[Book Review] Secrets of Sand Hill Road
- Title: Secrets of Sand Hill Road: Venture Capital―and How to Get It, 2019
- Author: Scott Kupor, Managing Partner @ Andreessen Horowitz
- Link: https://www.books.com.tw/products/CN10801071
- Excerpt from Chapter 1–5
- Reading End Date: 2022.1.16
Sand Hill Road — it holds as much promise for entrepreneurs as Hollywood Boulevard does for actors, Wall Street does for investment bankers, and Music Row does for country music artists.
Where does VC’s money come from?
Most venture firms invest money on behalf of larger institutional asset managers, aka. Limited Partners (LP). For instance, Yale’s university endowment fund, foundations, pension plans, and Vanguard retirement funds. Also, crazily rich families could be Limited Partners as well.
The asset managers allocate the portfolio for their best interest: stocks, bonds, hedge funds, buyout funds, etc. Sometimes, it includes the high-risk sector of venture fund investments. These LPs pour money into the VC industry.
Limited Partners v.s. General Partners
“Limited” is intended to describe two things: firstly, the LPs have limited governance over the investments the VC funds chose to invest. Similarly, LPs have limited ability to influence the decision to exit an investment. LP is investing in a “blind pool.” Secondly, the LPs are basically immune from any potential liability.
General partners (GPs) are the members of the VC fund who are responsible for the investment, managing them, and generating a return of capital back to LPs. For sure, GPs take on all liability if things go wrong. Additionally, LP pays management fees (~2%) to GPs based on the percentage of the contributed capital.
LPs and GPs are partners. Legally, partnerships don't pay taxes. Moreover, some LPs are entitled to be tax-free entities. For instance, university endowments and foundations don’t owe the government any taxes on earnings. Hence, passing through the income to them LPs they avoid taxes together.
The VC life cycle
This book aims to democratize access to opportunities. Information asymmetry happens between entrepreneurs and VCs. The VCs are repeated players; on the flip side, founders have been through the process only a few (or only one) times. VCs supports their portfolio companies with multiple investment rounds spanning 5–10 years. They do whatever they can to help their companies succeed. VCs are like shepherds — they give advice, but they do not run the business on their own. Knowing the Incentive Structures is equally important to the startup itself. Know your partner before you get married.
Dot-com Bubble
We see many ideas failed in the bubble being re-incarnated as successful businesses two decades later. Why? The market conditions have changed. The market size of available customers was simply too small. For instance, AWS would have failed if it was launched during the Bubble, and yet it is now succeeded. The market was just not ready to take the offer.
Debt v.s. Equity
Loans from banks are not always the best financing for all companies. Firstly, loans are not part of the permanent capital structure of a company. Secondly, loans have to be paid off in 3–5 years for principals plus interests. Banks are always avoiding the loan becoming defaulted. Bank lending is best suited for a company that is generating positive cash flow. However, many tech companies had negative cash flow for a long time.
With VC-backed equity, there is no requirement to pay back to VC. You exchange your complete ownership position of the business with free money. You have to live with their involvement in certain decisions as a tradeoff though.
Positive Signaling — VC returns do not follow a bell curve
VC is a winner-takes-all game. The VC returns do not follow a normal distribution; instead, it is more of a power-law (exponential) curve. All the investors (the LPs) are holding the same belief — the VC who has invested in Facebook must have a better taste to distinguish the next Facebook. Similarly, entrepreneurs share the same belief. They believe that the VCs who have invested in Facebook could do better in helping the business, have richer resources, and hence help their business succeed.
Moreover, VC is a zero-sum game, unlike the secondary stock market or bond market. If an entrepreneur has taken an offer from one VC, it will not take any money from the other one. Even if we might have a second chance (B round), the opportunities have changed.
If you don’t have the brand to create the positive signaling that attracts the best entrepreneurs/investors, it is hard to generate the returns.
In a similar fashion, what VC cares about in their portfolio companies is the home-run, not the 1-base or 2-base. Basically, it follows the power-law curve. We don’t want to diversify the portfolios in a VC mindset. The “batting average” means nothing, and we only care about the “bats per home-run”. In general, we expect home runs to return 10–100 times the money.
For instance, Accel partners scored 1000 times the money for investing in Facebook when it got IPOed.
False Negatives is more serious
If you invest in a company that turns out to be worse than anticipated (false positives) the worst you experience is to lose all invested capital. However, if you failed to invest in a winner (false negatives), it means that you forfeit all asymmetric upside that comes along with that investment. It can be a career ending for a VC if you missed the next Facebook.
Winner’s curse — buyers in auctions get emotionally attached to the buying process and are not rational. The irrational response causes investors to overpay for an asset.
Decide where to invest — People and the team
A decision to invest in a team means that the VC cannot invest in a different team that is doing exactly the same thing. In other words, it prevents VCs from investing in a direct competitor in that space. You have picked your horse to ride.
Use the concept of a “product-first company” instead of a “company-first company”. Start with a pain point, not with a gut feeling of someone who wants to start a company and then brainstorms.
Also, use the “product-market fit” as well as the “founder-market fit” to evaluate the investment. The founder should have a unique experience that exposed them to a market problem in a way that provided unique insights.
“I knew nothing about airlines, which I think made me eminently qualified to start one. Because what we tried to do at Southwest was get away from the traditional way that airlines had done business.”
Vitamin v.s. Aspirin
VCs are looking for Aspirin, not Vitamin. If they are marginal improvements against the existing BATNA, or Best Alternative to Negotiated Agreement — VCs will not give a ship-it. They need to be 10x or 100x better than the current best to make a home run.
Similarly, we care about the “market size”. If a great team builds great products, and yet the market size is niche, then it might not be worthwhile to invest. Always ask the “So What” question to evaluate the potential. Think about how Airbnb raised money. Is it only for the coach surfers who are mostly starving college students? Or is it for travelers all over the world?
