Secrets of Sand Hill Road #1 – The VC Process

Secrets of Sand Hill Road

Today’s post is our first visit to a new book – Secrets of Sand Hill Road by Scott Kupor.

Venture Capital

Secrets of Sand Hill Road is a book about Venture Capital (VC) in Silicon Valley.

  • Sand Hill Road is the street near Stanford where most Silicon Valley VCs are based.

VC investments are typically only available to accredited investors in the US:

Accredited investors are basically people who have achieved some level of financial success (the current rules require that you have a $1 million net worth or have earned for the last two years,2 and have an ongoing prospect of earning, at least $200,000 annually).

And it’s a similar story over here.

  • Even the VCT funds and EIS companies aimed at private investors often require you to self-certify as a “sophisticated” (experienced) or “high net worth” (£250K of liquid funds) investor.

The exception to this rule is equity crowdfunding, which allows the great unwashed to punt £10 at a very risky unlisted firm.

  • You might be able to tell that I’m not a big fan.

VC can have decent (or even spectacular) returns.

  • But it’s very risky, and its mythical low volatility likely comes from a lack of marking to market during the most severe and volatile downturns.

I also believe that the best opportunities are reserved for those in the inner circle.

  • I hope this book will explain how elite VC works, and why the best opportunities are not available to me and you.

Nevertheless, the tax-breaks available on VCT funds (30% income tax relief upfront and tax-free dividends) make them attractive to investors who have already filled their SIPPs.

Scott Kupor

Scott Kupor

Scott Kupor is a founder member – and now managing partner – at Andreessen Horowitz (also known as a16z), an elite Silicon Valley VC with 150 employees and more than $7 bn in AUM.

  • He has also been a startup executive (at LoudCloud and Opsware) and he now also teaches VC at Stanford and Berkeley.

For more on Scott’s background, check out Chapter 1 of the book, which is largely autobiographical.

  • It covers his time in startups, the growth of the Silicon Valley angel community, and how he became involved with Marc Andreessen (of Netscape fame) and a16z.
Secrets of Sand Hill Road

Scott starts his introduction to the book by breaking down the VC process:

  • VCs raise capital from limited partners (LPs – endowments, foundations, pension plans, family offices, and funds of funds)
  • They invest this with entrepreneurs at various “stages”, from early-stage (pre-revenue) to growth-stage (businesses with revenue that are ready to scale up).

VCs are distinct from PE or “buyout” investors, who like to take over a company completely and control it.

  • Usually, PE will cut costs, raise debt to increase returns, and then re-sell a firm back to the public markets.

There are three possible exits of VC investments:

  1. IPO (public listing)
  2. industry buyout/takeover (perhaps spun as a merger)
  3. bankruptcy (the most common outcome)

VCs are unlike most other asset managers (other than PE and activist hedge funds) in that they actively work with the companies they invest in – sitting on the board and helping with recruitment, suppliers and pilot customers.

  • They also often invest multiple times, in “rounds” as they are known.

VCs are only as good as the entrepreneurs in whom they have the privilege to invest. Simply put, entrepreneurs build businesses; VCs don’t.

The 665 VC-backed, US-listed companies spend 44% of the market’s R&D budget, make up a fifth of the total market cap and employ four million people.

Scott quotes a study from Stanford:

  • 42% of all US IPOs since 1974 were VC backed
  • They have been responsible for 85% of R&D spending since then
  • And created 63% of the total increase in market capitalization of public companies in that time.

Another study found that they were responsible for almost all of the twenty-five million net jobs created since 1977.

VC money has funded many very interesting technology startups, including Facebook, Cisco, Apple, Ama?on, Google, Netflix, Twitter, Intel, and LinkedIn.

Non-tech firms like Staples, Home Depot and Starbucks were also VC funded.

  • At the time of writing the book, the five largest companies by market cap – Apple, Microsoft, Facebook, Google and Amazon – were all VC funded.
The entrepreneur’s decision

Before raising VC money, entrepreneurs need to decide:

  1. Is the market size big enough that the scaled-up business can be a “home run” that “moves the needle” for a VC firm’s returns?
  2. What is the right balance of economic and governance terms to have with a VC?
  3. Are you happy to take on what will likely be a 10-year relationship?
  4. What are the downstream implications of the initial investment decisions?

The VC/entrepreneur relationship is asymmetric:

VCs get a lot of “at bats”, lots of chances to invest in a home-run company, while most entrepreneurs get to step up to the plate only a few times.

There’s also information asymmetry – VCs know a lot more about eg. term sheets (VC legal agreements).

The VC Life Cycle

The structure of the book follows the VC life cycle:

  1. the formation of a VC firm
  2. the funders of such firms, and their motivations
  3. startup company formation
  4. the VC financing process, and the term sheet
  5. the role of the board of directors
  6. the return of money to the investors (IPOs and acquisitions)
See also:  Secrets of Sand Hill Road #4 - Boards and Deals
Equity vs debt

The main alternative to VC funding is a loan from a bank.

  • But since the 2008 crisis, banks have been less willing to lend to new (and usually unprofitable) businesses.

In any case, loans are not suitable for all firms, since they need to be repaid.

Loans are best suited for businesses that are likely going to be generating near-term positive cash flow sufficient to pay interest and, ultimately, the principal amount of the loan.

Equity doesn’t suffer from this limitation. It is permanent capital.

Which means that it’s better suited for firms which need to reinvest their profits back into the business (or which don’t yet generate any cash, or are too risky for the banks).

  • Equity holders receive dividends (when a firm reaches the stage where it no longer needs to reinvest its profits) but they usually realize the value of their shares by selling them (hopefully for a lot more than they paid for them).

VCs sometimes invest through “notes”, which are in effect bonds which are convertible to equity at a later stage.

Players in VC

There are three main roles in the VC process:

  1. investor (the limited partner in the VC partnership
  2. the venture capitalist (the general partner), and
  3. the entrepreneur (whose startup company will be invested in).
VC as an asset class

Scott feels that VC is not a good asset class:

The median returns are not worth the risk or the illiquidity that the average VC investor has to put up with.

He claims that VC returns are 1.6% pa lower than the Nasdaq (as of 2017).

  • But the Nasdaq is on a pretty good run.
  • And UK private investors have a tax break to consider.

My experience is that a diversified portfolio of VCTs provides good and uncorrelated returns.

  • But they are risky and illiquid.
  • And you should fill your SIPP first.
  • And you need the taxable income that you can offset.

So they really aren’t for everyone.

  • True VC / Angel investment in the UK probably requires a minimum investment of £1M to £2M and therefore a net worth in the £10M to £20M range.

Scott’s point is that VC returns are asymmetric – they follow a power-law curve rather than a normal distribution.

  • This is a common finding in finance.

So the best firms get much better returns, even across successive fund cycles.

  • And it’s almost impossible for the average investor to access the best firms.

Here in the UK, I would say that returns are lower but more evenly distributed.

Signalling

Venture firms develop a reputation for backing successful startup companies, and that positive brand signaling enables those firms to continue to attract the best new entrepreneurs.

“[And] what about the engineers whom she is competing with fifty other companies to hire? Won’t they also think that the brand imprimatur of ABC Ventures might increase the likelihood of success?

The same goes for prospective customers.

We often use signaling as a shorthand way of informing judgments. And as with all forms of generalization, sometimes we have false positives. This happens when we overfit on the curve and ascribe success to individuals or companies that might in fact not be as good as we have presumed them to be.

In VC, underfitting (false negatives, where good candidates are eliminated) is much more serious.

  • This is because of another power law – the best startup companies win very big.

Failing to invest in a winner means that you forfeit all the asymmetric upside that comes along with that investment. Missing the next Facebook or Google can be career ending.

There will never be another first round of financing for Facebook. So whatever return is ultimately generated from that first round of investment accrues to a very small set of fortunate investors.

Diversification

Diversification is a bad strategy for investing in VC firms. Returns in the top end of VC funds can often be as much as 3,000 basis points higher than at the bottom end.

Here in the UK, VCT returns are much flatter.

  • Our startups are generally not so globally successful
  • And VCT investment has tended to be later stage and aimed at safer companies – though new rules are pushing the money closer to tech startups.

A UK investor might want to stick to the top half of the 80 or so funds available, but investing in 12 to 20 of those 40 is not a bad idea.

It’s very hard for new firms to break into the industry and be successful. If you don’t have the brand to create the positive signaling that attracts the best entrepreneurs, it’s hard to generate the returns. It’s a classic chicken-and-egg problem.

Batting average

Scott likes baseball analogies.

  • Luckily we have cricket as a substitute.

50% of VC investments lose some or all of the money invested.

  • 20% to 30% might double or triple in value.
  • 10% to 20% are “home runs” returning 10 to 100 times the investment.

So home runs are the key.

  • The main metric is “at bats per home run” – how few investments a fund makes to find one home run.

A good VC fund will target investor returns of 250% to 300%, which means 300% to 400% before VC fees.

  • Which means the “at bats per home run” needs to be 5 to 10 (10% to 20% home run rate).
How do VCs choose?

At the early stage of venture investing, raw data is very hard to come by. The company usually hasn’t gone to market yet, so qualitative evaluations dwarf quantitative ones.

VCs choose on three measures – people, product and market.

The fundamental assumption here is that ideas are not proprietary. If an idea turns out to be a good one, there will be many other founders and companies that are created to pursue this idea.

A corollory of this is that VCs can’t invest in two firms pursuing the same idea – it would be a conflict of interests.

Among the cardinal sins of venture capital is getting the category right but getting the company wrong.

In other words, backing the wrong horse.

See also:  Secrets of Sand Hill Road #3 - Raising Money & Term Sheet Economics
People

VCs look for a product-first company.

[Here] the founder identified or experienced some particular problem that led her to develop a product to solve that problem, which ultimately compelled her to build a company as the vehicle by which to bring that product to the market.

And they look for product-market fit.

A product so attractive to customers that they recognize the problem it was intended to solve and feel compelled to purchase. Consumer “delight” and repeat purchasing are the classic hallmarks. As consumers, we almost can’t imagine what we did before these products existed.

Scott uses Airbnb, Pinterest, Lyft, Facebook and Instagram as examples.

  • Interestingly, I find none of these firms compelling.
  • I’ve used Airbnb once and Uber (Lyft’s rival) three times, and I maintain a Facebook profile only so that people can find me if they need to.

VCs also look for founder-market fit.

Perhaps the founder has a unique educational background best suited to the opportunity, or a unique experience that exposed her to the market problem in a way that provided unique insights into the solution for the problem. [Or] perhaps the founder has simply dedicated his life to the particular problem at hand.

But sometimes, a completely different professional background can help:

  • The founder of Southwest Airlines was a lawyer:

I knew nothing about airlines. What we tried to do at Southwest was get away from the traditional way that airlines had done business.

And VCs look for leadership abilities.

[Will] this founder be able to create a compelling story around the company mission in order to attract great engineers, executives, sales and marketing people, etc.

And also customers, marketing partners and other VCs for later funding rounds.

Will the founder be able to explain her vision in a way that causes others to want to join her on this mission? And will she walk through walls when the going gets tough?

VCs look for leaders who are self-absorbed and borderline egomaniacal.

  • Which might not always be a good thing (eg. Theranos, or Facebook).

Non-obvious ideas that could, in fact, become big businesses are by definition non-obvious. My partner Chris Dixon describes our job as VCs as investing in good ideas that look like bad ideas.

Most ideas are not proprietary. Execution ultimately matters and derives from a team’s members being able to work in concert with one another toward a clearly articulated vision.

Product

The fundamental question is, will this product solve a fundamental need in the market such that customers will pay real money to purchase it?

“Most VCs assume that the product that is initially conceived of and pitched is not likely the product that will ultimately prevail. Only through iterative testing with real customers will the company get the feedback needed to build a truly breakthrough product.

So once again, the VCs are really looking at the founder’s thought process.

VCs say that they like founders who have strong opinions but ones that are weakly held, that is, the ability to incorporate compelling market data and allow it to evolve your product thinking.

This ability to “pivot” is very useful in investing, also.


The second is aspect is whether this is a breakthrough product – effectively something that makes the startup disruptive.

  • Established firms have a blind spot about these products. As Max Planck put it:

Science advances one funeral at a time.

Scott says:

New products ten times better or ten times cheaper to compel companies and consumers to adopt.

For once, the compounding of marginal improvements is not enough.

Ben Horowitz uses the difference between a vitamin and an aspirin to articulate this point. Vitamins are nice to have. If you have a headache, though, you’ll do just about anything to get an aspirin! VCs want to fund aspirins.

Market Size

As you would imagine, bigger is better.

[The] size of the winners is all that matters. Market size estimation is easiest when a new product is positioned as a direct substitute for an existing product.

The more challenging aspects of market size estimation come from startups going after markets that do not exist currently or that are smaller markets today.

Airbnb is a good example here – it started out in couch-surfing, before taking on hotels.

Conclusions

That’s it for today.

  • We’ve covered around one-fifth of the book, so there are probably four more articles to come (plus a summary).

It’s been an interesting start, though none of the content is particularly new to me (perhaps because of my experience investing in EIS and VCT).

  • At the same time, this is a quality book from a top-class practitioner, and it has few direct rivals to my knowledge.

So it’s well worth the time it takes to read it.

  • Until next time.

Mike is the owner of 7 Circles, and a private investor living in London. He has been managing his own money for 35 years, with some success.

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Secrets of Sand Hill Road #1 – The VC Process

by Mike Rawson time to read: 9 min