Scott Kupor has been at Andreessen Horowitz since the venture capital firm launched in 2009. As managing partner, he has overseen the firm’s growth to 150 employees and more than $7 billion in assets under management.
In a new book called, Secrets of Sand Hill Road: Venture Capital and How to Get it, Kupor demystifies the venture capital process by examining every angle — how VCs decide where to invest, what goes into a great founder pitch, and the financial details involved in forming and growing a startup. I recently caught up with Kupor about all of this and more.
Below is our conversation.
FORTUNE: It’s been a decade since you joined Andreessen Horowitz. What are the most significant, fundamental shifts you’ve seen take place in venture capital?
KUPOR: I think the biggest thing was the whole introduction of seed as a real institutional asset class. It’s hard to remember now, but there used to be these people called angels, and they would write small checks. I think the number is over 500 new seed funds over the last 10 years, all under $100 million in assets under management.
The reason it’s so significant is because, for one, it’s been fantastic in the sense that it encourages a lot of experimentation, which couldn’t have happened without that capital. And two, it changed the competitive dynamic in the industry because you had a whole set of traditional venture firms which always used to be the first money in and now you have this whole group fund of seed funds that come before them. That obviously changes the competitive dynamic, and it’s upped the ante for a lot of people in the industry to figure out what else besides money they can use to differentiate themselves.
Explain to me what goes into your “What do I need to believe?” valuation analysis.
Let’s go back to first principles. If we’re looking at a company that we think could be a standalone business and ultimately become a public company, that means you have to be able to support a several billion-dollar market cap. Unfortunately for most of our companies, there’s no such thing as a small cap market anymore.
What I do in the analysis is say, “OK how can this be a $5 billion company?” Well, it probably means it has to have $300 million to $400 million revenue business, and then you do the bottoms up. Can the market support this? Are there enough customers who would find utility from this product? What’s a reasonable price point you expect people to pay for it? What that enables you to do is think through a very simple bottoms up analysis of what you believe this company can achieve.
Under what circumstances is it a good idea to raise a down round (a down round refers to financing that is raised at a lower valuation than the company’s prior financing)?
I think it’s a good idea in a couple of areas. One, it’s a good idea if you still believe the market opportunity is there, you still have a team you feel confident in, and for whatever reason, you haven’t been able to reach your goal — either the product doesn’t make sense or maybe you raised more money initially and you didn’t spend it in the most effective ways. So if fundamentally, you still believe the business is still viable, then that’s a good reason to raise a down round. If the business works, and you’ve got alignment with your funders, then it’s a perfectly reasonable thing to do.
What are some of the more obscure but really detrimental mistakes you’ve seen entrepreneurs make during the fundraising process?
People don’t always think critically enough about what is the right amount of money to raise. What we try to encourage entrepreneurs to think about is: Think about what the story is around the milestones you’re going to want to tell at the next fundraise. When you’re raising the Series A round, think about what you’re going to tell your investors at the Series B round. And then you can back into your number.
People often get too enamored with what else is happening in the market and don’t think critically about what’s required of them. As we’ve seen, the problem with raising too much money can be that it raises the expectations for what people think you’ll accomplish by that B round, and then you might find yourself in a situation where you set the bar too high. I think that can be way more crippling to a company than potentially raising a little less at the A round and giving yourself a little more margin of error for that next financing.
How have some of the mega-VC funds like SoftBank’s Vision Fund affected venture capital?
A couple of years ago, the Vision Fund was a class of one. In terms of total capital, there’s still no one who rivals them, but there’s now plenty of people who can write $300 million, $500 million checks. I think the Vision Fund played an important role, but I don’t think it was the end all be all of the financing business that I think people expected when it first showed up. What it’s done is attracted a lot more other late-stage capital — whether that’s from sovereign wealth funds or mutual funds or even private equity funds.
I do think we’ve got this long-term issue trend of companies staying private longer. We can argue whether that’s a good or bad thing, but the fact that this type of money exists certainly enables this trend. In some cases, that may be good for companies, and in other cases, it means they’re staying private longer than they should and potentially going into a public raise without the level of growth that the public markets expect. For the most part, it’s been healthy in that we’ve seen other players come in on that end of the market and offer much more diversity in financing for companies than it looked like there was when SoftBank first came on the scene.
How important is spending time cultivating a company’s culture especially when it raises new funding and the company balloons from 10 people to 100 people?
I think it’s critically important. What happens is when you raise financing, you immediately remove a constraint. There’s a natural tendency at many of these companies to grow as fast as possible, and a lot of that requires hiring more people to make that happen. What the CEOs have to do this is be transparent because it’s no longer a good excuse to say, “We just don’t have the money to do it.” You have to be able to explain to people why you’re making these decisions and why you think growing at a slightly slower pace might actually be more important in some cases.
You explain that the public market’s role as an important source for companies pursuing large capital raises has diminished. So what is the purpose of an IPO these days?
I still think there’s value. I agree that some of the traditional reasons why companies went public (in many cases, to raise capital) may be less relevant today given the availability of capital in private markets. But I think there’s at least two foundational things that are critical.
One is that it’s increasingly hard as you get later-stage to attract employees without having the liquid RSUs (restricted stock units) that the public companies have. The person who might’ve joined Uber a year ago is probably also looking at Facebook and Google and other companies that have the ability to essentially use RSUs as a form of cash compensation for people. So I think that’s important as you continue to track and retain employees as you grow through stages.
Two, acquisitions have always been important in technology. It’s not impossible to do acquisitions as a private company, but it’s a lot easier to do it with public stock than private stock. Otherwise, we end up fighting not just about how much you’re going to pay for my company, but also how much I believe your company’s worth. So at least we take one of those out of the equation when we have a public price.
And the third thing that’s underrated is the level of discipline that it takes to be a public company is really an important part of the maturation process. Someone recently did an interview with Snap CEO Evan Spiegel, and he talked about this idea of how he didn’t realize the level of accountability that public investors require. It’s easy in the private markets to get lulled into this idea that, yes, quarterly numbers matter, but they don’t really matter because I don’t have this day-to-day report card in the form of a stock price. So I just think from a maturation and operational excellence perspective, we still believe that going public adds a lot of value.
Slack and possibly Airbnb are going public via a direct listing. Why do you think some of these companies are rejecting the traditional IPO path?
Some of these companies don’t need primary capital because they’ve raised significant amount of money in the private markets and they feel very comfortable with the cash availability they have. So why take some of the dilution if you don’t need the primary capital? I think that’s part of the motivation.
The other thing is that a big portion of the IPO process in the old days was a marketing coming-out event for these companies. We didn’t have reporters who would cover them all day, so the IPO process was a way for companies to present themselves to the world. I just think the reality is that Airbnb and Slack and these other companies have become household names because of the level of coverage they get and because they’re things people use every day.
I also think there’s a little bit of a fee motivation where companies just don’t love the idea of paying underwriters 6 or 7%. Of course, the reality is that for these big IPOs, no one’s paying 6 or 7% but they are still paying something. So there’s this view of: “If we can achieve what we want to achieve without dilution, without worrying about marketing, all while doing it more cost-effectively, then great.”
I still believe it’s a rare company that can actually achieve this, because you have to have really good awareness and enough secondary trading where there is price discovery happening. The reason why Spotify worked is there was a very, very active secondary market, and there was not as much of a price discovery problem that the underwriters would normally try to solve.
My personal view is that I still don’t think we’ll see a tidal wave of companies doing this. I still think it will be limited to a very select few, but it will probably have an ancillary benefit of making underwriters recognize that this is a viable alternative for some companies and you’ve got to think about what your real value add is. And I think that’s a net positive quite frankly.
You mention that initial coin offerings could potentially replace venture capital as we know it today. ICOs have somewhat of a mixed reputation with many that have turned out to be scams. What are your current thoughts on whether this is a sustainable model for fundraising in the future?
ICOs are a form of what I call ‘threat financing.’ There’s always this question of: Is venture capital as we know it dead? Specific to ICOs, the SEC has been pretty clear on this and most people agree that if you’re selling a pre-launch token to somebody and you do it other than through the traditional accredited investor and following Reg D rules, then that clearly violates securities law. So I don’t think ICOs in their current form will be the thing that displaces venture capital.
But the broader point I was trying to make is that capital is no longer the scarce resource. That was what characterized this industry for the first 35 to 40 years — capital was limited, VCs had it, and therefore, VCs had more leverage and control in the relationship with entrepreneurs. In the last 10 to 15 years, that’s completely flipped. Capital is no longer the scarce resource, so it’s a wonderful time to be an entrepreneur because there’s so much leverage to be had in identifying capital sources.
So whether it’s crowdfunding or ICOs, if all you are is going to be a capital source, that’s probably not a viable long-term strategy in this business. The industry’s going to continue to get more and more competitive and capital is going to be a non-scarce resource, so you’ve got to figure out what your edge is. If venture capital has value 30 years from now, it’ll have to be because it’s more than just a financing source.
Silicon Valley has been touted as the greatest wealth-generation machine in the world. Do you believe it will retain its dominance for the next decade or will wealth be generated elsewhere?
If you look at the numbers, U.S. venture capital 20 years ago was 90% of all global venture capital, and today U.S. venture capital is just about 50 to 51%. So on a relative global market share basis, it has fallen precipitously. Of course, the size of the market has also gotten a lot bigger.
There’s no reason to believe there ought not to be other places that over time can rival Silicon Valley in terms of the success it’s had around company formation. But I think people forget how long it takes for these network effects to build. There’s no question that there are incredibly brilliant engineers everywhere and that it’s easier for people to gain access to technology.
There’s definitely capital in lots of other places outside of the U.S, but I think the thing that might take longer to build is the strength of network effects. You’ve got to have an ecosystem where there are founders who want to play, and folks who are willing to invest their money, so I think there’s every reason to believe the conditions exist for this to happen. I just think that the time frame in which it takes for this to happen is probably going to be longer than people expect.
Finally, near the end of the book, you mention that your personal motto about most things is “Better to be informed.” What’s one area, outside of venture capital, where you think there’s an opportunity for people to be better informed?
I think the biggest thing that I see outside of venture capital is the relationship between technology and society at large. I think we’re lucky to live in this wonderful place that’s the U.S. and Silicon Valley, and we see the benefits of technology every day. What we forget is that the way in which those values are perceived by others outside of New York, California, and Boston is just very different than the way we perceive them.
Technology is moving at a pace that’s faster than ever before. The biggest thing we can do is be mindful of that and recognize that we ought to be having conversation with the government and other entities on how we make sure that we get the benefits of what we’re trying to achieve here while also recognizing that intermediate dislocations can be real and we have to be more sensitive to that.
This article originally ran in Term Sheet, Fortune’s newsletter about deals and dealmakers. Sign up here.