On Thursday night, this editor hosted nearly 200 investors and entrepreneurs who came together in San Francisco to hear several guest speakers, including Heidi Roizen, a former entrepreneur, a longtime VC, and a Stanford alum who has taught entrepreneurship at the university for more than a decade.
Roizen thinks the boom-boom tech economy we’ve been living through in recent years has officially turned the corner. She also thinks there are still plenty of great investing opportunities. (So do the LPs of her firm, DFJ, apparently; the Sand Hill Road outfit just closed a $350 million fund.)
Indeed, among other things, we talked about how today’s newer companies might avoid the various mistakes of their predecessors. Here’s part of that chat, edited for length.
TC: In recent years, founders became much more focused on valuation than on deal terms. How did that happen?
HR: You like to think all these markets are scientific and disciplined, but it’s human nature just like everything else. Your friend raises money and he or she gets this valuation and you think you should have that valuation.
So the Faustian bargain that happens is the entrepreneur tells the VC they need a certain number, and the VC says, “If you want that number, that means I’m going to own a lot less stock. In order for it to work for me, I’m going to put a bunch of terms on this. I’d like to have 2x [liquidation preference, meaning I’ll get two times my money back before anyone else gets anything] and ratchet provisions” and all this stuff. And the entrepreneur says okay, because he or she never thinks about the downside. They all think they are going to be the next Mark Zuckerberg.
So many entrepreneurs don’t even do the math to understand this calculation to understand: How big is the bucket I need to fill before I ever walk away with a dollar?
TC: You think they don’t fully understand their own funding situation?
HR: I’ve been amazed by how many entrepreneurs don’t understand that when you raise money, it has all this preference structure in it and that they’ve created a situation where they only get paid after a whole bunch of people get paid lots of money.
TC: I know you strongly advise doing a waterfall analysis during every fundraising round, so management teams understand who gets what in a number of scenarios.
HR: One of the first things I do when I take over a company [as a board member] is I run a waterfall analysis. Well, a super awesome analyst named Becca does it. And it’s not easy. Let’s say a company has done three or four rounds with stacked preferences; it takes Becca two days [to figure out what’s what]. This is non-trivial stuff, especially when some of the terms are kind of squirrely.
TC: What are you looking for specifically?
HR: What I’m looking at and trying to understand is everyone’s motivation around the table, because you can create these perverse situations for certain VCs. Some look at a company [with an underwhelming acquisition offer] and they say, “Well, I’m going to make 2x my money if it sells, whereas the chance that I’ll make 4x my money is zero given the way this company is going so I want to sell, sell, sell!”
Meanwhile, the guy at the bottom of the stack [who invested earlier and has fewer to no liquidation preferences] might be saying, “I’m going to see zero unless this company sells for $400 million, so I’m going to dig in and never ever sell no matter how unreasonable that is because frankly, I’m never going to make any money anyway.”
You need to understand that motivation.
TC: Can lawyers help?
HR: If you ask your lawyer for this, they’ll give you an analysis of what each class of stock will make. That won’t do you any good, because most VCs are in multiple classes, in different amounts, and sometimes people get bought out and they get Series this and that. I like to look by human being and not by class. Because human beings make decisions, not classes of shares.
TC: Which raises another point that you brought up to me once before, that the status of the person who invests in a startup is very important.
HR: Let’s say you have two investors, and one is super rock star who also invested in a WhatsApp and has already returned billions of dollars to her firm’s investors. Her fund has returned 10x [to its institutional investors] and now you [the entrepreneur] need another couple million dollars for your mediocre company. Well first, the venture firm has plenty of money and second, she’s a rock star, and when she goes to her partners and asks for money for her deal, they’re probably going to say yes. We all have rules and systems but at the end of the day, the winning partners have more sway.
On the other side, you have this other investor who’s part of a mediocre fund that is not going to return capital, and they had four shitty deals in the fund, and they are going to get fired if they have one more markdown. So that’s their life, and you [the founder] come in and you say, “You can write me a check [to keep the company going], or, we have this acquisition offer that’s only going to be for 20 cents on the dollar.” I can tell you right now that person will do anything they can not to take that acquisition offer, because they don’t want to go back to their partners and say, “Remember that $5 million you gave me? It’s now worth $1 million.”
The individual dynamics going on within a venture fund are critically important to you. Unfortunately, they’re also very opaque.
TC: What can founders do to minimize these situations?
HR: What I tell my Stanford students: [Be able to] build a company without raising venture capital. Venture capital is debt. People don’t understand that. You’re going to have partners who you may or may not want. Entrepreneurs see VCs as just, “Give me my money and get the hell out of my way and let me do what I want.” But VCs see entrepreneurs as: “You’re going to be my partner for seven to 10 years and I’m going to trust you with my money.” So we have a very different relationship.
Companies only to exist if they can make money from customers. So if you can actually start there, you’re in much better shape.
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