Today we're talking with Sumukh Sridhara who is a product engineer on AngelList's Venture Capital Team and the hilarious personality behind @vcstarterkit. While many engineers work at startups or are interested in starting their own company, Venture Capital can seem like a total mystery. In this episode, we'll learn about: - How venture capital firms function - How VCs make money - and how that affects you - Ridiculous start-up ideas - The reality of raising money - whether or not you even should raise money.
Welcome to the newline podcast. Our show is a conversation with experienced software engineers where we discuss new technology, career advice, and help you be amazing at work.
I’m Nate Murray and I’m Amelia Wattenberger and today we're talking with Sumukh Sridhara who is a product engineer on AngelList's Venture Capital Team and the hilarious personality behind @vcstarterkit.
While many engineers work at startups or are interested in starting their own company, Venture Capital can seem like a total mystery.
In this episode, we'll learn about:
We really enjoyed our conversation and I'm sure you will too. Let's dive in.
newline Podcast Sumukh
Nate: [00:00:00] Sumukh, I want to start by talking about venture capital from an engineer's perspective. So I imagine this coming from basically two different groups of people. One would be if you're an engineer and you want to get a job, or you're working at a small company that's either raised venture funding or they're about to like, how do you think about the offer that they're giving you, how do you kind of predict how much of those options might be worth and how do you work in that kind of environment? And then the other case would be like, let's say that you're an engineer, you've got a project, maybe on the side it's taken off. You've got an idea. How do you think about like when you should take venture capital, if you should?
How do you even go about doing it? And both of these, particularly from a perspective of somebody who's not necessarily living in Silicon Valley.
Could you just tell us a little bit about your work at AngelList and what you do there
Sumukh: [00:00:42] Yep. So I'm a product engineer at AngelList and I specifically work on our venture capital team. So most people know AngelList as a place where you can find startup jobs, and it's great for that. The original business of AngelList was helping people invest in startups. Specifically, venture capitalists are our primary customers, and we help them set up venture funds, everything from legal docs to actually sending money to companies. And so the way I think about it is it's the financial infrastructure of venture capital.
And as an engineer, I work on automating a lot of pieces of essentially the plumbing behind venture capital, and we just do it at scale. So we have one of the largest portfolios of any venture capital firm. We have over 4,000 companies at this point in our portfolio. And the typical venture fund has something between like 10 and if they're large, maybe a hundred so we just see venture capital at a very large scale. Because I have to approach this from engineering perspective, I think about the systems and all of the tax details of what venture capital looks like.
Nate: [00:01:49] How big is your team? Like how many other engineers are there like you on that, on your team?
Sumukh: [00:01:53] So our engineering team is about six people and the total company, the venture side of this company is around 25 and that comprises, operations, compliance, portfolio, maintainance and sales and business development.
Nate: [00:02:08] But the software that you're building. That's not just for one fund. It's not like you have one fund that has 4,000 companies in it, right? You're building infrastructure for many different funds. Is that right?
Sumukh: [00:02:18] Yeah, that's right. So we have around 200 or 250 ish venture capitalists that use our platform actively to run their funds.
We incorporate many, many LLCs and limited partnerships to run these.
Nate: [00:02:29] So you run the popular Twitter account, VC starter kit, and one of the things that I think is hilarious about your account is just the details and the nuances that you get from like interacting with VC in that world. Like are you interacting with VCs themselves on a daily basis?
Like how are you getting inspiration for that account?
Sumukh: [00:02:49] Yeah, a lot of it's from like my perspective having grown up in Silicon Valley and having raised venture funding before, as well as having worked with VCs. But I think a lot of the tropes are common and most of them are actually from the founder side rather than the VC side.
But even in my day job, I like talk to our customers quite often, and I get their perspective on what it's like to be an investor. And a lot of employees at AngelList are also investors themselves. So that perspective is kind of shared.
Again, a lot of it's coming from the founder side, so the complaints about VCs will usually come from founders. The thing is they're never voiced publicly. They're always voiced in private. And so having a pseudonymous Twitter account is a nice channel for that.
Amelia: [00:03:33] What have your favorite tweets been?
Sumukh: [00:03:35] So there was this Twitter thread about a 10X engineer. So some VC posted that here are the traits about a 10X engineer.
I thought it was a little flippant, so I posted something similar about like what a 10X VC looks like, and it was a whole thread mimicking that. So I think, I think that was probably my favorite.
Nate: [00:03:53] Okay. So let's talk about if you are an engineer and you've got a good idea and you think that you want to raise money for your idea, first off, how do you even think about the tradeoffs there?
I feel like, for example, a lot of engineers that I've talked to who want to raise money, you just sort of think like, I've got a good idea. I'm going to put together a deck, go meet a few investors. You know, I've heard on Twitter that capital's cheaper than it's ever been. It's an age of quantitative easing and they're throwing money at any idea.
I should be able to just send out my deck to a few VCs, get some money and start the company. How accurate would you say that view is?
Sumukh: [00:04:33] Yeah, I think it is accurate for a very small minority of people who happen to be vocal and well-networked, but by and large it is not true and the people you'll see that espouse the capital is cheap view and that there's so many VCs out there are always other VCs. So I found that like venture capitalists are in the mindset of like they see their friends and their, their peers investing in so many companies. They see so many companies and invested in a bunch of them. So they think it's easy to make investments or get investments. But the actual reality is, even if you are well networked and have connections to investors already, it is always grueling to raise money. There are very few people who are like, "I can raise around in one week" - that basically happens to no one.
Nate: [00:05:21] What does that mean, grueling? Like in terms of numbers, like I know that it just depends so much right?
Of course. If you're a proven entrepreneur, you maybe you could just make a few phone calls, but if you're a first time entrepreneur, how many pitches. Can you expect to do? Well, I know that it varies a lot, but how many pitches is like considered grueling? It's more than 10 right?
Sumukh: [00:05:41] Yeah. I mean, it's not unusual to hear numbers in the hundreds, in that the founders, will talk, will actually talk, not just like email, but like talk to hundreds of investors and get no's from basically all of them. Or even worse, they won't get a response. So yeah, we're talking in the hundreds and the reason is grueling is not necessarily that like the process of emailing and talking to investors is like mentally exhausting, which it can be. It's more that it's a time suck that is draining away your effort from like the core of the business, which is like developing your product and talking to customers. But instead of talking to customers, you're actually just talking to investors, most of whom will will either not respond or say no.
So yeah, hundreds.
Amelia: [00:06:24] How do people keep their spirits up when they're going through this process? It seems like it would be so demoralizing.
Sumukh: [00:06:31] Yeah. I think that's one of the things about being a founder: that a skill is your ability to push through it. There are some investors who like almost use that as a test of like whether you're committed to this business. So there are some investors who are famous for not really considering cold applications to their website, for example. So they will say, if you're entrepreneurial enough, you will find a way to get a warm introduction to me. And so like the same idea, it's almost like a test.
As for how they do it, I think there's some part of it where you just, if you have friends who are founders as well, you'll say like, Oh, if they can do it, I should be able to do it too. But it is gruelling and it's one of the things that's pretty difficult about being an early stage founder.
Nate: [00:07:16] So can you cut a, tell us a little bit about the participants in the ecosystem, right. So we can talk about investor. There's actually a lot of different types of investors plus people that work for them, plus people that gave them money.
Can you tell us a little bit about, like, I don't know, put labels to the different roles within this ecosystem.
Sumukh: [00:07:31] Sure. So when we talk about VCs broadly, but even within a venture firm, there are multiple roles, but probably the easiest way to think about it is to follow the money. And so we'll start at the source of the money in this ecosystem.
And that money comes from what are called limited partners in a fund. So VCs referred to these people as LPs, and these are the people who provide money to the venture capital firms to actually make investments. The limited partners typically are endowments, ultra high net worth individuals and governments sometimes, and these are institutions that don't need this money for a long time. And so they're willing to lock it up for 10 or more years with a venture capital firm. And so they make large commitments to venture firms, and then that money gets formed into a fund. So there might be 20 to 100 limited partners, typically in one fund, and VCs have to go out and fundraise and talk to limited partners to get the capital.
Nate: [00:08:31] On that topic of LPs, like what is the buy in? So for example, like if you wanted to, I don't know, get into Andreessen's next fund. What is like the scale of the minimum level of buy in that you're going to need for one of these, like, A-tier funds
Sumukh: [00:08:46] So first off, even if you have a lot of money, you will probably not get invited. Many of these funds are essentially invite only, and they're only continuing to raise capital from people that back them from their inception or what is considered prestigious universities or endowments. And we're talking at least hundreds of millions of dollars in terms of commitments like these.
These top tier funds are now raising billions of dollars for their new vehicles. So yeah, I'm wouldn't surprised if for an endowment, the minimum check size they're looking for (from a new anchor LP) is around 100 million. They might consider small ones, like $10 million, but you'd have to have some other value add as well.
Nate: [00:09:22] Can you explain what you, when you use the word vehicles, what you mean by that?
Sumukh: [00:09:25] Yup. A vehicle is like a fund. So one fund lasts for 10 years and sometimes VC's will raise multiple funds at the same time. So they'll raise one fund to do their investments and they'll raise another fund at the same time to follow on from investments that work in their previous fund.
Nate: [00:09:43] And just to clarify, so what you're saying is you might have one fund which you use to make like initial investments, which would be like earlier on the company, right?
So maybe like for example, some firms might do it for seed stage to, like Series A or something. And you would use that whole fund for these early stage investments. And then you might have a separate fund for follow on investments, which would be bigger check sizes for the small set of companies from your earlier fund who are doing well.
Is that what you're saying?
Sumukh: [00:10:10] Yup, that's exactly right. And these funds are usually called opportunity funds.
Nate: [00:10:14] Okay. So in terms of the members within the ecosystem, we have LPs, which are the people who put money into the venture funds. What about with in the venture funds themselves? You know, like what's difference between like a partner and an associate and how should you think about when you're talking to these different people?
Sumukh: [00:10:32] Yeah, that history is interesting between partner and associates. And the distinction is that a partner has a lot more say in investment decisions for a variety of reasons. And what's happened over time is partners realize that associates were being ignored by founders, because founders caught on to this idea that associates don't have as much say inside of the firm so that might not be worth their time. So some venture funds caught onto this and said, okay, we'll just let everyone call themselves partner. And the end result is now everyone's confused about what anyone does. But yeah, so the distinction between an associate and a partner is, the biggest difference is the partner has economics on the profits from the fund.
So this is called carried interest. And associates typically do not get this. They're typically just paid a salary. It's a junior role. And their job is primarily sourcing or doing diligence on companies. So their, their jobs to basically find companies and talk to them. And so partners have the profit sharing incentive.
They also have some other responsibilities as well. They are usually on the funds investment committees. If the fund needs a majority vote or unanimous vote or something, their vote counts. They get to go to the partner meetings. They have responsibilities for helping raise the fund as well. So it could be their job to go and talk to limited partners and get capital for the fund.
And in addition, they also have to contribute some of their own money to the fund as a what's called a general partner commit. So the best way to distinguish associates from partners now, now that everyone's calling themselves a partner, is to figure out if someone's a general partner at the fund. And if they're a general partner, they have all the roles and responsibilities of what's typically associated with a partner.
So to be a general partner within a fund, do you have to contribute some of your own money? What is the like standard rate for what percentage of the fund you've got to put in?
Yeah, so it's between one and 5% among all of the general partners of the fund. So if you raise $100 million, typically we see a 1% nowadays, like.
The general partners collectively have to put in 1% of their own money. And the incentive there is kind of interesting cause you want people to have, again, again VC saying "skin in the game", but you don't want them to have too much skin in the game, otherwise they might not be incentivized to take risks with the capital.
And so the standard has been set around 1%
Nate: [00:13:01] So if we continue this path of following the money, what's the next step on the path?
Sumukh: [00:13:06] Yeah. So the next step is where the, where the money goes. Right. And so. After the limited partners raise their money, they'll like give money to the venture fund. The venture fund takes a cut of the fees, which are substantial.
We can talk about, and they take the fees, they pay their associates, they pay the GPs a salary, and then from whatever is leftover, the venture firm invests in startups. So the startup might receive, depending on the stage of the company, might receive a check in between like 500K all the way up to like a hundreds of millions of dollars.
So. The startup gets the money and it's its job to deploy it responsibly. And so this is where founders and employees come into the picture.
Nate: [00:13:45] And where are the numbers at today? So for example, I don't know, I would assume that if you like go out, come out of YC, then your company's valuation is going to be at a premium.
So that's like the high end of an average or however you want to put it. What sort of funding terms are you looking to get if you're like, not like the hottest startup out of YC, but just like. You went through YC and you're like, yeah, promising.
Sumukh: [00:14:08] There's a funny trend that happens after every demo day recently, which is this like event at the end of every Y Combinator incubator batch: investors just complain about how high the valuations are going, but they keep going up and people keep investing. So anyway, so at the early stages, so we're, we're thinking about the angel and seed round, how much they (investors) collectively put into the rounds is (around) $5 million.
And that's gone up quite substantially over the last few years. I think if you asked two years ago, I think that number would be maybe like two and a half or three. So now startups are raising up to $5 million and the valuation caps again then this from a Bay Area perspective, but start around $10 million. If you're a particularly hot YC company, then you will see a valuation of $20 - $35 million as a valuation cap.
Amelia: [00:14:57] Have those numbers changed much over the past 10 or 20 years?
Sumukh: [00:15:01] Oh, incredibly. Over the past, the 10 or 20 years, even maybe over the last three years, it's maybe doubled. And the broader trend in the last 10 years is basically the round labels have shifted.
So what used to be a series A six or seven years ago is now considered. Seed round. And so like essentially what was then considered seed investments is now this new class of investment called pre-seed investment. And so accordingly, the benchmarks for what you need to do to hit a seed round have changed.
They look way more like a series a would 10 years ago.
Amelia: [00:15:37] Can we talk about what the different stages are for first startup and how many rounds a startup typically goes through?
Sumukh: [00:15:44] Yeah, so initially when we got started, there's this idea of a friends and family slash pre-seed round, which is, you know, when you have roughly an idea and you need additional capital, it gets started.
Then there's like a seed round, which also has angel investors once in a while, and there's now institutionalized seed investors, and then you have a series A and a series B, series C and D and as these rounds progress, it gets larger and larger, and there's actually no limit to like what the series is, these are just like basically markers or counters for legal docs. So you can go all the way from series a to series B to like I seen G H and you can actually go into double digits , they're just legal denominators.
But generally the amount you raise in the valuation usually always go up. Ideally.
Amelia: [00:16:33] How long do companies usually spend in between rounds?
Sumukh: [00:16:37] Yeah, that's a good question. It's almost a function of investor interest more than like the company, if that makes sense. Usually when you get financing the ideas, there's a set of benchmarks you should be able to hit to get to the next round and hopefully the amount you raised in the previous round was enough to get you to the next point. There have been cases where a companies have gone from a seed round to a series a within three to six months, just because they were growing that quickly and there was sufficient investor interest to do it. Usually the idea is you think about how much cash your startup is burning and how much time it might take for you to get to that next benchmark you've established with your investors that you think you should do to raise the next round and then add at least six to 12 months of estimated spend to make sure that you get there.
Nate: [00:17:28] So let's talk about whether or not you should raise venture capital because it sounds pretty great. Like, you know, you are just a person who has a job.
You have an idea, you want to start your own company. You may as well use other people's money to fund your company instead of your own. And it's better to have money than to just be poor eating ramen. So why doesn't everyone just go out and raise money for their startup? I mean, I guess part of it is, is it just that you have to convince the investors that you're worth it, but also what are sort of your own considerations going into it as the entrepreneur?
Sumukh: [00:18:01] Yeah. I remember when I started I a company and we saw this check come in from our investor and it's like, yeah. Wow, this is the most money we've ever seen, like in a bank account, and that's, that's a great feeling. But immediately after I thought about what the consequences of that were, meaning that like, this is an idea I'm committed to for like. you know, however long it can possibly take. Now I have obligations from other people and these investors to meet and I feel like I have to be able to return their money. So yeah, there are certainly obligations that come with this money. The big one is a commitment to try the idea. I think the way I hear entrepreneurs describe it nowadays is that they are taking essentially what is a 10 year commitment to work on this idea, and they'll work on it as long as possible, and to as good as an outcome as they can get. Possibly. What that means is if you find some other cool opportunity that pops up in the meantime, you've kind of socially committed to not taking that up and making sure that you can get the best outcome here. Other commitments are, once you've raised money from venture capitalists, there's an expectation on the return profile of your company.
So. Let's say you raise money for your company and a few months down the line someone comes in and says, we want to buy this company for $20 million and you might've raised money at (a) $10 million (valuation) . That would be a great outcome for you personally, but your investors would not be a fan. For them. A two X return is not meaningful and they would much rather that you continue to work on this company so that it becomes potentially grows by a hundred or a thousand times their original investment.
So there's a trade off that you accept personally and financially. When you take that money. Another one is you also kind of commit to the venture financing growth model, which is that, let's say things go down the line and you have a good solid business, but it's not growing. Three acts a year over a year or like.
Whatever growth targets you think are reasonable and instead, it's just growing steadily. At that point, you are kind of stuck in limbo where you might not be able to raise another round of financing because your company is it not growing fast enough, but at the same time, your company isn't structured to be self sustainable, and so you're, you're in a weird spot where either you're going to have to make massive changes and disappoint all your investors or you're going to have to commit to taking a huge risk to do whatever it takes to grow the company. So you've essentially committed to that high growth model. And if your business doesn't support it, well that's unfortunate, but it will be considered a failure even though you've built a good business.
Amelia: [00:20:41] What can the investors do if they're not happy with the way you're making decisions at your company?
Sumukh: [00:20:48] So it depends on what stage. At later stages, investors typically take a seat on the board of directors, which has direct authority over hiring and firing the company's leadership. At earlier stages there will be terms such as they will have the right to refuse acquisition offers from companies that they don't think are.
For whatever reason, they don't feel are appropriate for the company. So even if you get a good offer and you want to take it, the investors, depending on the terms that you've agreed to, will be able to block that acquisition. Other things they can do is prevent you from raising money from other investors, they can sully your reputation among other things. So investors can have a lot of control depending on how you've structured. Your company and the investment terms.
Nate: [00:21:37] So what are some of the benchmarks look like for being able to raise various rounds? You mentioned that what is a seed investment now, maybe it looks like a series A used to look a few years ago, and the metrics have basically become even more challenging to reach those benchmarks.
What do they look like in terms of numbers.
Sumukh: [00:21:57] Yeah, totally. So at the earliest stages, so we're talking like pre-seed, it's mostly about the founders and their prior experience and the market they are building in at this point, some founders have a product and if they're particularly experienced, they can raise solely off of a slide deck, but many founders at this point have some prototype of our product. At the seed stage, essentially you're looking for there to be evidence of what's called product-market fit. So basically the product is working and customers like it. Again, they're looking at the founding team because at this stage, the founding team is still a large part of the company.
And so it also depends by industry. So SaaS companies at the pre seed stage are looking to have like six digit annual revenue. And again, since it's SaaS it's going to be recurring revenue and as well as like a plan to increase that by multiples. And if it's a particularly like enterprise SaaS, maybe the revenue numbers aren't important, but you have multiple pilot deals with customers and for consumer companies.
We see something like if you're using metrics of engagement, you want to see daily active users. So I think this is somewhere around like 25,000 is what I've seen that at the seed stage, the only active roughly, and then at the series A, basically most companies at this point are making money. I forgot where I saw this, but I think it was like 80% plus of the companies that raising A rounds are making money, which is a huge shift from 10 years ago.
And then SaaS companies at this stage are seeing at least a million dollars and most likely a lot more than that in annual recurring revenue. Consumer social apps, are seeing like at least a million daily active users. And then there's an exception to all of this for like really heavily deep technology companies.
And usually at the series A, you expect to see some kind of like prototype with some level of traction. I can think of like Magic Leap, for example, was considered deep technology and they had not launched and they managed to raise up till, I don't know what, like series H or something without a like public product. So there are always exceptions, but those are like rough benchmarks.
Nate: [00:24:04] So if I'm an engineer or a founder, I suppose, and I have a company and I think that I'm ready to start raising, at least some early rounds, but I'm not necessarily in Silicon Valley and exposed to a whole network of folks.
How would you suggest somebody get plugged in and then create that network and be able to reach out to their first set of investors.
Sumukh: [00:24:27] Yeah. Ultimately, I think the best way to talk to investors in almost all circumstances is through a warm introduction. So if you, know a friend who's well-connected or have met someone before who is well connected inside of Silicon Valley and can introduce you to investors, that's probably your best bet.
You can try doing cold reach outs over email or Twitter. Those are primarily not effective. The one thing I would recommend against, or, it's not worth spending time on is like most VC firms websites have like a submit a slide deck button or something like that, and I'm convinced the real world analogy of that is if you had like a mailbox that feeds directly into a shredder, that is the equivalent. Basically, no one ever looks at that.
So it's not just by like submitting blindly on VC websites. You can try and email investors that are active in your space. So if you get a sense of like what investors have invested in similar portfolio company, maybe not similar portfolio companies, but in similar spaces as yours and ask for feedback.
There is a saying that doesn't really quite work, but if you're a founder and you're trying to raise money, you should ask for advice. And if you're trying to ask for, if you want advice, you should ask for money, which is kind of interesting and it's like maybe guides your approach. But I would say the best channel for sure is to get warm introductions from someone who is well connected in Silicon Valley or you've met before from your network.
One other potential good channel is finding local angel investors or finding local venture capitalists. It's not the best move. I think people forget that, you know, you can just fly to Silicon Valley to raise money. You don't have to raise from local investors, but it is an option. If you're much more well-networked inside of your local tech hub, than the bay area.
Amelia: [00:26:17] What's the like second and third most VC places that you would want to fly to?
Sumukh: [00:26:23] So I would say that the three most active regions are San Francisco Bay Area, broadly. Then New York, and then Boston. And Boston has traditionally been like a venture capital hub, though traditionally more focused on bio technology.
Nate: [00:26:40] Earlier you mentioned to connect with some local angels or maybe a local venture capitalist. Can you talk a little bit about the difference between angels and venture capitalists?
Sumukh: [00:26:50] Yeah. The biggest difference is that angels are typically investing their own money, whereas venture capitalists are investing money they've raised from other people.
So what that means is that angels usually cannot write as big of a check as venture capitalists can, however, they don't need to talk to 10 other people in their firm or get consensus to make an investment. It's really just up to them to make an investment decision. So that's probably the biggest difference.
Angels are typically not involved after the series A or even at the series A and beyond for companies. So they focus on those earlier stages where their checks can actually be meaningful.
Nate: [00:27:30] Is the return profile different for angels versus VCs?
Sumukh: [00:27:33] Yeah, absolutely. I think this goes into multiple dimensions.
One reason is like if you think about why angel investors write investments, I don't think it's entirely because of financial reasons. I think it's partially like a social or like fun thing they like to do on the side, not just like a purely financial instrument. I imagine it's kind of like social currency.
Like if you're in the New York elite scene, like you go to charity gala's and you like buy tickets and like you might not necessarily care about the like charity itself, but it's more about the like social scene. Maybe that's extremely reductive. I dunno, I haven't, I've never really been into the New York scene, but in the Bay Area it's about angel investing and it's like, Oh, which company did you get into?
And saying, "I helped start this company". And it's returning capital, which is great for the ecosystem, and it like plugs everything back in. So yeah, the desired financial outcome might be different, whereas VCs are professional investors who are expected to at least return three times their original capital back to their limited partners.
And so the return profiles are definitely different. I'd say broadly among early stage venture and late stage venture. The return profiles are very different. Most of the, like, enormous upside you see in venture is from early stage investing. At the later stage investing, we're talking like multiples are good, and that's just because the company has been de-risked.
So if you're a late stage investor and a company three-Xs, that might be like a great outcome for you. But as an early stage investor, if the company three axes, the math will not work out for you in terms of returning accounting for all the other failures. A really good early investment grows by a factor of 1000.
Nate: [00:29:12] When you talk about how you need these, like huge multiples to account for the failures.
One of the things that comes to my mind is the founders of the failures, which is like a significant percentage. A professional investor has an advantage in that they get to diversify their portfolio, but a founder, you know, is making, like you said, this 10 year commitment, or at least they're starting that way to one company.
What sort of like, tools or changes or ideas do you see for like founders to be able to diversify their risk? Are there things that are coming out that allow that? I mean, I guess maybe founders seed invest in each other's companies, but what sort of things are you seeing there?
Sumukh: [00:29:48] Yeah, so a common idea that comes up every few years is that founders should pool together with other founders and like basically diversify their holdings. The problem with this is that because it works on an opt in basis. You have adverse selection. So founders whose companies they know are really good or, or whatever are hot or for whatever reason, they decide not to opt in. And so then you end up holding shares in like companies that aren't as great. So that doesn't quite work.
It could work at the venture capital firm level. So one thing I've been thinking about is like what if a venture fund takes their stake of the profits, which is carry, and allocates, I don't know, let's say half of that, which would be very generous and probably wouldn't happen, but half of that to founders.
In their portfolio companies like that. That's one model that's not opt in, but the way that I actually see this happening is that founders are actually being given capital to invest in companies that they see and they get some economic upside on that. In addition to like angel investing their own money, venture funds might hire founders as what's called "scouts".
And so they get some fund size, typically around a million or less to just invest in companies that they see while they're doing their jobs or their friend's companies. And the results from the scout programs have been really good. There's this somewhat infamous investor named Jason Calacanis, and he started, some companies.
But what he's well known for is Sequoia gave him some money to run as a scout fund, and he used that money to invest in Uber in the earliest stage of Uber. And that's how Sequoia got into Uber essentially, and got the, like whenever I did, I forgot what the return factor is, but let's say 10,000 X (5000x) return on that investment.
And Jason, of course, shares some of that, that upside.
Nate: [00:31:35] Right. And then adjacent to AngelList, there's also like, what does it Spearhead capital, which is like a fund. I don't know what the formal relationship is
Sumukh: [00:31:43] Spearhead is a fund raise by investors and angel list. It's basically a fund, like a first one was like $40 million or something like that.
And it's sole intention is to give capital to founders of companies to start their fund. And the reason it works is because it's run on the AngelList fund infrastructure. So we're able to set up, you know, like 40 funds at relatively low cost and do all the administration. And, that's something we do for a few venture funds actually, is we just run their scout programs.
Amelia: [00:32:16] How far along are companies usually when they start trying to get funding? Are they tried to sell products that actually exist or are most of these conceptual?
Sumukh: [00:32:26] So I'd say it depends on how complicated the startup is. If you're starting like a small SaaS application and you're a technical founder, the expectation is that you would have already built a product and that could work, or you've displayed some like clear market insight or research.
I think regardless of how far you along your, I think all VCs expect that you've done really deep thinking about this space. It wouldn't be feasible to just enter the room without a deep understanding of the market and the competitors and how this product reaches venture scale. That's like the minimum baseline.
The extent of the products is basically just as far as you can possibly be.
Amelia: [00:33:07] What is someone's chances when they pitch a VC ?
Sumukh: [00:33:11] Yeah, that's a good question. So unsurprisingly, most founders will hear no when they pitches at VC, and it feels kind of demoralizing. But once you understand the like statistics behind how many investments an individual VC makes a year, it makes sense that most of their time spent saying no.
So an individual VC might target just like a handful of investments per year. So maybe between like anywhere from like zero to like five investments per year, if they're like involved investments and like involve taking a board seat or in some form. And so investors will frequently, I have to say no. So if they see, let's say 10 companies or 20 companies a week, they're saying yes to one company every quarter or something like that.
Amelia: [00:33:57] It's like one in one and 200
Sumukh: [00:34:00] Yeah, something like that. It would not surprise me if that's like the statistics, of venture funds. So yeah. But VCs are individually very selective. About what investments they make and they take a larger role. Okay. And there's also another distinction here, which is that within around there is usually a lead investor, and then they're just like other participating investors.
And so VCs will lead fewer rounds. And when you lead a round, you put more money into it and you're also more actively involved with the company. And so sometimes we see as well participate in other rounds, but they will try and not lead many other rounds. So a common response you might hear while fundraising is: "this seems interesting, but come back to us when you have a lead investor and we might participate" and all they're really doing is they're like buying optionality there because just in case Sequoia decides to invest in your company, they'd also like to participate.
And so. Yeah. But essentially they're saying no to most companies.
Nate: [00:34:54] When you say if Sequoia invests, we might invest too. I think any sort of listeners who are in the Bay area would immediately recognize the Sequoia brand name, but maybe if you're outside and you haven't been paying attention to VC very closely, you wouldn't know.
Let's see. Can you just like name, like, I don't know, maybe the top sort of like five or six brand names that like, would kind of be instantly recognizable at that sort of like that tier, right? Sequoia's sort of considered like top tier who's like also in that a list?
Sumukh: [00:35:26] Yeah, so I could just like list the funds at AngelList, we have like this benchmark of like 30 venture funds which consider it to be like high signal top tier investors, and (to be clear) this is not from that list. So like broadly speaking, I think the rankings, the "rankings" nowadays and I'm reading by like how other VCs perceive them, but also how founders rate them as well.
So we have Andreessen Horowitz and then Sequoia Capital, Accel. Benchmark is notorious for having really great returns on their investments. Union Square Ventures, which is a New York based fund and something like Greylock partners, or like General Catalyst, maybe Kleiner Perkins Caufield Byers which goes by KPCB.
And so these are the funds with the most like brand name cachet.
Nate: [00:36:16] All right, so let's say that I'm an employee and I'm considering joining a startup. And they said, if I join, I will get 20,000 shares. How do I think about that and how do I find out what that might eventually someday be worth?
Sumukh: [00:36:31] So equity compensation is a very complicated topic, and I can talk endlessly about this.
You know, as someone who's getting an offer, you would think that your equity is basically worth what percent of the company you own times how much the company is worth. And then that should be the value. And to some extent you're right, but there's actually a lot of terms and complications around this and it seems confusing.
As a result, a lot of people write off their equity to be, worth zero in their heads when they're thinking about this offer. And that kind of makes sense financially. You shouldn't assume that your equity will be worth anything, but this counting to zero takes it a little too far. Another thing to consider is that your initial equity grant will probably be the largest single grant you'll get at the company.
So it's worth thinking about the value and maybe negotiating it. And then there's two. There are two main forms of compensation inside of startups for equity. Either you're getting options or RSUs. And RSUs are typically seen at bigger companies, think like a thousand plus employees or something like that.
And RSUs are actually relatively simple. There's some tax consequences about it, but they're easier to model the value of. What are complicated are options and they're, they're actually like complicated financial instruments. That come along with their own set of gotchas. Okay, so there's some standard terms around options, and I'll go over each one.
I think the big one is your vesting schedule. Then what's called a cliff, a strike price, and the exercise window. So these are the important ones. Your vesting schedule, basically controls, how much of your initial grant you'll get over time, so you don't get all your equity at once. You get it over time.
And the reason why is it. It's an incentive for you to stay at the company. The usual terms are monthly, over four years, so you'll get one 48 of your equity grant every month. Alongside that, there is usually a cliff. So cliff is the period of time in which, if you leave the company for any reason, including if you're fired, you actually do not get any options.
The strike price is basically the price that you pay to exercise the option and turn it into actual shares. I know in your question, you said like what if the company says, I get shares? Usually you're not just getting shares. Usually you're getting an option instead, and so to exercise that option, you pay a strike price per share to convert it.
This price is usually lower than the company's valuation at set by something called a 409A valuation. And the lower is the better for the employee on that one. The exercise window is basically the period in which time after you leave the company, you can still exercise your options. The standard term is still 30 days, but some employee friendly companies are offering 10 year exercise windows.
And this is actually really important and we'll get into why in a bit.
Nate: [00:39:14] So when you talk about the strike price, you're saying that's basically the price that you will pay to exercise the option to buy a share. So for example, let's say that your strike price is$1 per share, and then the company, I don't know, gets acquired or goes public at $30 a share.
Then for example, let's say if it went public, you would be able to buy a share for $1. And you would sell it for $30 and then you'd take $29 worth of profit.
Is that right?
Sumukh: [00:39:43] That's exactly right.
Nate: [00:39:44] With the requisite tax consequences, of course, but
Sumukh: [00:39:46] Right, exactly. Where it gets tricky is if you exercise your stock or your option before you leave the company.
And that's something you can do. Or if you are fired or leave the company, you have the period of time within the exercise window to actually exercise your options. And if you don't exercise your options, you forfeit all of them. And so if the company isn't public yet, you are still on the hook for the difference between what the (Fair Market/409a) value of the share is and what you paid to exercise. So let's say in your example, the company wasn't public yet. And you could exercise on the current (fair market) value of the company is $30 a share and you're paying a dollar per share. So you're going to pay taxes on $29 of profit despite not actually being able to sell any of those shares.
So you could be looking at a tax bill that's in the order of like tens of thousands or even potentially hundreds of thousands of dollars for a stock that might never become liquid, and there's, you just have to pay the taxes, or you kind of forfeit the options.
Nate: [00:40:45] I have a close friend who that happened to and it was like hundreds of thousands of dollars, and the company is still private,
Sumukh: [00:40:51] Right, and there's really nothing you can do, or you give up your options, which also is kind of tragic. There are some solutions around this, but it (generally) requires a company to be open to this, and if companies offer a 10 year exercise window, you don't have to make that choice until it becomes clear that the company is going to go get acquired or go public.
Amelia: [00:41:09] Are there benefits to using your options as they become available. Where should you wait?
Sumukh: [00:41:15] There are some benefits. One of them is that it starts the clock on capital gains taxes if you're holding your shares for a certain time, like yeah, that being said, I, I don't think, and that depends on what kind of option grant you have, but generally, not really. I think there's not a huge advantage. I mean, the early exercise is an option, but it's kind of like advanced equity management and you should probably talk to it like a tax accountant to like really understand the implications. That's also what's tricky about getting advice about options or anything online is the tax consequences are really tricky. At the end of the day, everyone's just going to say like, go talk to like a tax lawyer cause this, this stuff does get really complicated. Most people won't for better or for worse. But yeah, it does get really complicated. And if you're listening to this and are like, I was confused by my equity grant, I'm pretty sure the vast majority of people and even recruiters do not understand the exact details of how equity works.
So it is definitely a confusing topic.
Nate: [00:42:15] Okay, great. So tell us more about the math behind options.
Sumukh: [00:42:19] Essentially what you want to model as an employee is, what a lot of people would advise you to ask for, what percent of the company you own. And the keyword they'll ask, tell you to ask for is like what is your fully diluted percentage ownership of the company. And that's kind of interesting, but it's not that useful. Like if I was an employee, I would focus on the share price. Rather than like the percentage of ownership. Over time as a company raises more money, your percentage of ownership will actually go down and that's totally okay because in theory, the value of your stock will go up.
Yeah. I would focus on the share price for the company and the way you can figure out what the current like share price for the company is, is you can ask what the latest preferred stock share price was. So preferred stock is the price of a stock that investors buy. And this is usually set by the last round of financing.
And so you can model that as the current value of one share. And if it's been a while before your last financing and the company has done really well, you can adjust that upwards by whatever percent you've grown or something like that. And if the company has correspondingly done worse. You can adjust it down, but usually if it's recent, you can just use the last financing round's share price of the preferred stock as the value of one share.
So you take the preferred share price, you subtract it from your strike price, and then times the number of options you can exercise. And that's what you can figure the value of your stock will be. Plus all did like tax consequences. So that's like the basic math. And that can model like what an acquisition would look like.
This doesn't capture everything because there is also a lot of like other hidden terms about financing. So one common one is what are called liquidation preferences. So when investors invest, they might set a liquidation preference on the company, could be as high as three to like four times if it's particularly egregious.
But basically what that means is that the VCs, the company agrees to make sure that the VCs get a least, let's say three times, three times their money back before anyone else gets their money back. So if the company, you know, exits for like two and a half times of the capital raised, but the liquidation preference was set at three times.
No one in the company is going to get any money aside from the investors because all of that money went back to funneling that investment or paying back. The investors get a three X return if there's money left over in the acquisition. Then it will funnel down to other stockholders accordingly. And so you might be left with a much smaller slice of the pie.
So it's almost impossible to model the exact terms unless you know all of the details about the company's cap table, which is just a listing of the shareholders and their terms. So it's kind of impossible model precisely. But that rough formula of a share price is probably your best bet to value what your options are worth.
Nate: [00:45:08] How common are liquidation preferences?
Sumukh: [00:45:11] 1X liquidation preferences is very common, which means that the investors will at least get their money back. So 1X is pretty common where investors will get their money back. If a company is not doing well, the liquidation preferences can tend to compund. So investors might only agree to invest if they are given 3X liquidation preference. So usually if a company is doing well, you will not see like egregious liquidation preference terms. But otherwise you might.
Nate: [00:45:37] And what are some of the most common misconceptions you've seen or heard about venture capital.
Sumukh: [00:45:42] Yeah, there are a lot. I think venture capital is like intentionally mysterious. One common one is that people think venture capital is like this huge financial play, and I mean it is true that it does deploy billions of dollars. I think globally venture capital is something like a hundred billion dollars per yearm if you exclude SoftBank's vision fund, it is about a hundred billion dollars deployed every year, and that number sounds like a lot, but in the world of finance, it's really not that much. There are so many other financial instruments that get measured in the trillions that venture capital is kind of like a niche play.
It gets a lot of attention in TechCrunch and in Silicon Valley and on Twitter, but in general, it's not a huge investment vehicle. It's pretty small asset class and it's just an offshoot of private equity.
Other big misconceptions are that like VCs would be happy if you double their money. And that's generally not true at the early stage investors are looking for 100, 1,000 Xs, which might occur once a decade in a VC's career or something like that. Other misconceptions are that like VCs will be founder friendly forever or they'll be very nice. Typically when the company doesn't start doing well, like the stakes change and the knives come out, so to speak.
So that's a misconception. The other one is that like VC cash will always be around and it's always going to be possible to raise money. That's not always the case. If there is like a macro slowdown in the economy, I think we'll see VCs start to like really slow down their deployment of capital.
Other ones: VCs say no because they hate your idea.
Well, like, like we talked about, the truth is that they say no to almost everything. There's other ones that VCs are the king-makers or queen-makers of like Silicon Valley and that's kind of true, but not really like, I think once you like understand how VCs work, they really just kind of like follow the smart founders.
It's not like they're like sitting in a room somewhere and be like, this year is going to be the augmented reality year or something. They're kind of sitting in a room and just like trying to find the right founders and trends. It's not this cabal of like investors figuring out what's going to be hot in Silicon Valley or not.
The people who have the most power ultimately I think are the founders at the end of the day.
Other ones are like, VCs all have MBAs and they like go to business school, but a lot of venture capitalists are actually just former software executives who have started companies and now want to like invest in other people.
Amelia: [00:48:05] How long has VC been around?
Sumukh: [00:48:07] Venture capital has not been around for very long. I think the earliest stages of venture capital (as we know it) started in the 1960s and there's this documentary called Something Ventured that talks about essentially the earliest venture capitalists who move from New York to Silicon Valley to fund entrepreneurs who are starting companies like Intel or Atari.
And once people saw the kind of returns that these early investors were getting from investing in these companies, they're starting to be more and more interest in venture capital as an asset class. But the idea of financing that's just purely based on equity and not through debt , was actually kind of like somewhat of a revolutionary concept.
Most companies, when you try and get financing for them, you're not able to just sell your equity. Usually they have to be secured and you'd go talk to a bank. So the development of the model was unique in the, in the sixties and seventies.
Amelia: [00:49:02] Okay. What is the most ridiculous startup idea you've ever heard.
Sumukh: [00:49:06] I think what I'm going to describe happens to everyone in Silicon Valley at some point and in other tech hubs, but I've stopped thinking of startup ideas as ridiculous. And the reason for that is because I remember going to this conference, I think it was a Thiel Fellowship summit or conference or something like that, and I remember talking to this person in San Francisco and they were like, I was like, Oh, what are you working on?
And they were telling me that they were working on like building a global computer or something like that. And I was like, that's cool, sounds crazy. You know, whatever. And I asked them what the name of their project was and they said, Oh, I'm calling it Ethereum. And that's something that's been wildly successful.
The next year I went to another summit or conference and I met someone who was like, yeah, I'm working on like hotels in India and I'm like, that's interesting. I mean India is not like super online yet and you want to do like hotels and in rural India and like other parts of India, I don't know if that'll work.
And that person was the founder of this company called Oyo Rooms, which is worth like, I don't know, like 17 billion, something like that. And so, yeah, at this point, I don't think of any startup ideas as ridiculous anymore. It's all just kind of like interesting and has different like potential market sizing goals.
So that's my answer. I mean, I've seen some ridiculous ones, but I've also seen like crazy ideas succeed, so I try not be dismissive of anything I hear.
Amelia: [00:50:26] So, what I'm hearing is the more ridiculous, the better.
Sumukh: [00:50:29] Yeah. In some ways that's totally true. I think as long as you have buy in on the like fundamentals, investors will respect you more if you have like a crazy idea.
Here's another misconception. Something that founders think will make VCs happy is when they go and pitch them and they say, I'm going to sell my company to Google. This is going to be like a perfect acquisition for Google. That's not something that VCs want to hear. What they want to hear is that you're going to build this to be a successful standalone company that's going to IPO and be very profitable.
Right? And that's just like setting your ambition to be higher than just like it's an acquisition. So yeah, sometimes the crazier the better. And that's why you see companies that are like. Oh, it's a juice company that raised like a hundred million dollars. But what you don't see is probably like on the back end, they're like promising that they're going to revolutionize like all food delivery and all, like they're going to sell to restaurants and like offices and individuals.
And like, there'll be some like grand vision behind the thing that investors have invested into.
Amelia: [00:51:27] So if I've seen shark tank, in what ways is that inaccurate?
Sumukh: [00:51:32] Yeah. Shark tank is a fun TV show, but it is so different from venture capital. Sometimes I like watch it with my Silicon Valley friends and we look at it and they're like, we're going to offer you $100,000 for 50% of the business or something like that.
And we just start laughing because that's like, those terms are ridiculous for venture backed companies. And it's not like they're like, companies are fundamentally different. Like everyone has like an idea and a prototype and some like basic customers, but if you're in Silicon Valley and have technology, you're able to raise on significantly better terms than those investors.
Other ways, it's different is that you are selling people on a vision more than like exact metrics. So a lot of times the companies on Shark Tank are saying like, here are our exact sales metrics and our growth plans are like two to three X or five X. When you're pitching on a venture scale, you do share metrics, but the goal is never about the current metrics or like even doubling the metrics.
It's always about like growing by a factor of 100 or 1000. Which is why that the valuations for these companies are much higher too. Ways it's similar is that you have competitive pressure where you like will work against multiple investors and you try and get better terms as you play term sheets off of one investor and the other.
And if you're pitching individual angel investors, oftentimes it's just after one meeting you might get a commitment with them. But generally the biggest difference is the terms are significantly better for technology based companies. I think there was one like Silicon Valley based company that pitched on Shark Tank, but I can recall which was Ring, which is like the webcam.
I don't know if they ended up getting funding. I think they rejected it because they didn't like the terms and they ended up raising from VCs, which offered them much better terms.
Nate: [00:53:19] All right, so if I am a founder and I want to learn more about VC, what are some resources that I should go to?
Sumukh: [00:53:25] I'll plug this blog and I'm somewhat biased in doing so, but AngeList itself actually kind of started out as a series of blog posts, which turned into like a mailing list, hence the name AngelList, which then turned into like an actual company. But I think the recommendation that I get the most feedback from about how useful it is, is the VentureHacks blog. So if you go to venturehacks.com there's a series of blogs that talk about everything, about how you negotiate term sheets, the details of options, and even how to like evaluate offers from companies.
And so, there is a PDF somewhere out there of like every VentureHacks blog post, and that's probably like the gold mine of how to like think about Silicon Valley and raising. And that material is almost 10 years old at this point, but it's still really good as content. So the the VentureHacks blog is the first one.
The second resource I would say is for entrepreneurs not in Silicon Valley is probably using Twitter effectively is probably your most like one of the most leveraged ways to get connections if you don't live in Silicon Valley, and if you do live in Silicon Valley, it's even better, but that's another resource.
There are some books that are out there if you really care about the intricacies of venture financing. There's this book by Brad Feld called Venture Deals. That really ties into the deep details. And ultimately I think the best resource is talking to founders who have done it. And one of the advantages of Silicon Valley and tech in general is that people are very helpful and open to answering questions that you might have. And so if you can take advantage of that, you will be in a better place. So the way you do this, you reach out to founders who are maybe six to 12 months ahead of you and ask for advice. And I've found that most people are willing to help. Which is great, and I think that's not as common in other industries so it's always something to take advantage of.
Nate: [00:55:13] Great, thanks. And so where can we go to find out more about you Sumukh?
Sumukh: [00:55:17] Yeah, so I have a personal Twitter. It's not very exciting, but if you care about venture or learning about like what's going on in venture, you can follow the Twitter for VC Starter Kit and that's probably the way it go and there's an email newsletter as well where you can get more detailed content.
Nate: [00:55:31] All right. Thank you very much.
Sumukh: [00:55:32] All right, thanks Nate. Thanks Amelia!