by Elad Gil
I think of money, of capital, like oxygen. Imagine if we all had to live our lives and pay for every breath. We might live our lives differently. Like we might not work out as much; maybe we couldn’t afford to run or sprint. But because oxygen is free, we don’t even calculate it. In a hot market, everybody thinks that capital is sort of free, but that changes really fast. The price of capital has moved many, many times over the last hundred to two hundred years. And the virtue of having lived through various cycles is you’re always calculating that in the back of your mind.
Elad: Are there any IPO process tactics that you’d recommend?
Keith: I think the canonical advice isn’t too bad in this case, which is the earlier you have a CFO on board, the easier it is. That doesn’t mean you should prematurely hire a CFO, but insofar as opportunistically you can find a great CFO, that will definitely help.
Secondly, I think that it can be done faster than people realize. The canonical advice again is that it’ll take about a year. I’ve seen it done in three to four months. That’s definitely pushing the envelope. Going from zero to sixty in three to four months would require incredible focus, energy, and probably some experience in the CFO or general counsel. So let’s say six months to nine months being more reasonable. But about a year of preparation is a good idea.
Elad: One other thing I’ve seen people do that I think sometimes helps is create an IPO team. They’ll pull either executives or mid-level managers from different teams and create a work plan. So they’ll treat it like any other project.
Keith: Yeah, I think having a DRI or directly responsible individual can be a great strategy. We did that at PayPal. We took one of our corp dev directors or VPs, and he became the DRI. He quarterbacked everything. So treat it like a major initiative. Assign somebody who you trust and who has credibility within the organization to the task, so they can stitch everything together and motivate people.
This interview has been edited and condensed for clarity.
PART 2: HACKING LATE-STAGE FUNDING
An interview with
Naval Ravikant
Naval Ravikant is the Chairman and a cofounder of AngelList. He previously cofounded Epinions (which went public as part of Shopping.com) and Vast.com. He is an active angel investor, and has invested in dozens of companies, including Twitter, Uber, Yammer, Stack Overflow and others.
As one of Silicon Valley’s most respected angel investors and entrepreneurs, a veteran of some of the Valley’s biggest startup success stories, and an investor in many others, Naval has a uniquely broad perspective on startups.
In this second part of our interview, Naval and I spoke about late stage funding.
Elad Gil:
There is a lot published (including on venturehacks.com) about early stage funding, but very little about later stage rounds. What are some of the key hacks for a late stage funding round?
Naval Ravikant:
First I don’t think all companies need large rounds anymore. The internet makes it possible for many kinds of companies to be built a lot more cheaply. Obviously that’s not true when you’re doing hardware or when you have local expansion issues. But overall, I think you can build companies a lot more cheaply than people used to.
But if you’re going to raise a late-stage round, what are the hacks? Frankly, late-stage rounds used to be done by venture capitalists. And now they’re done more and more by mutual funds, by other companies in the space, strategic players, even family offices often want to go direct. In those kinds of situations, I think companies can create custom bundles where they can keep control and can even sell common stock—which is the ultimate hack. They can make sure they don’t give up board seats, they don’t give up vetoes on M&A and option pool issuances and future fundraising. (On non-arm’s-length transactions, or insider self-dealing, though, you always do want investors to have the veto.)
We used to have a saying at Venture Hacks: “Valuation is temporary. Control is forever.” Whoever has control can effectively end up controlling your valuation later. Never give up control. And control is given up in subtle ways: A lot of term sheets will have so-called protective provisions that originally existed to protect the preferred shareholders, because they were minority shareholders. But effectively they give those shareholders control over the company. So, for example, if your preferred investor has the right to veto future fundraising, they effectively have a lock on your company. If you ever need more money, you have to get them to agree, which means they run the place. Same for expanding your option pool and issuing more shares to new employees, or to keep existing people. Same with M&A. That’s probably the big one, where the biggest fights happen. Sometimes the founders want to sell or don’t want to sell the company, and then the preferred shareholders try to control them for an opposite outcome.
So, in my ideal world, if I had a hot, late-stage, high-growth company, I would essentially sell common stock.
Elad: What would be the argument? A lot of times the investors are saying, “I really need the preference in order to protect my investment on the downside scenario.”
Naval: The preference is there for a very specific reason: Imagine that my company was raising at a pre-money valuation of $9 million. And then you came in and you invested $1 million in the company, so the post-money valuation is $10 million. And now you own 10% of the company. Suppose I try to take the million dollars and say, “Hey, we’re just going to divvy up the million dollars to all the shareholders.” Well, if you didn’t have a preference, I would get $900,000, and you would get $100,000 back. Not what you expected.
Elad: I see, so it’s really to protect in a distribution, versus to protect against some future downside.
Naval: Correct. That was the original theory behind liquidation preference. But as it’s gotten stacked on later and later, it’s become this giant freebie. And the easiest way to see that it doesn’t make sense for later-stage rounds is by seeing that it doesn’t exist in the public markets. The public markets are all common stock. Why? For exactly that reason—it doesn’t make sense anymore. If I have a $900 million company, and you come in and invest $100 million, well, presumably a $900 million company is really a $900 million company. I’m not going to turn around, shut the company down, and distribute the $100 million, because I’d be throwing away $900 million of real value.
The preference is really, really important at the early stages. You’d be a fool to do a seed round buying common stock. But it makes no sense at the later stages. And at the public stages, it’s gone.
If I had a high-growth, high-performance company with multiple bidders—and obviously these kinds of negotiations are only possible when there are multiple bidders—I would be selling common stock. Or, if that opportunity wasn’t available to me, I would be selling common plus liquidation preference. That’s it. I would be leaving out all the other junk.
Elad: I see. So they still get the liquidation preference, but they don’t get the protective provisions, they don’t get all the control provisions.
Naval: Right, that’s all left with the earlier rounds. Then the next hack you can do—suppose you can’t even get that—is to give them the protective provisions, but only for non-arm’s-length transactions. That means transactions that are not happening at a distance with other people. So if I’m issuing myself more stock, sure, I need your approval. If I’m issuing stock to a friend of mine or if I’m selling the company to my brother, then I need your approval. But if it’s an arm’s-length, bona fide transaction, I do not need your approval.
The next hack down from there is, okay, I need your approval, you have the veto, but the veto belongs to the preferred class as a whole. It doesn’t belong to each series individually. Because that way, if I can get the other investors to go along, then you have to go along. Presumably my earlier-stage investors are people that I trust more. I’ve worked with them longer, they’re friendlier, I chose them more carefully. They’re more understanding of how startups work. Wh
ereas my later-stage investors are more likely to be people who just showed up yesterday into the business. So that’s the series of strategies that you would fall back on.
Another thing that entrepreneurs obviously do is create founder shares, which have extra voting power. That works up to a point. There are rights that preferred shareholders have that you can’t take away from them legally, no matter what contract they sign, under Delaware law and California law. So you always have to be aware of that.
Elad: What are some examples of that?
Naval: I believe that under California law, for example—this was true in 2003 when it was relevant for me—every series has to separately approve an M&A, even if it says that preferred as a class can do it. That’s one example. Another one is inspection rights. So when you have a shareholder on the books and you’re a Delaware company, they can demand your financials. Even a small shareholder can, which a lot of people don’t realize.
Elad: How do you think about the secondary component of late-stage rounds? When should founders do it, should they not do it, how should they think about it, how should they think about other early investors relative to secondary? At what stage does it become okay?
Naval: It’s becoming more and more common. As the markets become more liquid, the industry becomes more hit-driven. So the odds of your thing working out all the way get lower. The incentives of founders and investors are starting to diverge more and more. You can have a $100 million exit as a founder and you’re really happy, but your investors may not be, because their funds are getting larger and larger. The incentives are diverging more and more, so it makes more sense to do early founder liquidity.
Maybe in 1999, if you started a venture-backed business, your odds of success were 1 in 10. Today they might be 1 in 50.
Elad: Just because there are that many more companies?
Naval: There’s a lot more companies. We’re going after hugely winner-take-all markets. The new entrants keep coming up, the platforms keep shifting faster and faster, the half-life of the winners is shorter. It’s becoming a much more competitive atmosphere.
A friend of mine described incubator graduates as the locust swarm of startups. And you just don’t know—with every graduating class, here’s another hundred locusts. And who knows which one is coming after you and what tack they’re taking? So every business is constantly under more and more sustained assault.
As a founder, you get a couple of shots on goal in your life. And you might even only have one for that thing you’re really super passionate about. I think good VCs now realize that if they’re going to ask you to go for the billion-dollar exit, then they have to be willing to let you take some off the table along the way. So I think the secondary component is becoming more and more common, and it will become more and more liquid. Secondary markets are here to stay.
Elad: Is there a specific valuation before which you don’t think a founder should ask for liquidity? Or alternatively, is a founder unwise for not diversifying before a certain point?
Naval: The situation you don’t want to be in is one in which you took substantial liquidity but your investors lost all their money. Once you’re convinced—almost beyond a shadow of a doubt—that the value of your company is greater than the stack liquidation preferences of your company, then I think it’s legit to start asking for a secondary. You want to know that you’re generating enough revenue or cash flow, or that you’ve built something that’s getting acquisition offers at a price that exceeds the liquidation preference value of your company and will make the investors some money (and they want you to keep going).
The most common way the secondary conversation starts internally is with an acquisition offer. The investors want you to turn down that acquisition offer, and you probably want to also—but you’re tempted. And a smart investor at that point will say, well, let’s let you take something off the table.
That’s why secondaries probably shouldn’t happen for seed and A and B companies. But generally it’s C and up now where you’re starting to see it quite commonly. Even in B-round cases, you’ll see it if the company’s made substantial progress.
Related to that, I think the single most important elephant in the room is that companies don’t need that much money anymore. It’s become a lot cheaper to build a company. All your software is open source. All your hardware is sitting at Amazon, in Amazon Web Services. All your marketing’s done on Google, Twitter, Facebook, Snapchat, App Store, contact lists. Even the people that you need—you need mostly engineers, and even half of them are outsourced. A lot of your customer service is happening through the community.
So, companies just don’t need that much money. Slack is a great example right now. Slack is raising money, but I don’t even know what they’re doing with it—probably secondary. Stewart famously said in the last round that he had, what did he say? Fifty or something?
Elad: Fifty or a hundred years.
Naval: Yeah, fifty or a hundred years of money, and he’s still raising more. Why? Because these funds have a lot of money and they can just put it in. You can raise it for acquisitions, which might be a good reason, and you can raise it for founder liquidity. But these are not the classic reasons.
Our heroes today as entrepreneurs should be [Bitcoin creator] Satoshi Nakamoto, who built a multibillion-dollar enterprise single-handedly, or just two people, whoever he or they are, anonymously. Or WhatsApp, 50 or so people, bought for $19 billion. YouTube, when it was bought, was probably under 60 people. And most of those people were working in datacenters and doing servers. In an AWS world, I’m not even sure they would have needed that many people. Instagram, when it was bought, was just a few people. So it’s possible to build something of huge value today with very few people.
Elad: I think the commonalities of all the things that you mentioned, except for Bitcoin, is that those were large, network-based consumer applications. But in general, when you’re thinking about an enterprise company—and there are some counterexamples, like Atlassian—people still believe that you should build a sales force, they still believe that you need some scale in other areas beyond the engineering side.
Naval: Although I think that Slack doesn’t really have much of a sales force.
Elad: Yeah, that’s fair. And that feels very much like a consumer model.
Naval: Exactly. Even the enterprise companies are starting to head that way. So yes, a company like a Slack or an Uber is going to need a lot more resources. But it’s still going to need less resources than the five-year-older version of it would have. And that’s less than the ten-year-older version would have. So the trend line is very, very clear.
Elad: Do you think people are raising too much money? And if so, why?
Naval: I think they’re raising money because money is cheap and available. The Federal Reserve and central banks of the world are printing money like crazy to fight deflation. Money is just cheap. Money is available. So why not? It’s insurance. It’s a scorecard. It’s a tool that you can use for acquisitions. You can hire a few more people. It’s brutally competitive to hire people, so you can pay them better—Google and Facebook are paying through the nose.
But the downside, the subtle difficulty of raising money, is that when you raise more money you do spend more money. There’s just no way around that, no matter how disciplined you are.
And what’s worse is you move slower. You get less stuff done. The meetings are bigger, the groups of stakeholders that have to be coordinated are larger. You’re less focused as a company; you take on too many projects because you have all these resources.
So it’s just human nature that when you have money you will spend it, and not always for the better. I think it takes your eye off the ball. In that sense, it is true that companies that are at least somewhat cash-constrained do better.
Pierre Omidyar is a famous example—this is back in the old days, from eBay. He had a lot of competitors, and he actually credited his success to being the only o
ne who didn’t have much outside financing for a long time. So when people were trading on his site, doing auctions, he came up with a rating system, which was very novel at the time. It seems obvious in hindsight, but his was one of the first sites to have automated ratings. Everybody else wanted to have a better customer experience, so they had individuals getting in the middle of every transaction. Which meant that as the whole thing spiked, he scaled much, much, faster than them and ran away with the market. By not having the headcount, he was forced to build scalable processes from day one.
Elad: There are all these different types of new investors who have come into the market or whose presence has grown: family offices, hedge funds, private equity firms, foreign funds, either sovereign funds or alternatively pools of capital that are raised externally. How should people think about those new sources of capital, and what do you think are the trade-offs?
Naval: I actually think it’s a positive development for entrepreneurs. I know VCs like to bash on them as dumb money. But you have to keep in mind that that’s like your local laundromat owner getting angry that a new laundromat opened up down the street. They don’t like competition. So you always have to filter venture advice through venture incentives.
