Sand Hill Road is as well-known an address to business people as Rodeo Drive, Wall Street and Pennsylvania Avenue. This arterial road in western Silicon Valley is home to many of the venture capital firms that provide the money that powers the most innovative technology companies in the world. Scott Kupor, a lawyer turned entrepreneur turned VC, works as managing partner in one of those firms, Andreessen Horowitz. He’s written a best-selling book that offers advice and guidance for entrepreneurs on how to work with venture capitalists. Kupor spoke about his book, The Secrets of Sand Hill Road: Venture Capital and How to Get It, during a segment on the Knowledge at Wharton radio show on SiriusXM. (Listen to the podcast at the top of this page.)
An edited transcript of the conversation follows.
Knowledge at Wharton: What’s your best advice to an entrepreneur looking for venture capital?
Scott Kupor: Make sure you understand what motivates the venture capitalists and whether you are aligned with their objectives. Venture capitalists want to invest in companies that are trying to create the next Facebook, the next Google — big, self-sustaining, long-term businesses. If that’s what you want to do, then I think that’s the right partner for you.
Knowledge at Wharton: VC has grown significantly in the past couple of decades. What impact is it having today?
Kupor: Last year in the U.S. alone, venture invested about $130 billion in startup companies and also raised about $50 billion from our limited partners or investors. Those numbers are 20-year highs.
It used to be the case that the U.S. was the major funder of venture-backed companies. About 20 years ago, the U.S. was about 90% of all global venture capital. Today, that’s about 50%. The pie has grown significantly, but also the relative market share of places outside the U.S. has grown very significantly. If you look at a bunch of the publicly traded companies today, I think the top five most valuable companies today were all venture-backed businesses. So, the impact of venture on job growth and economic growth is very, very significant.
Knowledge at Wharton: What has driven this global shift?
Kupor: For a long time, a lot of venture capital was based around hardware. A lot of the initial venture capital, for example, went to companies like Intel and others developing chips and other hardware-based products. Software has really permeated a lot of what happens in the industry. Software is much more malleable, and the presence of computer science students in all these different companies has really fueled that behavior.
“The last thing you want to do is anything that would risk the entrepreneurial spirit in which you’ve invested.”
Of course, when you get a critical mass of engineers in a location, then you get kind of early- capital that wants to fuel entrepreneurship among those groups. Israel, broader Europe, certainly China and India have been big places of growth. Our view looking over the next 20, 30, 40 years is there’s probably no reason to think that we won’t have very broad and distributed entrepreneurship in many, many new places.
Knowledge at Wharton: You write that, “VCs are only as good as the entrepreneur in whom they have the privilege to invest.” That plays back to something you said a few moments ago about the relationship between the VC and the entrepreneur.
Kupor: Yes, this is really important. I’ve been in the VC world now for 10 years, but before that, I was at a startup for about eight years. It’s a really important distinction that, at the end of the day, VCs are a financing source, and then hopefully we can provide value in other ways. But we shouldn’t kid ourselves that the hard work is being done by the entrepreneurs who are building these businesses. That is definitely kind of the Herculean effort to go from kind of conception of something into hopefully a very big, publicly tradable company. VCs can be helpful and partners along the way, but I think where VCs can go wrong is where they confuse who’s actually doing the real heavy lifting here. There’s no doubt that entrepreneurs are driving the ship.
Knowledge at Wharton: How big of a role should VCs take in the daily operation of a company they have invested in?
Kupor: Having been in a startup myself, I think it’s easy in the VC world to think that you know more about what’s happening day-to-day in the company because you’re on the board or because you’re talking to the CEO. But the magic of what these companies are trying to do is so tied up in the individual people they have in the company, the capabilities that that team can execute on. So again, where board members sometimes as venture capitalists risk overstepping their bounds is they think they understand more about what’s happening in the business and sometimes try to put too much of their fingerprint on the business. The last thing you want to do is anything that would risk the entrepreneurial spirit in which you’ve invested.
Knowledge at Wharton: How much has big data changed your side of the business?
Kupor: It’s still pretty early, to be completely honest. I think there are two places that VCs are exploring big data. One is, can we use big data to help find a signal out of noise as a way to generate new potential companies to invest in? Those efforts have not been that successful. Some of that is a function that the discovery process for finding companies is not that hard in VC. Most people generally are fishing in a lot of the same ponds, so we know what the opportunities are out there.
I think the more promising area for big data is in terms of diligence in companies. If we can amass datasets over time to help us say, “Hey, for this stage of company, this is kind of what we would expect the revenues to look like, based on thousands of companies that have come before them. Or this is what the daily user growth should look like.” I think those things that can really inform the diligence process are probably the most fruitful areas to explore.
Knowledge at Wharton: There’s an element of how-to in your book in terms of leading the entrepreneur in understanding the venture capital world. You tell entrepreneurs to start by asking the right questions. Can you talk about that?
Kupor: Particularly out here in the Valley, there are seemingly a lot of resources that you can go to to get the answers to these questions. But the genesis of the book was that I kept hearing a recurring set of questions from entrepreneurs over the last 10 years that go to the very heart and the very foundational nature of the relationship. The thing I mentioned in the book is that, unfortunately, some VC relationships will last longer than an average marriage in the U.S. Unfortunately, it’s only eight years versus the kind of 10+ years that we often spend with our companies. Just like in any good relationship, you’ve got to know your partner, you’ve got to do the dating process. And I think people sometimes don’t pay enough attention to that.
Knowledge at Wharton: Do you think that VC funding may not be the way to go for some entrepreneurs?
Kupor: That’s exactly right. Taking money from a VC means that you are aligned with what their objectives are. You both need to believe that the goal here is, “We may not succeed, but can we try to build a company of the scale or scope of a Facebook or a Google or an Apple or an Amazon?” There’s nothing wrong inherently if that’s not your objective, but I think it’s always dangerous if you have a different objective to align yourself with people who have different views about what success looks like.
Knowledge at Wharton: The success rate for startups is not great. What do entrepreneurs need to understand about that?
Kupor: Look, building a startup is incredibly hard. You have to be partly delusional to do it because it’s just an incredibly difficult path, and you’ve got to start from scratch and convince people to come work for you before you’ve shown anything. And the way our business works is probably as much as half of what we do, we end up losing all of our money on, so there’s no success there. If your kids went to school every day and scored 50% on tests, you’d be pretty disappointed. In this business, that’s just kind of par for the course. So much of this business is a function of finding those one or two needles in the haystack that can ultimately drive most of the returns for the firms that are investing in them.
Knowledge at Wharton: The VC community understands the success ratio is going to be low. Is it hard at times to communicate that to the entrepreneur who expects that when that partnership is built out, that success rate is probably going to be 100%.
“Just like in any good relationship, you’ve got to know your partner, you’ve got to do the dating process.”
Kupor: That’s exactly right. We are going to ultimately make our money as investors on the companies that succeed and that are winners financially. But we make our reputation on the ones that don’t succeed. I think one of the things for those who are thinking about being entrepreneurs is make sure you understand what is the nature of how the VCs are going to deal with you in the circumstances where things don’t work out well.
The most important thing for VCs is, you can’t cut and run. You’ve got to be there beside the entrepreneur and help them. Sometimes that means either winding down the business or finding an acquisition, but most importantly making sure that you respect the entrepreneur and the entrepreneurial process.
Knowledge at Wharton: When a VC invests in a company in a particular sector, should the entrepreneur expect to see that VC investing in another company in the same sector?
Kupor: Conflict is a real important issue in this business. We’re an investor in Lyft, for example. If you invest in Lyft, then that means we’re almost merging our brands to a certain extent. We are getting the benefit of Lyft’s brand, and hopefully they get benefit from our brand. If we were to turn around and then invest in Uber, it would be really hard from a signaling perspective for the market to understand how those three brands be aligned, as opposed to just Andreessen Horowitz with one of them.
Conflict, unfortunately, is always in the eye of the beholder. The Lyft/Uber example is probably an easy one, but sometimes companies pivot into other areas. But you’ve got to think about once you’ve aligned yourself on the brand side, that’s pretty much the horse that you’ve chosen to ride.
Knowledge at Wharton: Is a limited partner the best approach in the relationship between the VC and the startup?
Kupor: Yes, I think that’s probably a good way to describe it. Limited partner has a bit of a legal context to it, so I’m not sure I would want to overstate it. Think of the VC as a financing source, and then the VC as kind of coach/mentor/partner in terms of thinking through important strategies for the company.
The third area where we at Andreessen Horowitz have spent a lot of time is, how can you tangibly help the company grow their business? I’ll give you an example. In our business, we’ve got a group that is focused entirely on building customer- and business-development relationships with third parties who could ultimately benefit our companies. That’s good for us because if our companies do better, our investors do better. It’s good for the companies, because it helps them grow their customer base. And it’s good for those external customers because it gives them access to early-stage technology.
The biggest sea change in the business over the last 10 years is this idea that capital alone is not what differentiates a venture capitalist, but the value they can bring to the startup and company formation process.
Knowledge at Wharton: How does the VC react to a second funding round and whether they should invest further in that particular company?
Kupor: The general way it works, at least in the early stage, is if we invest in the first round of a company, our assumption is, “When they go to raise the next round on financing, hopefully there’s another party out there who finds the company valuable.” But we will do what we call our pro rata, which is we will typically invest to maintain our exiting percentage ownership of the company. That’s generally the way it works in the business for the first round or two after you’ve initially invested. Beyond that, the dollar values can escalate pretty quickly as these companies grow, so we do have this funny relationship which is sometimes in our business we compete against other venture capital firms, and then other times we are partnering with them because we are invested alongside them in our companies.
The way I would think about it as an entrepreneur is you have to assume that each independent financing round can stand on its own. But if you’re doing well, you’re probably going to get at least some reasonable participation from your existing VCs.
Knowledge at Wharton: You are a believer in the C corp. Why?
Kupor: Yes. The C corp has long been the model for most of these companies, and I think that’s because it has become so established. It’s a little bit of a self-fulfilling prophecy at this point in time that we all have the Delaware law that makes it work well. C corps make it easier for us to give stock options to people. Certainly, when companies go public, public investors are used to C corps, so there’s no sacrosanct rule that says you can’t do otherwise. But in general, there are places to innovate here. I’m not sure that innovating on a corporate structure is necessarily one of the best ones.
“So much of this business is a function of finding those one or two needles in the haystack that can ultimately drive most of the returns for the firms that are investing in them.”
Knowledge at Wharton: As a VC, how do you deal with the legal and financial issues when a group of founders wants to break up?
Kupor: This is a real issue and something that, unfortunately, founders don’t think as much about, probably because they don’t like to. You don’t like to think of the idea that you might separate at some point from your co-founders. But it’s definitely advice that we give our companies when they first start, which is people change and things change over time. One of you might want to be the CEO. The other person might decide, “Hey, this has been fun. I want to go do something else.”
It’s important that you set up the governance structure for the business to make sure that if something like that happens, the last thing you want is a co-founder who’s no longer actively involved in the company having a disproportionate say in the strategy or the governance for the company. We try to help them set up those mechanisms to make sure that if these break-ups happen, at least they don’t impact the ability of the company to go execute on their strategy.
Knowledge at Wharton: What role does the VC have if the firm is at the point where it can go public?
Kupor: Part of our job, of course, is kind of on the on-ramp to an IPO to help them get ready for that. That means you’ve got to often change the board and add independent experts because you’ve got these new listing standards you have to satisfy. Part of our job is to help them navigate through that process.
At some period of time, once the companies are public, it’s generally the case that the VCs will come off the board. That doesn’t need to be immediately, but over the first couple of years of companies going public, in general the VCs will give up their board seats, and you’ll tend to have more permanent, professional board members. I think that’s a reasonable thing that probably benefits the company and then allows the VC to recycle — in other words, to be able to take on new boards that allow them to continue their ongoing investment business.
Knowledge at Wharton: Having been on both sides of this, what should founders be thinking about when they are pitching to a VC for potential investment?
Kupor: I think there are two big takeaways that we try to make clear in the book. One is just that you’ve got to remember that a lot of what we invest in doesn’t materialize. We’re looking for a very small number of companies that can ultimately be very big winners. What that really leads you to is that market size becomes very important. So, the real question the VCs are asking at the early stage is, “Let’s just assume everything goes right. How big could this be?” And there’s no magic answer to that.
That’s lesson No. 1 for entrepreneurs to think about. Lesson No. 2 is, at the early stage, there’s not a whole lot other than team for the VCs to evaluate. You’ve convinced them that market size is big. You’ve probably told them about what your product ideas are, but we know from experience that your product is going to change many times once you actually get into marketing and feedback from customers.
The one thing that probably doesn’t change is team, so a lot of our evaluation is not why invest in this category, but why invest in you as a team? What is it that makes you uniquely qualified versus any of the other teams that we might see doing the same idea that gives us confidence that you’re going to be responsive to the market, you’re going to know how to hire people and grow the business, attract employees and do all the things that will be required to generate success?
Knowledge at Wharton: How you expect the world of VC to continue to grow?
Kupor: I think private markets and private assets generally will grow, and we’ve seen that certainly over the last 15 to 20 years. I think it’s going to be a very competitive market, as it continues to be.
“Once you’ve aligned yourself on the brand side, that’s pretty much the horse that you’ve chosen to ride.”
Most importantly, I think it’s going to be a market where capital is not the scarce resource anymore. There will always be someone out there who’s got more money than do we and who has a lower cost of capital than do we. I think the real question about survivorship for VC is, can you actually bring value and add value to the company-building process? For firms that can’t do that, I think it’s going to be a tough road ahead.
Knowledge at Wharton: There was a lot of talk in the first couple of months of this year about the IPO. Are we going to continue to see companies want to dip their toe into that water at a significant rate during the remainder of 2019 and beyond?
Kupor: I believe we will. If you look at what’s happened to date, I think there’s a little bit of a “Tale of Two Cities” happening in the IPO market. You’ve got enterprise software companies that have very attractive growth rates – 30%, 40%, 50% — but don’t necessarily have to grow at 75% or 100%. And they’ve got more line of sight into profitability. Those companies have traded very well.
Then you’ve got companies like an Uber or a Lyft, for example, where they are very high-growth companies but are requiring a significant amount of cash consumption to facilitate that growth. I think those will be fine over time, but given the macro uncertainty that we have around tariffs and other things that are creating volatility in the market, it’s understandable to me why those companies will have more volatility.
But if you talk to BlackRock or Fidelity or T. Rowe — a lot of these buyers in the IPO market — I think there is still very significant demand, particularly as we talked about for those more traditional enterprise software companies.
Knowledge at Wharton: Will we still see occasionally the company that has gone public that wants to go private, especially when they get bought out by some hedge fund or investment firm?
Kupor: Yes, I think that’s right. There’s a little bit of this natural flow, which is you go public when you have a growth rate to be able to sustain yourself as a stand-alone business. Then companies typically either go private or get acquired by public companies when they start to get to the tail end of those growth rates and consistent cash flow generation becomes a much more attractive asset for those businesses.