High Growth Handbook

by Elad Gil

  4. Ability to partner or sell at scale. A public company tends to be taken more seriously for partnerships, sales, and other business activities.

  5. Fiscal & business discipline. When Facebook went public, monetization was viewed as a low priority for the company. After the first serious drop in stock price after an earnings call, Zuckerberg moved engineering and other resources into the ads team to scale monetization. An argument could be made that Facebook would never have reached a $500 billion as a private company. Public market pressure forced Facebook to re-examine its own priorities and led to a highly valued, liquid currency that could be used to acquire Instagram, WhatsApp, and other potential competitors.

  Cons of going public

  1. Larger, more complex board of directors. Once you are public there are a number of committees you need to staff at the board level. This increases board size and complexity. Small boards tend to be more nimble.

  2. Financial and other controls. As you prepare for the IPO a number of financial and process controls need to be instated. Some of these are actually a net positive for the company, but many don’t help support the core business and just slow things down.

  3. Employee mix shifts. As your company scales from 10 to 1,000 people, the risk profile of the people who join also changes. In general, the later stage the company the more risk averse the cohort of employees. Once a company goes public the hiring profile hits another transition. In general you will have the same overall caliber of people joining, however their risk profile will shift to more conservative. This can be actively managed or augmented by acquiring entrepreneurial companies and integrating them in culturally. Alternatively, the executive team and founders will need to encourage risk taking and rule questioning as part of the new culture.

  Market cycles

  Many first time founders running high-growth, private companies today have not lived through a major economic and capital cycle. When the public markets collapse private markets tend to overreact. This is due to a few reasons:

  1. Comparables. If public market valuations drop by 20–30%, private market valuations tend to follow. This is the difference between a billion dollar valuation and a $700M valuation. If companies raised at a high price while the markets were strong, they may need to do a down round when markets rebalance.

  2. Venture and growth fund LP rebalancing. Many of the limited partners (endowments, family offices, pension plans) in venture and growth funds have a set limit on the percent of their capital that can be in venture capital. If there is a large public market shift, they need to reallocate capital out of venture capital—which means that funds can raise less money to invest in startups. This usually takes one to three years to take place as the typical venture fund lifecycle is two to three years.

  3. Fear replaces greed. When people get scared they sit on their wallets.

  In general, it is best to go public during an ongoing bull market. You can raise large amounts of capital and have a liquid currency by which to make acquisitions. The capital you raise in an up market allows you to survive, and act more aggressively in a down market. Amazon took advantage of being a public company masterfully. During the bubble in the 1990s they used their market cap to make a large number of acquisitions. As the bubble collapsed they used the large amounts of capital raised from public markets to sustain the company through the dark periods of the early 2000s.

  As founders wait longer to go public, they may end up with extra hurdles or obstacles relative to their IPO price. This may include drops in public markets, unusual private market terms (for example needing to clear an IRR or IPO price hurdle in order to raise private capital), or simply raising at too high a valuation and then spending a few years hopefully growing into it.

  While the 1990s were characterized by companies who went public too early, the 2010s perhaps had many companies that waited too long.

  IPO process

  As you approach your IPO you should appoint an IPO team and a directly responsible individual (DRI) to project manage that team with the CFO overseeing the overall IPO. In parallel, you can reach out to other CEOs and CFOs who have taken their companies public to learn more about tips and tactics for a successful IPO.

  * * *

  56 Note: I’ve made an effort to include usefully representative lists of investment firms in this section, but I must warn readers that these lists are not comprehensive—and they may soon be out of date in any event. Do your research and don’t rely solely on lists of investors that you find in books. Also, I offer my apologies to any firms I overlooked.

  57 An SPV (special purpose vehicle) is a one-time fund set up to invest in a particular company. Just as a venture fund raises money from limited partners to invest in multiple companies, an SPV is a one-off fund that raises money from LPs to invest in only one company. Recently, a number of funds (early-stage as well as traditional VCs), as well as individual angels, have raised SPVs to invest in specific companies.

  58 See eladgil.com. [http://fortune.com/2015/11/12/fidelity-marks-down-tech-unicorns/]

  59 Strategics are large, cash-rich companies in your industry who may want to invest in order to (1) cut a broader partnership with your company, (2) learn more about how software and technology may impact their industry, or (3) try to acquire you later. For example, Roche was part of $100 million round in Flatiron, GM was part of a $1 billion round in Lyft, and Intel was part of a major round in Cloudera. [http://arstechnica.com/cars/2016/01/general-motors-bought-sidecar-gave-lyft-millions-now-its-launching-maven/]

  60 See eladgil.com. [https://www.forbes.com/pictures/fiii45hlf/participating-preferred-vs-non-participating-preferred/]

  61 Related post on eladgil.com [http://blog.eladgil.com/2012/11/how-to-choose-right-vc-partner-for-you.html]

  62 Of course, there will be a number of these companies that are not worth $1 billion plus and will simply flame out. However, we will also see a number of companies that, two years from now, will look cheap in hindsight.

  63 Carry is the percentage of a fund’s return on investment that a VC earns in exchange for managing that fund. No capital returned=no carry, which greatly limits what the individual VC takes home.

  64 See article linked on eladgil.com. [https://www.law360.com/articles/516967/sec-settles-with-firms-over-pre-ipo-facebook-trading]

  65 See eladgil.com [https://beta.techcrunch.com/2009/07/13/dst-to-buy-up-to-100-million-in-facebook-employee-stock/]

  66 See link at eladgil.com. [https://dealbook.nytimes.com/2012/03/14/charges-filed-against-brokerage-firms-that-trade-private-shares/?_r=0]

  67 There are always rumors that a stock is selling for much higher and much lower prices. In my experience, these rumors often turn out to be false. Focus on closed transactions, where money actually changed hands, versus “a friend of a friend was offered $X but did not sell.”

  68 The reason for this discount is that preferred stock gets paid out first if the company exits at lower than its last round’s valuation. So while preferred stock has “insurance” that makes it more likely to get paid in full, common stock does not, hence the discount. As a company gets more valuable and has more traction, the risk of a low exit goes down, and the gap in price between common and preferred shrinks and eventually disappears.

  In some cases, as part of a financing round, a venture firm will buy common shares from founders at the same time it buys preferred stock from the company. In this case, the venture firm will pay the same price for preferred and common, as (1) it wants to help the founders partially cash out, and (2) the percentage of common stock it owns is low enough to not be material versus its preferred stock position.

  69 If you work for a super-hot company that has made a ton of progress since its last round, and a lot of time has passed since the funding, then you can demand a premium to the last round of funding. Companies also track their own internal valuation at board meetings and via 409As, so you can ask the company what price they think the company is now worth in order to set a
price.

  70 I know a number of investors who stopped buying secondary shares after they got “burned” by speculating on Facebook pre-IPO.

  71 Thanks to Naval Ravikant for reviewing and providing feedback on this chapter.

  PART 2: GOING PUBLIC—WHY DO AN IPO?

  An interview with

  Keith Rabois

  Keith Rabois is an investment partner at Khosla Ventures. Since 2000, he has been instrumental in driving five startups from their early stages to successful IPOs, with executive roles at PayPal, LinkedIn, and Square, and as a board member with Yelp and Xoom.

  At Khosla Ventures, Rabois has led investments in a broad array of startups including, DoorDash, Stripe, Thoughtspot, Affirm, Even Financial, and Piazza. While working as a VC he simultaneously cofounded Opendoor, a startup in the real estate tech world.

  In this second part of our interview, Keith and I spoke about taking companies public.

  Elad Gil:

  You’ve been involved with a number of companies, either as an executive or board member, which have gone public: PayPal, LinkedIn, Square. Yelp and Xoom as a board member. A lot of founders today don’t want to go public. What is your view of the pluses and minuses of being a public company?

  Keith Rabois:

  My view is pretty simple, which is companies should go public as soon as they can. Increased transparency and accountability is always a good thing. It’s something we always teach and proselytize through our organizations, to our executives. And being prepared to go public creates a discipline, a focus, that most other processes don’t.

  It’s also very binary. Once you are public, you have a lot of tools and levers at your disposal, about incremental financing, acquisitions, M&A. It unlocks a lot of potential that you may not otherwise be able to take advantage of or avail yourself of.

  For example, Facebook tried to acquire Twitter. You know, there was a lot of debate about a $500 million offer. Had Facebook—at the time it was still private—had liquid currency, Facebook might have been able to acquire Twitter, which I think would have changed history. Twitter is a very successful independent company that actually has more influence in the world than Facebook, at least in my view. And that acquisition couldn’t happen because there was a big debate about the value of Facebook’s currency. There are a lot of examples like this.

  I think the reasons why people don’t go public are basically excuses. For example, people frequently talk about innovation. Well, ask anybody in Silicon Valley what the top five most innovative companies on the planet are, and inevitably you get some version of the following answer: Google, Facebook, Tesla, SpaceX, Apple, maybe Amazon. Five of those six are large-market-cap, publicly traded companies, and they’re innovating at a pace that’s clearly better than private companies. With the right leadership, you can innovate on the public stage better actually than on the private stage. So I think that’s an excuse.

  Second thing is people talk about the distractions of stock price and things like that. The truth is, when you run a company, people are distracted by lots of things: gossip in the office, the food you serve, these days their cryptocurrency holdings. At least when you’re public, you as an executive have the same perspective as your employees, and you can tell when they’re going to be distracted. You have knowledge and then you can countersteer against that. Whereas when they get distracted because you’re taking away their bacon or some perk in the office, you actually don’t have a lot of visibility into that. It also lags. I think countermanaging against distractions is part of the job as a leader or an executive or a CEO.

  In addition, people talk about the cost of going public. Truthfully, that’s overrated as well. You have a year post going public to implement most of the compliance burden. By the time you actually have to put in place the SOX compliance measures, you’ve already been public for a year and clearly have the resources. You probably raised several hundred million dollars to a billion dollars in going public. You can pay for four or five more accountants and some software at that point. I think that’s another excuse.

  Discipline around financials and reporting is also good and healthy to start as early as possible in the company’s history. Doesn’t mean you have to be profitable. I think lots of companies go public that are not profitable. In fact, I suspect most technology companies went public, historically, when they were unprofitable. I don’t think that’s a gating factor.

  I think some people learned the wrong lessons from earlier companies. PayPal, for example, had a pretty searing experience of going public. We filed to go public the day before 9/11. We had a state regulator sort of attack us on the precipice of our IPO. And I think Peter Thiel learned from that lesson that going public is kind of a pain in the ass, and I think he’s proselytized a little bit too much about that. Because it was an unusual set of circumstances that affected PayPal. That said, we did eventually go public, and I think everybody thought it was a good thing.

  Yelp went public and it really boosted retention. A year before going public, everybody was motivated and excited about the opportunity to go public and create a permanent stand-alone company. And post going public, the company’s retention of engineers and general employees actually went up by double digit percentages. So I think it was very healthy, even though Jeremy had originally been hesitant.

  Elad: I think people in general underestimate the impact on employees in terms of retention and the ability to attract and compensate great employees. I was talking with one recruiting firm, and their data shows that after a company goes public they close a higher proportion of people with lower offers.

  Keith: That doesn’t surprise me. I’ve never rigorously analyzed it. But based upon the Yelp data where that was true, it wouldn’t surprise me if that’s true globally.

  Elad: What do you think is most unexpected to first-time founders about having a public company?

  Keith: Well, there is some incremental drag in board meetings. You wind up having a more process-oriented board meeting. I think both of us would probably advise startups having a smaller board, three to seven members max. Probably five more typically. When you go public, because of the committee requirements—audit committee, nomination committee—and various structural requirements, you wind up with a larger board, which does create disadvantages in having dialogue and debate, versus just presentations.

  Now, there’s ways to countermanage around that. Obviously you don’t have to make the formal board meeting your only strategy session. So that can be solved. But it is different.

  The type of employee that you attract is a little bit different, too, more compensation-focused definitely. More of the market is compensation focused today because the cost of living in the Bay Area is so high. Even people who might in other eras have been more willing to take more upside and equity and less cash are focused a bit more on their cash compensation.

  I think the ability to attract younger colleagues that are recent graduates goes up. The recent graduates from CS departments at Stanford, CMU, other top universities are starting their careers, and they’re looking for a place to learn. Now, some of those will become founders and go to YC and other escape ramps. But a lot of the meat-and-potato software engineers want to go to a stable company for at least two years. And once you’re public, parents and significant others think of it as a stable entity. So candidates run into a lot less resistance from people that are important to them in their lives in accepting those offers.

  And I think you can learn something from a large company. There are some practices that are very destructive for people who want to start their own company and that you wouldn’t want to adopt. But there are a lot of things you can learn from large companies, too.

  Elad: You mentioned that you think companies should go public as soon as they can. What are signs that a company is ready? How do you know that it’s time?

  Keith: I think predictability is one. Meaning you can easily forecast your next quarter, your next six months. That
means that, underneath that, you understand the levers of your business. There’s a business equation of X x Y x Z, and you have precisely mastered that equation. You know exactly how what you do in one part of the company affects the next part which affects the final result, which is, let’s say, your contribution margin.

  Once that’s well understood and the N is large enough so that the variance is rare, then I think you’re ready to be a public company, assuming you’re at some level of scale, which probably means about $50 million in revenue.

  “I think of money, of capital, like oxygen. Imagine if we all had to live our lives and pay for every breath.”

  —Keith Rabois

  Elad: A lot of private company founders don’t think the public market cycle itself is important. They say that it doesn’t matter if the S&P or NASDAQ is at an all-time high. They can go public at any time. What do you think about the macro market cycles relative to time frames for going public?

  Keith: I think that’s somewhat naïve, and it’s a function of having probably grown up in an environment that was very stable. If you think that since the global financial crisis of 2008, we’ve basically been in a hot market for the last ten years. Most founders have grown up, professionally and psychologically, in a fairly stable, attractive market.

  Whereas if you started your career when the bubble collapsed or in the aftermath of the bubble, in 2000–2003, you understand what happens when there isn’t liquidity in the market. For example, a lot of our companies use debt as an oxygen to grow. It’s part of the business model of Opendoor, it’s part of the business model at Affirm, it’s part of the business model at Upstart, as examples. The price of that oxygen can change very radically and very quickly. Bill Me Later and Zappos famously had to sell, even though their businesses were performing quite well, because their access to debt was affected. Just as access to debt is affected by general macroeconomic changes, the ability to use money as a resource to grow can be completely changed overnight.