This book was one of the most informative books that I read this year. The information that Scott Kupor provides goes a long way to balancing out the information discrepancy between VCs and entrepreneurs.
The book taught me a great deal about the complexity of raising a round, the role of the board and the goals and roles of many of the players. I learned a huge amount about the importance in understanding the incentives of the various players involved between the LPs, VC firm and startup.
Limited partner (LP)
Institutional and sophisticated investors who contribute to a fund. They will be hands-off in order to avoid influencing decisions which could open them to legal implications. Many have start to get involved in the seed-stage of companies in order to realize larger gains.
A partnership that raises funds from LPs and finds startups to invest in. A firm may have several funds and each fund will back several startups. They will reserve part of a fund for follow-on investments.
A fund is a pool of money that several LPs have committed to providing upon request. This money will be given to startups. The lifetime of a fund is usually 7-10 years. The goal is to return money to LPs by the end this lifetime. When receiving money from a fund it is important to know where it is in its lifecycle; a GP for an older fund may prefer an early exit in order to return money to their LPs. Similarly, the current outlook for the fund may influence the GP’s preference for risk and the timeframe of a liquidity event.
General partner (GP)
Joint owner of a VC firm with the authority to act on behalf of the business. A GP finds companies to invest in and raises funds. The GP will also sit on boards of companies in which they invest. A GP can usually handle sitting on 10-12 boards. This is the main limiter in how many companies they will invest in. Board obligations come with a big opportunity cost of not being able to sit on another board.
GPs are measured on their returns. A single early investment that has a massive return can cover their losses in all the other companies that they invest in. This single massive return can guarantee their ability to raise a future fund. This means that a GP will usually look to maximize their chances at hitting a home run.
GPs charge their LPs a management fee which is about 2% of the committed money in the fund. There are other fee structures as well. GPs also charge carried interest of 20-30% on the profits of the fund. Since parts of the fund return at different times there are many structures for determining when the GP realizes their portion of the profits. In order to ensure GPs have skin in the game, most contribute 1% of the fund’s capital and some contribute up to 5%.
Board of directors
A governing and oversight body with the primary fiduciary duty of protecting the common shareholder. When making decisions, the board must be well informed and act in good faith for the best interest of the corporation and its common shareholders. Their decision processes should be documented in meeting minutes. When deciding on financing decisions it is common to use independent third parties who do not have a financial stake in the decision to advise on what is best for the common shareholders.
The board has a fixed number of seats, usually an odd number to break ties. The first seat is usually held by an early lead investor. The second seat represents the common shareholders and is usually held by the CEO. The third seat is usually independent selected by the other two board seats. This is just one example of a common board structure, many boards have more seats and not all seats are filled all the time.
Usually held by investors. This stock gives the holder a right to vote. Upon liquidation, these shareholders can choose to convert to common shares and/or get their investment back depending on the value of the common shares, liquidation preference and their participation status.
Usually held by founders and current/former employees that were granted stock. This stock does not give the holder a right to vote.
Pro rata investment
Many VCs will reserve part of their fund for follow-on investments in a company. A pro rata agreement gives the VC firm the right, but not the obligation to bring their ownership back up to their previous percentage after dilution. This is usually only reserved for “major investors”. This is used by GPs to avoid dilution while keeping the number of their investments limited.
Under GAAP, VC firms must “mark to market” the value of their holdings every quarter. Multiple VCs involved in the same company may mark it differently. The main methods of computing valuation are last round/waterfall, comparable company analysis and an options pricing model. Even though these methods may arrive at very different valuations, they are all accepted as consistent with GAAP. This mark is used to determine when a GP can realize part of the carried interest from early returns.
Raising a round
Raise enough money to ensure you can raise the next round. Ideally you will have a list of targets that your company will hit before raising the next round. You want enough runway to hit these targets so that you can raise the next round from a position of power. Be careful not to raise too much. You want to limit and prioritize your list of targets for the next round and having a limited amount of money helps focus on the true priorities.
Be careful of taking too many convertible notes during a seed round as these notes can give away too much governance and result in VCs feeling that the seed terms were much better. This could be a turn-off to VCs from investing in your Series A round.
Be mindful of how a term sheet will affect future financing rounds. In general, simplicity is better. Just because one has leverage to get better terms might not be worth it if the result makes future rounds more complicated. Liquidation preference, participation, anti-dilution provisions and voting classes can increase complexity drastically and need to be carefully managed. Some VCs may avoid future rounds if your governance and liquidity structures are too complicated.
Understand the goals of the VCs that you are working with. Are they looking for a home run, in which case they may hold out for a huge liquidity event even if a decent one presents itself? Is the GP’s current fund doing well, in which case they might not seek an exit as early as if their fund is going poorly? What is the age of the fund which is providing your money, funds that are nearing their end have their own pressures to return money? After several rounds you will be involved with many GPs and each will have their own incentives and timelines for returning money to their LPs.
There were a few points that the book made about how the startup space has changed over the last couple decades.
The amount of capital to start a company is declining
With the commoditization of computing it is easier and cheaper than ever to spin up servers, networking and data storage services. This is allowing companies to start smaller than ever before while also allowing them to scale their compute resources faster than ever before.
Y Combinator and the rise of incubators
There are more and more schools for entrepreneurs to attend to learn skills, meet potential founders and network with VCs. The community effect between entrepreneurs is making it easier than ever for entrepreneurs to leverage their network to get advice on any decisions they and/or their companies are working through.
VCs are raising larger and larger funds
There may be too much money chasing too few opportunities. In order to stand out, VC firms must offer more than just money. Examples include recruiting assistance, finding executives and other post-investment support that helps companies move faster and achieve greater success.
Companies are staying private longer
This has the effect of providing a larger upside for LPs and VCs since they are in during the mega-growth stage. Historically many of these companies would have gone public with a lower valuation and the public markets would have realized some of that growth.