Secrets of Sand Hill Road #3 – Raising Money & Term Sheet Economics

Today’s post is our third visit to Scott Kupor’s book Secrets of Sand Hill Road.

Raising Money from a VC

Chapter 7 looks at whether you (the entrepreneur) should raise VC capital, and if so, how much and at what valuation.

• The obvious answer is to raise as much money as you can – when you can.

John Doerr famously compared fund-raising to attending a cocktail party. When the waiter comes around with the tray of mini hot dogs, you should always take one. You never know when the waiter will make it back to you.

The analysis is similar to the one we looked at as part of the VC investing approach, only in reverse:

The cardinal rule of VC investing: everything starts and ends with market size.

No matter how interesting or intellectually stimulating your business, if the ultimate size of the opportunity isn’t big enough to create a stand-alone, self- sustaining business of sufficient scale, it may not be a candidate for venture financing.

Scott takes this to mean several hundred million dollars of revenue within seven to ten years.

• Which in turn would support a post-IPO market cap of several billion dollars

These kinds of returns will “move the needle” on the VC fund’s returns.

For smaller firms, there are smaller funds:

Smaller VC funds (less than $100 million) invest very early in companies – the business model is to exit companies largely through acquisitions at lower ultimate end valuations.

This sounds more like the EIS / VCT market in the UK.

• Some angel investors also fall into a similar bracket.

If the business does fit, the entrepreneur needs to think about whether they are happy to give up equity and deal with VC governance for possibly ten years.

How Much Money?

Raise as much money as you can that enables you to safely achieve the key milestones you will need for the next fund-raising.

This means being able to demonstrate to future investors that the business has been de-risked (commensurate with a higher future valuation).

• And this process usually takes one to two years.

Typical milestones include a commercially available product and some customers (and several $M of sales).

Some will ask why companies don’t just raise all the money they will ever need.

• But this is often north of $100M, and even VCs don’t want to take this risk upfront.

They prefer to invest gradually, as signs of progress emerge.

• If they were willing to invest all the money upfront, it would need to be at a low valuation (which is bad for the entrepreneur).

Scarcity of capital during phase one can also work to the firm’s advantage, by forcing real cost-benefit trade-offs.

What valuation?

There’s a trade-off here, between giving up equity on the cheap and setting the valuation bar too high for future raises to be successful.

• If an entrepreneur does go for an aggressive early valuation, they need to raise more money, to ensure they will have the time they need to justify an even higher valuation next time.

In practice, valuations will be decided by listed market comparatives, and VC competition (“deal heat”).

• So too high a valuation in the A round can lead to less VC competition in the B round.

And a higher valuation followed by a lower valuation (or a modestly higher valuation) can lead to greater dilution for the entrepreneur over the two rounds.

• Lower later vaulations can also hit employee sentiment.

Ultimately, the best story for you as a CEO is to be able to point to the proverbial “up and to the right” valuation graph.

Foot in the Door

Chapter 8 is about the art of the pitch.

• I’ve never been an entrepreneur, so I’ve never had to pitch a business.

But I was once a screenwriter, and then a film producer, so I have some experience of pitching movie ideas.

• So I’m looking forward to understanding the differences between the two processes.

---

First, you have to be asked to pitch.

Angel or seed investors are often an important source of referrals for VCs.

The symbiotic relationship between early angels and later VCs is obvious.

Law firms also tend to be important avenues into venture firms.

So choose your lawyer carefully.

Apart from these two routes, you’ll need to be creative.

• And VCs will use your ability to reach them as a proxy for your ability to solve the future problems that your business will face.

The Pitch

We can work out what makes a good pitch from what we’ve already learned about the VC market cycle:

• You need to persuade the VC that your firm has a large market opportunity that will lead to outsize returns (10x to 25x) that will move the needle on the VC fund’s returns.

So that means:

1. Potential market size
   • Especially where this may not be obvious from the initial product (MVP), or the first product that your firm is disrupting
   • Network effects are particularly useful here
2. The team
   • Because ideas are cheap, and execution is crucial
   • The founder is key here, and a track record that includes some previous failure need not be an obstacle, so long as something was learned for next time
   • Story-telling skills were key to a16z
3. Product
   • VCs want to know how the entrepreneur’s brain works, and the look to the product plan and the “idea maze” as evidence of this
   • Is the product ten times better or 10x cheaper than its competition?
   • What is your process of evaluating market needs?
   • Ideally, you will have “strong beliefs, weakly held” – you can adapt to new market data and if necessary pivot the company (ie. dump the original product for something better)
4. Go-to-Market
   • How will you profitably acquire customers (ie. without paying too much for them relative to their lifetime value)?
   • This section in a pitch is often weak, since customers may not be a big part of phase one.
5. Planning for the next round
   • You need to explain what you will do with the money from this round and how it will prepare you for the next (at a higher valuation due to de-risking)
   • Achievability of the milestones is key.

Term Sheet Economics

Chapter 9 is the first of two chapters aimed at explaining term sheets to those who have never seen them.

• It deals with the economic terms in the sheets.

Scott says the governance terms are actually more important for the long-term success of the company.

• Obviously, VCs have an informational advantage over entrepreneurs in the negotiations over terms, and Scott wants to offset this to some extent.

Valuation Methods

Scott covers three methods:

1. Comparable company analysis
   • As mentioned above, valuations are done in comparison to similar listed companies.
   • Key inputs include price to revenue, growth rates, margins and market size.
2. Discounted Cash Flow Analysis – I will assume readers have come across DCF before.
   • The idea is that a company is worth the present value of its future cash flows.
   • This involves discounting future payments using a discount rate (usually the company’s cost of capital or the opportunity cost on alternative investments).
   • DCF is hard (and subjective) even for mature companies, but for startups, most of the positive cash flows are from the far-out years, and there is the problem of future dilution to deal with.
3. “What do I need to believe analysis”
   • In practice, many VCs work backwards from their target exit price.
   • If a winner is anything above a 10x return, the maximum expected return will need to match the revenues from target market size, and will in turn cap the valuation for Series A.

Key terms

1. Preferred shares
   • VCs like to buy preferred shares, which have different economic and governance rights relative to common shares.
2. Aggregate Proceeds
   • The VC investment, plus the converted value of outstanding debt/notes (which outranks equity, meaning the VCs want it gone), including convertibles.
3. Convertible debt
   • To ensure people will buy this before the Series A equity injection, the conversion price is usually capped (at a particular valuation of the entire company).
   • There may alternatively or additionally also be a conversion discount to the Series A price.
   • This approach allows early investors to defer the majority of the valuation discussion until the Series A round.
   • Too much convertible debt can mean founder dilution at Series A, which can only be remedied by issuing more equity (diluting everyone else).
4. Post-money valuation
   • This is the value of the company after the VC investment (pre-money valuation is the valuation before the investment).
   • Pre-money + investment = post-money.
   • Conversion of notes happens along with investment, not after.
   • Post-money valuation includes the unallocated employee option pool (usually 15%, but based on an 18-month hiring plan from the CEO).
   • VC percentage ownership = post-money / investment.
5. Dividends
   • Though most startups won’t generate the cash to pay dividends, term sheets usually specify that preferred shareholders (VCs) get paid first.
6. Liquidation Preference
   • This section describes how money is returned to investors after a “liquidation event” (a sale, or wind-down).
   • There will usually be a term by which the VCs get their capital back (or 1.5x, or 2x or even more) first. 1x is normal.
   • “Nonparticipating” means that if the VC takes his capital back, those shares are not also converted into common stock, to receive a second set of rewards(the “double-dip”) – but the VC can choose which option he prefers.
   • The “indifference point” will be the valuation at which the initial VC investment was made, so this term merely protects the VC investment when the sale price is low.
   • “Participating” means the double-dip (and is unusual).
   • After multiple financing rounds, there may be multiple liquidation preference terms (for multiple investors), and an order of execution will be required – early preference is known as seniority.
   • When all investors are ranked equally this is known as pari passu – this is sometimes better for entrepreneurs as competing incentives might mean that a low-ball takeover offer gets approved.
7. Redemption would allow VCs to get their money back (possibly with interest) by selling their shares to the company.
   • This is the opposite of permanent capital and the rights would likely be exercised at a bad time for the entrepreneur (possibly bankrupting the company).
   • It is hence unusual.
8. Conversion/Auto-Conversion
   • There may be options for the VC’s preferred stock to be converted to the common outside of a liquidation event, and the common shareholders may want to force this conversion under certain circumstances.
   • The VC would usually do this on an IPO, but there may be a restriction that the IPO needs to be of a certain size (for liquidity) and/or valuation (to ensure the VC is rewarded).
   • The valuation can be via the IPO size, or by share price, or explicitly as a return multiple for the VC.
   • A forced conversion term would normally only be introduced as part of a recapitalisation scheme after things have gone wrong once.
   • Voluntary conversion of preferred stock usually applies across all preferred stock from all funding rounds, in a single transaction.
9. Anti-dilution Provisions
   • These are designed to protect early investors in the event of a “down round” (further investment at a lower price than that at which the VC invested).
   • There is dilution in an up round, too (new shares are created), but less, and there is compensation from the increased per-share valuation.
   • The middle course of protection is called “broad-based weighted average antidilution protection.
   • The VC does not get to reset its original purchase price fully to the new, lower price, but it does get a blended price, weighted by the amount of capital raised in the two financing rounds.
   • Note that the VC does not need to stump up new capital to achieve the dilution mitigation.
   • Sometimes VCs will use some of their protection to also help out founders and/or the employees’ option pool.
10. Voting Rights
    • Normally each share – common and preferred – has one vote.
    • Sometimes this changes at IPO to protect the founders’ control (and sometimes this happens automatically, via a “springing dual-class structure” – pre-IPO shares are granted multiple votes).
    • Sometimes in private companies, some investors (usually lat-stage, passive investors) hand over their voting proxies to the founders.

---

That’s it for today.

• We’re 60% of the way through the book, with two more articles to come, plus a summary.

Until next time.