Mary Meeker: The State Of The Web, December 2012

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Mary Meeker’s Presentation On The State Of The Web December 2012

Peter Thiel’s CS183 @ Stanford: Startup – Thiel’s Law

I.Origins, Rules, Culture

Every company is different. But there are certain rules that you simply must follow when you start a business. A corollary of this is what some friends have (somewhat grandiosely) called Thiel’s law: A startup messed up at its foundation cannot be fixed.

Beginnings of things are very important. Beginnings are qualitatively different. Consider the origin of universe. Different things happened then than what we experience in everyday life. Or think about the origin of a country; it necessarily involves a great many elements that you do not see in the normal course of business. Here in the U.S., the Founders generally got a lot of things right. Some things they got quite wrong. But most of the time they can’t really be fixed. Alaska has 2 senators. So does California. So Alaska, despite having something like 1/50th of California’s population, has equal power in the Senate. Some say that’s a feature, not a bug. Whatever it is, we’re likely to be stuck with it as long as this country exists.

The insight that foundings are crucial is what is behind the Founders Fund name. Founders and founding moments are very important in determining what comes next for a given business. If you focus on the founding and get it right, you have a chance. If you don’t, you’ll be lucky at best, and probably not even that.

The importance of foundings is embedded in companies. Where there’s a debate or controversial claim at Google, one says, “The Founders have scientifically determined that x is true,” where x is his preferred position. If you think that certain perks should be extended since happy people are the most productive, you say that Larry and Sergey have already settled the matter. The point is that all the science is done at the founding. No new data can interfere with the founding moment.

Foundings are obviously temporal. But how long they last can be a hard question. The typical narrative contemplates a founding, first hires, and a first capital raise. But there’s an argument that the founding lasts a lot longer than that. The idea of going from 0 to 1—the idea of technology—parallels founding moments. The 1 ton of globalization, by contrast, parallels post-founding execution. It may be that the founding lasts so long as a company’s technical innovation continues. Founders should arguably stay in charge as long as the paradigm remains 0 to 1. Once the paradigm shifts to 1 to n, the founding is over. At that point, executives should execute.

There is, of course, a limit to how much you can do with rules. Things can and will break down even with perfect rules. There is no real chance of setting things up correctly such that the rest unfold easily. But you should still get the early stuff as right as possible. Consider a 2 x 2 matrix. On one axis you have good, high trust people and then you have low trust people. On the other axis you have low alignment structure with poorly set rules, and then a high alignment structure where the rules are well set.

Good, high trust people with low alignment structure is basically anarchy. The closest to this that succeeded is Google from 2000 to maybe 2007. Talented people could work on all sorts of different projects and generally operate without a whole lot of constraints.

Sometimes the opposite combination—low trust people and lots of rules—can work too. This is basically totalitarianism. Foxconn might be a representative example. Lots of people work
there. People are sort of slaves. The company even installs suicide nets to catch workers when they jump off the buildings. But it’s a very productive place, and it sort of works. The low trust, low alignment model is dog-eat-dog sort of world. People who you might not trust can do a lot of whatever they want. An investment bank might be a good example. It’s best to avoid this combination.

The ideal is the combination of high trust people with a structure that provides a high degree of alignment. People trust each other and together create a good culture. But there’s good structure to it, too. People are rowing in the same direction, and not by accident.

Equity is one of the key ways to think about alignment in startups. Different groups share in a company’s equity. Founders obviously get a stake. First they have to figure out how to allocate the equity amongst themselves. Angel investors also get equity. Early employees and advisors get equity. Later, series A investors will invest for equity too. And then you have your option pool. As this structure is built out and equity division occurs, the key is to think about how to get all the stakeholders aligned so that the company can succeed.

In this calculus, one factor dominates all others. That factor is whether the founders are aligned with each other. This is key both in terms of structure and company culture. If the founders are in sync, you can move on to the rest of the equation. But if they aren’t, it will blow up the company. Nothing will work. This is why investors should and do focus so much on founding teams. Everything matters. How well the founders know each other matters. How they interact and work with each other matters. Whether they have complimentary skillsets and personalities matters. This set of questions is very important. Any fissures in the founding team will be amplified later on.

One of Peter Thiel’s first investments was in a company that Luke Nosek was starting back in 1998. The investment didn’t go very well. Luke had met someone at a networking event and they decided to start a business together. The problem was that they had very different perspectives. Luke was this sort of chaotic, brilliant thinker. The other guy was very “by the books”—the kind of guy who had deliverables. It was doomed to fail. In a way choosing co-founders is like getting married. Getting married sometimes makes sense. But getting married to the first person you meet at the slot machines in Vegas probably doesn’t. You might hit the jackpot. But chances are you won’t. Good relationships amongst founders tend to drive a company’s success. The question of the founding team is thus the single most important question in assessing an early startup. There are a couple different versions of it. How do the founders split up equity amongst themselves? How well do they work together?

II. You Should Be a Delaware C-corp.

A very important preliminary question is how you should set up your company. This isn’t a hard question. You should set up as a Delaware C corporation. That is the right answer. You incorporate to achieve separation of your personal affairs and company affairs. You want to create a structure where you can let other people in, sell equity, etc. And incorporating can give you a lot more legitimacy. A business group called “Larry Page and Friends” might work today. It would not have worked in 1997. Give yourself the basic structure you’ll need. There are different kinds of corporations. None is better for startups than C corporations. S corporations are good for tightly held businesses. There can be just one class of shareholders; there is no preferred vs. common stock. You can’t have stock options. There are limits to the number of shareholders you can have. And you can’t go public. So S corps are only good for companies that won’t scale beyond a certain point. LLCs are more similar to C corps. But there can be problems when you want to issue preferred stock, grant options,
or go public. In theory you can get specially drafted agreements to do all these things. In practice it doesn’t work so well.

The big disadvantage for C corps is double taxation. You pay taxes on corporate income and then personal income too. Suppose your C corporation earns $100. The U.S. corporate tax rate is 39.2%. So $39.20 goes to the government right away. Now you have $60.80 in net income. But the U.S. individual income tax is 35% at the highest tier. That amounts to $21.28. So you end up with $39.52 if you are a sole proprietor. LLCs and some other non-C corporate entities are singly taxed entities. This is why consulting firms and law firms aren’t usually C corporations.

The big advantage of C corps is that exits are easier. You can take them public. They are also easier to sell. Chances are anyone that acquires you will also be a C corporation. That means that they’re already used to being doubly taxed, and, regardless of your corporate form, they are evaluating your business as if it were already double taxed. So being an LLC doesn’t make you a more attractive acquisition target. You might as well just be a C corp.Over 50% of C corporations get incorporated in Delaware. There are many reasons for this. Delaware business law is clear and well-understood. Its chancery courts are fast and predictable. The judges are pretty good. And there’s some signaling too; everybody sort of does it, and most everybody thinks it’s a good thing to do. You can just take it on faith that you want to be a Delaware C corporation.

III. Ownership, Possession, Control

As a founder, you must always be thinking about how and why things may get misaligned. Your job is to prevent misalignment from happening and fix it where it does. One framework to help think about misalignment distinguishes between ownership, possession, and control. These are related categories, but the differences are important. Ownership is who actually owns the company. This means who has equity and in what amounts. Possession is who operates the company. That is, who, on a day-to-day basis, is making decisions and doing stuff in company offices. You might think of possession as relating to job titles. Finally, control is who exercises control over the company in a formal sense. Control lies with the various people you put on your board, most of whom really don’t know your business that well.

Consider a political analogue using this framework. Say you have to go to the DMV to get your drivers license. In some sense, you, as a voter, control the government, and the DMV is a part of the government. Voters elect government people. Those people appoint other people. Presumably you had some indirect control on who becomes the head DMV bureaucrat.

But that head bureaucrat isn’t who you talk to after you wait in line. You have to talk to the people in possession: the window clerks and managers who actually run the DMV. They are the people who possess the ability to help you or not. You can tell them they suck. You can remind them that, under the theory of representative government, you are their boss. But that may not work very well. There is a misalignment between control and possession. It may not be a catastrophic one, but it is representative. Misalignment often happens when dealing with bureaucrats in government or, say, senior managers in the business world.

In many parts of the world, it’s hard to separate ownership, possession, and control. That makes it really hard to set up viable businesses. If a majority owner also exercises exclusive control, there are no real benefits to being a minority shareholder, so there are no minority shareholders. You end up with all these entities that could have been a lot better had people been able to separate out these elements.

That is not to say that things are easy when you do separate ownership from possession from control. Serious misalignments can happen between these groups, as the DMV example suggested, and even within these groups as well. Things can get messy quickly. Suppose you start a company. You are the sole founder. You have 100% ownership, possession, and control. Assuming no multiple personality issues, everything is fully aligned. But adding even a single co-founder is possible source of imbalance. That may open you up to serious disagreements about how to exercise ownership, possession, and control. Since now there are only two of you, you are still mostly aligned. But the more people you add, the more complex it gets. Employees tend to have lots of day-to-day possession, small ownership stakes, and very minimal control. But issues arise if they’re not happy with their ownership or control pieces. Things are even trickier when you add investors to mix.

IV. Founders and Employees

A. Equity Alignment

Your initial task is to try and achieve alignment between founders, employees, and early investors. In tech startups, equity is the classic alignment tool. Equity is critically important because it is the thing that everybody has in common. Since everyone benefits from an increased share price, everyone everyone tries to increase the share price. It’s hard to overstate the importance of equity in forging the long-term, perspectives that matter most. The flipside of that is that bonuses and cash salaries produce opportunities for misalignment. Salary caps are very important. A categorical rule of thumb that Founders Fund has developed is that no CEO should be paid more than $150k per year. Experience has shown that there is great predictive power in a venture-backed CEO’s salary: the lower it is, the better the company tends to do. Empirically, if you could reduce all your diligence to one question, you should ask how much the CEO of a prospective portfolio company draws in salary. If the answer is more than $150k, do not invest.

The salary issue is important because when CEOs get low salaries, they believe that their equity will be worth a lot and they try to make it happen. That effect extends to the whole company because capping CEO pay basically means capping everyone’s pay. You create an equity-focused culture. Contrast that with the CEO who gets $300k per year. When something does wrong in that salary-heavy culture, there is no course correction. The CEO’s incentive is to keep his well-paying job, not fix things. If the CEO had a much lower salary, issues would get raised very quickly. Low pay is simply good incentive alignment.

B. Get On Board or Don’t

Another important insight is that people must either be fully in the company or not in it at all. As Ken Kesey said on his bus tour proselytizing LSD use in the ‘60s, “Now you’re either on the bus or off the bus.” Being part-time, holding other jobs, or bringing on consultants or advisors to do important work are big red flags because those arrangements are very misaligning. It’s hard to imagine any of those people caring about the equity as much as they need to.

As always, there are exceptions. Peter didn’t invest in YouTube in the summer of 2005 because all the guys were working on it part-time. Then things took off quickly and Sequoia wound up getting (or taking, depending on your perspective!) the investment. But the general rule stands. You need to think carefully and then either get on the bus or not. And if you do get on a bus, you should get on the right bus.

C. Vesting and Time

How the equity you give people vests over time is key. You don’t want to grant it all at once, since then they could just get it and leave. The standard is to have it vest over 4 years, with 25% vesting at a 1 year cliff, and then with 1/48th vesting each month for the 3 years after
that. This means that if people don’t work out before putting in a whole year, they get no equity. Often you still give them the fraction they earned, so long as they didn’t cause a bunch of trouble. But once they’re there a year, they have their 25% and the rest accrues gradually.

Founders need vesting schedules too. It’s not ideal to have founders who are fully vested from the outset. One founder might decide to quit. If he’s fully vested, the co-founder would be stuck working for 2 people. In practice, things are structured so that part of founders’ equity vests immediately. They might have 20-25% vest as credit for the work they’ve done up to the first round of financing. But the rest should vest over time.

Consultants either get cash or equity that vests right away. But you should never hire any consultants. The equity reason is that immediate vesting produces bad incentives. The non-equity reason is that consultants break the bus metaphor. Everyone needs to be on board, rowing really hard in the same direction.

V. Equity

There are several different forms of equity. There is common stock, which is basically a simple fraction of ownership in a firm. It is typically expressed in number of shares. But that number itself is meaningless. Number of shares is just the numerator. You also need to know the number of shares outstanding, which is the denominator. Only the percentage of firm ownership matters. 200k/10m is the same as 20m/2bn. 2% is 2%.

A stock option is the right to buy a share of a company’s stock for a set price at some point in the future. Its exercise price is its purchase price, set at the time the option is granted. The exercise price is typically set at or greater than FMV at the time of the grant to avoid an immediate tax event; if FMV is $20 and you price an option at $10, the $10 in value that you’re giving is taxable compensation. Pricing options at FMV ensures that they are worth zero on day one.

Options also have an expiration date, after which they expire. The idea is that the options become more valuable if the company goes up in value between the grant and the expiration date. If that happens, the option holder gets to buy at the exercise price, and realizes a gain of the FMV at expiration minus that exercise price. In theory, this is super aligning, since the options could be quite valuable if the company has done well in the interim.

There are two different types of options. Incentive Stock Options, also called ISOs or qualified options, must expire 10 years after being granted or 3 months after employees leave the company. This has the effect of locking employees in. If they leave, they have to decide whether to exercise soon. ISOs are also good for individuals because they have favorable tax characteristics. Any option that’s not an ISO is an NSO. With NSOs, all gains up until exercise are treated as ordinary income.

Finally, there is restricted stock, which is basically stock sold to an employee at a very heavy discount. The company has the right to buy back that stock at the discounted price. It is sort of the mirror image of an option grant in that there is a reverse vest on the restricted stock. The company has the right to buy less and less back as time goes on.

The crucial takeaway is that most measures of equity are irrelevant.The number of shares is irrelevant. Share price is irrelevant. The share of the option pool is irrelevant. Your share relative to other employees’ share should be irrelevant, at least ideally. What matters is your share of the company. This is 3rd grade arithmetic. You have to do some division. Lots of ostensibly smart technical people fail to do this. Why people can’t or don’t do the basic arithmetic when they join tech companies is curious indeed. It may be that psychological anchoring effects just fool people into thinking that 1m/1bn is better than 1k/1m.

In practice, equity shares goes down quite a bit as you add more people. The surest way to blow up a company is to circulate a spreadsheet listing everyone’s equity stake. Secrecy can be so important here because timing really matters. Some of your people will have very unique skills. Others will be more commodity employees with fungible skills. But the incentives are keyed to when you join, not just what you can do. Key people who arrive later get different stakes than less key people who were early. At eBay, secretaries might have made 100x what their Stanford MBA bosses because they joined three years earlier. You can say that’s fair since early employees took more risk. But the later and possibly more important employees don’t always see it that way. So in practice, even if you calibrate everything correctly, things are imperfect. You won’t be able to please everyone.

VI. The Fundraising Process

Angel investors are the first significant outside investors in a startup. Ideally they add experience, connections, and credibility. They need to be accredited, which means a net worth over $1m or an annual income of over $200k. The angel market is pretty saturated, and the recent passage of the JOBS Act should induce even more angel investing activity. There are typically two classes of shares: common, which goes to founders and employees, and preferred, which investors investors get. Preferred shares come with various sorts of rights that allow investors to protect their money. A standard rule of thumb is that common is price around 10% of preferred in a Series A raise. If FMV of one share of preferred is $1, a common share would be worth $0.10.

A. Simple Angel Math

Suppose you have 2 founders, each with 1m shares bought at a price of $0.001 per share (each founder put in $1k). The company has 2m shares and is valued at $2k. An angel might come along and invest 200k at $1/share. So you issue 200k new shares to angel. Now you have 2.2m shares outstanding. Then say you hire some people. You bring on 6 employees, and, because you weren’t listening earlier, 2 consultants. Each of these 8 people gets 100k shares. So you grant 800k shares at $0.10/share.

Now you have 3m shares outstanding. The company valuation is $3m, since the deal price was $1/share. The angel owns 200k shares, which is 6.7%. Consultants and employees own 3.33% each, or 26.7% together. The two founders each have 1m shares, or 1/3 of the company.

B. Why Debt May Be Better

An alternative to this model is to do a convertible debt deal. There are two standard ways that debt gets structured. First, you can cap and discount. This means that valuation is capped, say at $4m. The noteholder gets a discount of, say, 20% for the next round. Second, you can do no cap, no discount, and just have warrants/options accumulate for each round. Convertible notes are often better than equity rounds. One of the main benefits is that they allow you to avoid determining a valuation for the company. Angel investors may have no clue how to do valuations. Convertible notes allow you to postpone the valuation question for Series A investors to tackle.
Other benefits include mathematically eliminating the possibility of having a down round. This can be a problem where angels systemically overvalue companies, as they might with, say, hot Y Combinator companies. Additionally, debt loans are much cheaper and faster than equity rounds, which typically cost between $30k and $40k in Silicon Valley.

C. Series A

After you meet with a VC who wants to invest, you put together a term sheet outlining the deal. After about a month of final due diligence, where the VC takes a thorough look at the people as well as the financial and technical prospects, the deal closes and money is wired. You have to set up an option pool for future employees. 5% is a small pool. 15% is a large one. Larger options pools dilute current shareholders more, but in a sense they can be more honest too. You may have to give up considerable equity to attract good employees later down the road. The size of the pool is classic fear vs. greed tradeoff. If you’re too greedy, you keep more, but it may be worth zero. If you’re too fearful, you give away too much. You have to strike the right balance. Investors want option pools created before a round of financing so they don’t suffer immediate dilution. You want to make the option pool after you raise. So this is something you negotiate with your VC.

VII. Investor Protection

There are a bunch of terms and devices that help VCs protect their money when they invest in you. One thing VCs tend to care a lot about is liquidation preference. A 1x preference basically means that investors get their money back before anyone else does. You can also have an Nx liquidation preference where investors get their investment repaid n times before you make any money.

You need liquidation preferences because they align incentives. Without any preference term, you could just take an investment, close up shop, and distribute the cash amongst your team. That’s obviously a bad deal for investors. They need some guarantee that you won’t take the money and run. So by providing that, upon winding down, they get all their money back before you get any, you are realigned and your incentive is to grow the business so that everyone makes money.

VCs often try to get an even higher preference. A 2x preference would mean that if a VC puts in $5m, he’d get $10m back before founders and employees get anything. But the big problem with participating preferred or multiple preferred arrangements are that they skew incentives in intermediate exits. If a company sells for a billion dollars, these things don’t matter so much and everything works. But in an intermediate exit, investors may want to sell because they’ll double their money, whereas founders won’t want to because they won’t make anything. So the best arrangement tends to be 1x preference, non-participating. Anti-dilution provisions are also an important form of investor protection. They basically retroactively reprice past investment if and when there is a later down round. The basic math is that the revised share count equals the original investment amount divided by the new conversion price.

There are a few different types of anti-dilution provisions. The most aggressive is the full ratchet. It sounds like a form of medieval torture because, in a way, it is. It reprices a past investment as if the investor had just invested in the down round. That’s great for investors, and quite bad for everyone else. More common is what’s called the broad-based weighted average, which considers the down round size relative to the company’s total equity. Investors end up getting somewhat more shares. Sometimes a similar provision called a narrow-based weighted average is used instead.

If there is one categorical rule, it’s that you should never ever have a down round. With few exceptions, down rounds are disastrous. If there are tough anti-dilution provisions, down rounds will wipe out founders and employees. They also make the company less appealing to other investors. The practical problem is that down rounds make everybody really mad. Owners might blame controllers, who in turn might blame possessors. Everybody blames everybody else. Companies are essentially broken the day they have a down round.

If you must have a down round, it’s probably best that it be a really catastrophic one. That way a lot of the mad people will be completely wiped out and thus won’t show up to cause more problems while you start the hard task of rebuilding. But to repeat, you should never have a down round. If you found a company and every round you raise is an up round, you’ll make at least some money. But if you have a single down round, you probably won’t.

VIII. More Investor Protection

There are lots of other important terms in financings. The overarching goal is to get everybody’s incentives aligned. So you should always be thinking about how different combinations of terms do or don’t accomplish that goal.

Pro rata rights are pretty standard terms whereby existing preferred investors are guaranteed the right to invest in subsequent rounds at same terms as new investors. This is good for VCs, since it gives them a free option to participate in next round. But one problem is that if previous investors don’t participate later on, that can signal a red flag to prospective new investors.

Restrictions on sales are commonly used. Some forms provide that common shareholders can’t sell their shares at all. Other times sales are allowed only if 100% of the proposed sale is offered to the company and existing investors. These terms severely limit early employees’ ability to cash out. The upside is that this aligns founders and VCs around the growth of the company’s equity. But misalignment may persist because of relative wealth differences among the parties. VCs tend to be fairly wealthy already, and can wait for the payoff. Early employees may want to cash out a bit to get some security when they can.

Then there are co-sale agreements, dividends on preferred stock, no-shop agreements, redemption terms, and conversion terms. All of these can be important. They’re all worth learning about, understanding, and possibly negotiating. But they tend not to be the most crucial terms in a financing agreement.

IX. The Board

Your board of directors is responsible for corporate governance. Another way of saying that is that the board is in charge. Preferred shareholders typically have voting rights that allow them to approve actions, waive protective provisions, etc. But the importance of the board of directors cannot be overstated.

Every single person on your board matters. Each person must be a really good person. The typical board is two VCs, one “independent” director, and two founders. Five people is a pretty large board. More than five is suboptimal, and should only be done where absolutely necessary. With boards, less is often more. The ideal board is probably three people: one VC and two founders. It’s easier to keep board members aligned if they are all great people and if there are just a few of them.

X. Planing For The Future

Building a valuable company is a long journey. A key question to keep your eye on as a founder is dilution. The Google founders had 15.6% of the company at IPO. Steve Jobs had 13.5% of Apple when it went public in the early ‘80s. Mark Pincus had 16% of Zynga at IPO. If you have north of 10% after many rounds of financing, that’s generally a very good outcome. Dilution is relentless. The alternative is that you don’t let anyone else in. We tend to give this approach the short shift. It’s worth remembering that many successful businesses are built like this. Craigslist would be worth something like $5bn if it were run more like a company than a commune. GoDaddy never took funding. Trilogy in the late 1990s had no outside investors. Microsoft very nearly joined this club; it took one small venture investment just before its IPO. When Microsoft went public, Bill Gates still owned an astounding 49.2% of the company. So the question to think about with VCs isn’t all that different than questions about co-founders and employees. Who are the best people? Who do you want—or need—on board?

Peter Thiel’s CS183: Startup – Class 6 Notes Essay

Peter Thiel’s CS183 @ Stanford: Startup—Venture Capital and You

I.  Venture Capital and You

Many people who start businesses never deal with venture capitalists. Founders who do interact with VCs don’t necessarily do that early on. First you get your founders together and get working. Then maybe you get friends, family, or angels to invest. If you do end up needing to raise a larger amount of capital, you need to know how VC works. Understanding how VCs think about money—or, in some cases, how they don’t think about it and thus lose it—is important.

VC started in late 1940s. Before that, wealthy individuals and families were investing in new ventures quite frequently. But the idea of pooling funds that professionals would invest in early stage companies was a product of the ‘40s. The Sand Hill road, Silicon Valley version came in the late 1960s, with Sequoia, Kleiner Perkins, and Mayfield leading the field.

Venture basically works like this:  you pool a bunch of money that you get from people called limited partners. Then you take money from that pool and invest it in portfolio companies that you think are promising. Hopefully those companies become more valuable over time and everybody makes money. So VCs have the dual role of encouraging LPs to give them money and then finding (hopefully) successful companies to back.

Most of the profits go back to LPs as returns on their investment. VCs, of course, take a cut. The typical model is called 2-and-20, which means that the VC firm charges an annual management fee of 2% of the fund and then gets 20% of the gains beyond the original investment. The 2% management fee is theoretically just enough to allow the VC firm to continue to operate. In practice, it can end up being a lot more than that; a $200m fund would earn $4m in management fees under a 2-and-20 structure. But it’s certainly true that the real payout that VCs look for come with the 20% cut of the gains, which is called the carry.

VC funds last for several years, because it usually takes years for the companies you invest in to grow in value. Many of the investments in a given fund either don’t make money or go to zero. But the idea is that the companies that do well get you all your money back and then some; you end up with more money in the fund at the end than LPs put in to begin with.

There are many dimensions to being a good VC. You have to be skilled at coming up with reasonable valuations, identifying great entrepreneurs, etc. But there’s one dimension that is particularly important, yet surprisingly poorly understood. It is far and away the most important structural element of venture capital: exponential power. This may seem odd because it’s just basic math. But just as 3rdgrade arithmetic—knowing not just how many shares you get, but dividing that by the shares outstanding—was crucial to understand equity, 7th grade math—understanding exponents—is necessary to understand VC.

The standard Einstein line on this is that the most powerful force in universe is compound interest. We see the power of compounding when companies grow virally. Successful businesses tend to have an exponential arc to them. Maybe they grow at 50% a year and it compounds for a number of years. It could be more or less dramatic than that. But that model—some substantial period of exponential growth—is the core of any successful tech company. And during that exponential period, valuations tend to go up exponentially.

So consider a prototypical successful venture fund. A number of investments go to zero over a period of time. Those tend to happen earlier rather than later. The investments that succeed do so on some sort of exponential curve. Sum it over the life of a portfolio and you get a J curve. Early investments fail. You have to pay management fees. But then the exponential growth takes place, at least in theory. Since you start out underwater, the big question is when you make it above the water line. A lot of funds never get there.

To answer that big question you have to ask another: what does the distribution of returns in venture fund look like? The naïve response is just to rank companies from best to worst according to their return in multiple of dollars invested. People tend to group investments into three buckets. The bad companies go to zero. The mediocre ones do maybe 1x, so you don’t lose much or gain much. And then the great companies do maybe 3-10x.

But that model misses the key insight that actual returns are incredibly skewed. The more a VC understands this skew pattern, the better the VC. Bad VCs tend to think the dashed line is flat, i.e. that all companies are created equal, and some just fail, spin wheels, or grow. In reality you get a power law distribution.


An example will help clarify. If you look at Founders Fund’s 2005 fund, the best investment ended up being worth about as much as all the rest combined. And the investment in the second best company was about as valuable as number three through the rest. This same dynamic generally held true throughout the fund. This is the power law distribution in practice. To a first approximation, a VC portfolio will only make money if your best company investment ends up being worth more than your whole fund. In practice, it’s quite hard to be profitable as a VC if you don’t get to those numbers.

PayPal sold to eBay for $1.5bn. PayPal’s early stage investors had a large enough stake such that their investment was ultimately worth about the size of their fund. The rest of the fund’s portfolio didn’t do so well, so they more or less broke even riding on PayPal. But PayPal’s series B investors, despite doing quite well with the PayPal investment, didn’t break even on their fund. Like many other VC funds in the early 2000’s, theirs lost money.

That investment returns take a power law distribution leads to a few important conclusions. First, you need to remember that, management fees aside, you only get paid if you return all the money invested plus more. You have to at least hit the 100% of fund size mark. So given power law distribution, you have to ask the question: “Is there a reasonable scenario where our stake in this company will be worth more than the whole fund?”

Second is that, given a big power law distribution, you want to be fairly concentrated. If you invest in 100 companies to try and cover your bases through volume, there’s probably sloppy thinking somewhere. There just aren’t that many businesses that you can have the requisite high degree of conviction about. A better model is to invest in maybe 7 or 8 promising companies from which you think you can get a 10x return. It’s true that in theory, the math works out the same if try investing in 100 different companies that you think will bring 100x returns. But in practice that starts looking less like investing and more like buying lottery tickets.

Despite being rooted in middle school math, exponential thinking is hard. We live in a world where we normally don’t experience anything exponentially. Our general life experience is pretty linear. We vastly underestimate exponential things. If you backtest Founders Fund’s portfolios, one heuristic that’s worked shockingly well is that you should always exercise your pro rata participation rights whenever a smart VC was leading a portfolio company’s up round. Conversely, the test showed that you should never increase your investment on a flat or down round.

Why might there be such a pricing inefficiency? One intuition is that people do not believe in a power law distribution. They intuitively don’t believe that returns could be that uneven. So when you have an up round with a big increase in valuation, many or even most VCs tend to believe that the step up is too big and they will thus underprice it. The practical analogue would be to picture yourself working in a startup. You have an office. You haven’t hit the exponential growth phase yet. Then the exponential growth comes. But you might discount that change and underestimate the massive shift that has occurred simply because you’re still in the same office, and many things look the same.

Flat rounds, by contrast, should be avoided because they mean that the VCs involved believe things can’t have gotten that much worse. Flat rounds are driven by people who think they might get, say, a 2x return from an investment. But in reality, often something has gone very badly wrong—hence the flat round’s not being an up round. One shouldn’t be mechanical about this heuristic, or treat it as some immutable investment strategy. But it actually checks out pretty well, so at the very least it compels you to think about power law distribution.

Understanding exponents and power law distributions isn’t just about understanding VC. There are important personal applications too. Many things, such as key life decisions or starting businesses, also result in similar distributions. We tend to think about these things too moderately. There is a perception that some things are sort of better than other things, sometimes. But the reality is probably more extreme than that.

Not always, of course. Sometimes the straighter, perceived curve actually reflects reality quite closely. If you were to think about going to work for the Postal Service, for example, the perceived curve is probably right. What you see is what you get. And there are plenty of things like that. But it’s also true that we are, for some reason or other, basically trained to think like that. So we tend to miscalculate in places where the perceived curve does not, in fact, accurately reflect reality. The tech startup context is one of those places. The skew of distributions for tech startups is really vast.

This means that when you focus on the percentage of equity you get in a company, you need to need to add a modifier: given something like a power law distribution, where your company is on that curve can matter just as much or more than your individual equity stake.

All else equal, having 1% of a company is better than having 0.5%. But the 100themployee at Google did much better than the average venture-backed CEO did in the last decade.  The distribution is worth thinking hard about. You could spin this into argument against joining startups. But it needn’t go that far. The power law distribution simply means you have to think hard about a given company is going to fall on the curve.

The pushback to this is that the standard perception is reasonable—or at least is not unreasonable—because the actual distribution curve turns out to be random. The thesis is that you are just a lottery ticket. That is wrong. We will talk about why that is wrong later. For now, it’s enough to point out that the actual curve is a power law distribution. You don’t have to understand every detail and implication of what that means. But it’s important to get some handle on it. Even a tiny bit of understanding of this dimension is incredibly valuable.

 Peter Thiel’s CS183: Startup—Notes Essay—Follow the Money

Peter Thiel’s CS183 @ Stanford: Startup – Value Systems

The history of the ‘90s was in many ways the history of widespread confusion about the question of value. Valuations were psychosocial; value was driven by what people said it was. To avoid herd-like confusion of decades past, we need to try and figure out whether it’s possible to determine businesses’ objective value and, if it is, how to do it.

As we discussed back in Class 1, certain questions and frameworks can anchor our thinking about value. The questions are necessarily personal: What can I do? What do I think is valuable? What do I see others not doing? A good framework might map globalization and technology as the two great axes of the 21st century. Synthesizing all this together forges the higher-level question: What valuable company is nobody building?

A somewhat different perspective on technology—going from 0 to 1, to revisit our earlier terminology—is the financial or economic one. Since that perspective can also shed considerable light on the value question, it’s worth covering in detail now.

I. Great Technology Companies

Great companies do three things. First, they create value. Second, they are lasting or permanent in a meaningful way. Finally, they capture at least some of the value they create.

The first point is straightforward. Companies that don’t create value simply can’t be great. Creating value may not be sufficient for greatness, but it’s hard to see how it’s not at least necessary.

Great companies last. They are durable. They don’t create value and disappear very fast. Consider disk drive companies of the 1980s. They created a lot of value by making new and better drives. But the companies themselves didn’t last; they were all replaced by others. Not sticking around limits both the value you can create and the value you can capture.

Finally—and relatedly—you have to capture much of the value you create in order to be great. A scientist or mathematician may create a lot of lasting value with an important discovery. But capturing a meaningful piece of that value is another matter entirely. Sir Isaac Newton, for example, failed to capture much of the immense value that he created through his work. The airline industry is a less abstract example. The airlines certainly create value in that the public is much better off because they exist. And they employ tons of people. But the airlines themselves have never really made any money. Certainly some are better than others. But probably none can be considered a truly great company.

II. Valuation

One way that people try and objectively determine a company’s value is through multiples and comparables. This sort of works. But people should be on guard against social heuristics substituting for rigorous analysis, since analysis tends to be driven by standards and conventions that exist at the time. If you start a company at an incubator, certain conventions exist there. If everyone is investing at a $10M cap, the company might be deemed to be worth $10M. There are a bunch of formulas that incorporate metrics like monthly page views or number of active users that people use sometimes. Somewhat more rigorous are revenue multiples. Software companies are often valued at around 10x annual revenues. Guy Kawasaki has suggested a particularly unique (and possibly helpful) equation:

pre-money valuation = ($1M*n_engineers) – ($500k*n_MBAs).

The most common multiple is the price-earnings ratio, also known as P/E ratio or the PER. The PER is equal to market value (per share)  / earnings (per share). In other words, it is the price of a stock relative to a firm’s net income. The PER is widely used but does not account for growth.

To account for growth, you use the PEG, or Price/Earnings to Growth ratio. PEG equals (market value / earnings) / annual earnings growth. That is, PEG is PER divided by annual growth in earnings. The lower a company’s PEG ratio, the slower it’s growing and thus the less valuable it is. Higher PEG ratios tend to mean higher valuations. In any case, PEG should be less than one. The PEG is a good indicator to keep an eye on while growing your business.

One does valuation analysis at a given point in time. But that analysis factors in many points in time. You look not just at cash flows for the current year, but over future years as well. Sum all the numbers and you get the earnings value. But a quantity of money today is worth more than it is in the future. So you discount the time value of money, or TVM, since there are all sorts of risks as you move forward in the future. The basic math for TVM is:


Things are harder when cash flows aren’t constant. Here is the math for variable cash flows:


So to determine the value of a company, you do the applicable DPV or NPV calculation for the next X (or infinite) years. Generally, you want to be greater than r. Otherwise your company isn’t growing enough to keep up with the discount rate. Of course, in a growth model, the growth rate must eventually decline. Otherwise the company will approach infinite value over time—not likely.

Valuations for Old Economy firms work differently. In businesses in decline, most of the value is in the near term. Value investors look at cash flows. If a company can maintain present cash flows for 5 or 6 years, it’s a good investment. Investors then just hope that those cash flows—and thus the company’s value—don’t decrease faster than they anticipate.

Tech and other high growth companies are different. At first, most of them losemoney. When the growth rate—g, in our calculations above—is higher than the discount rate r, a lot of the value in tech businesses exists pretty far in the future. Indeed, a typical model could see 2/3 of the value being created in years 10 through 15. This is counterintuitive. Most people—even people working in startups today—think in Old Economy mode where you have to create value right off the bat. The focus, particularly in companies with exploding growth, is on next months, quarters, or, less frequently, years. That is too short a timeline. Old Economy mode works in the Old Economy. It does not work for thinking about tech and high growth businesses. Yet startup culture today pointedly ignores, and even resists, 10-15 year thinking.

PayPal is illustrative. 27 months in, its growth rate was 100%. Everybody knew that rate would decelerate, but figured that it would still be higher than the discount rate. The plan was that most of the value would come around 2011. Even that long-term thinking turned out to undershoot; the discount rate has been lower than expected, and the growth rate is still at a healthy 15%. Now, it looks like most of PayPal’s value won’t come until in 2020.

LinkedIn is another good example of the importance of the long-term. Its market cap is currently around around $10B and it’s trading at a (very high) P/E of about 850. But discounted cash flow analysis makes LinkedIn’s valuation make sense; it’s expected to create around $2B in value between 2012 and 2019, while the other $8B reflects expectations about 2020 and beyond. LinkedIn’s valuation, in other words, only makes sense if there’s durability, i.e. if it’s around to create all that value in the decades to come.

III. Durability

People often talk about “first mover advantage.” But focusing on that may be problematic; you might move first and then fade away. The danger there is that you simply aren’t around to succeed, even if you do end up creating value. More important than being the first mover is being the last mover. You have to be durable. In this one particular at least, business is like chess. Grandmaster José Raúl Capablanca put it well: to succeed, “you must study the endgame before everything else.”

IV. Capturing Value

The basic economic ideas of supply and demand are useful in thinking about capturing value. The common insight is that market equilibrium is where supply and demand intersect. When you analyze a business under this framework, you get one of two options: perfect competition or monopoly.

In perfect competition, no firms in an industry make economic profit. If there are profits to be made, firms enter the market and the profits go away. If firms are suffering economic losses, some fold and exit. So you don’t make any money. And it’s not just you; no one makes any money. In perfect competition, the scale on which you’re operating is negligible compared to the scale of the market as a whole. You might be able to affect demand a little bit. But generally you’re a price taker.

But if you’re a monopoly, you own the market. By definition, you’re the only one producing a certain thing. Most economics textbooks spend a great deal of time talking about perfect competition. They tend to treat monopoly as somehow being within, or as some small exception to perfect competition. The world, say these books, defaults to equilibrium.

But perhaps monopoly is not some strange exception. Perhaps perfect competition is only the default in economics textbooks. We should wonder whether monopoly is a valid alternative paradigm in its own right. Consider great tech companies. Most have one decisive advantage—such as economies of scale or uniquely low production costs—that make them at least monopoly-esque in some important way. A drug company, for instance, might secure patent protection for a certain drug, thus enabling it to charge more than its costs of production. The really valuable businesses are monopoly businesses. They are the last movers who create value that can be sustained over time instead of being eroded away by competitive forces.

V. The Ideology of Competition

A. PayPal and Competition

PayPal was in the payments business. There were considerable economies of scale in that business. You couldn’t compete with the big credit card companies directly; to compete, you had to undercut them in some way. PayPal tried to do that in two ways: through technical innovation and through product innovation.

The primary technical problem that PayPal faced was fraud. When Internet payments started to get going, there was much more fraud than people expected. Also unexpected was how hard it was to stamp it out. Enemies in the War on Fraud were many. There was “Carders World,” a dystopian web marketplace that vowed to bring down Western Capitalism by transacting in stolen identities. There was a particularly bothersome hacker named Igor, who evaded the FBI on jurisdictional technicalities. (Unrelatedly, Igor was later killed by the Russian mafia.) Ultimately, PayPal was able to develop really good software to get a handle on the fraud problem. The name of that software? “Igor.”

Another key innovation was making funding sources cheaper. Getting users’ bank account information drove down blended costs. By modeling how much money was in an account, PayPal could make advance payments, more or less circumvent the Automatic Clearing House system, and make payments instantaneous from the user’s perspective.

These are just two examples from PayPal. Yours will look different. The takeaway is that it’s absolutely critical to have some decisive advantage over the next best service. Because even a small number of competing services quickly makes for a very competitive dynamic.

B. Competition and Monopoly

Whether competition is good or bad is an interesting (and usually overlooked) question. Most people just assume it’s good. The standard economic narrative, with all its focus on perfect competition, identifies competition as the source of all progress. If competition is good, then the default view on its opposite—monopoly—is that it must be very bad.  Indeed, Adam Smith adopted this view in The Wealth of Nations:

People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.

This insight is important, if only because it’s so prevalent. But exactly why monopoly is bad is hard to tease out. It’s usually just accepted as a given. But it’s probably worth questioning in greater detail.

C. Testing for Monopoly

The Sherman Act declares: “The possession of monopoly power will not be found unlawful unless it is accompanied by an element of anticompetitive conduct.” So in order to determine whether a monopoly is illegal or not, we just have to figure out what “anticompetitive conduct” means.

The DOJ has 3 tests for evaluating monopolies and monopoly pricing. First is the Lerner index, which gives a sense of how much market power a particular company has. The index value equals (price – marginal cost) / price. Index values range from 0 (perfect competition) to 1 (monopoly). The intuition that market power matters a lot is right. But in practice the Lerner index tends to be intractable with since you have to know market price and marginal cost schedules. But tech companies know their own information and should certainly pay attention to their Lerner index.

Second is the Herfindahl-Hirschman index. It uses firm and industry size to gauge how much competition exists in an industry. Basically, you sum the squares of the top 50 firms’ market shares. The lower the index value, the more competitive the market. Values below 0.15 indicate a competitive market. Values from 0.15 to .25 indicate a concentrated market. Values higher than 0.25 indicate a highly concentrated and possibly monopolistic market.

Finally, there is the m-firm concentration ratio. You take either the 4 or 8 largest firms in an industry and sum their market shares. If together they comprise more than 70% of the market, then that market is concentrated.

D. The Good and Bad of Monopoly

First, the cons: monopolies generally produce lower output and charge higher prices than firms in competitive markets do. This may not hold true for some natural monopolies. And some industries have monopolies of scale, which are a bit different. But monopolies generally get to be price setters, not price takers. There also might be price discrimination, since monopolists may capture more consumer surplus by charging different groups different prices. Another criticism is that monopoly stifles innovation; since it earns profits whether it innovates or not, a monopoly business might grow complacent and not develop any new technology.

But the innovation argument can go the other way too. Monopoly might net incentivize innovation. If a company creates something dramatically better than the next best thing, where’s the harm in allowing it to price it higher than its marginal cost of production? The delta is the creators’ reward for creating the new thing. Monopolistic firms can also conduct better long-term planning and take on deeper project financing, since there’s a sense of durability that wouldn’t exist in perfect competition where profits are zero.

E. Biases for Perfect Competition

An interesting question is why most people seem biased in favor of perfect competition. It’s hard to argue that economists don’t tend to idolize it. Indeed the very term “perfect competition” seems pregnant with some normative meaning. It’s not called “insane competition” or “ruthless competition.” That’s probably not an accident. Perfect competition, we’re told, is perfect.

To start, perfect competition may be attractive because it’s easy to model. That probably explains a lot right there, since economics is all about modeling the world to make it easier to deal with. Perfect competition might also seem to make sense because it’s economically efficient in a static world. Moreover, it’s politically salable, which certainly doesn’t hurt.

But the bias favoring perfect competition is a costly one. Perfect competition is arguably psychologically unhealthy. Every benefit social, not individual. But people who are actually involved in a given business or market may have a different view—it turns out that many people actually want to be able to make a profit. The deeper criticism of perfect competition, though, is that it is irrelevant in a dynamic world. If there is no equilibrium—if things are constantly moving around—you can capture some of the value you create. Under perfect competition, you can’t. Perfect competition thus preempts the question of value; you get to compete hard, but you can never gain anything for all your struggle. Perversely, the more intense the competition, the less likely you’ll be able to capture any value at all.

Thinking through this suggests that competition is overrated. Competition may be a thing that we’re taught, and that we do, unquestioningly. Maybe you compete in high school. Then more, tougher competition in college and grad school. And then the “rat race” in the real world. An apt, though hardly unique example of intense professional competition is the Big Law model for young lawyers from top law schools. You graduate from, say, Stanford Law and then go work at a big firm that pays you really well. You work insanely hard to try and make partner until you either do or you don’t. The odds aren’t in your favor, and you’ll probably quit before you get the chance to fail. Startup life can be tough, but also less pointlessly competitive. Of course, some people like the competitiveness of law firms. But it’s probably safe to say that most don’t. Ask anyone from the latter camp and they may well say that they never want to compete at anything again. Clearly, winning by a large margin is better than ruthless competition, if you can swing it.

Globalization seems to have a very competitive feel to it. It’s like a track and field sprint event where one runner is winning by just a few seconds, with others on his heels. That’s great and exciting if you’re the spectator. But it’s not a natural metaphor for real progress.

If globalization had to have a tagline, it might be that “the world is flat.” We hear that from time to time, and indeed, globalization starts from that idea. Technology, by contrast, starts from the idea that the world is Mount Everest. If the world is truly flat, it’s just crazed competition. The connotations are negative and you can frame it as a race to the bottom; you should take a pay cut because people in China are getting paid less than you. But what if the world isn’t just crazed competition? What if much of the world is unique? In high school, we tend to have high hopes and ambitions. Too often, college beats them out of us. People are told that they’re small fish in a big ocean. Refusal to recognize that is a sign of immaturity. Accepting the truth about your world—that it is big and you are just a speck in it—is seen as wise.

That can’t be psychologically healthy. It’s certainly not motivating. Maybe making the world a smaller place is exactly what you want to do. Maybe you don’t want to work in big markets. Maybe it’s much better to find or make a small market, excel, and own it. And yet, the single business idea that you hear most often is: the bigger the market, the better. That is utterly, totally wrong. The restaurant business is a huge market. It is also not a very good way to make money.

The problem is that when the ocean is really big, it’s hard to know exactly what’s out there. There might be monsters or predators in some parts who you don’t want to run into. You want to steer clear of the parts painted red by all the carnage. But you can’t do that if the ocean is too big to get a handle on. Of course, it is possible to be the best in your class even if your class is big. After all, someone has to be the best. It’s just that the bigger the class, the harder it is to be number one. Well-defined, well-understood markets are simply harder to master. Hence the importance of the second clause in the question that we should keep revisiting: what valuable company are other people not building?

F. On VC, Networks, and Closing Thoughts

Where does venture capital fit in? VCs tend not to have a very large pool of business. Rather, they rely on very discreet networks of people that they’ve become affiliated with. That is, they have access to a unique network of entrepreneurs; the network is the core value proposition, and is driven by relationships. So VC is anti-commoditized; it is personal, and often idiosyncratic. It thus has a lot in common with great businesses. The PayPal network, as it’s been called, is a set of friendships built over the course of a decade. It has become a sort of franchise. But this isn’t unique; that kind of dynamic arguably characterizes all great tech companies, i.e. last mover monopolies. Last movers build non-commoditized businesses. They are relationship-driven. They create value. They last. And they make money.

Notes Essays—Peter Thiel’s CS183: Startup—Stanford, Spring 2012

Wilson Sonsini Goodrich & Rosati: The Entrepreneurs Report Q3, 2012

This in-depth report analyzes the key issues and trends the firm has observed in recent private company financings.

Deal Terms

Liquidation preferences. Senior liquidation preferences were used in 39% of all Series B and later deals in the first three quarters of 2012, down from 47% of deals in 2011 and 50% in 2010. The use of such preferences decreased in both up rounds, from 34% of deals in 2011 to 28% in the first three quarters of 2012, and down rounds, from 79% of deals in 2011 to 63% in Q1-3 2012.
Conversely, the use of pari passu liquidation preferences increased to 58% of Q1-Q3 2012 financings from 51% of 2011 financings and 48% of 2010 financings. The percentage increased both for up rounds (69% in Q1-Q3 2012 versus 64% in 2011) and down rounds (34% in Q1-Q3 2012 versus 18% in 2011).
These trends likely reflect the increasing valuations in later-stage rounds in 2012 as compared with 2011 and, thus, the corresponding greater negotiating power of earlier investors.

Participation rights. The proportion of deals with non-participating preferred stock continued to increase in the first three quarters of 2012 as compared with prior years, to 66% in Q1-Q3 2012 from 58% in 2011 and 49% in 2010. The proportion increased both in up rounds, from 59% in 2011 to 68% in Q1-Q3 2012, and in down rounds, from 32% in 2011 to 38% in Q1-Q3 2012. The percentage of deals with capped participating preferred stock remained at 16% in Q1-Q3 2012, the same level as for 2011, while the percentage with fully participating preferred stock decreased from 26% in 2011 to 18% in Q1-Q3 2012. Again, these trends likely reflect the increasing valuations in later-stage rounds in 2012 as compared with 2011 and, thus, the corresponding greater negotiating power of companies and earlier investors.

Anti-dilution provisions. Broad-based weightedaverage anti-dilution protection provisions continued to be overwhelmingly prevalent, being used in 91% of Q1-Q3 2012 deals, the same percentage as in each of 2010 and 2011. Broadbased weighted-average was used in 93% of Q1-Q3 2012 up rounds, as compared with 91% of such rounds in 2011, and in 80% of Q1-Q3 2012 down rounds, unchanged from 2011. The use of full-ratchet anti-dilution stayed level at 3% of financings in Q1-Q3 2012, the same proportion as in 2011.

Pay-to-play provisions. The use of pay-to-play provisions decreased slightly, from 12% of 2011 deals to 11% of those in Q1-Q3 2012. Pay-to-play usage decreased slightly in both up rounds, from 5% of 2012 financings to 4% of Q1-Q3 2012 deals, and down rounds, from 31% of 2011 financings to 29% of Q1-Q3 2012 deals.

Redemption. The use of redemption provisions dropped slightly, from 24% of deals in 2011 to 23% in Q1-Q3 2012. Investor-option redemption (used in 22% of deals) continued to be far more popular than mandatory redemption (1%).

Bridge Loan Terms

For the first time, we include data on bridge loans in the Entrepreneurs Report. Venture stage companies frequently raise funds through such financings, almost always through convertible notes, either before their first true equity financing round (termed “Pre Series
A” in the table below) or to bridge the companies between later-stage equity rounds (“Post Series A”). These financings increasingly are favored because they typically can be negotiated and closed far more quickly and cheaply than priced equity financings, as there are fewer terms and, as a result, much shorter documentation. Clients frequently ask WSGR attorneys for benchmark data on the terms of such bridge loans, including interest rates, maturities, subordination, and conversion prices and discounts, so we are pleased to present the data below as a service to both companies and investors.
The data in the chart is aggregated from 2012 debt financings through September 30, 2012, in which Wilson Sonsini Goodrich & Rosati represented either the company or an investor.


1 Of the Pre Series A bridges that have warrants, 50% also have a discount on conversion into equity. For Post Series A bridges with warrants, 22% also have a discount on conversion into equity.
2 Of the Pre Series A bridges that have a discount on conversion into equity, 7% have warrants. For Post Series A bridges that have a discount on conversion into equity, 20% have warrants.


Fenwick & West Results: Silicon Valley Venture Capital Survey – Third Quarter 2012

The terms of venture financing for 117 companies headquartered in Silicon Valley that reported raising money in the third quarter of 2012

Overview of Fenwick & West Results

Venture financings in 3Q12 continued to show solid price increases from their prior round, but 3Q12 was not as strong as 2Q12.

  • Up rounds exceeded down rounds in 3Q12, 61% to 17%, with 22% of rounds flat. This was another strong quarter, but not as strong as 2Q12 when 74% of rounds were up, 11% down and 15% flat. This was the 13th quarter in a row in which up rounds exceeded down rounds.

Series B rounds were especially strong, with 92% of Series B rounds up, and Series E (and later) rounds were relatively weak, with only 44% up. However 64% of the Series B rounds were software and internet/digital media companies, while only 39% of the Series E rounds were from those industries, and as described below, software and internet/digital media were the strongest industries.

  • The Fenwick & West Venture Capital Barometer™ showed an average price increase of 78% in 3Q12 – again a solid result but a decrease from 99% in 2Q12. There were three financings in 3Q12 that were up over 750% (two in internet/digital media and one in hardware), and if these three were excluded the Barometer would have been up 50% rather than 78%.
  • The median price increase of financings in 3Q12 was 23%, down from 30% in 2Q12, and the lowest median price increase in the past two years.
  • The results by industry are set forth below. In general the software and internet/digital media industries continued to be the strongest, cleantech showed good results on very low volume, hardware lagged a bit and the life science industry trailed significantly.

Overview of Other Industry Data

The third quarter of 2012 was generally not a strong one for the venture industry, with the upcoming election, the looming “fiscal cliff” and global economic uncertainty perhaps weighing on investors’ minds.

  • Venture investing in the U.S. was down slightly in 3Q12 compared to 2Q12, and 2012 is on track to be below 2011.
  • M&A was down slightly in 3Q12 compared to 2Q12, and was also down slightly in the first nine months of 2Q12 compared to the first nine months of 2011.
  • The number of IPOs was down slightly both in 3Q12, compared to 2Q12, and in the first nine months of 2012 compared to the first nine months of 2011.
  • Venture fundraising in 3Q12 lagged 2Q12, but year to date fundraising in 2012 was above 2011 levels. Funding continues to be concentrated in a limited number of large funds, although less so in 3Q12 than 2Q12.
  • Venture Capital Investment.Dow Jones VentureSource (“VentureSouce”) reported that U.S. companies raised $6.92 billion in 820 venture financings in 3Q12, a 14.6% decrease in dollars and a 5% decrease in transactions from the $8.1 billion raised in 863 financings in 2Q12 (as reported in July 2012). Similarly, venture investment was down 15%, and the number of financings was down 3%, for the first nine months of 2012 compared to the first nine months of 2011.Venture capital investment in Silicon Valley was down 22% from the first nine months of 2012 ($8.2 billion) compared to the first nine months of 2011 ($10.5 billion), although the number of deals was only down 6.5%. That said, Silicon Valley received 39% of all U.S. venture investment in 3Q12.

The median amount raised in a 3Q12 financing round was $3.7 million, the lowest quarterly median amount since 1997. This result was driven in part by first round financings, whose median amount raised is on track to be $2.5 million for 2012, which would be the lowest annual amount since 1992.

The lead venture investors in 3Q12 were Google Ventures with 21 deals, Kleiner Perkins with 17, and 500 Startups and NEA with 16 each. Google Ventures recently announced that it was increasing its annual fund size from $200 million to $300 million, which will allow it to make more late stage investments (Sarah McBride, Reuters, 11/8/12).

Similar to VentureSource, the PwC/NVCA MoneyTree™ Report based on data from Thomson Reuters (the “MoneyTree Report”) reported that $6.5 billion was invested in 890 deals in 3Q12, a 7.1% decrease in dollars and a 1% decrease in transactions from the $7.0 billion raised in 898 deals in 2Q12 (as reported in July 2012). The MoneyTree Report also indicated that venture investing in 2012 is on track to be below 2011 amounts in both dollars and deal volume, and that seed stage venture investing was especially weak.

The MoneyTree Report also reported that software and internet/digital media investing remained strong in 3Q12 at $2.1 billion, but both industries declined in dollar terms from 2Q12 amounts. Life science investing, led by follow-on biotech financings, increased in dollar terms from 2Q12, but is down 19% year-to-date compared to the first nine months of 2011. Cleantech investing declined 20% in dollars compared to 2Q12, but saw an increase in the number of deals as investing in this sector appears to be shifting to smaller, less capital intensive deals.

  • Merger and Acquisitions Activity. Dow Jones reported 99 acquisitions (including buyouts) of venture-backed U.S. companies for $13 billion in 3Q12, a 10% decrease in transactions, and a 5% decrease in dollars from the 110 transactions for $13.7 billion reported in 2Q12 (as reported in July 2012). Nearly half of the companies acquired this quarter were based in California. For the first nine months of 2012, there were 314 acquisitions of venture backed companies for a total of $39.5 billion, a decrease from the 404 acquisitions for $40.6 billion in the first nine months of 2011.

Similarly, Thomson Reuters and the NVCA (“Thomson/NVCA”) reported 96 venture-backed acquisitions in 3Q12, a 6% decrease from the 102 reported in 2Q12 (as reported in July 2012). IT companies dominated the acquisition environment in 3Q12, with 70 of the 96 transactions.

  • IPO Activity.VentureSource reported 10 IPOs of U.S. venture-backed companies raising $807 million in 3Q12. This was a slight decrease from the 11 IPOs raising $7.7 billion ($6.8 billion was Facebook) in 2Q12 (as reported in July 2012).Similarly, Thomson/NVCA reported 10 IPOs raising $1.1 billion in 3Q12, compared to 11 IPOs raising $1.3 billion in 2Q12. (It appears that Thomson/NVCA includes sales by shareholders in their calculation of the amount raised). Six of the IPOs were in the IT industry, six were from companies based in California and all were from companies in the U.S. For the first nine months of 2012, there were 40 IPOs compared to 41 IPOs in the first nine months of 2011.
  • Venture Capital Fundraising. Thomson/NVCA reported that 53 U.S. venture funds raised $5.0 billion in 3Q12, a 15% decrease in dollars but a 40% increase in funds from the $5.9 billion raised by 38 funds in 2Q12 (as reported in July 2012). Fundraising for the first nine months of 2012 was $16.2 billion raised by 148 funds, a 31% increase in dollars from the $12.4 billion raised in the first nine months of 2011, but a 13% decrease in funds. The concentration of fundraising by a few large funds decreased a bit in 3Q12, where the top five funds accounted for 55% of fundraising, as compared to 2Q12 when they accounted for 80% of fundraising, but was still significant.Thomson/NVCA also reported that the number of mid-sized venture funds ($250-800 million in size) raising funds has declined significantly over the past five years, with 41 and 45 raising money in 2006 and 2007 respectively, while only 16 raised money in 2011 and only 10 raised money in the first half of 2012 (Private Markets, Mark Boslet, 10/2/12).Dow Jones reported generally similar fundraising results, finding that $4.73 billion was raised in 3Q12 (but by only 37 funds) and that fundraising for 2012 to date was $17.5 billion versus $12.7 billion in the first nine months of 2011. However Dow Jones found that 9% more funds raised money in 2012 to date compared to the same period in 2011.Venture fundraising again lagged venture investment in 3Q12 by a significant amount.
  • Developments in Non-IT Fundraising. With traditional fundraising by non-IT venture funds (e.g. life science, cleantech and hardware funds) especially challenging, some alternative funding mechanisms are appearing. This funding is often by entities, such as large corporations and governments, that have motives for investing in addition to financial return (e.g. filling product pipelines, diversifying a nation’s economy), or that have a longer time horizon.For example Thomson/NVCA has reported that corporate venture capitalists participated in 17.5% of life science financings in 2011 through the first half of 2012, up from 15.3% in the 2010/2011 time frame. Large pharmaceutical companies are also expanding their investments in, and forming closer ties with, traditional venture capitalists (Timothy Hay, VentureWire, 10/9/12). Johnson & Johnson is even creating early stage “innovation centers” in life science hubs such as San Francisco, Cambridge, London and China to improve access to early stage life science companies. (Brian Gormley, VentureWire, 9/18/12).Similarly, in the cleantech area, Broadscale Investment Network has been formed to connect large energy corporations with energy start-ups for investing and partnership purposes, and well known companies like GE and Duke Energy have paid to participate in this venture. (Yuliya Chernova, Venture Wire, 9/24/12).In sovereign investing, the Russian government backed fund of funds, RVC-USA, has committed up to $400 million to U.S. start-ups focused in medical devices, IT infrastructure, energy efficiency technologies and telecommunications. Similarly, another Russian fund, Rusnano has invested hundreds of millions in U.S. venture funds, especially those focused in the life sciences (Jonathan Shieber, LBO Wire, 9/11/12).
  • Kauffman Report on Immigrant Entrepreneurs.A recent Kauffman Report by Vivek Wadhwa concludes that the U.S. is becoming less attractive to foreign entrepreneurs. The report found that the percentage of Silicon Valley-based companies with a foreign born founder decreased from 52% over the period 1995-2005 to 43% over the period 2005-2012. Visa/immigration problems was listed as a major problem. The improvement in the entrepreneurial environment in countries outside the U.S. was also a likely factor. The report found that by far the largest number of entrepreneurial immigrants to the U.S. came from India (33%), followed by China (8.1%), the U.K. (6.3%), Canada (4.2%), Germany (3.9%), Israel (3.5%) and Russia (2.4%).
  • Accelerators and Angels.As noted above, early stage venture investing has declined recently, but the growth of early stage non- venture funding is continuing and may be offsetting this trend.For example, the number of accelerators and incubators continues to grow, with worldwide estimates ranging from 200-700. There is concern, however, about the value of some of these accelerators. A recent study by Kauffman Fellow Aziz Gilani of venture firm DFJ Mercury analyzing 29 accelerators found that 45% failed to produce even one graduate that obtained venture funding. David Cohen of Techstars has encouraged accelerators to publish their track records, so that entrepreneurs can be better informed in their selection process. A possible trend in the accelerator environment is increased specialization, with accelerators focusing on assisting entrepreneurs in a specific industry. (Tom Stein, Private Markets, 9/512; Mark Boslet, Private Markets, 10/2/12).Angel investing also continues to grow, increasing 3.1% in the first half of 2012 over the first half of 2011, with 40% of such funding going to seed and early stage companies. Jeffrey Sohl, “The Angel Investor Market in Q1/Q2 2012: A Market in Steady Recovery”, Center for Venture Research, October 10, 2012.
  • Venture Capital Return.Cambridge Associates reported that the value of its venture capital index increased by 0.61% in 2Q12 (3Q12 information has not been publicly released) compared to -5.06% for Nasdaq. The venture capital index was also slightly higher Nasdaq for the 12 month period ended June 30, 2012, 6% vs. 5.82%, but still lagged for the ten year period ending June 30, 2012, 5.28% to 7.21% per year. The Cambridge Associates venture index is net of fees, expenses and carried interest.
  • Venture Capital Sentiment.The Silicon Valley Venture Capitalist Confidence Index™ produced by Professor Mark Cannice at the University of San Francisco reported that the confidence level of Silicon Valley venture capitalists was 3.53 on a 5-point scale in 3Q12, a small increase from the 3.47 reported in 2Q12. Venture capitalists expressed concern about high valuations, macro economic uncertainty and life science funding, but felt positive about the depth and breadth of innovation in Silicon Valley, especially in the mobile, cloud and payment industries, and the availability of strategic acquirors with substantial cash holdings.
  • Nasdaq.Nasdaq increased 6.1% in 3Q12, and is flat in 4Q12 through November 8, 2012.


Startup Ecosystem Infographic

Venture Capital IPO Report For Technology Companies Based In The United States – 2012,1st Half

During the first half of calendar year 2012, 30 venture capital-backed U.S. technology companies went public, raising a total of $18.6 billion in gross offering proceeds. This compares quite positively to the $2.19 billion raised during the second half of 2011. $16 billion of the difference was attributable to one oversized deal, the Facebook IPO. Stripping out that large transaction from the aggregate dollar amount, the IPO market showed a sequential increase of 18%.

Eight Digital Media and Internet venture-backed companies had IPOs garnering $16.7 billion total consideration. 11 Software, Financial Services, IT and Mobile companies secured $1.1 billion during the period. 5 life science companies went public, raising $331 million in gross proceeds. 6 companies in the remaining industries of Electronics, Alternative Energy, Manufacturing and Networking raised $468 million.

With respect to pricing, of the 30 total IPOs, 15 priced above their expected range. 3 priced within the expected original or revised range and the remaining 12 companies priced below the original range sought. There was a much higher percentage of companies pricing their offerings either above or below their range and relatively few within their original expectations, suggesting significant pricing volatility. Also, as of 7.31.2012, 22 of 30 (73%) IPO share prices were higher than their initial flotation price, little improved when compared to 69% of positive IPOs in the second half of 2011.


The Pitch Book 4Q 2012 Venture Capital Rundown

VC Overview

VC investors completed 685 investments in U.S.-based companies totaling $6.1 billion in 3Q 2012, dramatic drops from the levels achieved in 2Q 2012. The drop-off in dealmaking was not confined to a particular stage of the
investment cycle, as angel/seed, early, and late stage deal volume all fell by approximately one-third. It’s important to put this decline into context, as VC investment year-todate is still even with 2011.
The second quarter of 2012 registered the most VC financings of all-time for a single quarter, so a pullback should not be too alarming. Furthermore, activity had increased 30% from 4Q 2011 to 2Q 2012, which has led some to speculate that VCs took advantage of the summer months to recharge before a push at the end of the year.
VC deal flow has been on a general upward trajectory since the beginning of 2011, but the total amount of money invested through VC deals has been trending downward since 1Q 2011.
A contributing factor has been that angel and seed stage deals have grown from 17% of financings in 3Q 2011 to 23% in 3Q 2012, while the typically larger late stage financings have contracted from 36% to 31% during the same period.
On a yearly basis, it will be difficult for 2012 to surpass the record-breaking numbers posted in 2011. Still, deal-making has been strong despite the disappointing 3Q figures, and 2012 could still prove to be the second-best year for VC investments by both deal count and capital invested.

Industry Rundown

It should come no surprise that the IT industry accounted for the majority of VC investment during 3Q 2012, representing 50% of deal flow and 48% of the capital invested. The proportion of VC money flowing into the IT industry has steadily been rising since dipping to 33% in 2Q 2011 and now sits at its highest level since 3Q 2006.
One of the most significant trends in VC investing has been the increasing prevalence of deals being executed in the B2C space, particularly in the earlier stages. Since 1Q 2009, B2C has expanded from 14% of VC financings to 20% in 3Q 2012. Over the same period, B2C grew from 10% to 16% of capital invested. For the first time ever, B2C now accounts for a higher proportion of VC deals (20% through the first three quarters of the year) than the Healthcare industry (17%). However, Healthcare companies continue to attract significantly more
dollars as the bulk of the industry’s financings come in the later stages.
Renewable energy and clean tech are commonly thought of as a prime spaces for VC investment, but the data tell a different story. Investors closed just 16 Energy deals totaling $298 million in 3Q 2012, representing a measly 2% of deal flow and 5% of capital invested.

VC exits

At first blush, the quarterly exit numbers seem abysmal with a 75% drop-off in capital exited from 2Q to 3Q. However, the quarterly comparisons for exit activity are a bit muddled due to the $16 billion Facebook IPO in 2Q. With that deal removed, the decline in capital exited is a much more tolerable 8%. Still, exit volume did fall substantially from 113 deals in 2Q 2012 to 96 in 3Q. The outlook is much better when looking at the data on a yearly basis; 2012 has already broken the record for most capital exited with $35.5 billion and the  final exit count should be on par with the two preceding years. Corporate acquisitions continue to be the exit method of choice for VC companies, but the exit strategy has fallen to 72% of activity, the lowest level since 2Q 2007. IPO activity declined slightly in 3Q, but 2012 has already seen 36 VC-backed IPOs, which is the highest total for the first three quarters of a year since 2000.

Private equity firms have increasingly been turning to the VC space to source deals and set a new record (42) for VC-backed company buyouts in the first three quarters of 2012.
While VC investment activity is driven by IT, the industry plays an even larger role when it comes to exits. IT companies have accounted for 57% of exit volume and 78% of the capital exited through the first three quarters of the year.


The Pepperdine Private Capital Martkets Project. 2013 Capital Markets Report

The Pepperdine private cost of capital survey (PCOC) is the first comprehensive and simultaneous investigation of the major private capital market segments. The survey deployed in September 2012, specifically examined the behavior of senior lenders, asset‐based lenders, mezzanine funds, private equity groups, venture capital firms, angel investors, privately‐held businesses, investment bankers, business brokers, limited partners, and business appraisers. The Pepperdine PCOC survey investigated, for each private capital market segment, the important benchmarks that must be met in order to qualify for capital, how much capital is typically accessible, what the required returns are for extending capital in today’s economic environment, and outlooks on demand for various capital types, interest rates, and the economy in general.

Findings indicate that the cost of capital for privately‐held businesses varies significantly by capital type, size, and risk assumed. This relationship is depicted in the Pepperdine Private Capital Market Line, which appears below.

Of the 71 participants who responded to the venture capital survey, approximately 28% of respondents expect a shrinking of the venture capital industry. The majority (55%) of respondents plan to make five investments or more over the next 12 months.

Other key findings include:

  • The types of businesses respondents plan to invest in the next 12 months are very diverse with over 33% targeting information technology and another 23% planning to invest in health care or biotech. Approximately 44% of  respondents plan to make new investments outside of the U.S.
  • Respondents’ exit strategies include selling to a public company (40%) followed by selling to a private company (25%).
  • Respondents believe access to capital is the most important issue facing privately‐held businesses today.Domestic economic uncertainty is indicated as the most important emerging issue.