AI transcript
0:00:05 The content here is for informational purposes only, should not be taken as legal business
0:00:10 tax or investment advice or be used to evaluate any investment or security and is not directed
0:00:14 at any investors or potential investors in any A16Z fund.
0:00:19 For more details, please see A16Z.com/disclosures.
0:00:20 I’m Frank Chen.
0:00:23 Today I’m here with Scott Cooper and we’re doing a three-part series.
0:00:27 You’ve landed in part two, which is all about fundraising.
0:00:32 What we’re going to do is dig into the mechanics of how you work with a VC during the fund
0:00:36 raise process, how you interpret the terms of the term sheet, and hopefully this will
0:00:42 give you a sense of how you can actually have a meaningful dialogue with a venture capitalist.
0:00:47 We produce this video for the same reason that Scott wrote this book, which is as venture
0:00:49 investors we do this day in and day out.
0:00:54 We will see thousands of entrepreneurs will write dozens of term sheets, whereas you may
0:00:56 end up doing this once in your life.
0:01:01 And so we wanted to help you understand some of the terms and the art and the science that
0:01:02 go into fundraising.
0:01:05 All right, so let’s get right into it.
0:01:06 Why do I need to be a Delaware C-Corp?
0:01:11 Like what’s special about Delaware and what makes other entities hard to fund from a VC’s
0:01:12 point of view?
0:01:16 Yeah, so there are lots of varieties of, you know, kind of organizations of business you
0:01:17 can do.
0:01:19 There’s C-Corps, there’s things called partnerships.
0:01:24 The main reason why you do a C-Corp and why it’s in Delaware, quite frankly, is there’s
0:01:26 a lot of just legal precedent there.
0:01:29 Delaware had kind of made themselves kind of the home of businesses many, many years
0:01:30 ago.
0:01:34 And so it makes people like us and lawyers feel comfortable because we know that there’s
0:01:39 hundreds of years of, you know, kind of legal precedent that says, hey, if this thing happens,
0:01:40 this is what happens.
0:01:41 And things are fairly well settled.
0:01:45 So you could certainly go other places, but Delaware is pretty good.
0:01:46 The C-Corp does a lot of things.
0:01:49 I think the main advantage of a C-Corp is it allows you to have lots of shareholders.
0:01:53 And so if you’re going to grow over time, you’ll want to do that.
0:01:56 It allows you to have kind of different classes of shareholders, right?
0:01:59 So one of the things we’ll talk about probably is the fact that you as an entrepreneur might
0:02:03 hold what are called common shares, whereas the VC investors might hold what are called
0:02:04 preferred shares.
0:02:08 And Delaware has a very well-established legal framework for us to have different shares
0:02:11 that have different types of rights associated with them.
0:02:14 And then ultimately, if you go public, you know, kind of the way public investors are
0:02:17 used to, you know, investing in and taking public C-Corps.
0:02:21 And so it’s a much easier and quite frankly, just more seamless way to think about kind
0:02:24 of starting with ultimately quite frankly, where you want to end up.
0:02:25 Got it.
0:02:26 So the rails are well-defined.
0:02:27 That’s right.
0:02:29 And I don’t have to, like, place my own trails with a machete.
0:02:30 That’s right.
0:02:31 You can do a trail on this one, right?
0:02:32 Exactly.
0:02:33 Right.
0:02:34 Every now and then we do get some entrepreneurs who come in here and want to do it.
0:02:38 And they’ve got lots of interesting reasons, but so far I haven’t heard a really compelling
0:02:39 one.
0:02:40 Fourteen reasons.
0:02:41 I need to be an LLC.
0:02:42 Exactly.
0:02:43 Right.
0:02:44 Okay.
0:02:45 Good.
0:02:46 All right.
0:02:47 Let’s pretend I’m still working at a company.
0:02:48 Yeah.
0:02:49 Let’s call it BigCo.
0:02:50 Yeah.
0:02:51 And I haven’t incorporated yet.
0:02:55 I need to make sure that whatever I do is protected, my old company is going to come
0:02:56 after me, right?
0:02:57 Yeah.
0:03:01 This is one of those things where I would say a little foresight can go a very, very
0:03:02 long way.
0:03:07 So what the VCs will worry about when you come to pitch them is you’ll say, “Hey, I’m
0:03:08 working at BigCo.
0:03:11 And oh, by the way, in my spare time on nights and weekends, I developed this wonderful new
0:03:15 product and now I’d love you, Ms. VC, to kind of fund it for me.”
0:03:18 And the first question that’s going to go off our heads is, “Okay, wait a second.
0:03:22 Do you actually own that technology or could there be some theory under which your existing
0:03:25 employer says, “Hey, I may own that stuff?”
0:03:30 You may remember this whole case that happened with Uber and the company called Waymo, right?
0:03:35 Where Waymo was part of Google and then a number of people left and ended up at Uber.
0:03:39 There was this whole question about whether kind of the principle of that company had
0:03:44 basically taken some kind of proprietary knowledge outside of Google and kind of given it to
0:03:45 Uber.
0:03:48 And the challenge with these cases is you’re kind of proving the negative, right?
0:03:54 So in that case, Anthony Lewandowski, who was the person, he had to prove that he didn’t
0:03:55 take anything, right?
0:03:58 As opposed to them proving that he did take something in many respects.
0:04:01 Now, the law doesn’t actually work that way, but in practice and perception, that’s the
0:04:02 way it works.
0:04:07 So our best advice on this stuff is, look, if you’ve got a great idea, number one, don’t
0:04:10 ever use your work laptop for any of these things, right?
0:04:12 So have some physical separation.
0:04:15 And when you really get to the point where you feel like, “Okay, now it’s really, this
0:04:20 is a real thing, either take a leave of absence from your company, quit your company, do whatever
0:04:21 you do.”
0:04:24 Because the last thing you want to do is find that you’ve come up with this wonderful idea,
0:04:28 but you’ve just been sloppy and all of a sudden you just can’t find a way to commercialize
0:04:30 it anymore.
0:04:31 Got it.
0:04:35 And then let’s get into the question of how much money should I raise?
0:04:38 And there’s a couple of Twitter questions around it.
0:04:41 So beginning with, do I even mention a check sign?
0:04:43 Should I come with an ask or do I let the VC tell me?
0:04:44 Yeah.
0:04:45 Yeah.
0:04:46 Let’s talk about the broad question.
0:04:51 So the simple answer to how much money to raise is, how much money do you need to accomplish
0:04:54 the objectives that you will need to accomplish to be able to raise the next round?
0:04:57 And I know in some ways that sounds funny, but kind of the best advice I think we give
0:05:02 entrepreneurs is, if you’re raising your Series A round today, you should be at that point
0:05:06 in time thinking about, “What’s the pitch I’m going to give the Series B investors?”
0:05:09 And then essentially work backwards and say, “Okay, for the Series B investors to be compelled
0:05:14 by what I’m doing, what milestones, what objectives will they need to be able to see?
0:05:16 Therefore how much money will I need to do that?
0:05:18 How much time will I need to do that?”
0:05:22 And that’s kind of the way to kind of back into your amount of money.
0:05:27 And the answer to the Twitter question is, “Look, absolutely, you should tell the VC’s
0:05:30 what you want and you should be able to articulate for X amount of dollars.
0:05:31 This is what I can do.”
0:05:36 And oh, by the way, if you gave me X plus 50%, I could do this much more.
0:05:40 And part of the exercise, I think, for you and your VC partners to do is to say, “Okay,
0:05:44 what is the right amount of money that doesn’t dilute us too much today, but gives us kind
0:05:48 of enough degrees of freedom that when we go for that next round of financing, somebody
0:05:53 will come in and put more money in at a higher price, hopefully, than kind of we did this
0:05:54 first round.”
0:05:55 Got it.
0:06:00 So if I’m raising a Series A of financing, I need to start this whole sort of mental process
0:06:02 with, “What’s the Series B investor want to see?”
0:06:03 That’s exactly right.
0:06:04 That’s how you start.
0:06:08 And I think that’s the best mental framework to think about it because if you remember,
0:06:12 if you think about from the perspective of the VC, who’s going to do the Series A, that’s
0:06:15 what they’re worried about is, “Okay, do I believe this person can accomplish enough
0:06:18 so that we can continue this ride?”
0:06:23 And for you as the CEO, you care about that too because the best thing you can do is to
0:06:27 have this very nicely, monotonically increasing valuation and share price over time.
0:06:32 I tell the story of the book, which I know you’ll remember when we were at Loud Cloud.
0:06:35 And Ben Horowitz and I spent a bunch of time raising this very large round.
0:06:40 We raised $120 million and an $820 million post-money valuation.
0:06:44 And so we walk into this all hands thinking that we’re heroes and everybody’s going to
0:06:46 clap for us and tell us how smart we are.
0:06:51 And we get this very muted silence and it turns out that everybody was upset, not because
0:06:52 we didn’t raise at a very high valuation.
0:06:54 In fact, our last round was about 60 million.
0:06:59 So we raised at whatever that number is, 12, 13, 14 times our last round.
0:07:04 But the company down the street from us, Storage Networks, had raised at a billion-dollar valuation.
0:07:11 And so I tell people that story just because so much of company success and employee engagement
0:07:15 is a function of these external benchmarks that people think about.
0:07:19 And so that’s why thinking ahead to the next round is important because as much as you
0:07:23 want to focus on accomplishing the objectives for your business, you also want to set yourself
0:07:27 up so that you can continue to show progress to your employees by demonstrating that kind
0:07:32 of a new investor values the company at a higher level than your prior investor did.
0:07:33 Interesting.
0:07:37 So that’s the perfect segue to this other Twitter question, which is, how often do you
0:07:41 find that founders pushing too hard on high valuations end up hurting themselves?
0:07:46 And so maybe talk about structurally, what happens if you get too high a valuation in
0:07:47 this round?
0:07:50 Because on the face of it, it’s kind of like, look, too high a valuation means I suffer the
0:07:51 less solution.
0:07:52 I own more of this company.
0:07:53 Victory.
0:07:54 Right?
0:07:55 Like why is that not always victory?
0:07:56 I agree.
0:08:01 But honestly, this is a very hard thing as a VC to talk about because look, the immediate
0:08:04 reaction from an entrepreneur, understandably so, is, well, of course you want the valuation
0:08:08 to be lower because that’s right, it’s in your own financial interest to pay as little
0:08:10 as possible and own as much as my company.
0:08:15 And I won’t fight that argument, which is that’s true, but let me at least try to make
0:08:18 the pro case for why I do think entrepreneurs should care about this.
0:08:22 And I think it goes back to kind of the story I just mentioned, which is, if you think about
0:08:26 running the business, you’re the CEO, you’re telling your company, okay, hey, good news,
0:08:29 we just raised $5 million from Andrews and Horowitz, okay?
0:08:31 Now, here’s all the things that we’re going to accomplish.
0:08:34 Here’s your objectives, here’s what we’re going to do in terms of hiring, here’s what
0:08:39 we’re going to do in terms of customer acquisition, and hopefully you’re executing all those, right?
0:08:45 And so 18 months comes down the road and you say, great, we’ve accomplished all those objectives.
0:08:48 I’ve been telling my employees, they’re right on track, and then all of a sudden I go out
0:08:52 to raise money and I run into this buzz saw where a new investor says, hey, congratulations
0:08:53 on all that.
0:08:58 But by the way, I think you actually overvalued your company at that last round, and so even
0:09:04 though all of your metrics have doubled from where you had said they were, I’m only willing
0:09:07 to pay 50% more for the company or something like that, right?
0:09:10 And there’s reasons why that may happen that are outside your control, right?
0:09:15 So maybe the market has changed and we just now value companies differently, and of course,
0:09:17 there’s nothing you can do about that.
0:09:21 But what you can do is at least derisk the situation and say, okay, if I accomplish the
0:09:26 things that I set out to accomplish, do I believe the market will reflect that in how
0:09:27 they value the business?
0:09:31 And it’s really hard as a CEO to imagine going up and doing it all hands when you’ve
0:09:35 been telling everybody all along, everything’s great, and now you have to kind of tell them,
0:09:39 oh, by the way, it’s not that great based on some external metric.
0:09:43 And even though it’s only one metric, these are important data points that unfortunately,
0:09:47 for better or worse, do have psychological impact on how the employees feel about their
0:09:50 progress, on how you think about recruitment and retention of employees.
0:09:56 So it’s a hard balancing act, of course, to happen, but in general, the idea of kind
0:10:01 of having a stock price that goes up and down all the time is more probably kind of disheartening
0:10:06 to the company than kind of something that where the progress of the business also is
0:10:08 reflected in the progress on valuation.
0:10:11 Yeah, it’s hard because there’s sort of an emotional moment, which is I’m negotiating
0:10:13 this round of financing.
0:10:14 That’s right, exactly.
0:10:17 And I want to preserve as much ownership as I can, and it’s harder to think about the
0:10:18 long-term consequences.
0:10:19 Absolutely.
0:10:20 Right, yeah.
0:10:21 It’s a very hard thing.
0:10:24 And look, as I said, this is a hard tension between entrepreneur and venture capitalist
0:10:29 because in one level, the incentives are different, which is at the point of time I’m investing
0:10:30 as a venture capitalist, yes.
0:10:35 If I could invest less money for more ownership, that’s better for me.
0:10:39 Where we are aligned is that it’s not good for either one of us if we end up in these
0:10:43 situations down the road where kind of we can’t raise more money or we can only raise
0:10:47 more money at a substantially lower value than we thought because that has both emotional
0:10:50 and economic implications for both of us.
0:10:51 Got it.
0:10:55 Let’s talk a little bit about the form of investment.
0:10:59 And so you can raise a priced equity round or you can raise a convertible note where
0:11:00 there’s no price.
0:11:03 So you have a recommendation in the book and maybe walk me through it.
0:11:06 Yeah, so I talk in the book a lot about convertible notes.
0:11:09 You’ll hear this term if you’ve been in the YC world of something called a safe, which
0:11:14 is basically just a fancy way of saying it’s a piece of debt that ultimately converts into
0:11:18 equity at some predetermined price in the future.
0:11:20 They’re very good because they’re very simple.
0:11:22 There’s very low legal costs for doing them.
0:11:27 The paperwork’s very easy and all that is good and I’m all for efficiency and cost.
0:11:31 The failure case that I’ve seen, unfortunately, with a number of entrepreneurs is in some
0:11:35 respects because in number one, it’s so easy to raise money on a safe.
0:11:39 You often find people do what are called rolling closes, which is usually on a priced round
0:11:41 we’re like, this is your date, right?
0:11:43 Get your money in by June 30th or else you’re out of this deal, right?
0:11:48 And the safes have this very nice convention, which is I can close one on June 30th and
0:11:51 I can kind of do one on July 31st, I can kind of keep doing it.
0:11:53 And that’s very good and convenient.
0:11:58 The problem is never along that way does the entrepreneur see the actual capitalization
0:12:03 table of what is it going to look like when all those safes convert into equity.
0:12:07 And so several times we’ve had entrepreneurs come in here and it’s kind of sticker shock
0:12:12 when we give them an offer on the A round and then we actually kind of build the capitalization
0:12:16 table out of that and they realize that they inadvertently sold more of the company than
0:12:20 they had realized based upon this kind of concept of these rolling closes of notes.
0:12:26 So I’m not against safes, I would just say if you do it, this is kind of a failure case
0:12:27 that I think happens.
0:12:32 And I think you can accomplish the same efficiency goals with there’s a thing called series seed,
0:12:34 which is a very, very lightweight way of doing an equity deal.
0:12:38 So I just would encourage entrepreneurs to make sure if they go that route, they really
0:12:43 do pay attention and understand how much of the company they’ve sold and don’t kind of
0:12:48 find themselves kind of all of a sudden frightened one day when they realize kind of how much
0:12:51 money they may have given away in the company.
0:12:52 It’s very tempting, right?
0:12:56 Because the reason that you do a rolling close with these safes is, oh, I found the perfect
0:12:57 advisor.
0:12:58 That’s right.
0:13:00 Or I found the perfect early customer who wants to invest.
0:13:02 Or I found somebody else, right, a friend or family.
0:13:04 And so it feels convenient.
0:13:05 Yeah, it’s convenient.
0:13:06 Right.
0:13:11 Yeah, arbitrarily why we should have these kind of specific hard closes at different
0:13:12 times.
0:13:13 But yeah, it is convenient.
0:13:14 And again, it’s got a lot of value.
0:13:15 So I don’t want to suggest it’s never the right thing.
0:13:21 But I think it’s something to be aware of and make sure that you consider as an entrepreneur.
0:13:23 So let’s imagine I go through this process.
0:13:24 I’ve assembled my pitch deck.
0:13:27 I’ve got an offer and now I’m evaluating offers.
0:13:32 Yay, I’m in this enviable position evaluating term sheets.
0:13:36 So you talk a little bit in the term sheet about sort of the economic parts versus the
0:13:37 governance parts.
0:13:40 And so maybe let’s talk about each of them in turn.
0:13:47 So on the economic parts of my term sheet, maybe let’s talk about what is this thing
0:13:49 called, liquidation preferences?
0:13:50 What is this?
0:13:53 Yeah, there’s a whole several chapters in the book on this.
0:13:54 So I’ll give you the 30 second version.
0:13:58 So the simple way to think about liquidation preference is just the order in which money
0:14:00 comes out of the company.
0:14:03 So a liquidation is a fancy way of saying hopefully not an actual liquidation where
0:14:06 we’re saying now the company, but hopefully a sale of the company.
0:14:08 But it could certainly be the former as well.
0:14:12 And so what that means is who gets their money and in what order.
0:14:16 And generally what happens in venture fencing is the money that I invest as a venture capitalist
0:14:21 has what’s called a liquidation preference on it, which means my money comes out first
0:14:24 relative to the monies that would be owed the common shareholders, which is typically
0:14:26 where the founders and the team.
0:14:27 That’s right.
0:14:34 A simple example, if I invest $10 million and let’s say we sell the company for $10 million,
0:14:38 typically I will have $10 million worth of liquidation preference, which means all 10
0:14:43 of that money comes back to me and unfortunately for you and your employees, you have nothing.
0:14:45 And so that’s kind of the simple way to think about it.
0:14:53 It’s fairly common in venture deals, but typically it is kind of capped by just the amount of
0:14:56 money that the venture investors have put into the company.
0:15:01 And what’s kind of the most entrepreneur friendly liquidation preference formula that I should
0:15:02 live with?
0:15:05 There’s so many different kinds of liquidation preference.
0:15:08 Participating prefer non-3x, right?
0:15:09 So what’s the most entrepreneur friendly?
0:15:12 The most entrepreneur friendly and the one that I think generally predominates quite
0:15:16 frankly, particularly in Silicon Valley is what you would call a 1x non-participating
0:15:17 liquidation preference.
0:15:21 If you break that apart, 1x just means one times the money we put in, right?
0:15:25 So I don’t get two times my money, I don’t get three times my money, I get my $10 million
0:15:27 in that example we talked about.
0:15:31 And then non-participating means I don’t get to do what’s called double dipping.
0:15:35 And what double dipping means is not only do I get to take my liquidation preference
0:15:41 off, but then I also get to share in the proceeds that reflect my percentage ownership of the
0:15:42 company, right?
0:15:48 So in an example where let’s just say I put in $10 million and I own 25% of the company
0:15:54 or something like that, if I had participating preference, I would get my $10 million first
0:15:56 and then there’d be 10 left over, right?
0:15:57 Because we sold it for 20, there’s 10 left over.
0:16:02 Then I would also get 25% of that additional $10 million, fundamentally, you know, and
0:16:06 I say this the book, like I think that’s very unfair to the entrepreneurs and to the common
0:16:10 shareholders because liquidation preference is really intended to protect your downside.
0:16:11 And so it’s not obvious to me-
0:16:12 Something’s gone wrong.
0:16:13 Yeah, right.
0:16:16 Once you’ve kind of gotten your money out, it’s not obvious to me why you should also
0:16:20 participate in the upside and obviously take money away from the founders or the employees.
0:16:21 Yeah.
0:16:26 So when I hear my friends complaining about deals with structure, I guess this is an example
0:16:29 of deals with structure, like unfair liquidation preferences.
0:16:35 Right, unfair liquidation preferences, other structures sometimes you see is things, there’s
0:16:39 something called anti-dilution protection, which is again a basic way to say, “Hey, look,
0:16:44 if we later in the future raise money at a lower price than we raise today, it kind of
0:16:47 trues up the venture capitalist to a certain extent.”
0:16:52 And there’s a very common one, which is called weighted average anti-dilution, which is fairly
0:16:55 common, but there’s also a very egregious form of that, which you sometimes hear called
0:16:56 a ratchet.
0:16:59 And what a ratchet is, is really a complete price reset.
0:17:04 So it says, “Hey, if today I bought shares at $2 a share, and tomorrow you sell shares
0:17:09 at $1 a share, my $2 price converts to the $1 price,” meaning I literally get double
0:17:12 the number of equity ownership in the company than I thought.
0:17:18 And so you’ll see structure like that is sometimes happens when kind of people are trying to balance
0:17:20 off valuation with some of these other rights.
0:17:23 And that’s really a lot of what I try to point out in the book, is that it’s very hard to
0:17:26 look at these in isolation because they all have some kind of economic value.
0:17:30 So if you’re going to push on valuation, you might expect a venture capitalist to push
0:17:32 on some of these structure items.
0:17:35 And so the big advice that we always give entrepreneurs, and I echo this in the book,
0:17:38 is the simpler you can keep it the better.
0:17:42 And so if you’ve got one deal that’s got a lot of structure at this price, ask the
0:17:47 question for a lower price, what would a deal that’s a clean deal that doesn’t have all
0:17:52 the structure look like, that’s often quite frankly the advice that we give to entrepreneurs.
0:17:58 So I can actually get myself in trouble by sort of taking the highest post money because
0:18:02 of all of this structure and how does the money come out in these scenarios.
0:18:05 Yeah, I think there’s two risks that you always have to think about when you do the structure.
0:18:09 One is just, you’re potentially postponing the inevitable, right, which is you don’t
0:18:13 really know what the impact of these things will be until you have that next financing
0:18:14 event, right.
0:18:18 And so, look, the world may be perfect and you may never have to, you know, everything
0:18:21 may go up and to the right, which we all hope, but that’s not always the case.
0:18:25 And so, you know, a great example of this was, this is public information, but when Square
0:18:29 went public, they went public at $8 a share.
0:18:32 Their last round of financing was at $16 a share.
0:18:36 And those $16 investors had this full ratchet that we were talking about.
0:18:41 So, those $16 shareholders basically got issued two times the number of shares to bring their
0:18:42 price down to eight.
0:18:47 And so, all the existing shareholders obviously bore the brunt of that incremental, you know,
0:18:48 dilution from those shares.
0:18:49 So that’s kind of thing number one.
0:18:53 Thing number two is just, and this is why we always say keep it simple, is everything
0:18:56 you do today has the risk of creating precedent for the future.
0:18:58 And so, you may think, hey, look, you know, you and I are buddies.
0:19:01 This is, you know, I’m giving you these special rights because we’re friends.
0:19:05 But when that next investor comes in and looks at the paperwork from the previous round and
0:19:09 sees that you gave that stuff to the other investor, you know, the likely outcome is
0:19:10 they’re going to want the same thing.
0:19:13 And now you start to kind of get the cumulative effect of some of these things, which can
0:19:15 be, you know, pretty harmful at one time.
0:19:16 Right.
0:19:19 So, every subsequent investor is going to kind of want the same deal with a prior investor
0:19:20 or better.
0:19:21 Yeah, exactly.
0:19:22 Right.
0:19:23 You have to think into the future.
0:19:24 That’s exactly right.
0:19:25 You have more than one shareholder.
0:19:26 Yeah.
0:19:27 And you just don’t know how much negotiating leverage you’ll have at that time.
0:19:30 So, you don’t want to set yourself up to kind of start by having to defend or walk
0:19:33 away from a deal that you did prior.
0:19:34 Got it.
0:19:38 So, we’ve come back to the idea that, like, when I’m raising the Series A, I need to really
0:19:42 think about Series B and Series C and Series D, right, sort of like the sequence of investors
0:19:43 that I’m going to need.
0:19:44 That’s right.
0:19:50 I should sort of think through the entire financing plan before I start fundraising for
0:19:51 the Series A.
0:19:52 I think that’s right.
0:19:55 Yeah, look, I mean, you know, you want to kind of project as much foresight as you can,
0:19:58 recognizing that, look, markets may change, you know, kind of the financing environment
0:19:59 may change.
0:20:01 Those are things out of your control.
0:20:04 What’s in your control, at least, is to have a thoughtful plan for if I accomplish these
0:20:09 things, is that likely to lead to, you know, a favorable financing situation.
0:20:13 And if I make sure that I don’t kind of load up my terms with all kinds of crazy bells
0:20:16 and whistles, hopefully I set myself up for success.
0:20:17 Right.
0:20:19 So, it sounds like on the economic side of the term sheet, let’s keep it simple.
0:20:20 Yeah.
0:20:23 It’s sort of the big advice and think about the subsequent investors.
0:20:24 Absolutely.
0:20:27 I mean, so don’t do something abnormal early because that’s just going to bite you later.
0:20:31 Let’s talk a little bit about governance, the governance side of the term sheet.
0:20:35 So maybe the first question is, I heard that Google and Facebook have these dual class voting
0:20:38 shares and then, like, the founders have ultimate control.
0:20:39 That sounds good to me.
0:20:41 Like, don’t I always want that?
0:20:43 I want 10 times the voting share.
0:20:44 Right, exactly.
0:20:45 Does anybody else?
0:20:47 We do get some entrepreneurs, even, in the private markets who come ask us for that.
0:20:51 So, the important thing, I think, to think about in these, the idea, by the way, behind
0:20:55 dual class shares, for people who don’t know, is that literally shares have differential
0:20:56 voting rights.
0:21:00 Like, in the Facebook and Google cases, you’re right that Mark Zuckerberg and Larry Page
0:21:03 and other founders have kind of, you know, a high vote stock, which means they have more
0:21:07 influence on corporate matters and then everyone else has a low vote stock.
0:21:12 The reason those exist in the public markets is out of concerns of kind of potential misalignment
0:21:15 between long-term versus short-term incentives in the market, right?
0:21:19 And so, in a company like Facebook, let’s use that, you know, Mark probably has all
0:21:23 kinds of product ideas that he wants to execute over the next three, five, 10 years.
0:21:24 Those will all take time.
0:21:25 They will cost money.
0:21:29 There could be quarter-to-quarter gyrations in his expenses and revenue as a result of
0:21:31 these product plans.
0:21:34 And the main reason why somebody like that puts in dual classes, because he wants to
0:21:39 be able to make sure that if there are investors who are more short-term oriented, they can’t
0:21:42 out-vote him and say, “Hey, look, I don’t like your product strategy because of kind
0:21:44 of these short-term gyrations.”
0:21:48 The reason why those tend not to exist in the private markets is we’re all completely
0:21:50 aligned, which is none of us have liquidity, right?
0:21:54 So, we can’t, you know, in general, in many times we are prevented from selling our shares
0:21:55 legally.
0:21:59 So, there’s no liquid market, and we have a time horizon that’s consistent with the
0:22:01 entrepreneur’s time horizon, right?
0:22:04 You know, we don’t care, you know, obviously we don’t care about what they do quarter-to-quarter
0:22:07 other than to the extent it just represents them not being able to manage the business
0:22:09 in a way that makes sense.
0:22:14 And so, that’s why you tend not to see them in private markets.
0:22:17 What we’ve done with many of our companies is as they get closer to going public, we
0:22:21 have agreed with them that, okay, having these dual-class shares when and if you go public
0:22:26 is a good thing to do, but we haven’t done that, obviously, in the private markets.
0:22:27 Got it.
0:22:32 So, my first board members will likely be sort of either my co-founders and then my
0:22:33 early investors.
0:22:34 Right.
0:22:38 At some point, we’re going to go on a quest for an independent board member, and how should
0:22:39 I think about that?
0:22:40 When do we do that?
0:22:41 Why do I need one?
0:22:42 Who should I look for?
0:22:43 Yeah.
0:22:47 So, most boards you’re right are, in fact, most boards at the beginning don’t have independent
0:22:48 board members.
0:22:49 You’re right.
0:22:52 So, if you’re a co-founder and then typically as part of a venture capitalist coming into
0:22:56 your company as an investor, you will generally give them a board seat.
0:23:00 The reason I think independence are important is you want to have kind of balance on the
0:23:01 board.
0:23:05 And so, one of the phenomenon that we’ve seen over the last 10 years is a change in the
0:23:08 board structure in that it used to be that the venture capitalist would outnumber the
0:23:14 common shareholders, and that was of concern to many founder CEOs because it gave the venture
0:23:17 capitalist kind of the unilateral right in many cases to be able to remove the CEO if
0:23:19 they didn’t like them.
0:23:23 Over the last 10 years, that’s really shifted, and more of our boards have more common shareholders,
0:23:29 more founder and employee-led board members than they have preferred shareholders.
0:23:34 And that’s understandable and fair given some of the kind of changes we’ve had in governance.
0:23:39 The idea, though, behind an independent is can we find someone who is kind of not representing
0:23:42 either just the founders and not representing the preferred shareholders, but someone who’s
0:23:45 going to take a more neutral and expansive view of the business?
0:23:51 And so, I think it’s hard to probably do it early in your days, but as the board grows,
0:23:56 maybe as the board gets to four or five people, having an independent or two will be valuable.
0:23:59 And I think most people who’ve done it have gotten great value out of it, and oftentimes
0:24:04 they’ll look for an industry expert in the domain they’re in, or maybe they’re looking
0:24:08 for, hey, we need more sales and marketing help, and so let’s bring in someone who has
0:24:10 kind of expertise from an organizational perspective.
0:24:13 So those are the characteristics we tend to see with independence.
0:24:19 And as I approach an IPO, if all goes well, it seems like it’ll be expected that I have
0:24:20 an independent board member.
0:24:21 That’s exactly right.
0:24:22 One of the checklist items for going public.
0:24:23 That’s right, yeah.
0:24:24 So you’ll see this with companies, right?
0:24:26 When they go public, there are the different exchanges.
0:24:32 NASDAQ and NYSE have what they call listing rules, which require some number of independence.
0:24:35 They require some number of financial experts to be able to sit on things like the audit
0:24:36 committee.
0:24:39 So it becomes much more prescriptive as you go, and so you’ll often see a company kind
0:24:44 of, you know, T-minus one or two years leading up to an IPO start to kind of augment their
0:24:47 boards to satisfy these listing standards.
0:24:48 Got it.
0:24:51 Let’s talk a little bit about pro-rata rights.
0:24:54 So there’s going to be this element in the term sheet that says, here are what my existing
0:24:59 investors can be expected or are allowed to invest in subsequent rounds.
0:25:02 So how should I have that conversation with an investor?
0:25:05 What kind of pro-rata rights do I want them to have, and so on?
0:25:09 So it’s pretty typical when you do a fundraise that, you know, kind of one of the things that
0:25:13 we as venture caps will ask for is exactly this right, and what it means is it’s the
0:25:17 right for us to invest additional dollars in the next round of financing in order to
0:25:20 preserve the economic ownership that we already have in the company, right?
0:25:25 So if I own 25% of the company today, this gives me the right to hopefully put more money
0:25:29 in later such that my 25% kind of stays, you know, in and around that.
0:25:30 At a higher price?
0:25:31 Because I’ve made progress?
0:25:32 At a higher price, right?
0:25:34 So in general, it’s a very good thing.
0:25:39 Now, pro-rata rights become more challenging in the very, very good case, which is a nice
0:25:43 place to be, but, you know, if you are just executing phenomenally well and you’ve got
0:25:47 a new investor, you’re going to raise money and a new investor comes in and says, “Hey,
0:25:51 I want to put a bunch of money in, but for me to make my business model work, I need
0:25:53 to own a certain percentage of the company,” right?
0:25:57 Because if you go back to where we started from our last session, so much of what the
0:26:01 venture capitalist incentive is, can I get a Facebook, can I get a Google, and, you know,
0:26:03 there’s kind of two big cardinal sins in this business.
0:26:06 One is you miss one of those companies, you don’t invest in them.
0:26:09 The other is that you invest in it, but you don’t own enough of it so that when it gets
0:26:12 to be Facebook, it still doesn’t meaningfully change your economics.
0:26:16 And this pro-rata thing is kind of an example of the latter where that new investor may
0:26:19 come in and say, “Hey, look, I’m going to give you all this money, but I still only
0:26:24 own 3% or 4% of the company, and so, hey, I want you to go back to your existing investors
0:26:27 and tell them, ‘Don’t do your pro-rata, but let this new investor do it.'”
0:26:30 Now, admittedly, it’s a good problem to have, right?
0:26:32 Because it means we’ve got people who are bound, you know, kind of pounding down the
0:26:34 door to let us in.
0:26:36 But that does create tension.
0:26:40 You often see this even in the series A to seed side of things, that seed investors feel
0:26:44 like many times that they get compromised, and that the A round investors are trying
0:26:46 to kind of prevent them from doing pro-rata.
0:26:50 So it’s a very common thing to have, but I think it’s something where it puts you as
0:26:54 a CEO in a situation where you may have to manage kind of conflicting incentives among
0:26:55 your investors.
0:26:58 And so, you know, you just need to kind of go in eyes wide open, and hopefully you’ve
0:27:02 got a good enough dialogue with your existing investors where you can say, “Hey, let’s figure
0:27:05 out some compromise here that makes sense where everybody can feel like they can walk
0:27:08 away happy from the table.”
0:27:10 And what should I expect from my existing early investors?
0:27:14 So somebody invest in my A, should I expect them to be along for the ride and do their
0:27:18 pro-rata in the B and the C and the D all the way?
0:27:21 Yeah, you know, different firms have different philosophies on this.
0:27:25 You know, the way we do it here is, if we’re the A round investor, our general thinking
0:27:29 is that, you know, unless something dramatic happens with the company, you know, we should
0:27:32 expect that we’re going to participate pro-rata in the next round of financing.
0:27:35 We think, I think that’s kind of generally the convention in the industry.
0:27:38 On that, though, the answer for most firms, and we treat it the same way, is it’s kind
0:27:42 of an independent decision at that point in time because, you know, the dollars can get
0:27:45 very, very big and, you know, kind of, you have to think about, you know, how much do
0:27:47 I own at what kind of cost basis.
0:27:51 So I think it’s an important conversation, actually, to have with your VC when you take
0:27:55 money from them because you certainly don’t want to kind of, you know, miss set expectations,
0:27:58 you know, between the two of you, and you also want to be able to make sure when you
0:28:03 go raise money that you’re not creating some signaling effect otherwise where the new investors
0:28:07 are expecting your existing investor to participate and the fact that they don’t do it, they read
0:28:08 as a negative signal.
0:28:12 That can happen sometimes if you haven’t kind of had this conversation and, you know, already,
0:28:14 you know, set the right expectations up front.
0:28:15 Yeah.
0:28:18 So I need to be clear with you as soon as you put your money in.
0:28:22 I can count on you for the next round, or maybe the round after that, but like we should
0:28:23 just be on the same page.
0:28:24 That’s exactly right.
0:28:25 Yeah.
0:28:26 Great.
0:28:27 Good.
0:28:28 So last few questions on sort of governance.
0:28:32 Let’s talk about stock restrictions, like what are they, how should I think about them?
0:28:33 Yeah.
0:28:37 So this is one that’s come up more often because of this phenomenon now that companies are
0:28:38 staying private longer, right?
0:28:42 So it used to be not a big deal because companies about, you know, six years or so from founding
0:28:44 was kind of the median time to going public.
0:28:46 Now we’re talking 10, 12 years.
0:28:49 And so the things that you want to think about as a founder is two things.
0:28:53 Number one is, what are my investors going to do?
0:28:56 And so often you will see that investors will have restrictions on their ability to sell
0:29:00 shares and those come in lots of different flavors, which we won’t go into detail, but
0:29:01 you can read about on the book.
0:29:03 And then the other question is, what do you do about employees, right?
0:29:07 Because you’re probably going to have employees who will have fully vested their shares, some
0:29:09 of whom will have left the company.
0:29:11 And you know, this is one is a tough one to navigate, right?
0:29:15 Because on one level as a CEO, you know, I think you want to, you know, you want to
0:29:19 get flexibility to your employees, particularly the ones who are still, you know, at the company,
0:29:21 right, doing great work.
0:29:25 The thing you want to be careful about though is making sure that those shares don’t kind
0:29:29 of take up demand that would otherwise exist for people to buy shares from the company,
0:29:32 where the cash would come into the company, and therefore allow you to kind of raise money
0:29:33 and grow the business, right?
0:29:37 So if you think about this at some level, there may be a finite amount of dollars that
0:29:40 all the investors are willing to put in this company.
0:29:44 And if you have employees share sales competing with sales that you’re making as the company
0:29:48 to try to raise money to put in your own coffers, there can be a kind of a tension there.
0:29:54 And so more generally these days, we see fairly restrictive provisions here, which is most
0:29:58 companies try to kind of, you know, say, “Hey, look, if you’re going to sell as an employee,
0:30:02 you need the consent of the company,” or something like that, so that you kind of have more control
0:30:07 over the timing and also the volume, potentially, of these purchases.
0:30:12 Thinking about employee incentives, since this is sort of part of the discussion, my
0:30:17 friends who are doing longer vesting schedules or back-loaded employee options instead of
0:30:22 sort of, you know, one 48th over four years, they’re doing, you know, 10, 20, 30, 40, right,
0:30:26 to incent people to stay longer, how should I think about those types of incentives?
0:30:27 Yeah.
0:30:29 You know, there’s lots of discussions on this right now.
0:30:32 The short answer is I’m not sure there’s yet a real change in convention.
0:30:35 I think most people are still doing the pretty straight four years.
0:30:40 The big change that you may have heard about from some people is normally when you leave
0:30:44 the company and you’re vested, you typically have about 90 days to either exercise your
0:30:47 shares or you have to forfeit them.
0:30:51 And because of this elongation of companies staying private, a lot of companies now have
0:30:54 extended that period and they say, “Hey, look, we’re going to give you a year or two years
0:30:58 or something because we recognize there’s not a liquid market in the form of an IPO
0:31:02 to be able to sell them and we know it’s expensive for you to come out of pocket to have to exercise
0:31:03 your options.”
0:31:07 So, there’s probably more creativity, I would say, happening on that side, less creativity
0:31:11 on fundamentally rethinking whether we should have just a different investing schedule overall
0:31:14 that reflects, you know, kind of the fact that companies are staying private longer.
0:31:15 Got it.
0:31:19 So, if I wanted to be as sort of maximally employee-friendly as possible, I’d be extending
0:31:22 the time that people can choose to exercise their contracts.
0:31:23 That’s exactly right.
0:31:24 Yeah.
0:31:27 And, you know, the only thing that, you know, and we’ve talked about this in some of our
0:31:32 blogs, the only thing to think about there is that means that those shares, you know,
0:31:36 those shares will be what’s called an overhang, meaning that, you know, kind of they’re sitting
0:31:37 out there.
0:31:40 You don’t really know if they’re going to get exercised or not, but, you know, sometimes
0:31:43 in the alternative, people might not have exercised them.
0:31:46 Those shares can be returned to the company and the company could use them, obviously,
0:31:48 to issue new options to people.
0:31:52 So, there’s a, you know, a very emotional, understandably so, and a very kind of deep
0:31:53 debate on this.
0:31:57 But, yes, in the perfectly employee-friendly case, you would extend it out as long as possible
0:31:59 to give people the maximum time period.
0:32:00 Got it.
0:32:01 Great.
0:32:04 Thanks for talking to us about all of the economic and governance terms.
0:32:08 The term sheet can be very intimidating, so I’m glad you sort of went through it and
0:32:09 demystified it.
0:32:10 Thanks, Frank.
0:32:11 All right.
0:32:12 Congratulations.
0:32:16 You’ve survived to the end of part two, where we talked about understanding fundraising
0:32:19 and the terms that go into a term sheet.
0:32:23 Hopefully this gives you a sense of all of the mysterious terms you’ve now seen, maybe
0:32:28 for the first time, when a term sheet has arrived.
0:32:31 Next up, we’re going to do part three of our series.
0:32:35 And part three is all going to be about living with your venture investor over a long period
0:32:36 of time.
0:32:41 So, you might actually have the same person on your board of your company for 10 years,
0:32:49 and so Scott has great tips for how to understand the bends in that relationship and how it
0:32:55 will change over time, and we’re going to dig right into three concrete scenarios that
0:32:59 you might end up encountering, one in which you are winding down your company, one in
0:33:03 which you’re selling your company, and one in which you are actually going public.
0:33:06 Congratulations, and we’ll see you at part three.
0:00:10 tax or investment advice or be used to evaluate any investment or security and is not directed
0:00:14 at any investors or potential investors in any A16Z fund.
0:00:19 For more details, please see A16Z.com/disclosures.
0:00:20 I’m Frank Chen.
0:00:23 Today I’m here with Scott Cooper and we’re doing a three-part series.
0:00:27 You’ve landed in part two, which is all about fundraising.
0:00:32 What we’re going to do is dig into the mechanics of how you work with a VC during the fund
0:00:36 raise process, how you interpret the terms of the term sheet, and hopefully this will
0:00:42 give you a sense of how you can actually have a meaningful dialogue with a venture capitalist.
0:00:47 We produce this video for the same reason that Scott wrote this book, which is as venture
0:00:49 investors we do this day in and day out.
0:00:54 We will see thousands of entrepreneurs will write dozens of term sheets, whereas you may
0:00:56 end up doing this once in your life.
0:01:01 And so we wanted to help you understand some of the terms and the art and the science that
0:01:02 go into fundraising.
0:01:05 All right, so let’s get right into it.
0:01:06 Why do I need to be a Delaware C-Corp?
0:01:11 Like what’s special about Delaware and what makes other entities hard to fund from a VC’s
0:01:12 point of view?
0:01:16 Yeah, so there are lots of varieties of, you know, kind of organizations of business you
0:01:17 can do.
0:01:19 There’s C-Corps, there’s things called partnerships.
0:01:24 The main reason why you do a C-Corp and why it’s in Delaware, quite frankly, is there’s
0:01:26 a lot of just legal precedent there.
0:01:29 Delaware had kind of made themselves kind of the home of businesses many, many years
0:01:30 ago.
0:01:34 And so it makes people like us and lawyers feel comfortable because we know that there’s
0:01:39 hundreds of years of, you know, kind of legal precedent that says, hey, if this thing happens,
0:01:40 this is what happens.
0:01:41 And things are fairly well settled.
0:01:45 So you could certainly go other places, but Delaware is pretty good.
0:01:46 The C-Corp does a lot of things.
0:01:49 I think the main advantage of a C-Corp is it allows you to have lots of shareholders.
0:01:53 And so if you’re going to grow over time, you’ll want to do that.
0:01:56 It allows you to have kind of different classes of shareholders, right?
0:01:59 So one of the things we’ll talk about probably is the fact that you as an entrepreneur might
0:02:03 hold what are called common shares, whereas the VC investors might hold what are called
0:02:04 preferred shares.
0:02:08 And Delaware has a very well-established legal framework for us to have different shares
0:02:11 that have different types of rights associated with them.
0:02:14 And then ultimately, if you go public, you know, kind of the way public investors are
0:02:17 used to, you know, investing in and taking public C-Corps.
0:02:21 And so it’s a much easier and quite frankly, just more seamless way to think about kind
0:02:24 of starting with ultimately quite frankly, where you want to end up.
0:02:25 Got it.
0:02:26 So the rails are well-defined.
0:02:27 That’s right.
0:02:29 And I don’t have to, like, place my own trails with a machete.
0:02:30 That’s right.
0:02:31 You can do a trail on this one, right?
0:02:32 Exactly.
0:02:33 Right.
0:02:34 Every now and then we do get some entrepreneurs who come in here and want to do it.
0:02:38 And they’ve got lots of interesting reasons, but so far I haven’t heard a really compelling
0:02:39 one.
0:02:40 Fourteen reasons.
0:02:41 I need to be an LLC.
0:02:42 Exactly.
0:02:43 Right.
0:02:44 Okay.
0:02:45 Good.
0:02:46 All right.
0:02:47 Let’s pretend I’m still working at a company.
0:02:48 Yeah.
0:02:49 Let’s call it BigCo.
0:02:50 Yeah.
0:02:51 And I haven’t incorporated yet.
0:02:55 I need to make sure that whatever I do is protected, my old company is going to come
0:02:56 after me, right?
0:02:57 Yeah.
0:03:01 This is one of those things where I would say a little foresight can go a very, very
0:03:02 long way.
0:03:07 So what the VCs will worry about when you come to pitch them is you’ll say, “Hey, I’m
0:03:08 working at BigCo.
0:03:11 And oh, by the way, in my spare time on nights and weekends, I developed this wonderful new
0:03:15 product and now I’d love you, Ms. VC, to kind of fund it for me.”
0:03:18 And the first question that’s going to go off our heads is, “Okay, wait a second.
0:03:22 Do you actually own that technology or could there be some theory under which your existing
0:03:25 employer says, “Hey, I may own that stuff?”
0:03:30 You may remember this whole case that happened with Uber and the company called Waymo, right?
0:03:35 Where Waymo was part of Google and then a number of people left and ended up at Uber.
0:03:39 There was this whole question about whether kind of the principle of that company had
0:03:44 basically taken some kind of proprietary knowledge outside of Google and kind of given it to
0:03:45 Uber.
0:03:48 And the challenge with these cases is you’re kind of proving the negative, right?
0:03:54 So in that case, Anthony Lewandowski, who was the person, he had to prove that he didn’t
0:03:55 take anything, right?
0:03:58 As opposed to them proving that he did take something in many respects.
0:04:01 Now, the law doesn’t actually work that way, but in practice and perception, that’s the
0:04:02 way it works.
0:04:07 So our best advice on this stuff is, look, if you’ve got a great idea, number one, don’t
0:04:10 ever use your work laptop for any of these things, right?
0:04:12 So have some physical separation.
0:04:15 And when you really get to the point where you feel like, “Okay, now it’s really, this
0:04:20 is a real thing, either take a leave of absence from your company, quit your company, do whatever
0:04:21 you do.”
0:04:24 Because the last thing you want to do is find that you’ve come up with this wonderful idea,
0:04:28 but you’ve just been sloppy and all of a sudden you just can’t find a way to commercialize
0:04:30 it anymore.
0:04:31 Got it.
0:04:35 And then let’s get into the question of how much money should I raise?
0:04:38 And there’s a couple of Twitter questions around it.
0:04:41 So beginning with, do I even mention a check sign?
0:04:43 Should I come with an ask or do I let the VC tell me?
0:04:44 Yeah.
0:04:45 Yeah.
0:04:46 Let’s talk about the broad question.
0:04:51 So the simple answer to how much money to raise is, how much money do you need to accomplish
0:04:54 the objectives that you will need to accomplish to be able to raise the next round?
0:04:57 And I know in some ways that sounds funny, but kind of the best advice I think we give
0:05:02 entrepreneurs is, if you’re raising your Series A round today, you should be at that point
0:05:06 in time thinking about, “What’s the pitch I’m going to give the Series B investors?”
0:05:09 And then essentially work backwards and say, “Okay, for the Series B investors to be compelled
0:05:14 by what I’m doing, what milestones, what objectives will they need to be able to see?
0:05:16 Therefore how much money will I need to do that?
0:05:18 How much time will I need to do that?”
0:05:22 And that’s kind of the way to kind of back into your amount of money.
0:05:27 And the answer to the Twitter question is, “Look, absolutely, you should tell the VC’s
0:05:30 what you want and you should be able to articulate for X amount of dollars.
0:05:31 This is what I can do.”
0:05:36 And oh, by the way, if you gave me X plus 50%, I could do this much more.
0:05:40 And part of the exercise, I think, for you and your VC partners to do is to say, “Okay,
0:05:44 what is the right amount of money that doesn’t dilute us too much today, but gives us kind
0:05:48 of enough degrees of freedom that when we go for that next round of financing, somebody
0:05:53 will come in and put more money in at a higher price, hopefully, than kind of we did this
0:05:54 first round.”
0:05:55 Got it.
0:06:00 So if I’m raising a Series A of financing, I need to start this whole sort of mental process
0:06:02 with, “What’s the Series B investor want to see?”
0:06:03 That’s exactly right.
0:06:04 That’s how you start.
0:06:08 And I think that’s the best mental framework to think about it because if you remember,
0:06:12 if you think about from the perspective of the VC, who’s going to do the Series A, that’s
0:06:15 what they’re worried about is, “Okay, do I believe this person can accomplish enough
0:06:18 so that we can continue this ride?”
0:06:23 And for you as the CEO, you care about that too because the best thing you can do is to
0:06:27 have this very nicely, monotonically increasing valuation and share price over time.
0:06:32 I tell the story of the book, which I know you’ll remember when we were at Loud Cloud.
0:06:35 And Ben Horowitz and I spent a bunch of time raising this very large round.
0:06:40 We raised $120 million and an $820 million post-money valuation.
0:06:44 And so we walk into this all hands thinking that we’re heroes and everybody’s going to
0:06:46 clap for us and tell us how smart we are.
0:06:51 And we get this very muted silence and it turns out that everybody was upset, not because
0:06:52 we didn’t raise at a very high valuation.
0:06:54 In fact, our last round was about 60 million.
0:06:59 So we raised at whatever that number is, 12, 13, 14 times our last round.
0:07:04 But the company down the street from us, Storage Networks, had raised at a billion-dollar valuation.
0:07:11 And so I tell people that story just because so much of company success and employee engagement
0:07:15 is a function of these external benchmarks that people think about.
0:07:19 And so that’s why thinking ahead to the next round is important because as much as you
0:07:23 want to focus on accomplishing the objectives for your business, you also want to set yourself
0:07:27 up so that you can continue to show progress to your employees by demonstrating that kind
0:07:32 of a new investor values the company at a higher level than your prior investor did.
0:07:33 Interesting.
0:07:37 So that’s the perfect segue to this other Twitter question, which is, how often do you
0:07:41 find that founders pushing too hard on high valuations end up hurting themselves?
0:07:46 And so maybe talk about structurally, what happens if you get too high a valuation in
0:07:47 this round?
0:07:50 Because on the face of it, it’s kind of like, look, too high a valuation means I suffer the
0:07:51 less solution.
0:07:52 I own more of this company.
0:07:53 Victory.
0:07:54 Right?
0:07:55 Like why is that not always victory?
0:07:56 I agree.
0:08:01 But honestly, this is a very hard thing as a VC to talk about because look, the immediate
0:08:04 reaction from an entrepreneur, understandably so, is, well, of course you want the valuation
0:08:08 to be lower because that’s right, it’s in your own financial interest to pay as little
0:08:10 as possible and own as much as my company.
0:08:15 And I won’t fight that argument, which is that’s true, but let me at least try to make
0:08:18 the pro case for why I do think entrepreneurs should care about this.
0:08:22 And I think it goes back to kind of the story I just mentioned, which is, if you think about
0:08:26 running the business, you’re the CEO, you’re telling your company, okay, hey, good news,
0:08:29 we just raised $5 million from Andrews and Horowitz, okay?
0:08:31 Now, here’s all the things that we’re going to accomplish.
0:08:34 Here’s your objectives, here’s what we’re going to do in terms of hiring, here’s what
0:08:39 we’re going to do in terms of customer acquisition, and hopefully you’re executing all those, right?
0:08:45 And so 18 months comes down the road and you say, great, we’ve accomplished all those objectives.
0:08:48 I’ve been telling my employees, they’re right on track, and then all of a sudden I go out
0:08:52 to raise money and I run into this buzz saw where a new investor says, hey, congratulations
0:08:53 on all that.
0:08:58 But by the way, I think you actually overvalued your company at that last round, and so even
0:09:04 though all of your metrics have doubled from where you had said they were, I’m only willing
0:09:07 to pay 50% more for the company or something like that, right?
0:09:10 And there’s reasons why that may happen that are outside your control, right?
0:09:15 So maybe the market has changed and we just now value companies differently, and of course,
0:09:17 there’s nothing you can do about that.
0:09:21 But what you can do is at least derisk the situation and say, okay, if I accomplish the
0:09:26 things that I set out to accomplish, do I believe the market will reflect that in how
0:09:27 they value the business?
0:09:31 And it’s really hard as a CEO to imagine going up and doing it all hands when you’ve
0:09:35 been telling everybody all along, everything’s great, and now you have to kind of tell them,
0:09:39 oh, by the way, it’s not that great based on some external metric.
0:09:43 And even though it’s only one metric, these are important data points that unfortunately,
0:09:47 for better or worse, do have psychological impact on how the employees feel about their
0:09:50 progress, on how you think about recruitment and retention of employees.
0:09:56 So it’s a hard balancing act, of course, to happen, but in general, the idea of kind
0:10:01 of having a stock price that goes up and down all the time is more probably kind of disheartening
0:10:06 to the company than kind of something that where the progress of the business also is
0:10:08 reflected in the progress on valuation.
0:10:11 Yeah, it’s hard because there’s sort of an emotional moment, which is I’m negotiating
0:10:13 this round of financing.
0:10:14 That’s right, exactly.
0:10:17 And I want to preserve as much ownership as I can, and it’s harder to think about the
0:10:18 long-term consequences.
0:10:19 Absolutely.
0:10:20 Right, yeah.
0:10:21 It’s a very hard thing.
0:10:24 And look, as I said, this is a hard tension between entrepreneur and venture capitalist
0:10:29 because in one level, the incentives are different, which is at the point of time I’m investing
0:10:30 as a venture capitalist, yes.
0:10:35 If I could invest less money for more ownership, that’s better for me.
0:10:39 Where we are aligned is that it’s not good for either one of us if we end up in these
0:10:43 situations down the road where kind of we can’t raise more money or we can only raise
0:10:47 more money at a substantially lower value than we thought because that has both emotional
0:10:50 and economic implications for both of us.
0:10:51 Got it.
0:10:55 Let’s talk a little bit about the form of investment.
0:10:59 And so you can raise a priced equity round or you can raise a convertible note where
0:11:00 there’s no price.
0:11:03 So you have a recommendation in the book and maybe walk me through it.
0:11:06 Yeah, so I talk in the book a lot about convertible notes.
0:11:09 You’ll hear this term if you’ve been in the YC world of something called a safe, which
0:11:14 is basically just a fancy way of saying it’s a piece of debt that ultimately converts into
0:11:18 equity at some predetermined price in the future.
0:11:20 They’re very good because they’re very simple.
0:11:22 There’s very low legal costs for doing them.
0:11:27 The paperwork’s very easy and all that is good and I’m all for efficiency and cost.
0:11:31 The failure case that I’ve seen, unfortunately, with a number of entrepreneurs is in some
0:11:35 respects because in number one, it’s so easy to raise money on a safe.
0:11:39 You often find people do what are called rolling closes, which is usually on a priced round
0:11:41 we’re like, this is your date, right?
0:11:43 Get your money in by June 30th or else you’re out of this deal, right?
0:11:48 And the safes have this very nice convention, which is I can close one on June 30th and
0:11:51 I can kind of do one on July 31st, I can kind of keep doing it.
0:11:53 And that’s very good and convenient.
0:11:58 The problem is never along that way does the entrepreneur see the actual capitalization
0:12:03 table of what is it going to look like when all those safes convert into equity.
0:12:07 And so several times we’ve had entrepreneurs come in here and it’s kind of sticker shock
0:12:12 when we give them an offer on the A round and then we actually kind of build the capitalization
0:12:16 table out of that and they realize that they inadvertently sold more of the company than
0:12:20 they had realized based upon this kind of concept of these rolling closes of notes.
0:12:26 So I’m not against safes, I would just say if you do it, this is kind of a failure case
0:12:27 that I think happens.
0:12:32 And I think you can accomplish the same efficiency goals with there’s a thing called series seed,
0:12:34 which is a very, very lightweight way of doing an equity deal.
0:12:38 So I just would encourage entrepreneurs to make sure if they go that route, they really
0:12:43 do pay attention and understand how much of the company they’ve sold and don’t kind of
0:12:48 find themselves kind of all of a sudden frightened one day when they realize kind of how much
0:12:51 money they may have given away in the company.
0:12:52 It’s very tempting, right?
0:12:56 Because the reason that you do a rolling close with these safes is, oh, I found the perfect
0:12:57 advisor.
0:12:58 That’s right.
0:13:00 Or I found the perfect early customer who wants to invest.
0:13:02 Or I found somebody else, right, a friend or family.
0:13:04 And so it feels convenient.
0:13:05 Yeah, it’s convenient.
0:13:06 Right.
0:13:11 Yeah, arbitrarily why we should have these kind of specific hard closes at different
0:13:12 times.
0:13:13 But yeah, it is convenient.
0:13:14 And again, it’s got a lot of value.
0:13:15 So I don’t want to suggest it’s never the right thing.
0:13:21 But I think it’s something to be aware of and make sure that you consider as an entrepreneur.
0:13:23 So let’s imagine I go through this process.
0:13:24 I’ve assembled my pitch deck.
0:13:27 I’ve got an offer and now I’m evaluating offers.
0:13:32 Yay, I’m in this enviable position evaluating term sheets.
0:13:36 So you talk a little bit in the term sheet about sort of the economic parts versus the
0:13:37 governance parts.
0:13:40 And so maybe let’s talk about each of them in turn.
0:13:47 So on the economic parts of my term sheet, maybe let’s talk about what is this thing
0:13:49 called, liquidation preferences?
0:13:50 What is this?
0:13:53 Yeah, there’s a whole several chapters in the book on this.
0:13:54 So I’ll give you the 30 second version.
0:13:58 So the simple way to think about liquidation preference is just the order in which money
0:14:00 comes out of the company.
0:14:03 So a liquidation is a fancy way of saying hopefully not an actual liquidation where
0:14:06 we’re saying now the company, but hopefully a sale of the company.
0:14:08 But it could certainly be the former as well.
0:14:12 And so what that means is who gets their money and in what order.
0:14:16 And generally what happens in venture fencing is the money that I invest as a venture capitalist
0:14:21 has what’s called a liquidation preference on it, which means my money comes out first
0:14:24 relative to the monies that would be owed the common shareholders, which is typically
0:14:26 where the founders and the team.
0:14:27 That’s right.
0:14:34 A simple example, if I invest $10 million and let’s say we sell the company for $10 million,
0:14:38 typically I will have $10 million worth of liquidation preference, which means all 10
0:14:43 of that money comes back to me and unfortunately for you and your employees, you have nothing.
0:14:45 And so that’s kind of the simple way to think about it.
0:14:53 It’s fairly common in venture deals, but typically it is kind of capped by just the amount of
0:14:56 money that the venture investors have put into the company.
0:15:01 And what’s kind of the most entrepreneur friendly liquidation preference formula that I should
0:15:02 live with?
0:15:05 There’s so many different kinds of liquidation preference.
0:15:08 Participating prefer non-3x, right?
0:15:09 So what’s the most entrepreneur friendly?
0:15:12 The most entrepreneur friendly and the one that I think generally predominates quite
0:15:16 frankly, particularly in Silicon Valley is what you would call a 1x non-participating
0:15:17 liquidation preference.
0:15:21 If you break that apart, 1x just means one times the money we put in, right?
0:15:25 So I don’t get two times my money, I don’t get three times my money, I get my $10 million
0:15:27 in that example we talked about.
0:15:31 And then non-participating means I don’t get to do what’s called double dipping.
0:15:35 And what double dipping means is not only do I get to take my liquidation preference
0:15:41 off, but then I also get to share in the proceeds that reflect my percentage ownership of the
0:15:42 company, right?
0:15:48 So in an example where let’s just say I put in $10 million and I own 25% of the company
0:15:54 or something like that, if I had participating preference, I would get my $10 million first
0:15:56 and then there’d be 10 left over, right?
0:15:57 Because we sold it for 20, there’s 10 left over.
0:16:02 Then I would also get 25% of that additional $10 million, fundamentally, you know, and
0:16:06 I say this the book, like I think that’s very unfair to the entrepreneurs and to the common
0:16:10 shareholders because liquidation preference is really intended to protect your downside.
0:16:11 And so it’s not obvious to me-
0:16:12 Something’s gone wrong.
0:16:13 Yeah, right.
0:16:16 Once you’ve kind of gotten your money out, it’s not obvious to me why you should also
0:16:20 participate in the upside and obviously take money away from the founders or the employees.
0:16:21 Yeah.
0:16:26 So when I hear my friends complaining about deals with structure, I guess this is an example
0:16:29 of deals with structure, like unfair liquidation preferences.
0:16:35 Right, unfair liquidation preferences, other structures sometimes you see is things, there’s
0:16:39 something called anti-dilution protection, which is again a basic way to say, “Hey, look,
0:16:44 if we later in the future raise money at a lower price than we raise today, it kind of
0:16:47 trues up the venture capitalist to a certain extent.”
0:16:52 And there’s a very common one, which is called weighted average anti-dilution, which is fairly
0:16:55 common, but there’s also a very egregious form of that, which you sometimes hear called
0:16:56 a ratchet.
0:16:59 And what a ratchet is, is really a complete price reset.
0:17:04 So it says, “Hey, if today I bought shares at $2 a share, and tomorrow you sell shares
0:17:09 at $1 a share, my $2 price converts to the $1 price,” meaning I literally get double
0:17:12 the number of equity ownership in the company than I thought.
0:17:18 And so you’ll see structure like that is sometimes happens when kind of people are trying to balance
0:17:20 off valuation with some of these other rights.
0:17:23 And that’s really a lot of what I try to point out in the book, is that it’s very hard to
0:17:26 look at these in isolation because they all have some kind of economic value.
0:17:30 So if you’re going to push on valuation, you might expect a venture capitalist to push
0:17:32 on some of these structure items.
0:17:35 And so the big advice that we always give entrepreneurs, and I echo this in the book,
0:17:38 is the simpler you can keep it the better.
0:17:42 And so if you’ve got one deal that’s got a lot of structure at this price, ask the
0:17:47 question for a lower price, what would a deal that’s a clean deal that doesn’t have all
0:17:52 the structure look like, that’s often quite frankly the advice that we give to entrepreneurs.
0:17:58 So I can actually get myself in trouble by sort of taking the highest post money because
0:18:02 of all of this structure and how does the money come out in these scenarios.
0:18:05 Yeah, I think there’s two risks that you always have to think about when you do the structure.
0:18:09 One is just, you’re potentially postponing the inevitable, right, which is you don’t
0:18:13 really know what the impact of these things will be until you have that next financing
0:18:14 event, right.
0:18:18 And so, look, the world may be perfect and you may never have to, you know, everything
0:18:21 may go up and to the right, which we all hope, but that’s not always the case.
0:18:25 And so, you know, a great example of this was, this is public information, but when Square
0:18:29 went public, they went public at $8 a share.
0:18:32 Their last round of financing was at $16 a share.
0:18:36 And those $16 investors had this full ratchet that we were talking about.
0:18:41 So, those $16 shareholders basically got issued two times the number of shares to bring their
0:18:42 price down to eight.
0:18:47 And so, all the existing shareholders obviously bore the brunt of that incremental, you know,
0:18:48 dilution from those shares.
0:18:49 So that’s kind of thing number one.
0:18:53 Thing number two is just, and this is why we always say keep it simple, is everything
0:18:56 you do today has the risk of creating precedent for the future.
0:18:58 And so, you may think, hey, look, you know, you and I are buddies.
0:19:01 This is, you know, I’m giving you these special rights because we’re friends.
0:19:05 But when that next investor comes in and looks at the paperwork from the previous round and
0:19:09 sees that you gave that stuff to the other investor, you know, the likely outcome is
0:19:10 they’re going to want the same thing.
0:19:13 And now you start to kind of get the cumulative effect of some of these things, which can
0:19:15 be, you know, pretty harmful at one time.
0:19:16 Right.
0:19:19 So, every subsequent investor is going to kind of want the same deal with a prior investor
0:19:20 or better.
0:19:21 Yeah, exactly.
0:19:22 Right.
0:19:23 You have to think into the future.
0:19:24 That’s exactly right.
0:19:25 You have more than one shareholder.
0:19:26 Yeah.
0:19:27 And you just don’t know how much negotiating leverage you’ll have at that time.
0:19:30 So, you don’t want to set yourself up to kind of start by having to defend or walk
0:19:33 away from a deal that you did prior.
0:19:34 Got it.
0:19:38 So, we’ve come back to the idea that, like, when I’m raising the Series A, I need to really
0:19:42 think about Series B and Series C and Series D, right, sort of like the sequence of investors
0:19:43 that I’m going to need.
0:19:44 That’s right.
0:19:50 I should sort of think through the entire financing plan before I start fundraising for
0:19:51 the Series A.
0:19:52 I think that’s right.
0:19:55 Yeah, look, I mean, you know, you want to kind of project as much foresight as you can,
0:19:58 recognizing that, look, markets may change, you know, kind of the financing environment
0:19:59 may change.
0:20:01 Those are things out of your control.
0:20:04 What’s in your control, at least, is to have a thoughtful plan for if I accomplish these
0:20:09 things, is that likely to lead to, you know, a favorable financing situation.
0:20:13 And if I make sure that I don’t kind of load up my terms with all kinds of crazy bells
0:20:16 and whistles, hopefully I set myself up for success.
0:20:17 Right.
0:20:19 So, it sounds like on the economic side of the term sheet, let’s keep it simple.
0:20:20 Yeah.
0:20:23 It’s sort of the big advice and think about the subsequent investors.
0:20:24 Absolutely.
0:20:27 I mean, so don’t do something abnormal early because that’s just going to bite you later.
0:20:31 Let’s talk a little bit about governance, the governance side of the term sheet.
0:20:35 So maybe the first question is, I heard that Google and Facebook have these dual class voting
0:20:38 shares and then, like, the founders have ultimate control.
0:20:39 That sounds good to me.
0:20:41 Like, don’t I always want that?
0:20:43 I want 10 times the voting share.
0:20:44 Right, exactly.
0:20:45 Does anybody else?
0:20:47 We do get some entrepreneurs, even, in the private markets who come ask us for that.
0:20:51 So, the important thing, I think, to think about in these, the idea, by the way, behind
0:20:55 dual class shares, for people who don’t know, is that literally shares have differential
0:20:56 voting rights.
0:21:00 Like, in the Facebook and Google cases, you’re right that Mark Zuckerberg and Larry Page
0:21:03 and other founders have kind of, you know, a high vote stock, which means they have more
0:21:07 influence on corporate matters and then everyone else has a low vote stock.
0:21:12 The reason those exist in the public markets is out of concerns of kind of potential misalignment
0:21:15 between long-term versus short-term incentives in the market, right?
0:21:19 And so, in a company like Facebook, let’s use that, you know, Mark probably has all
0:21:23 kinds of product ideas that he wants to execute over the next three, five, 10 years.
0:21:24 Those will all take time.
0:21:25 They will cost money.
0:21:29 There could be quarter-to-quarter gyrations in his expenses and revenue as a result of
0:21:31 these product plans.
0:21:34 And the main reason why somebody like that puts in dual classes, because he wants to
0:21:39 be able to make sure that if there are investors who are more short-term oriented, they can’t
0:21:42 out-vote him and say, “Hey, look, I don’t like your product strategy because of kind
0:21:44 of these short-term gyrations.”
0:21:48 The reason why those tend not to exist in the private markets is we’re all completely
0:21:50 aligned, which is none of us have liquidity, right?
0:21:54 So, we can’t, you know, in general, in many times we are prevented from selling our shares
0:21:55 legally.
0:21:59 So, there’s no liquid market, and we have a time horizon that’s consistent with the
0:22:01 entrepreneur’s time horizon, right?
0:22:04 You know, we don’t care, you know, obviously we don’t care about what they do quarter-to-quarter
0:22:07 other than to the extent it just represents them not being able to manage the business
0:22:09 in a way that makes sense.
0:22:14 And so, that’s why you tend not to see them in private markets.
0:22:17 What we’ve done with many of our companies is as they get closer to going public, we
0:22:21 have agreed with them that, okay, having these dual-class shares when and if you go public
0:22:26 is a good thing to do, but we haven’t done that, obviously, in the private markets.
0:22:27 Got it.
0:22:32 So, my first board members will likely be sort of either my co-founders and then my
0:22:33 early investors.
0:22:34 Right.
0:22:38 At some point, we’re going to go on a quest for an independent board member, and how should
0:22:39 I think about that?
0:22:40 When do we do that?
0:22:41 Why do I need one?
0:22:42 Who should I look for?
0:22:43 Yeah.
0:22:47 So, most boards you’re right are, in fact, most boards at the beginning don’t have independent
0:22:48 board members.
0:22:49 You’re right.
0:22:52 So, if you’re a co-founder and then typically as part of a venture capitalist coming into
0:22:56 your company as an investor, you will generally give them a board seat.
0:23:00 The reason I think independence are important is you want to have kind of balance on the
0:23:01 board.
0:23:05 And so, one of the phenomenon that we’ve seen over the last 10 years is a change in the
0:23:08 board structure in that it used to be that the venture capitalist would outnumber the
0:23:14 common shareholders, and that was of concern to many founder CEOs because it gave the venture
0:23:17 capitalist kind of the unilateral right in many cases to be able to remove the CEO if
0:23:19 they didn’t like them.
0:23:23 Over the last 10 years, that’s really shifted, and more of our boards have more common shareholders,
0:23:29 more founder and employee-led board members than they have preferred shareholders.
0:23:34 And that’s understandable and fair given some of the kind of changes we’ve had in governance.
0:23:39 The idea, though, behind an independent is can we find someone who is kind of not representing
0:23:42 either just the founders and not representing the preferred shareholders, but someone who’s
0:23:45 going to take a more neutral and expansive view of the business?
0:23:51 And so, I think it’s hard to probably do it early in your days, but as the board grows,
0:23:56 maybe as the board gets to four or five people, having an independent or two will be valuable.
0:23:59 And I think most people who’ve done it have gotten great value out of it, and oftentimes
0:24:04 they’ll look for an industry expert in the domain they’re in, or maybe they’re looking
0:24:08 for, hey, we need more sales and marketing help, and so let’s bring in someone who has
0:24:10 kind of expertise from an organizational perspective.
0:24:13 So those are the characteristics we tend to see with independence.
0:24:19 And as I approach an IPO, if all goes well, it seems like it’ll be expected that I have
0:24:20 an independent board member.
0:24:21 That’s exactly right.
0:24:22 One of the checklist items for going public.
0:24:23 That’s right, yeah.
0:24:24 So you’ll see this with companies, right?
0:24:26 When they go public, there are the different exchanges.
0:24:32 NASDAQ and NYSE have what they call listing rules, which require some number of independence.
0:24:35 They require some number of financial experts to be able to sit on things like the audit
0:24:36 committee.
0:24:39 So it becomes much more prescriptive as you go, and so you’ll often see a company kind
0:24:44 of, you know, T-minus one or two years leading up to an IPO start to kind of augment their
0:24:47 boards to satisfy these listing standards.
0:24:48 Got it.
0:24:51 Let’s talk a little bit about pro-rata rights.
0:24:54 So there’s going to be this element in the term sheet that says, here are what my existing
0:24:59 investors can be expected or are allowed to invest in subsequent rounds.
0:25:02 So how should I have that conversation with an investor?
0:25:05 What kind of pro-rata rights do I want them to have, and so on?
0:25:09 So it’s pretty typical when you do a fundraise that, you know, kind of one of the things that
0:25:13 we as venture caps will ask for is exactly this right, and what it means is it’s the
0:25:17 right for us to invest additional dollars in the next round of financing in order to
0:25:20 preserve the economic ownership that we already have in the company, right?
0:25:25 So if I own 25% of the company today, this gives me the right to hopefully put more money
0:25:29 in later such that my 25% kind of stays, you know, in and around that.
0:25:30 At a higher price?
0:25:31 Because I’ve made progress?
0:25:32 At a higher price, right?
0:25:34 So in general, it’s a very good thing.
0:25:39 Now, pro-rata rights become more challenging in the very, very good case, which is a nice
0:25:43 place to be, but, you know, if you are just executing phenomenally well and you’ve got
0:25:47 a new investor, you’re going to raise money and a new investor comes in and says, “Hey,
0:25:51 I want to put a bunch of money in, but for me to make my business model work, I need
0:25:53 to own a certain percentage of the company,” right?
0:25:57 Because if you go back to where we started from our last session, so much of what the
0:26:01 venture capitalist incentive is, can I get a Facebook, can I get a Google, and, you know,
0:26:03 there’s kind of two big cardinal sins in this business.
0:26:06 One is you miss one of those companies, you don’t invest in them.
0:26:09 The other is that you invest in it, but you don’t own enough of it so that when it gets
0:26:12 to be Facebook, it still doesn’t meaningfully change your economics.
0:26:16 And this pro-rata thing is kind of an example of the latter where that new investor may
0:26:19 come in and say, “Hey, look, I’m going to give you all this money, but I still only
0:26:24 own 3% or 4% of the company, and so, hey, I want you to go back to your existing investors
0:26:27 and tell them, ‘Don’t do your pro-rata, but let this new investor do it.'”
0:26:30 Now, admittedly, it’s a good problem to have, right?
0:26:32 Because it means we’ve got people who are bound, you know, kind of pounding down the
0:26:34 door to let us in.
0:26:36 But that does create tension.
0:26:40 You often see this even in the series A to seed side of things, that seed investors feel
0:26:44 like many times that they get compromised, and that the A round investors are trying
0:26:46 to kind of prevent them from doing pro-rata.
0:26:50 So it’s a very common thing to have, but I think it’s something where it puts you as
0:26:54 a CEO in a situation where you may have to manage kind of conflicting incentives among
0:26:55 your investors.
0:26:58 And so, you know, you just need to kind of go in eyes wide open, and hopefully you’ve
0:27:02 got a good enough dialogue with your existing investors where you can say, “Hey, let’s figure
0:27:05 out some compromise here that makes sense where everybody can feel like they can walk
0:27:08 away happy from the table.”
0:27:10 And what should I expect from my existing early investors?
0:27:14 So somebody invest in my A, should I expect them to be along for the ride and do their
0:27:18 pro-rata in the B and the C and the D all the way?
0:27:21 Yeah, you know, different firms have different philosophies on this.
0:27:25 You know, the way we do it here is, if we’re the A round investor, our general thinking
0:27:29 is that, you know, unless something dramatic happens with the company, you know, we should
0:27:32 expect that we’re going to participate pro-rata in the next round of financing.
0:27:35 We think, I think that’s kind of generally the convention in the industry.
0:27:38 On that, though, the answer for most firms, and we treat it the same way, is it’s kind
0:27:42 of an independent decision at that point in time because, you know, the dollars can get
0:27:45 very, very big and, you know, kind of, you have to think about, you know, how much do
0:27:47 I own at what kind of cost basis.
0:27:51 So I think it’s an important conversation, actually, to have with your VC when you take
0:27:55 money from them because you certainly don’t want to kind of, you know, miss set expectations,
0:27:58 you know, between the two of you, and you also want to be able to make sure when you
0:28:03 go raise money that you’re not creating some signaling effect otherwise where the new investors
0:28:07 are expecting your existing investor to participate and the fact that they don’t do it, they read
0:28:08 as a negative signal.
0:28:12 That can happen sometimes if you haven’t kind of had this conversation and, you know, already,
0:28:14 you know, set the right expectations up front.
0:28:15 Yeah.
0:28:18 So I need to be clear with you as soon as you put your money in.
0:28:22 I can count on you for the next round, or maybe the round after that, but like we should
0:28:23 just be on the same page.
0:28:24 That’s exactly right.
0:28:25 Yeah.
0:28:26 Great.
0:28:27 Good.
0:28:28 So last few questions on sort of governance.
0:28:32 Let’s talk about stock restrictions, like what are they, how should I think about them?
0:28:33 Yeah.
0:28:37 So this is one that’s come up more often because of this phenomenon now that companies are
0:28:38 staying private longer, right?
0:28:42 So it used to be not a big deal because companies about, you know, six years or so from founding
0:28:44 was kind of the median time to going public.
0:28:46 Now we’re talking 10, 12 years.
0:28:49 And so the things that you want to think about as a founder is two things.
0:28:53 Number one is, what are my investors going to do?
0:28:56 And so often you will see that investors will have restrictions on their ability to sell
0:29:00 shares and those come in lots of different flavors, which we won’t go into detail, but
0:29:01 you can read about on the book.
0:29:03 And then the other question is, what do you do about employees, right?
0:29:07 Because you’re probably going to have employees who will have fully vested their shares, some
0:29:09 of whom will have left the company.
0:29:11 And you know, this is one is a tough one to navigate, right?
0:29:15 Because on one level as a CEO, you know, I think you want to, you know, you want to
0:29:19 get flexibility to your employees, particularly the ones who are still, you know, at the company,
0:29:21 right, doing great work.
0:29:25 The thing you want to be careful about though is making sure that those shares don’t kind
0:29:29 of take up demand that would otherwise exist for people to buy shares from the company,
0:29:32 where the cash would come into the company, and therefore allow you to kind of raise money
0:29:33 and grow the business, right?
0:29:37 So if you think about this at some level, there may be a finite amount of dollars that
0:29:40 all the investors are willing to put in this company.
0:29:44 And if you have employees share sales competing with sales that you’re making as the company
0:29:48 to try to raise money to put in your own coffers, there can be a kind of a tension there.
0:29:54 And so more generally these days, we see fairly restrictive provisions here, which is most
0:29:58 companies try to kind of, you know, say, “Hey, look, if you’re going to sell as an employee,
0:30:02 you need the consent of the company,” or something like that, so that you kind of have more control
0:30:07 over the timing and also the volume, potentially, of these purchases.
0:30:12 Thinking about employee incentives, since this is sort of part of the discussion, my
0:30:17 friends who are doing longer vesting schedules or back-loaded employee options instead of
0:30:22 sort of, you know, one 48th over four years, they’re doing, you know, 10, 20, 30, 40, right,
0:30:26 to incent people to stay longer, how should I think about those types of incentives?
0:30:27 Yeah.
0:30:29 You know, there’s lots of discussions on this right now.
0:30:32 The short answer is I’m not sure there’s yet a real change in convention.
0:30:35 I think most people are still doing the pretty straight four years.
0:30:40 The big change that you may have heard about from some people is normally when you leave
0:30:44 the company and you’re vested, you typically have about 90 days to either exercise your
0:30:47 shares or you have to forfeit them.
0:30:51 And because of this elongation of companies staying private, a lot of companies now have
0:30:54 extended that period and they say, “Hey, look, we’re going to give you a year or two years
0:30:58 or something because we recognize there’s not a liquid market in the form of an IPO
0:31:02 to be able to sell them and we know it’s expensive for you to come out of pocket to have to exercise
0:31:03 your options.”
0:31:07 So, there’s probably more creativity, I would say, happening on that side, less creativity
0:31:11 on fundamentally rethinking whether we should have just a different investing schedule overall
0:31:14 that reflects, you know, kind of the fact that companies are staying private longer.
0:31:15 Got it.
0:31:19 So, if I wanted to be as sort of maximally employee-friendly as possible, I’d be extending
0:31:22 the time that people can choose to exercise their contracts.
0:31:23 That’s exactly right.
0:31:24 Yeah.
0:31:27 And, you know, the only thing that, you know, and we’ve talked about this in some of our
0:31:32 blogs, the only thing to think about there is that means that those shares, you know,
0:31:36 those shares will be what’s called an overhang, meaning that, you know, kind of they’re sitting
0:31:37 out there.
0:31:40 You don’t really know if they’re going to get exercised or not, but, you know, sometimes
0:31:43 in the alternative, people might not have exercised them.
0:31:46 Those shares can be returned to the company and the company could use them, obviously,
0:31:48 to issue new options to people.
0:31:52 So, there’s a, you know, a very emotional, understandably so, and a very kind of deep
0:31:53 debate on this.
0:31:57 But, yes, in the perfectly employee-friendly case, you would extend it out as long as possible
0:31:59 to give people the maximum time period.
0:32:00 Got it.
0:32:01 Great.
0:32:04 Thanks for talking to us about all of the economic and governance terms.
0:32:08 The term sheet can be very intimidating, so I’m glad you sort of went through it and
0:32:09 demystified it.
0:32:10 Thanks, Frank.
0:32:11 All right.
0:32:12 Congratulations.
0:32:16 You’ve survived to the end of part two, where we talked about understanding fundraising
0:32:19 and the terms that go into a term sheet.
0:32:23 Hopefully this gives you a sense of all of the mysterious terms you’ve now seen, maybe
0:32:28 for the first time, when a term sheet has arrived.
0:32:31 Next up, we’re going to do part three of our series.
0:32:35 And part three is all going to be about living with your venture investor over a long period
0:32:36 of time.
0:32:41 So, you might actually have the same person on your board of your company for 10 years,
0:32:49 and so Scott has great tips for how to understand the bends in that relationship and how it
0:32:55 will change over time, and we’re going to dig right into three concrete scenarios that
0:32:59 you might end up encountering, one in which you are winding down your company, one in
0:33:03 which you’re selling your company, and one in which you are actually going public.
0:33:06 Congratulations, and we’ll see you at part three.
So you’ve decided raising venture capital is the best fundraising strategy for your startup. Now what?
In this second of a 3-part series, a16z Managing Partner Scott Kupor shares actionable fundraising advice based on his experience of seeing thousands of startup pitches and working on all of a16z’s investments.
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/).
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