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Introduction
I am writing this book from my office on Sand Hill Road, the hallowed Silicon Valley street that holds as much promise for entrepreneurs as Hollywood Boulevard does for actors, Wall Street does for investment bankers, and Music Row does for country music artists. And, as with most of the storied streets, it’s not much to write home about—Sand Hill Road is a drab collection of modest, low-rise office buildings, upstaged by its much more famous neighbor, Stanford University.
But I’m not writing it from on high. This is no sermon, no stone tablet passed down. This book isn’t intended to be the venture capital (VC) bible. There are far too many important nuances in the field, with lots of different firms that invest at different stages, under different investment theses, with different portfolio constructions, and different return expectations. Not to mention different personalities.
And that’s just on the venture capitalist side of things. More importantly, no two entrepreneurs are the same. The innovative, often world-changing companies they create always come with a unique set of opportunities, challenges, and conditions to be navigated.
I also fully acknowledge the personal biases I bring to the table. The first is my experience, hard-won, on the startup side of things via my years at LoudCloud and then Opsware. The other bias has been personally developed, on the VC side, in my role as managing partner at Andreessen Horowitz, or a16z, where I have been since the firm started in 2009. This means I’ve had the opportunity to see VC from multiple vantage points.
And, in fact, my hope is to help us stop thinking divisively in terms of one side or the other, one side versus the other. Entrepreneurs and VCs are not on opposing sides, the way one soccer team tries to crush another in the World Cup. Rather, we are partners, and once we agree to work together (and even if we don’t), we are on the same side. What we share is a desire to create benign businesses, see them have an impact on and improve the world, and together realize some financial benefit along the way.
The story of venture capital is really a subset of the story of entrepreneurship. As venture capitalists, we raise investment funds from a broad range of limited partners (LPs), such as endowments, foundations, pension plans, family offices, and fund of funds. The capital raised from LPs is then invested in great entrepreneurs with breakthrough ideas.
Venture capitalists invest anywhere from the very early stage, where the startup is little more than an idea and a couple of people, to growth-stage startups, where there is some decent revenue coming in and the focus is on effectively scaling the business. Generally, a company leaves the venture ecosystem one of three ways: via an initial public offering (IPO), a merger or acquisition, or bankruptcy and a wind down.
There is often a misconception that venture capitalists are like other investment fund managers in that they find promising investments and write checks. But writing the check is simply the beginning of our engagement; the hard work begins when we engage with startups to help entrepreneurs turn their ideas into successful companies.
For example, at Andreessen Horowitz, we often work with our companies to help them identify talented employees and executives to bring into the company or to identify existing companies that can serve as live customer test sites for their products. The reality is that those who are successful in our field do not just pick winners. We work actively with our investments to help them throughout the company-building life cycle over a long period of time. We often support our portfolio companies with multiple investment rounds generally spanning five to ten years, or longer. We serve on the boards of many of our portfolio companies, provide strategic advice, open our contact lists, and generally do whatever we can to help our companies succeed.
All that being said, VCs are only as good as the entrepreneurs in whom they have the privilege to invest. And nobody should confuse the tireless heavy lifting that the entrepreneurs and their teams do to build a successful business with the investing activity of a VC. Simply put, entrepreneurs build businesses; VCs don’t. Great VCs help in any way they can along the company-building path, but it is the entrepreneurs and their teams who tread that path every day and make the difference between success and failure. And while all VCs hope that each of our companies succeeds against huge risks and grows into a successful business, the reality is that the majority fail.
Entrepreneurship is inherently a risky endeavor, but it is absolutely essential to the American economy. Successful venture-backed companies have had an outsize positive impact on the US economy. According to a 2015 study by Ilya Strebulaev of Stanford University and Will Gornall of the University of British Columbia, to the impact on the American workforce, a 2010 study from the Kauffman Foundation found that young startups, most venture backed, were responsible for almost all of the twenty-five million net jobs created since 1977.
What does all this mean? Simple. We need you. We need your ideas and your guts. We need your companies and your commitment to growth.
What I want to do most with this book is help entrepreneurs. Access to capital is critically important to the success of a startup, and at one time or another you have to (or will) consider whether or not your business can and should raise VC. I hope this book helps to democratize access to the information about what makes the venture business tick—to the benefit of you, the entrepreneur.
The decision to raise capital from a venture firm is a huge one, and should not be undertaken without a full consideration of the benefits and risks of this source of capital. For example, is your business even appropriate in the first instance to raise venture financing? Is the market size big enough that the business at scale has the prospect of being a home run, and thus moving the needle for a venture capitalist in terms of her overall fund returns? How can you better understand the economic incentives of the VC industry in order to determine whether you are in fact looking for capital in all the right (or wrong) places?
If you choose to raise venture money, how do you think about the appropriate balance of economic and governance terms with your VC financier? What trade-offs are you willing to make, and what are the downstream implications of those decisions, particularly if you need to raise subsequent capital when the business develops at a different pace than you expect? And how will you and the board work effectively to achieve the long-term goals of the business?
It’s an unfair truth that 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. Or to mix my sports metaphors, you get only a few real shots on goal in your lifetime while we VCs get several. Because of this imbalance, specifically regarding investment decisions, information asymmetry can come into play (often at the expense of the founder). The VCs are repeat players and thus have the benefit of lots of years of developing their understanding of the various mechanics (especially when negotiating term sheets), whereas founders have been through the process only a handful of times, at most. What I hope to lay out for founders is a better understanding of and appreciation for the interplay between VCs and founders in order to level the playing field. Information asymmetry should not pollute the foundation of a marriage that could last ten years or more.
Does that timeline surprise you? That you are likely entering into a (minimum) ten-year marriage of sorts with your venture partners? It’s longer now than ever before, yet for too long there has been a lack of transparency into the inner workings of that partnership.
That is why I want to give you, a founder, some insider information, secrets, and advice so that you can best navigate your way through your interactions with venture capital firms, from the initial pitch session all the way through to an IPO or acquisition.
I’ve now had the opportunity to see VC from both perspectives—as a member of a startup and now as the managing partner for Andreessen Horowitz. While my seat has changed—and certain elements of the venture business have evolved—the fundamentals remain the same: VCs seek investment opportunities with asymmetric upside payoff potential (and capped downside—after all, you can only lose the money you invest), and entrepreneurs who are funded by VCs seek to build industry-changing and valuable stand-alone companies. And every so often when these incentives align, magic happens.
Entrepreneurs need to understand their own goals and objectives and see whether they align with those of the funding sources they want to tap. To determine that calculus, entrepreneurs would be wise to understand how the VC business works, what makes VCs tick, and what ultimately motivates (and constrains) them. After all, we are each motivated by the incentive structures that our industries engender; understanding those is in many ways a key part of the entrepreneurial journey.
Have you ever seen those Charles Schwab commercials about how to talk to your financial advisor? Unless you watch a lot of golf on TV or actually pay attention to YouTube ads, you probably haven’t. Here’s the premise.
Your average middle-aged couple goes through a series of life events. They ask their home contractor to explain why she recommends cedar versus synthetic wood for a remodel. They meticulously debate the merits of a particular school for one of their kids. They grill the car salesman on whether the 467- or 423-horsepower car is more appropriate. But then, in the final vignette of the commercial, the couple sits across a large mahogany desk from a well-dressed financial advisor who tells them, “I think we should move you into our new fund.” The couple glance blankly at each other for about a second—pregnant pause—and then immediately accede to the request. No questions asked.
The commercial’s narrator benignly reminds the viewers: “You ask a lot of good questions . . . but are you asking enough about how your wealth is managed?” The implication, of course, is that we all feel empowered to dig deep into many important life decisions, but for some reason we give a free pass to others if it’s a topic we don’t understand or feel intimidated by, no matter how important the decision.
This book is not about how to solve that underlying problem—we’ll all need to search in the psychology book section on Amazon for answers to that issue.
But this book is about helping you to ask the right questions about one of the most important life events for entrepreneurs—your startup and your career—so that you can make an informed decision about how best to proceed.
Why?
Because if you are going to raise money from VCs or join a company that has venture money, the only way to know if that is a good idea is to understand why VCs do the things that they do. In other words, know your partner before you get married.
Having a deep understanding of a prospective partner’s motivations will help you anticipate their moves and (hopefully) interpret them correctly when they happen. More importantly, it will help you determine whether entering into the partnership is the right path to pursue in the first place.
This book follows the VC life cycle as it relates to and informs entrepreneurs. The first section of the book deals with the formation of a VC firm—who are the players who fund them, what incentives (and constraints) do they provide for the firms, and how do the partners within a firm interact with each other. To understand how VCs choose to invest in certain companies and how they might act once involved with a company, we also need to look upstream to understand the motivations of the funders of such firms. For if VC firms fail to satisfy the needs of their masters, there will be no more money with which to invest in new startups.
Next, we’ll explore startup company formation. We’ll look at all the things that founders need to think about when deciding to start a company—from dividing up founder equity, to deciding who sits on the board of directors, to how to incent employees, and much more. A lot of the ultimate decision about whether to seek VC financing will be influenced by decisions that founders make at the time of company formation.
We’ll spend a big chunk of time on the VC financing process itself—in particular, the term sheet. This is the Magna Carta of the industry, as it ultimately defines the economic and governance rules under which the startup and the VCs will operate.
Then, with funding in hand, founders will need to be able to operate within the economic and governance constraints that they agreed to. Thus, we’ll talk about the role of the board of directors and how it influences the path of the startup and potentially the ability of the founder to keep steering the ship. Boards, including the founder, also have to operate under various well-defined legal constraints that can materially affect the degrees of freedom of a company.
In the last section, we’ll complete the circle of life. In the beginning, money comes into the VC firm through the investors in the fund. That money in turn goes into startup companies. Finally, the money comes back (or not) to the investors in the fund in the form of initial public offerings or acquisitions. If enough money doesn’t make it through the full cycle, then life, at least as we know it in VC land, ceases to exist. The financing spigot dries up, which can have downstream effects on the rate of funding for new startup ideas. Hopefully, everyone in the ecosystem does her part to avoid that.
Of course, not all VCs are the same, and, as I mentioned earlier, what I write about here is heavily influenced by my experiences at Andreessen Horowitz. So your mileage may indeed vary. That said, I’ve tried to broaden the conversation to make this book more general for the overall venture industry.
This book may not answer all the questions you have and is not intended to be a comprehensive source on the topic. There are plenty of academics who teach semester-long classes on VC, and of course there are lots of VCs and others in the venture capital ecosystem—entrepreneurs, lawyers, accountants, and other service providers—who spend their professional lives learning and perfecting their craft.
Nonetheless, I hope this book shines a light on how VC works and why, in order to create more and better company-building opportunities.