High Growth Handbook

by Elad Gil

  Type of investor: Private equity fund

  Individual check sizes: $10M to $500M

  Valuations for investment: Mainly later-stage rounds in the $500M-plus range, although some private equity funds have done series A or series B rounds.

  Benefits: May have broad or differentiated networks. May be able to provide introductions to other late-stage portfolio companies if doing enterprise sales.

  Drawbacks: There are many great, supportive, private equity firms investing in private technology companies. However, one private equity fund in particular is known to wrap a nasty set of terms into financing rounds or act badly once a term sheet is signed. Others, such as banks with private equity funds (e.g., Goldman Sachs or Morgan Stanley), are known to value the longer-term banking relationships and are more company-friendly. Be cautious when selecting a private equity partner to work with, and make sure to do diligence by checking with other technology company entrepreneurs they have funded.

  What they will look for: Private equity firms tend to invest based on numbers and a large revenue stream. They will take a close look at margin structure, growth rates, topline revenue, as well as the overall macro market dynamics and defensibility of your business.

  Type of investor: Family office

  Individual check sizes: $5M to $500M

  Valuations for investment: Any valuation, although typically family offices get involved in later-stage rounds.

  Benefits: May have a strong network to help company, depending on market and who they represent. May or may not be valuation-insensitive depending on how professionalized their investing is.

  Drawbacks: Often do not understand early-stage or startup investing and can get uneasy if things get tough. In general, it is better to work directly with the person whose money it is then the family office staff. Alternatively, look for family offices who have done a number of private market investments in the past and understand the dynamics.

  What they will look for: Typically family offices look for signals from other institutional investors for round quality. They will look for startups in large markets and typically prefer high-margin businesses.

  Type of investor: Angel SPV (Special Purpose Vehicle)57

  Individual check sizes: $1M to $50M

  Valuations for investment: Anything from series A on up.

  Benefits: Usually this is an investor or angel already on your cap table who raises money for you as part of a large venture round. This is a way for angels or small funds to increase ownership in your company with your permission. This may also be a way to increase time spent or deepen the engagement by an existing investor, or to raise money for the company in a way that ensures additional equity/preferred stock votes go to someone the company trusts.

  Drawbacks: Your VCs may push back on an angel making a large investment this way. May have issues actually raising or delivering the money. You need to make sure to define the process they are allowed to follow and what information they can or cannot share with their potential LPs.

  What they will look for: SPVs can either lead a round, or be part of a syndicate. If they lead a round, they will act like any other venture capital lead. If they are part of the syndicate, they may be a little more momentum-driven. For late stage round and large check sizes, expect an SPV to do full diligence on the company, its team, financials, and overall market trends, defensibility, and growth rates.

  Type of investor: Public market investor

  Individual check sizes: Up to $500M

  Valuations for investment: Usually in the hundreds of millions to billions.

  Benefits: Large source of trusted capital. Typically seen as “smart money.” Tend to hold on to stock post-IPO and send signal to public markets that your company is legitimate.

  Drawbacks: May publically mark down your stock and affect future fundraises or secondaries.58

  What they will look for: Tend to assess company through the lens of what an IPO and beyond will look like (e.g., core financial metrics, competition and defensibility, etc.).

  Type of investor: “Strategic” investors59

  Individual check sizes: Typically range from tens of millions to a billion or more

  Valuations for investment: Usually in the hundreds of millions or more. Strategic investors may ask to invest earlier, but you may want to save them for later rounds and decrease the risk of signaling in early rounds.

  Benefits: Valuation insensitive and more likely to pay a premium. May have core ties or knowledge that can dramatically help your company. May be able to wrap a broader “strategic” deal around investment that can accelerate your company.

  Drawbacks: For early round, may cause “signaling,” in which other strategic investors avoid buying or partnering with you. For example, if you are a digital health company and Pfizer buys a stake in you early, other pharmaceutical companies may be less likely to partner with or try to buy you. Once rounds get later this signaling tends to decrease. Strategic investors may also try to use their investment to get information and learn about your business so they can eventually compete with you.

  What they will look for: Strategic value of your company in their industry. Ability to learn from your startup about how their market may get reshaped. In some cases a strategic investment is a prelude to an acquisition offer, so strategics view it as a way to get to know you better.

  Type of investor: Large Foreign Internet company

  Individual check sizes: Up to $1B

  Valuations for investment: Huge range, from early-stage to multi-billion-dollar range.

  Benefits: Less valuation sensitive. May help you enter China or other markets or simply be a source of capital. Tencent, Alibaba, Rakuten, and others have invested aggressively in tech startups over time.

  Drawbacks: May try to tie investment to joint venture or other structures in their home market. May be trying to learn from your company so they can launch competitor in their own market.

  What they will look for: Strategic value of potential investment upside, depending on firm and individual objectives.

  Type of investor: Sovereign Wealth Fund

  Individual check sizes: Up to a few billion

  Valuations for investment: Huge range, from early-stage to multi-billion-dollar range.

  Benefits: Some are less valuation sensitive (others are quite sensitive). May help you enter new markets depending on the country they represent or sell to large state-owned enterprises. Have enormous scale of capital. In a subset of cases some sovereign wealth funds may invest for strategic reasons—for example they want to understand or get closer to technology that may impact companies in their country, or to trade petro dollars for tech assets to diversify their economic holdings.

  Drawbacks: Some may be slow to move or have multiple hurdles in place for investment. Some funds newer to direct investment may lack savvy or misunderstand how startups work.

  What they will look for: Strategic value and potential investment upside, depending on fund and individual objectives.

  How to evaluate late-stage funding sources

  As a later-stage company, you will have a broader set of investors to choose from than you did in the early days. If you are a high-growth company choosing from a strong crop of investors, consider the following factors when selecting a later-stage funder:

  Follow-on capital. Some late-stage funds can deploy hundreds of millions or billions of dollars. Is the fund able to follow on as you raise larger rounds?

  Public market impact. Some public market investors, such as T. Rowe Price and Fidelity, send a strong positive market signal, as they are known as long-term holders of public equities. As you go public, they may hold your stock over the longer run, and this may impact your post-IPO perception and performance.

  Note: At least one public market investor recently began publicly listing month-by-month changes in value in their private market portfolio (which makes no sense—can you really change a public company’s valuation on a monthly basis?)
. This has caused issues for these companies in follow-on fundraises, secondaries, and employee morale.

  Strategic value. Late-stage investors may have specific industry knowledge, partnership/introduction potential, or country-specific knowledge. For example, when entering the Chinese market, Uber originally set up a stand-alone subsidiary through which money was raised from Chinese funders who can help with government relations and other aspects of entering China. An investment from a strategic investor can also solidify a key partnership. For example, when Google signed the deal to power Yahoo! Search (at the time a company-making move), Google took an investment round from Yahoo!

  Simple terms. Some late stage private equity firms or hedge funds ask for complex structures or extra liquidation preferences when doing investments. Terms may include additional issuance of shares under an IPO price, extra clawback of value during a sale under a certain price, and the like. If you are able to keep terms simple that is often worth the trade-off of also getting a lower valuation.

  Board seats. A number of late-stage investors are willing to invest without taking a board seat—something DST pioneered. Avoiding a bloated board may become challenging as the number of rounds a company completes grows.

  Ability to buy secondary stock or drive tenders. Some companies will couple a primary financing event (buying preferred stock) with a secondary sale or tender (allowing employees, founders, or early investors to sell part of their stake). Depending on the fund they may or may not have the appetite or the SEC registrations to buy significant amounts of secondary.

  Key terms

  Late-stage financings are not that different from earlier-stage rounds for the key terms to consider. However, at the later stages the two most important items you’ll weigh tend to collapse down to preference and board membership.

  Preference. While top-tier early-stage investors tend to have a clean preference structure (i.e., non-participating preferred60), private equity firms and family offices may ask for unusual preference structures that effectively convert an equity round into a debt round. For example, if the company and investor cannot agree on valuation, the private equity fund may ask for a 2X or 3X preference, as well as a ratchet on the next round. Similarly, later-stage investors may put in special provisions around IPOs (e.g., if the IPO prices under a certain valuation, or takes longer than six to nine months, the investor gets extra stock), future fundraises, or other aspects of the company’s life cycle. In general, you should avoid these special terms if you can, although you may not have the chance to do so, especially if your valuation starts to exceed your core business metrics or capital is scarce.

  Board membership. As with all financings, a key element to think through is whether or not to add a board member as part of the round. In general, larger boards are harder to manage. However, late-stage investors may bring a perspective to the board that has been lacking up to this point—around financial discipline, for example, or the state of the public market. This perspective can be helpful or destructive, depending on the board member and broader company context. On average, later-stage investors will be more numbers/revenue/margin driven, and this can drive a company down either a very good or a very bad path.

  Additionally, later-stage investors may not be as used to dealing with the many “oh shit” moments that a startup typically faces in a rapidly evolving market, with a shifting product road map, and a changing org structure. Some late-stage investors are notoriously hands-off/founder-friendly (e.g., Yuri Milner and DST). However, many are used to “safer” late-stage investments and can cause trouble for a high-growth startup that’s still rapidly evolving.

  Choose your board members carefully! And consider avoiding new additions altogether, unless your late-stage investors can help in unique ways. Depending on the dynamics around your fundraise, you may not have a choice—e.g., if the investor requires a board seat and you do not have a good alternative option.

  Before adding anyone as a board member, make sure to (1) do due diligence on her past investments and board seats; (2) have frank conversations about company direction and expectations; and (3) decide if there are other ways to give late-stage investors meaningful impact and access to company information—without adding a board seat. Alternatively, a late-stage investor may be able to add enormous value to your board and even help to clean out poorly performing early-stage investors. See the section on Removing Board Members for more information on this.61

  HOW DST REVOLUTIONIZED LATE-STAGE INVESTING

  The three biggest innovations in venture investing in the last 10 years include (in no particular order) (1) Y Combinator and the early-stage revolution, (2) AngelList Syndicates and distributed angel networks, and (3) DST and late-stage investing.

  Yuri Milner and DST revolutionized late-stage investing by taking large stakes in a number of companies, starting with Facebook in 2009, with the following characteristics:

  Investments could be primary, common stock secondary, or a mix of the two.

  Investments were entrepreneur-friendly, with no board seat taken.

  Investments were typically large in nature and could total $1 billion or more over the lifetime of the company. A company could effectively do a private IPO.

  While this style of investing is now more commonplace, at the time DST entered the market with its Facebook investment its approach was quite radical. In those days, later-stage investors typically asked for complicated preferences, board seats, or other ways to control the company. A number of funds have since copied DST, but the firm seems to always be a step ahead of the rest with its global diversification and ability to cherry-pick some of the best companies and investments.

  One word of caution

  One downside of dealing with private equity investors is their tendency to throw around their weight or act in ways not aligned with the traditional Silicon Valley venture capital ethos. One PE group in particular is known for signing a term sheet, then three weeks later trying to renegotiate those terms (after the company has told other investors it has selected a lead and lost leverage on negotiation). This firm got kicked out of at least one “unicorn” round recently and is known as a bad choice. However, their shenanigans are not fully public, so tread carefully when dealing with PE firms. There are some perfectly good actors in the private equity world (e.g., KKR) but also a small number of bad actors when it comes to venture.

  Don’t over-optimize your valuation

  A common temptation for founders is to raise money at the highest possible valuation. High valuations may help with employee recruitment and compensation, generate positive PR for a company, provide ammunition for M&A, and stoke founder egos. Unfortunately, too high a valuation can lead to a host of problems down the line. For example, for many of the unicorn companies, their ability to raise their next round has less to do with whether they are viable businesses, and more to do with the valuation at which they previously raised money.62

  Too high a valuation relative to the overall market can cause the following issues:

  1. Follow on fundraises become hard. Investors typically expect a 2–3X increase in valuation with each round. At very high valuations (e.g., billions) this decreases to a 50%–100% markup with each round. Nonetheless, adding $1 billion in market cap is actually a lot of value creation (revenue, user growth, etc.). The higher the valuation, the harder it is to grow % market cap.

  2. Investor mix may shift. At high valuations the time horizons of the investors who will become involved may shift. Many of the non-traditional late stage investors who have entered private equity venture markets have a short time horizon of 18 to 24 months, and they may push for liquidity or progress in ways that may not be aligned with a company’s ultimate goals.

  3. Internal pressure to hit a target valuation causes bad behavior. This is a biggie which I will mention more below: The pressure a founder puts on herself with a high valuation may distort her behavior and cause her to lead her company down the wrong path.

&n
bsp; 4. Employee expectations. People who join the company due to the perceived value and upside of the stock will be upset if a down round occurs or the valuation does not grow in the next few years. This can also occur if the company valuation slides flat for three to four years while waiting to catch up to its valuation.

  The above are all fundamentally issues of expectations. The higher your valuation, the higher the expectations. The worst manifestation of this is the pressure founders put on themselves when valuations are high.

  “In general, a $500 million to $1 billion valuation is usually where founders and/or employees might start to consider selling stock.”

  —Elad Gil

  Founder pressure

  When a founder has a multi-billion-dollar valuation two challenges arise: (1) the founder may push unsustainable growth at all costs to hit the valuation and (2) a lot of distractions arise that may not help the business (e.g., press, speaking opportunities, investments, etc.).

  The pressure to increase revenue or growth at all costs to meet rising expectation valuations is where companies can often go wrong. For example, doubling down on money-losing customer acquisition in order to show growth may accelerate market share, but also flip your company from default alive to default dead.

  This pressure to grow may be self-imposed by the entrepreneur, but more often than not it also comes at the board level. Later stage investors may aggressively push for growth, especially if the projections that the startup company used in its fundraising deck are not being met. Late-stage investors may not always understand the uncertain nature of a startup, even one on a high-growth trajectory.

  As an entrepreneur raising a round you should ask yourself the following questions:

  Will the money I am raising get me to a healthy multiple on my last valuation? If not, should I take a lower valuation so that this multiplier may be more feasible?