Inside Silicon Valley

How the Deals Get Done

Marc Phillips

• Publisher: Melbourne Books
• Year: 2013
• ISBN:
  9781922129208
• Topic: Business
• Subtopic: Entrepreneurship
• Index: Business

Inside Silicon Valley is a must read for entrepreneurs wishing to raise venture capital and anyone with a fascination for the inner workings of Silicon Valley, the epicentre of the dot com world of venture capital. The book relates 'fly on the wall stories' from venture capital investment presentations made by entrepreneurs who have successfully raised hundreds of millions of dollars. You will learn the craft of creating an investment pitch deck, how to pitch your business idea and how valuations are determined. The book also gives insights into the entrepreneurial culture of Silicon Valley and how venture capitalists evaluate start up companies, written by someone who has been both a successful entrepreneur and is now a partner in a venture capital firm.

THE GOLDEN ROLODEX PROMISE

Just about all entrepreneurs have looked at the Sand Hill Road venture capital websites (Sequoia Capital, Benchmark Ventures, Khosla Ventures, to name a few) and read the biographies of managing partners who have taken companies public or sold for hundreds of millions. The promise on many Silicon Valley venture capital websites is that they come with a ‘golden rolodex’ of contacts — insiders and influencers, the right people to meet both socially and, more importantly, professionally to fast-track your start-up company’s growth.

In May 2007, as Tim Guleri, Managing Partner of Sierra Ventures (a $1 billion+ venture fund located on Sand Hill Road), and I were heading south on the Interstate 280 to Yahoo! in Santa Clara, I remember thinking, ‘This guy is the real deal.’ Tim had arranged a meeting with John Galatea, Vice President of Sales, and Dustin Suchter, a sales engineer, both with Yahoo! They were kind enough to accept a meeting to review some technology in the search sector. The ability to give entrepreneurs access to executives offers kudos to VCs. The meeting went well with John and Dustin, providing me and Tim with commercial feedback on the viability of the search technology solution.

This is how good VCs conduct due diligence and is a great way for entrepreneurs to meet potential partners and eventual acquirers of their technology.

Driving out of the Yahoo! offices, I parked just off Great America Parkway in Santa Clara and noticed lots of people praying on the lawn in front of the 40-foot statute of Mary towering over the US Interstate 101. There’s a lot of praying in Silicon Valley, and not only by entrepreneurs. VCs provide value, direction and a good ear, but often they are not in control and really would be better off praying for their portfolio companies.

The most important point to understand if you’re an entrepreneur is that, inside the Valley, there’s an unspoken agreement between VCs and corporate executives. That is, for the advice and analysis given by the executives, the VC will keep them in mind for future job opportunities. Most executives in Silicon Valley are not working for the pay packet. It’s presumed that their base compensation is the opportunity cost of not working in a start-up themselves and their stock option package, which typically vests over four years on a quarterly in-arrears basis, is the ‘upside’ that executives are really working for. That’s how real money is made. That’s an each-way bet on how to get rich. Pay the bills and the options convert when the company’s common stock is at a much higher price.

This is a good thing. It’s the quid pro quo or payback for executives helping each other. When executives are thinking of jumping from one company to another, they often reach out to VCs and ask for any openings in hot start-up companies. That’s how it rolls here in the Valley. Not too different from most parts of the world, but here it’s more orchestrated. It’s part of the mechanics and is well understood. You help a VC do the due diligence and they’ll help get you into a hot company they are funding if the opportunity arises.

It even goes deeper than that. If a VC is thinking of funding a company, they might do so on the proviso that an executive they like becomes part of the team. It’s a well-oiled employment production machine.

Silicon Valley can be a lonely place for entrepreneurs. It’s akin to a nightclub when you’re first going out socially. You’re young, want to look good and act smart, but there are always cooler guys and better-looking girls. So, when someone takes an interest in you personally and you get it (Silicon Valley parlance for understanding their business model or technology), then they often befriend you.

It’s important for entrepreneurs to realize that mentorship is at best, in my opinion, hollow promises that often come at a steep price. The right way to structure an advisor role in your company is to provide 0.25 to one percent of the stock option pool to an advisor over 18 to 24 months. I think four years is too long, as advisors are good for a short burst in start-ups, and as the business grows you need other people with broader skill sets.

Mentors are great for young kids fresh out of college and new to the Bay Area. But, they are not needed when you’re older. I know of several accelerators in Silicon Valley that take too much for their mentorship. They take five to ten percent of founders’ common stock and then give $200,000 to $250,000 in an uncapped convertible note. That’s good for the investor but not so good for entrepreneurs. My advice is to find mentors elsewhere.

Take heed in the words of Gordon Gecko from Wall Street: ‘If you need a friend, get a dog.’ Because in Silicon Valley, dogs have hotels, they go to work with their owners, and generally are great social initiators to get you talking to other people in parks. You’re just as likely to meet someone that can help you while you’re walking your dog as you are giving up five to ten percent to tech mentors who order in lunch everyday and wave their hands in front of PowerPoint presentations.

Be wary of mentors and mentorship programs. They prey on the inexperienced with their so-called intellectual capital or value capital. Look for VCs that add value and make introductions even before they invest. That’s your due diligence as much as it is theirs. VCs like Tim Guleri listen intently, don’t promise mentorship but rather get into the field with entrepreneurs and take them to market as part of the investment process — which is great for entrepreneurs who want real feedback from experienced people.

Forget the promise of the VC’s golden rolodex. What is important is their managing partners’ willingness to make introductions. My advice is to pick one like Tim who has sold his company for several hundred millions of dollars before becoming a VC.

WHAT’S MY START-UP WORTH?

Valuation is not as hard as you think. It’s an inevitable question that VCs will ask entrepreneurs and one that I know often pains the start-up guys. The way most Silicon Valley VCs like to hear it is that you’re going to arrive at a valuation for them to reasonably be able to calculate a minimum 10x return on their money. Remember, venture capital is high-risk investment. The bigger VCs, like Sequoia, Accel Partners and Benchmark Ventures, live for their 500x return on investments. Think: Google, eBay and Facebook as companies that have return on investment multiples 200 to 500 times the initial investments.

Living in Palo Alto, I’ve seen many friends and family deals get done by neighbors and college alumni. It’s typical for a $100,000–150,000 seed investment to be syndicated out to five to ten seed investors at between $10,000 and $20,000 per investor. That’s enough for two people to quit their jobs to work on their software start-up full-time for six months, just enough to cover what they would have been paid if they were still working in their corporate job.

‘First-in’ investors typically want a 2–3x return or uptick on their invested money. In Silicon Valley as private investors, it is expected that, on the next valuation, their shares are worth two to three times more. For example, if the $100,000 is raised at a valuation of $1 million, then the investors would hope that the next investment round will be between $2 million to $3 million.

The smarter seed or angel investors want to have between five and ten percent if they write a check for up to $100,000. It’s often for a chunk of a company that is little more than an idea, a very basic demo or alpha software that isn’t even built or demonstrable to prospective customers.

By the time you get your software start-up to professional angel investors or ‘smart money’ (the VCs who understand the market and have strategic connections), the metrics behind a valuation need to be understood. You’re not asking your parents or friends for money. You’re swimming with sharks now.

Working from the previous example, you’ve given up ten percent for $100,000 at a valuation of $1 million. To be exact, that’s a ‘post-money valuation’ of $1 million and it’s a pre-money valuation of $900,000. It’s better to include a pre-money valuation in the pitch deck, as it’s a lower number and looks sweeter to potential investors.

It is very important that entrepreneurs understand the difference between pre-money and post-money valuations. Often, angle investors will say to an entrepreneur, ‘You don’t need to raise $1 million — so what is the valuation if you raise only $750,000?’ Savvy investors will ask these questions to determine how flexible the valuation is. It’s a cunning way for investors to test your resolve on valuation and what propensity you have to negotiate.

Nonetheless, Silicon Valley venture capital needs their billionaire founders. Like movie stars, the Valley needs pin-up poster kids that rake in hundreds of millions of dollars. They are the tangible examples of what Silicon Valley is to entrepreneurs, that the promise of venture capital pays off for everyone involved.

Today, with online news beats like TechCrunch, Vator, Crunchbase and Wikipedia recording the acquisition prices and how many shares of a public company a founder was issued, it’s easier to calculate the worth of the founders in exits. As a rule of thumb, VCs typically like to see the founders of a company ending up with between ten and 15 percent each after two or three rounds of funding.

Here is an example. Say you’re looking at a $1.5 million Series A after raising $100,000 in seed capital. You may value your company at a pre-money valuation of $4.5 million. This means you’re going to give up around 25 percent, which translates to a post-valuation of $6 million. Most importantly, the next round of funding gives you 12 to 18 months of financial runway (Silicon Valley speak for the length of time you have to burn through the money) and allows you to build a team, release more enhanced versions of the software, and execute on sales and distribution.

The Series B valuation can move into a much larger amount, between $10 million and $20 million, depending on how fast you are growing and how capital-intensive the company is. Again, the Series B valuation will want to see the VC take an additional 15 to 25 percent of the company. All the time, the VC is looking at how they can turn their investment into a 10– 20x return at a minimum.

As the Series C and D rounds of venture capital take place, the higher valuation ensures that the founders’ and previous shareholders’ equity value increases. If the company isn’t able to raise money at a higher valuation than the previous round of capital, it is known as a down round. If the company raises money at the same valuation as previous rounds, it is referred to as a flat round because the valuation is the same.

My overall advice to entrepreneurs is: don’t overly concern yourselves with your start-up company valuation because, if it succeeds, your founding stock will be worth more money than you could ever really spend.

I’ve seen VCs shut down companies that they have invested tens of millions of dollars into because it would not provide the internal rates of return that they wish to show their investors. I’m serious. Silicon Valley venture funds will kill a company if they don’t believe it will ever return the multiples of investment, or when they lose faith in the management team or the business model becomes unstable. This happened to a Los Angeles–based start-up technology company called Geodelic. As an advisor and shareholder for four years, Geodelic raised $600,000 in seed capital, and $3.1 million in Series A and $6 million in Series B from notable VCs such as Shasta Ventures, Clearstone Venture Partners, MK Capital and Verizon Ventures. Geodelic went from being a mobile app that merchants like Universal Studios and Carl’s Jr. fast food stores could brand as their own location-based app, to a platform for telcos to enable mobile deals for their retail customers. In hindsight, you could say there were too many pivots (a Silicon Valley term to describe the changing product and business models a technology start-up company has). Valuations at seed round, Series A and Series B proved worthless, given the VCs would not fund the company into a Series C round and, as such, Geodelic eventually closed down.

While business models morph, there needs to be a consistency of revenue model through the various rounds of funding in order to maximize valuation and funding opportunities.

Remember that valuations are arbitrary before a company is sold. You can have a great valuation on Series A of $10 million and Series B of $30 million, and if the company fails then everyone’s shareholding is worth zero.

BEING INVESTMENT-READY

You can tell pretty quickly by looking at the emails from start-up founders if they are investment-ready. I suggest to entrepreneurs to only send the investment presentation to VCs. I believe that multiple attachments in emails are confusing and overwhelming to VCs. Entrepreneurs should hold back letters of intent, white papers, press articles and Excel spreadsheets with complex financials in the first initial communications with VCs. Keep it simple; keep it to the investment presentation.

It is really easy for young entrepreneurs to mess up during VC meetings and phone calls. A light-hearted story illustrates where one young entrepreneur I know by the name of Eric didn’t have the attention to detail. He was meeting some of us at the Dutch Goose, (www.dutchgoose.net) which is located on Alameda de las Pulgas in Menlo Park, minutes from Sand Hill Road. It’s a local drinking hole for Stanford alumni and the locals. He decided to take the Friday afternoon call from the car he’d parked outside the pub. When he entered the Goose, his face was blank. To his dismay, he seriously messed up. The GoToMeeting ( www.gotomeeting.com) hadn’t been downloaded onto the boardroom computer at the San Francisco office the VC was visiting for the day. Then, it started raining and the noise from the raindrops bouncing off the car roof was almost deafening. Johan had switched to Skype in the car, yet the echoing on a three-way conference call via Skype (he’d patched in another VC who was in another location) meant one of the other VCs had to hang up.

What a disaster. Therein lies the lesson: entrepreneurs should be prepared for every communications hiccup. You should make it easy on the VC. Don’t assume th...

Table of contents

• AUTHOR’S NOTE
• CONTENTS
• INTRODUCTION: THE BILLIONAIRE’S FACTORY
• Section 1: BEFORE THE PITCH
• Section 2: THE PITCH
• Section 3: AFTER THE PITCH
• Section 4: LIVING IN THE VALLEY: A VC’S PERSPECTIVE
• Section 5: THE FUTURE IS NOW