What I’ve Learned About Venture Capital
…Without Working in Venture Capital
Paths Into Venture Capital
There seem to be two pretty consistent starting points when entering venture capital: 1) as an analyst/associate and 2) as a partner. So let's go over the entry paths for both.
Analyst/Associate
The background of an analyst at a VC firm tends to be a combination of demonstrated skill and connections. The demonstrated skill can consist of things like a blog that gained a lot of traction, performance as an intern, experience in business development at a startup, and exceptional performance in school. The connections part can actually develop from the demonstrated skill. From what I've gathered, connections alone will get you a meeting or a foot in the door, but you need to have some demonstrated skill to stay in the industry. So when you hear about people saying, "it's all about connections," from my research, that's not entirely true. This is also the case for most prominent industries like entertainment and sports. This is why I think displaying your work in public is the best strategy. It checks the box of demonstrated skill and can lead to connections .
Partner
You will never find a job application to become a partner at a VC firm. It’s something that is usually offered to you. To receive an offer, it seems like you need a combination of reputation and connections, but those go hand in hand. Reputation creates connections. The typical track record for getting into VC as a partner usually seems to involve:
Founding a successful company.
Experience at a portfolio company as a high-ranking executive.
Being a part of a unicorn (we'll talk about these later) resulting in receiving an invite to join as a partner by the same VC firm that was the company’s lead investor.
Being a partner at a VC firm is usually someone's second career after their initial successful one. They founded a company, funded it through a couple of rounds, took it to an M&A or IPO, then cash out. They know the process, understand what makes a great company & founder, and can pick and operate winners.
Responsibilities Inside a VC firm
Now let's get into what specific roles are inside a VC firm. Personnel inside VC firms tend to wear a lot of hats, and there is a growing list of positions being added to firms, but here are some of the responsibilities you would typically see inside a VC firm:
Analysis & market research
Sourcing investments
Investment and portfolio management
Fundraising
The more senior employees are usually in charge of the more critical roles: sourcing investments and fundraising the funds. Investment decisions are generally made in a couple of different ways. First, the firm might have an investment committee, which requires a majority voting process. Some will be more casual and just read the room for a general consensus. More corporate VC funds will have one person hear from the group, but ultimately it will be their decision to go forward or not. I would imagine the first structure would be the most common. It's a solid way to keep people accountable (you don't want to be the guy/gal that voted against too many future unicorns). These investment decisions are critical because they will impact your ability to fundraise for the next fund. If you don't receive good returns on one fund, good chance you'll struggle to raise the next.
Dynamics & Strategies of Funding Rounds
When a venture capitalist finds a company they want to invest in, there is usually a dynamic balance between negotiating with the founders and convincing the partners/fund to finance the company.
Meeting with founders.
When you're working in venture capital, you're going to be constantly meeting with startup founders. When you go into these meetings, you must assume it will be a $1B company. Keep that mindset throughout the pitch. You don't have to be a cheerleader. In fact, you're going to be doing more listening and note-taking than talking anyway. Still, your physical actions, facial expressions, responses should all exude a combination of excitement & curiosity. If you show any distastefulness towards the founder, it will more than likely hurt you later on. Venture capital seems to be a small world; stuff gets around. It will significantly hurt if that founder's next startup is a unicorn, and you have to explain to your LPs that you couldn't get into a funding round because you were an ass to the founder four years ago. When you work with founders, it's so important to have an open mind. These people usually think 10 to 20, sometimes 80 years down the road, and some think even further. Do not be dismissive of big crazy ideas.
Pump your partner's tires.
It's essential to sell your firm’s partnership. Talk about your partner's success and background and how you love working for them. Founders want to see the VC firm act as a family. It shows the ability to work together long-term. To sell yourself, the best way to do that is by already having an effective & positive reputation.
Building your reputation from scratch.
The best way to build your reputation is by being involved. Some ways you can do this is by volunteering to sit on panels, judge demo days, go to networking events, and do as much media as you can do. I believe the best way to do this is with the use of social media, such as Twitter. Twitter has a robust venture capital community filled with VCs sharing their thoughts, engaging with eachother, and sharing their own work, such as essays or blogs. Creating and sharing your own content can be an excellent way to build a strong reputation. We're even seeing VC firms such as Andreessen Horowitz building their own media companies to control their reputation by leveraging their own written content with the announcement of Future last week. Bottom line, when you're working in venture capital, you should act as your own PR firm. Make sure the founder knows who you are before actually meeting with them. Remember, the founder will have to trade off a portion of control of their company in exchange for the funding. They're going to want to have someone in that board seat that they know can help them get to the finish line. Someone they can trust. That's what you should be selling when building your reputation.
Pitching the company to your partners.
Once you find a founder & a startup that you love and think the fund should invest in, you're going to want to immediately go pitch that to your partners. You have to remember that you're not the only one making the decisions. A VC firm is a partnership. Once you pitch the partners about the startup and the founder, you should constantly ask for feedback and try and identify challenges early on. In most cases, the decision to fund a company is usually a consensus vote, so everyone should be on the same page. But you'll also want to get to that consensus fast. If the company is as great as you think, there are probably other VCs competing to lead that financing round.
Closing the deal
Once you know that the deal is going to happen, the next step is negotiating the terms. Typically, VCs are usually looking to fund a startup in exchange for 20% ownership of the company and board seats. The 20% will contribute to their future profit, and the board seats give them control. Once the term sheet is signed, the VC will do their due diligence. This consists of tech diligence and background & reference checks. The tech diligence is usually contracted out by an industry expert. If the startup is a late-stage company, the VC will probably do financial diligence as well. After that is completed, the final docs are signed.
Important to remember: Term sheets are not legally binding, and the deal is not finished until the money is wired from the VC to the startup. Anything can happen until then. So there shouldn't be any significant celebrating until that is done.
Compete!
I've learned in my research that you should assume every round of funding is a competitive round, and you should expect to be competing with other VC firms. You have to stay focused, and you have to compete your ass off! Get that 20%. Get the board seats. Be involved with the company. Have a great relationship with the founder. Win. The. Round!
Here are a couple of strategies that I've researched to win fundraising rounds.
Move Fast (spray & pray): This is where you meet with a founder who you know hasn't started fundraising yet, but you think they're super talented, and you love their idea/vision for the company, so you throw down a term sheet immediately. When you're in the "move fast" strategy, you'll want to...well, move fast. So when you throw down the term sheet, you'll make it an exploding term sheet - a term sheet that has an expiration date, usually about a week long from when it was delivered. This strategy can backfire, though. It puts the founder in an awkward spot. The founder also usually has advisors around him who will have connections to other VC firms. The advisors will see this and know what you're doing. They'll reach out to other VCs and then try and get the fundraising done before the term sheet "explodes."
This is also referenced as the "spray & pray" strategy. We've seen firms such as Tiger Global using this method. They've already invested in over 100 companies in 2021 alone and have an estimated $65B in total assets under management. Softbank's Vision Fund has also been known for this. The "spray & pray" strategy usually involves funding companies well above their valuation so the firm can close them fast. The purpose of this is if you have a large volume of quality companies in growing sectors under management, at least a couple of them will become a unicorn or decacorn, returning a massive profit. This has proven to work for Tiger Global. They currently have ~130 unicorns in their portfolio. This strategy is similar to the current approach we see in the baseball industry with hitters: would you rather have the guy who just tries to make contact and goes 3 for 10 with three singles or the guy that takes guerrilla hacks and will go 2 for 10 with two home runs creating more run-production? -the answer is the 2nd guy.
Patience: Patience seems like the most effective strategy when trying to lock in a startup. But only if the VC firm is well informed. Successful VC firms like Sequoia, Founders Fund, and Andreessen Horowitz will try to be the last ones to put down the term sheet. This only works if you have all the connections in the industry. You know who offered the term sheets and at what valuation. You're probably close friends with the advisors to the founder, and you know what number to put on the term sheet that will outbid all the other VC firms. You have a pulse on the entire industry. Picture the Henry Hill of venture capital, specifically the scene when he's walking into the restaurant through the kitchen. Access, reputation, relationships, and connections. Again, this is an excellent strategy if you have all the things mentioned, otherwise being last is very risky, and you could miss out by never even getting an offer in.
Average pace: You don't have the capital to spray and pray, and you don't quite have the resources to try and be the last to put down the term sheet. If this is the case, just focus on research, the relationship with the founder, display your growing reputation & skills, pump the tires of your partners, offer them a favorable valuation and try to stay involved. Then, do whatever you (ethically) can to win the deal. Do the work. In the meantime, continue to build your network so that one day you can be in a position to be the last to put down the term sheet or raise enough capital to spray and pray.
Co-investors
VC firms will always have other co-investors in the company. These co-investors are usually angel investors or strategic investors. They typically take up to 1-2% of the entire round, which sets them up for a good return on their investment, but not enough to control the company. If a VC is committed to the company, it should get into as many fundraising rounds as possible to optimize its ownership. You have to remember that there will be more money that wants to get into a fundraising round than there is actual space for. So you'll want to stay focused and continue to provide value to the founder and the company. One important thing I've learned about co-investors is they can be great because they're bringing more capital to the company, but you absolutely want to keep them off the board. If there was a currency for the VC industry, it would be board seats. Board seats mean control. Never give up control, especially as the one who is pumping the most capital into the company. Also, try to refrain from arguing with the founder if they bring on an individual investor you absolutely do not want to work with. Just stay positive and do everything you can to ensure individual investors don't get a board seat.
Deal Sourcing
VC Firms spend most of their time looking for opportunities, billion-dollar opportunities at that. To find these opportunities, you have to have a good deal sourcing infrastructure. You need quality information constantly coming in from reliable sources. There are a couple of ways to build a deal sourcing infrastructure. One way is by using alternative data (which I wrote about here!!!) to look for trends in specific industries. Alt data can help identify startups that can take up a significant percentage of market share. When I say that, I'm not necessarily talking about the majority of that market share. For example, I would rather have 1% market share of a $1B industry than 100% of a $10M industry. Another way you can build your deal sourcing infrastructure is by attending demo days at incubators and accelerators (the value of this is self-explanatory). And finally, have a point of contact in every industry. Have experts you can reach out to for quality industry knowledge. If you find ways to incentivize them, they'll be the ones feeding you information rather than you seeking it. The best personnel for this are research departments at universities. They’ll have a heartbeat on specific sectors, and they work with talented individuals who may be starting companies. Also, these strategies are not exclusive from each other. The best infrastructure includes all three of these. One rule of thumb to remember when trying to source deals: If it's on the internet, or showcased at an incubator/accelerator, assume everyone has already seen it or knows about it. You have to find unique ways to source deals.
Portfolio Management
A VC firm's portfolio will typically have three types of companies; unicorns (or a decacorn), dragons (or dragon eggs), and walking dead companies.
Unicorns
Unicorns are the big ones. These are companies that have a valuation of $1B or higher. VCs spend most of their time with the unicorns. Unicorns will by far be the VC's largest reward on their investment. Also, the founder(s) will become billionaires, and they could be potential prospects to angel invest in a company alongside the firm in the future. Unicorns are your franchise players. - If a company reaches a $10B+ valuation, it's considered a decacorn.
Dragon Eggs
Dragon egg companies are steady and vital for a strong portfolio. They have the potential to become a unicorn, but more than likely, their valuation will end up below $1B, but they will return your fund, which is very important. Getting back the returns to your fund is crucial to be able to raise another. If a firm's portfolio were the 90's Bulls, the unicorns are Michael Jordan, the dragon eggs are Pippen and Rodman.
Walking Dead
Walking dead companies are pretty simple. They're consistently operating, they don't cause a lot of trouble, may even be profitable, but they're more than likely not going to create a successful exit for you. There's a couple of different ways to deal with walking dead companies. One is being super active - come in, fire the CEO, bring in a new one, trim the fat, and rebuild the company from scratch. Another way to go about it is by being supportive - maybe invest a little more, support the founder, and hope they turn it around. And finally - Just ignore them - the firm thinks there's no hope, nothing they can do will turn it around, mark it up as a lesson learned, and move on. However, there are plenty of stories of walking dead companies turning into unicorns by pivoting; one example is Paypal.
Term Sheet Basics
Below are some basics that will typically be in a term sheet. Term sheets are not overly complicated and are usually 1-2 pages. However, here are some essential items to know when putting one together or receiving one.
Pre and post-money valuation:
This is actually laughably simple, so I'll explain it with an example. Say you started a company, and you conclude that it's worth $4M based on all your assets. A VC comes in to fund your round and pumps in $1M. This would make your pre-money valuation $4M and your post-money valuation $5M (4+1=5). But you also have to remember that the $1M from the VC firm holds the most weight and will raise the most eyebrows from the outside. Founders should be optimistic about their pre-money valuation but not delusional. You'll see examples of founders giving delusional valuations to their company on shark tank, usually followed by the sharks confirming the valuation in disbelief. If you're a founder, don't do that. It will speak more to your inability to logically operate a company.
Liquidation Preference
Liquidation preference is what distinguishes preferred stock from common stock. It's what makes sure the VCs get their money back first. This only comes into play when the company sells below its valuation price. So if that company we mentioned above that's valued at $5M sells for $3M, whatever number the VC put in the term sheet for their liquidation preference, they get that back first. There are two different types of liquidation preferences. One is called "participating." It typically doesn't happen, and it's viewed as very aggressive; the VC literally gets their money back and their percentage of ownership. The other is "non participating," which means the VC gets the cash they put in back first.
Board of Directors
As we mentioned above, VCs are always hungry for board seats. It's their currency. It gives them control. The structure of the board usually happens after the first institutional round with a three-person board. It typically consists of the founder, the lead VC investor, and an independent seat. The independent seat isn't filled right away in some cases, although the VC will try and fill it with another partner (control, control, control). In the next financing round, the board will usually expand to a five-person board; two VC investors, one independent, 2 people from the founder's side (usually an additional higher up in the company). The most critical role for the board of directors is to hold the CEO accountable and guide them. In some cases, the founder will still be the CEO, but in other cases, an experienced executive comes in as CEO to help guide the company to an IPO or M&A. The board of directors have a fiduciary responsibility, so if they feel the founder should be transitioned out of CEO into another role to bring in someone more qualified, they're obligated to do so. There should still be a good dynamic that enables the founder to keep building and innovating while the CEO can focus on operating the company.
Protective Provisions
This just protects the investors from the company doing what might seem like overstepping. So, for example, if the company wants to spend x amount of capital, they have to get it approved by the board first. So, again, these are just put in place to protect the investors.
Right of Refusal
I'm sure most of you understand what right of refusal is. In this case, VCs will reference this in the term sheets if the company wants to sell secondary shares. This gives the VC's the option to buy them first.
Pro-Rata
Pro-rata is a heavily used word in the private markets (and no it doesn’t mean you’re a @emrata fan). The purpose is to make sure the VC maintains its ownership percentage. For example, after the series A round, the VC owns 20% of the company. However, when new money comes in for series B, its ownership can get diluted. Pro-rata gives the VC the option to put in additional capital at the series B valuation to maintain its 20% if it chooses to do so. Pro-rata is very important. Prominent angel investor, Jason Calacanis, won't do a deal without pro-rata. Pretty sure he mentions pro-rata in his book, Angel, 247 times (that's a guess, but it's a lot).
Drag Along
This is a term that makes sure the lead investor is making a majority of the decisions. This has a lot of operational value. You do not want all the investors to have a say in all the decisions. There can be a lot of individual investors in one company. Trying to get approval from all of them would be an absolute nightmare.
Employee Option Pool
Employee option pools are an excellent way for employees to get some ownership in the company, which is vital for organizational buy-in. Most savy VCs will want the option pool to be created at 15-20% of the company and created before they finance the startup. The reason being is that in this case, the option pool will dilute the founder's ownership and not the VC firm. However, experienced entrepreneurs know this game well and will prefer to create the option pool after the financing round. In this case, both the founder(s) and the investor's ownership get diluted instead of just the founder's—an "eye for an eye" type of move.
No Shop Agreement
Typically there is a no-shop agreement in the term sheet meant to cover the time it will take for the VC to do the due diligence we mentioned earlier. Basically, the VC doesn't want the startup to go shopping for other funding when executing their due diligence. Generally, founders want to make that window shorter, and VCs want to make that longer.
Limited Partners
Limited partners (LPs) are the ones who invest in the VC firm's fund. So when you hear "so & so" capital has raised a $500M fund, that money comes from the limited partners who trust the venture capitalist to put that money to work for them and bring back delicious returns. LPs usually range from high-net-worth individuals, corporations, institutional investors, and you'll also see some universities get in on the action.
How to Pitch Limited Partners
Limited partners like to see how the general partners work together. Are they getting along, supporting each other, or give/receive critical feedback without being defensive. They like to see a good culture among the partners, enabled by a common goal (picking winners and making delicious profits). Limited partners also want to hear your investment strategy and a thesis on the market. Most importantly, "how is what you're doing different from the other VCs, and why will it be more successful?".
Limited Partner Agreements
An agreement between an LP and a general partner usually consists of 2-3% management fees - so, for example, if a general partner raises a $200M fund, they would receive $4-6M to manage that fund. There is also an 80/20 split of profits. LPs take 80% - If you have a $1B fund and profit $2B, LPs get $800M, and the general partners get $200M. Important: The firm must have voting rights when putting together these agreements. It's imperative. You do not want the LPs making investment decisions. From what I've gathered, the general consensus is it's better not to take an LP's money if it requires them to be a part of the investment decisions. If that's what the LP is looking for, then they're better off doing the work themselves as an angel investor.
The Current State of Venture Capital
The current state of venture capital is filled with VCs quite literally chucking cash at startups right now. It’s never been a better time to be a startup founder. There has been ~$182B in VC funding and 155 companies that have reached unicorn status from January through April this year (there were 156 startups that reached unicorn status throughout all of 2020, and we're already on pace to shatter the total '20 funding of $322B).
There has been a lot of speculation and commentary in the media on why this is. From what I’m seeing, I believe it’s a combination of the “spray and pray” tactic being escalated by firms such as Tiger Global and Softbank’s Vision Fund. This is causing other firms to try and match their pace to keep up. I also think we’re entering a pretty crazy age of innovation that we didn’t think would be practical until the era of covid-19 escalated it. We’re seeing disruption in education, healthcare, and services that eliminate human friction such as delivery, payroll, billing, & insurance. Technology and innovation have accelerated growth in every sector. There is potentially a unicorn/decacorn being born in every quarter of every sector. Some may even have a couple. Either way, everybody is unicorn/decacorn hunting right now, and I really don’t see it slowing down anytime soon.
As far as I can tell, I don't see this as a bad thing either. More money should drive more innovation. More innovation should create more young billionaires who will fund other innovations. Of course, like all things in life, there are trade-offs, but holistically I view this as a positive. There has never been more motivation for builders and operators to create new companies than today.