’re enjoying the reward of being in a bigger company and having access to more resources.
I hear that sometimes in these cases and also with the recaps or the down rounds, there
are these things called management carve-outs.
Yes.
What are they?
Yes.
Should I be looking for one?
Is that a good thing, a bad thing?
Yeah, sometimes you’ll see, yeah, management carve-out, management buyout, MBO sometimes
is what they’re called.
Yeah, so the basic idea is typically sometimes what happens is, and it goes back a little
bit to this liquidation preference discussion we’re having, is the company might be doing
well, but there may be so much money invested in the company that even in a nice acquisition,
a lot of that money ends up going towards people like me, the VCs, as opposed to you
and the people who are going to actually go have to run this business now.
And so oftentimes what the VCs will do is say, “Hey look, we want to incent you to kind
of be motivated to try to find a buyer for this business if we all agree that that’s
the right outcome for the company.”
And so essentially the VCs will say, “Look, let’s carve out some of the money that might
have otherwise gone to the VCs or in some cases other common shareholders and make a
pool that effectively becomes a bonus pool for the executives and/or the people who are
responsible for the acquisition.”
And that’s a perfectly fair and reasonable thing to do.
We do it, you know, in many cases in that scenario.
And then in addition, on top of that, sometimes the acquire themselves will also put an additional
incentive pool in place and say, “Okay, as we talked about post the acquisition, maybe
on the first and second and third year anniversaries or something, we will also contribute to a
pool that will inset longer term retention for people.”
Got it.
So the management carve out pre the transaction is about, “Look, this is the way the waterfall
would have worked.”
That’s right.
And that’s the portion of it and basically giving it a choice.
That’s exactly right.
Yeah.
So think of the just time periods, right?
Which is kind of, you know, let’s reallocate some of the dollars to the existing shareholders,
you know, and then post and post, you know, acquisition as we talked about.
It’s just an incentive structure to kind of create a long-term, it’s like new options.
That’s exactly right.
Yeah.
Got it.
Good.
Well, let’s talk about the happy scenario.
We’re going public.
All right.
We don’t want to end on a depressing note.
Yeah, of course.
Exactly.
Here we go.
This is what Silicon Valley does, is create IPOs.
So maybe talk a little bit about picking an investment bank and what are some of the incentives
they have.
Yeah.
And they bring the bear.
And are they always aligned with my existing investors or can they be?
Yeah.
Yeah.
Sort of differently.
Yeah.
The investment banks, you know, you’ve heard of these names, Goldman Sachs, JP Morgan, Morgan
Stanley.
You know, their main job is to kind of, you know, help you prepare for the IPO and make
sure all the documentation of things ready.
And then to basically kind of shepherd you through the process by introducing you to
all the relevant institutional investors who will hopefully go on to kind of, you know,
be the long-term shareholders for your business.
And so, you know, they do that.
They’re professionals.
They do this all the time.
So, you know, you certainly generally don’t go through that process without an investment
banker.
Where the conflicts potentially come up is, you know, they’ve got kind of two clients,
right, which is you’re their client for this transaction, but, you know, a firm like Fidelity
or T-Row Price or BlackRock, who is a institutional investor who buys, shares all the time in lots
of IPOs and also trades, shares through the desks that the firms have.
They’re also a client of the bank, right?
And so, there’s this tension.
You see this in the pricing for when IPOs are priced, where your incentive as the entrepreneur
is I want the price to be as high as possible because that means I raise more money for
less dilution, right?
But I don’t want to be too high where obviously the stock trades, you know, kind of poorly
the next day.
And, you know, the financial investor has the opposite incentive, of course, which is
I’d like to buy it as cheap as possible so that I have the maximum amount of upside in
the stock.
And so, this is where I think sometimes, you know, sometimes fairly and sometimes unfairly
I think that bankers, you know, are accused of potentially kind of favoring the institutional
investors because they are the repeat players for the business at the expense sometimes of
the company.
Having done this once, you know, I was a banker, you know, earlier in my career and having
seen the process, I, you know, there’s always some, you know, I think true to that, but
I think more likely these are just more art than science, quite frankly, and it’s really
hard to know based on the demand signals that they get exactly where to price the stock.
And so, you know, sometimes they get it right, sometimes they don’t, I think it’s probably
a little bit unfair to assume that there’s all kind of nefarious, you know, activity
at work here.
And what do I want to get out of my board in this situation?
Are they basically sort of at this point not that important?
Yeah, the board really starts to shift as you go public from being kind of, you know,
more active and probably more, you know, in some cases, more valuable in the business
to more of, quite frankly, a governance and a legal board in that sense, right, which is
making sure that the process is good, making sure that you’re doing your audit committee
and all the other things.
So it’s not that boards are irrelevant as a public company, but I would say the nature
of where boards spend their time starts to shift towards more compliance related activities
versus kind of, you know, potentially forward business looking activities.
Great.
Fantastic.
Well, Scott, thank you for spending so much time demystifying this entire process.
I appreciate it and I hope this is helpful and I hope people will find, you know, they
can go buy the book and, you know, dig deeper into a lot of these topics.
Yes, there’s one big takeaway from having written the book and then been on the circuit
promoting it.
Like, what’s the big takeaway you would want entrepreneurs to take?
Yeah, look, I think the biggest thing, and we hit on a lot of this, is, you know, look,
understand, you know, who your partner is, as I mentioned, you know, somewhat facetiously,
but it’s true, you know, these are marriages, right?
You’re going to be with these companies for eight, 10, 12 years.
And so, you know, I don’t want to over strain the analogy, but the concept of dating and
understanding them really is relevant here, which is, you know, you wouldn’t get married
without really understanding your spouse and who they are and what makes them tick.
And I think in many respects, that is the equivalent of the dating process in the venture capital
game is know what their incentives are, know what they’re interested in, and, you know,
make sure you’re aligned.
Great.
All right, congratulations.
You’ve made it to the very end of part three of our three-part series with Scott Cooper.
Hopefully, you’ve got a really good sense of what goes on inside our heads when you meet
with us because you understand what our incentives are, how we work, and how we’re trying to help
you build a big, great, durable software business.
We hope that this encourages you to continue your entrepreneurial journey, that it demystifies
part of the process.
Look, we’re in this together.
Entrepreneurs and investors are here to change the world together.
And yeah, there’s going to be tension on the line.
There’s going to be times when we disagree.
But fundamentally, we need to be about being side by side entrepreneur and investor because
that’s the way that we get to change the world.
So, we encourage you on your entrepreneurial journey.
And if you’ve got a company that you’re building that seems like a good fit for the types of
investments we make, the house is open, and we’d love to meet.
[BLANK_AUDIO]
tax or investment advice or be used to evaluate any investment or security and is not directed
at any investors or potential investors in any A16Z fund.
For more details, please see A16Z.com/disclosures.
I’m Frank Chen.
Today I’m here with Scott Cooper and we are now in part three of three of our de-mystifying
Silicon Valley.
This part is all about living with your investor.
As Scott will point out, the average length of time that you will work with a venture
investor, 8, 10, 12 years, is longer than the average marriage, terrifying statistic.
And so you want to make sure that you understand how to work and pick with an investor that
you can live with over a long period of time.
And so we’re going to talk about ways that you can think about getting the most out of
your venture investor and board member and how to handle situations from the bad situations
where you have to wind down the company to the awesome situations where we hope you find
yourself, which is you’re doing an IPO for your company.
So let’s dig right into it.
Let’s talk a little bit about, fundamentally, what do I want from my investor?
And usually they’ll live basically as my board member.
Yeah.
Right?
Like what are the big things I’m looking for?
Yeah.
So look, I think, you know, certainly you want a board member and all the things that a board
member entails, which is hopefully they are a good coach, a good mentor, a good sounding
board for you, hopefully they’re good stewards of corporate governance and help you kind of
think through important strategic decisions for the company.
But then I think more importantly, you know, and this extends beyond often just the general
partner who’s sitting on your board, you want some value from them that allows you to help
you accelerate the growth of the business.
I mean, ultimately, you and the venture capitalists are along for the same ride, which is you’re
both trying to achieve an outcome that yields a very important, longstanding, hopefully independent
and publicly traded company.
And so, you know, whatever the venture capitalists can do to help you with that, whether it’s
making customer introductions or helping you understand, you know, how and when to add
a CFO or a head of sales or, you know, how best to kind of navigate, you know, the PR
and marketing world and who are the right press relationships to have.
All those things are, I think, fair game where, you know, kind of good VCs find ways in which
they can be valuable to entrepreneurs in that regard.
So one of the jobs of the board is that they can fire me as the CEO.
Yes.
Okay.
So now I’ve got this weird incentive, which is on the one hand, I want that partnership.
Yeah.
I want to get great advice.
And on the other hand, like if I share too much or like I, you know, too open about my
vulnerabilities or my shortcomings, like I could get fired.
And so how should I think about transparency, trust?
Exactly right.
It’s a little bit like the relationship, you know, probably your youngest has with you
as a parent, right?
Which is okay.
I want to be truthful.
Right.
I want to tell them what I’ve wrong, but I know there’s consequences for doing that, right?
So yeah, look, I think, so you’re absolutely right, which is, look, the fundamental power
the board does, of course, is to be able to hire a private CEO.
Now we talked about this in a different session.
It’s also changing these days, which is often the boards are not controlled by the venture
capitalist, but controlled by the CEO and, you know, kind of, you know, other common shareholders,
in which case the board really can’t, you know, the venture capitalist can’t, you don’t
really do anything.
They would have to actually really generate consensus with a much broader set of folks.
So I think some of those risks of kind of, you know, a VC being, you know, kind of random
or, you know, kind of, you know, not thinking through these things and, you know, and doing
that is much, that risk is much lessened today.
Technically they can’t out-vote me.
That’s exactly right.
Right.
They would have to kind of, you know, co-opt other members of your kind of, you know, constituents
to do so.
But that notwithstanding, I think even in the scenario where that’s not the case, I think
you’re right.
In some cases, look, you have to, you still have to build a relationship, though, where,
you know, you are willing to share enough information to, you know, to kind of, you know, get their
advice and get their help.
Yeah, in some cases, maybe that means you’re vulnerable, but I think in most cases, I think
most VCs would say, hey, look, if there’s, if you can tell us stuff and we can help you
fix it and help you address it, then, you know, there’s no reason, it doesn’t necessarily
mean that every time you do something wrong, you know, you get punished and you basically
find yourself out of a job.
So I think most people are pretty rational about this, but you’re right.
There is this kind of strange dichotomy of kind of, you know, having somebody who’s also
your boss essentially be your consigliary as well.
And then sort of as I build the company, I’m going to basically grow the board from, you
know, people who invest in money, right?
So I have a Series A investor who takes a board seat, then the B investor takes a board
seat.
So now I’ve got like a whole cat herding exercise to go through.
And there are situations in which the economic interest of my investors, A’s and B’s and
C’s, can diverge.
Absolutely.
Like I might get into a situation where somebody’s heading into a fundraise.
They need a liquidity event.
Yeah, yeah, yeah.
They need to put up some dollars and so like now they’re pressuring me to sell the company.
Yeah, yeah, yeah.
Right?
Whereas the A and B investors might be like, no, no, no, we’re like, let’s go for a bigger
outcome.
Yeah.
So how do I manage these situations?
Those are tough issues in managing, I think, again, as a CEO, it’s really important for
you to kind of understand exactly what those incentives are.
And you mentioned it, hey, maybe I, as the VC, need to go fundraise a new fund and so
I need to show my LPs that I’m smart and I’m making some money and we get an acquisition
offer for your company.
And for me, it’s a good outcome, but maybe it’s not a good outcome for you and others.
Now the good news is, as a board member, you are a fiduciary to those shareholders.
And so you do have legal constraints on your ability to be completely self-serving.
But still, even within that, you have to think about it.
And so this is, you know, oftentimes you’ll see, you may have heard of this term called
a waterfall analysis, which is oftentimes it’s a mechanism by which often the lawyers
will do it for you for the company and they’ll say, hey, look, if you sell the company at
this price, here’s what the A people will get, here’s what the B people get, here’s what
you and your employees get.
And it’s good in those situations to look at that because that will help you understand
if you do have this kind of divergence of interest among folks.
You know, again, I think, as with all things, look, the best thing you can do is hopefully
you’ve stacked your board with good people who are rational and who respect things like
fiduciary duties.
And you can have a meaningful conversation around that.
Yeah.
In theory, the board is supposed to be exercising duty of care.
In theory, they’re not supposed to put their own interests ahead of all of the, but there
are situations where you will get this sort of self-serving behavior.
Yeah, well, you kind of find this weird situation and is often times when company, we talked
about liquidation preference in one of our prior sessions, where a company is getting
sold for at or around the liquidation preference.
This is where you tend to kind of get these issues that come up, right?
Because the VCs are, you know, if they’ve got $30 million of liquidation preference,
they’re probably indifferent between a $30 million sale and a $35 million sale and a
$40 million sale because, you know, I’m just making up these numbers.
But let’s assume in those cases, they’re still going to get the same amount of their
liquidation preference because the price isn’t high enough to actually cause them to convert
and take their normal equity ownership.
And so you do get these weird scenarios.
Now, again, as I said, the good news is most of the time, you know, people still act rationally.
There are a couple cases, though, that we’ve seen where the courts have kind of said, “Hey,
we don’t like the behavior we’re seeing from the VCs because you kind of didn’t take
care of the common shareholders, which is really your main job here.”
And so, you know, I don’t want to put everybody to sleep on this webcast here, but, you know,
there’s a whole chapter on this in the book which kind of helps you understand how we
got there.
And then, importantly, what are the kinds of things that you can do to make sure that
you don’t run afoul of those problems?
So the take home message for me as the startup CEO is like, “I need to understand all of
the incentives and the timeframes of the people who are on my board so I can try to understand
why are you saying what you’re saying?”
That’s exactly right.
Yeah, and look, it goes, again, you know, it goes back to, you know, where we started
the conversation.
Our first session when we started talking was, you know, incentives drive behavior for
better or worse.
Right?
You know, you know, we, again, you and I spent time in the enterprise world where, look,
if you want to change the way you sell your product, the best thing to do is change the
quota structure for your sales reps, right?
And that’s not, you know, a denigrating statement.
It’s just the way that, look, incentives may have a matter and people respond to incentives.
And just like that, you know, venture capitalists are people, too.
And so, they respond to the incentive structure they have, and the more you understand that,
the more I think you can finally cut through and actually have a rational dialogue.
Great.
Now, I want to do some sort of play acting with you on three scenarios.
So scenario one is things aren’t going well, we’re going to have to do something tough
like raise a down round or a bridge, and then a scenario where, hey, yeah, we’re getting
acquired and, you know, we’re going to clear the liquidation preferences.
It’s going to be happy.
Yeah.
And then the super happy scenario where we’re going public.
All right.
So let’s, advice for each one of those.
All right.
Tough times.
Yeah.
It’s not going the way I expect.
I have to raise a bridge.
Yeah.
Maybe I have to raise a down round.
How should I think about this?
Yeah.
This is hard.
I talk about this in the book a lot, but I’d say the most important thing I think to think
about here is, and this is where I do think having good relationship with your VC is critically
important, is having a real open, honest discussion, right?
So sometimes, unfortunately, despite your best efforts and, you know, despite our best
efforts, hopefully to be supportive of you, maybe the market’s just not there or the product’s
not taking, you know, for whatever reason, you know, look, you gave it 110% and it’s
just not there.
And, you know, it’s interesting when I’ve had those conversations with entrepreneurs,
I was kind of, I was, you know, dreading going into that conversation because I was worried
that, you know, it was going to be a contentious discussion.
And more times than not, they actually come out and they say, you know what, I’m kind
of relieved because I was thinking the same thing you were, which is I was doing this
because I thought my job to you as the VC was to just run through walls no matter what.
And honestly, I don’t know that spending another three, four years doing this is likely to yield
a better outcome.
It doesn’t always happen that way, but more often than not, I’d say that happens.
And so I think in those cases, look, it’s perfectly respectable to say, hey, look, we
all gave it our best and it didn’t work.
And the right thing to do is let’s wind it down in a reasonable fashion so that we can
hopefully, you know, take care of our employees and take care of our vendors and do all the
things we can.
If you still feel like, you know, the alternative is true, which is, hey, yes, maybe we got
the product wrong or maybe the market’s developed more slowly, but you know what, like, I’m committed
as an entrepreneur and I really believe this market is still here in the survival business.
Then, you know, kind of, I talked about this in the book, but things like what you call
like a recapitalization, which is kind of almost a reset, right?
Which is we say, hey, look, we raised a bunch of money, we spent it, it didn’t yield what
we want, but we’re all still believing this thing and I want to go spend the next 10 years
of my life trying to do this.
Then let’s set the company up for success, right?
And it’s unpleasant, the word recap is obviously has such a negative connotation, but in that
respect, it’s actually a positive thing, which is we’re going to figure out, okay, how do
we kind of make the company attractive for potentially new investors to come back in
by cleaning up some of these things like liquidation preference we’ve talked about, resetting the
price to a point that actually reflects the progress of the business.
But importantly, and this is where I think entrepreneurs need to make sure they’re aligned
with their VCs, for you as an entrepreneur and your employees to also make sure that
you get reset as well, right?
So there’s no sense in any of us putting more money in the company if it turns out all of
your stock options are underwater and you’ve got no financial incentive and then tomorrow
everybody’s going to walk away from the business, right?
So this requires kind of give and take on both sides, which is, you know, the VCs will
give up a lot of the rights that they otherwise had.
But importantly, the give that the VCs, you know, need to do to make this successful is
to kind of re-insent the team as well and make sure that you all are, you know, shooting
for the same ultimate outcome.
So there’s a lot of emotional freedom, just sort of listening to you talk, right?
Because even if we have to wind it down, we can have the conversation and then realizing
that like half your portfolio is going to go belly up anyway, right?
I don’t have to feel like, oh my god, I’m like the world’s biggest failure, right?
Which is like you’re kind of expecting this.
I think that’s right.
Yeah.
But it’s, you know, it’s more, obviously look, it’s more emotional and more personal
for you as the entrepreneur, of course, right?
Because you’ve, you know, this has been your life’s dream.
But you’re right.
So you shouldn’t feel sorry for the VCs, right?
And I certainly never, would never suggest that you should feel sorry for the VCs because
you’re right.
We expect that that kind of risk is what’s inherent to the business.
The more important question is really, do you still believe in the market?
Do you still want to pursue this or also do you feel like, hey, it was a good idea, but
just for a variety of reasons, didn’t materialize in the way we thought and the more rational
thing to do is go do something else?
Got it.
Great.
Let’s move on to scenario two.
Right.
So we’re getting an acquired and an attractive price, yay, it’s not quite an IPO, but it’s
not a wind-down.
Yeah.
It’s not a recap.
So what are things that are important to think about as we’re going through this process?
So maybe let’s start with sort of how, you know, how are we getting value?
Is it cash or private stock or public stock?
Yeah.
Yeah.
So there’s lots of things to think about, right?
One is you’re right, which is look, what’s the economic interest we’re getting here?
And, you know, sometimes, as you said, that could be you might be getting paid in cash,
sometimes you might get stock of the other acquirer.
And so depending on the scenario, right, you may want to do some homework if you’re getting
stock to understand what do I think about that stock, what do I think about the prospects
of that company, because your economic future is now going to be tied to the success of
that business as well.
I think the most important thing, though, to think about, obviously price is important,
so I don’t want to belittle that.
But the next most important thing to think about is what is the go-forward business going
to look like, right?
Are you being acquired because they really love your product and love your vision and
now you’re going to go be the general manager of some new unit in the company and have the
ability to affect the vision that you had hoped you would affect as a standalone company,
but now inside of a bigger, you know, better resource, better capitalized company?
That’s wonderful.
Obviously if you’re signed up to do that and your employees are signed up for that, or
are they saying, hey, you know what, we really like those engineers, but all these sales guys,
all these product guys, you know, we don’t need them.
And so like we’re going to, you know, incent the engineers to stick around, but quite frankly,
we want you to lay off everybody else before you kind of, you know, come over.
So those are, I think those are the most important things, which is kind of, you know, what is
going to happen to the employees?
What does the go-forward business look like?
And you know, again, I know we all get excited and we like to talk about the price because
of course it’s a lot more fun and sexy to talk about money, but it’s, I think, I think,
you know, managers and CEOs make their reputations quite frankly in these types of situations
where, you know, they are thinking first and foremost about kind of the prospects for their
employees and their team members, you know, kind of, you know, not secondary to the actual,
you know, value of the company, right?
So who’s getting a job?
Who’s not getting a job?
That’s right.
What are the terms of the stock options?
That’s exactly right.
What’s the financial incentive look like, right?
Are they going to give you new stock options in the new company or are they just going
to take the ones you had and move them over?
Sometimes people do what are called retention bonuses, right, where they say, hey, you know
what, like, for the first two or three years of the deal on each of the one-year anniversaries
of the deal, if you’re still here, we’re going to give you maybe a cash bonus or we’re going
to give you a stock bonus.
So all those things that kind of allow you to kind of get a better sense of what is that
go-forward structure going to look like and is that something that you as a CEO believe
you can sell to your employees to say, hey, look, you know, we gave it a shot, we did well,
and now here’s an opportunity for you to both enjoy financial reward as well as feel like
you’re enjoying the reward of being in a bigger company and having access to more resources.
I hear that sometimes in these cases and also with the recaps or the down rounds, there
are these things called management carve-outs.
Yes.
What are they?
Yes.
Should I be looking for one?
Is that a good thing, a bad thing?
Yeah, sometimes you’ll see, yeah, management carve-out, management buyout, MBO sometimes
is what they’re called.
Yeah, so the basic idea is typically sometimes what happens is, and it goes back a little
bit to this liquidation preference discussion we’re having, is the company might be doing
well, but there may be so much money invested in the company that even in a nice acquisition,
a lot of that money ends up going towards people like me, the VCs, as opposed to you
and the people who are going to actually go have to run this business now.
And so oftentimes what the VCs will do is say, “Hey look, we want to incent you to kind
of be motivated to try to find a buyer for this business if we all agree that that’s
the right outcome for the company.”
And so essentially the VCs will say, “Look, let’s carve out some of the money that might
have otherwise gone to the VCs or in some cases other common shareholders and make a
pool that effectively becomes a bonus pool for the executives and/or the people who are
responsible for the acquisition.”
And that’s a perfectly fair and reasonable thing to do.
We do it, you know, in many cases in that scenario.
And then in addition, on top of that, sometimes the acquire themselves will also put an additional
incentive pool in place and say, “Okay, as we talked about post the acquisition, maybe
on the first and second and third year anniversaries or something, we will also contribute to a
pool that will inset longer term retention for people.”
Got it.
So the management carve out pre the transaction is about, “Look, this is the way the waterfall
would have worked.”
That’s right.
And that’s the portion of it and basically giving it a choice.
That’s exactly right.
Yeah.
So think of the just time periods, right?
Which is kind of, you know, let’s reallocate some of the dollars to the existing shareholders,
you know, and then post and post, you know, acquisition as we talked about.
It’s just an incentive structure to kind of create a long-term, it’s like new options.
That’s exactly right.
Yeah.
Got it.
Good.
Well, let’s talk about the happy scenario.
We’re going public.
All right.
We don’t want to end on a depressing note.
Yeah, of course.
Exactly.
Here we go.
This is what Silicon Valley does, is create IPOs.
So maybe talk a little bit about picking an investment bank and what are some of the incentives
they have.
Yeah.
And they bring the bear.
And are they always aligned with my existing investors or can they be?
Yeah.
Yeah.
Sort of differently.
Yeah.
The investment banks, you know, you’ve heard of these names, Goldman Sachs, JP Morgan, Morgan
Stanley.
You know, their main job is to kind of, you know, help you prepare for the IPO and make
sure all the documentation of things ready.
And then to basically kind of shepherd you through the process by introducing you to
all the relevant institutional investors who will hopefully go on to kind of, you know,
be the long-term shareholders for your business.
And so, you know, they do that.
They’re professionals.
They do this all the time.
So, you know, you certainly generally don’t go through that process without an investment
banker.
Where the conflicts potentially come up is, you know, they’ve got kind of two clients,
right, which is you’re their client for this transaction, but, you know, a firm like Fidelity
or T-Row Price or BlackRock, who is a institutional investor who buys, shares all the time in lots
of IPOs and also trades, shares through the desks that the firms have.
They’re also a client of the bank, right?
And so, there’s this tension.
You see this in the pricing for when IPOs are priced, where your incentive as the entrepreneur
is I want the price to be as high as possible because that means I raise more money for
less dilution, right?
But I don’t want to be too high where obviously the stock trades, you know, kind of poorly
the next day.
And, you know, the financial investor has the opposite incentive, of course, which is
I’d like to buy it as cheap as possible so that I have the maximum amount of upside in
the stock.
And so, this is where I think sometimes, you know, sometimes fairly and sometimes unfairly
I think that bankers, you know, are accused of potentially kind of favoring the institutional
investors because they are the repeat players for the business at the expense sometimes of
the company.
Having done this once, you know, I was a banker, you know, earlier in my career and having
seen the process, I, you know, there’s always some, you know, I think true to that, but
I think more likely these are just more art than science, quite frankly, and it’s really
hard to know based on the demand signals that they get exactly where to price the stock.
And so, you know, sometimes they get it right, sometimes they don’t, I think it’s probably
a little bit unfair to assume that there’s all kind of nefarious, you know, activity
at work here.
And what do I want to get out of my board in this situation?
Are they basically sort of at this point not that important?
Yeah, the board really starts to shift as you go public from being kind of, you know,
more active and probably more, you know, in some cases, more valuable in the business
to more of, quite frankly, a governance and a legal board in that sense, right, which is
making sure that the process is good, making sure that you’re doing your audit committee
and all the other things.
So it’s not that boards are irrelevant as a public company, but I would say the nature
of where boards spend their time starts to shift towards more compliance related activities
versus kind of, you know, potentially forward business looking activities.
Great.
Fantastic.
Well, Scott, thank you for spending so much time demystifying this entire process.
I appreciate it and I hope this is helpful and I hope people will find, you know, they
can go buy the book and, you know, dig deeper into a lot of these topics.
Yes, there’s one big takeaway from having written the book and then been on the circuit
promoting it.
Like, what’s the big takeaway you would want entrepreneurs to take?
Yeah, look, I think the biggest thing, and we hit on a lot of this, is, you know, look,
understand, you know, who your partner is, as I mentioned, you know, somewhat facetiously,
but it’s true, you know, these are marriages, right?
You’re going to be with these companies for eight, 10, 12 years.
And so, you know, I don’t want to over strain the analogy, but the concept of dating and
understanding them really is relevant here, which is, you know, you wouldn’t get married
without really understanding your spouse and who they are and what makes them tick.
And I think in many respects, that is the equivalent of the dating process in the venture capital
game is know what their incentives are, know what they’re interested in, and, you know,
make sure you’re aligned.
Great.
All right, congratulations.
You’ve made it to the very end of part three of our three-part series with Scott Cooper.
Hopefully, you’ve got a really good sense of what goes on inside our heads when you meet
with us because you understand what our incentives are, how we work, and how we’re trying to help
you build a big, great, durable software business.
We hope that this encourages you to continue your entrepreneurial journey, that it demystifies
part of the process.
Look, we’re in this together.
Entrepreneurs and investors are here to change the world together.
And yeah, there’s going to be tension on the line.
There’s going to be times when we disagree.
But fundamentally, we need to be about being side by side entrepreneur and investor because
that’s the way that we get to change the world.
So, we encourage you on your entrepreneurial journey.
And if you’ve got a company that you’re building that seems like a good fit for the types of
investments we make, the house is open, and we’d love to meet.
[BLANK_AUDIO]
In this final of a 3-part series (which originally aired as YouTube videos) on working with venture investors, a16z Managing Partner Scott Kupor shares best practices for working with your board as it grows from just you, your co-founders and first investor all the way through the time when you are recruiting independent board members in preparation for going public.
Want to learn more? Read Scott’s book ”Secrets of Sand Hill Road: Venture Capital and How to Get It” (https://a16z.com/book/secrets-of-sand-hill-road/).
The views expressed here are those of the individual AH Capital Management, L.L.C. (“a16z”) personnel quoted and are not the views of a16z or its affiliates. Certain information contained in here has been obtained from third-party sources, including from portfolio companies of funds managed by a16z. While taken from sources believed to be reliable, a16z has not independently verified such information and makes no representations about the enduring accuracy of the information or its appropriateness for a given situation.
This content is provided for informational purposes only, and should not be relied upon as legal, business, investment, or tax advice. You should consult your own advisers as to those matters. References to any securities or digital assets are for illustrative purposes only, and do not constitute an investment recommendation or offer to provide investment advisory services. Furthermore, this content is not directed at nor intended for use by any investors or prospective investors, and may not under any circumstances be relied upon when making a decision to invest in any fund managed by a16z. (An offering to invest in an a16z fund will be made only by the private placement memorandum, subscription agreement, and other relevant documentation of any such fund and should be read in their entirety.) Any investments or portfolio companies mentioned, referred to, or described are not representative of all investments in vehicles managed by a16z, and there can be no assurance that the investments will be profitable or that other investments made in the future will have similar characteristics or results. A list of investments made by funds managed by Andreessen Horowitz (excluding investments and certain publicly traded cryptocurrencies/ digital assets for which the issuer has not provided permission for a16z to disclose publicly) is available at https://a16z.com/investments/.
Charts and graphs provided within are for informational purposes solely and should not be relied upon when making any investment decision. Past performance is not indicative of future results. The content speaks only as of the date indicated. Any projections, estimates, forecasts, targets, prospects, and/or opinions expressed in these materials are subject to change without notice and may differ or be contrary to opinions expressed by others. Please see https://a16z.com/disclosures for additional important information.
Leave a Reply