Silicon Valley: The Best Way to Prepare for a New Gig at a Startup or Venture Capital Firm?
Can you learn about the world at large from TV shows?
But your learnings might be far from reality, even for shows that purport to be “realistic.”
It gets especially bad when you look for shows about the finance industry.
There have been a few notable movies, which range from “not that great, but still classic” (Wall Street), to “no educational value whatsoever, but entertaining scenes with drugs and strippers” (The Wolf of Wall Street).
While I’m a huge fan of both drugs and strippers, even I begrudgingly admit that a good movie or TV show needs more than that.
That’s why I was pleasantly surprised when a high-quality series detailing life in startups and venture capital began last year on HBO: Silicon Valley.
If you want to learn what that world is like, or you’re thinking about those industries as exit opportunities, you should check it out immediately.
Why Does This Matter?
But more importantly, many financiers are considering tech-related jobs such as venture capital in greater numbers than ever before.
Despite that, there’s a serious lack of knowledge about how startups, startup funding, and blissful corporate tricks like losing control of your company actually work.
Just the other day, in fact, a friend sent me this message:
“Have you watched the show Silicon Valley? I didn’t quite get the different rounds of funding, why getting a higher valuation (more money from VCs) can potentially screw your company, how VCs can kick you out from your company, how you can potentially lose everything by picking the wrong investors.”
And that’s when I decided to write this article.
Silicon Valley, in a Nutshell
SPOILER ALERT: If you haven’t seen the show yet, I am going to describe the overall story and certain plot points below. Here’s the summary:
A Mark Zuckerberg-looking programmer, Richard Hendricks, quits his job at “Hooli” (Google) to develop a music app called “Pied Piper” after inventing a revolutionary data compression algorithm and turning down a $10 million buyout offer from Hooli.
He raises $200K in seed funding from “Peter Gregory” (Peter Thiel), hires a team, wins TechCrunch Disrupt with his product demo, and gets mobbed by eager investors.
In Season 2, Pied Piper gets sued for copyright infringement by Hooli, struggles to raise funding as a result, and gets forced into accepting funding from “Russ Hanneman” (think: Mark Cuban meets Sean Parker from The Social Network).
This move causes various disasters – including deleting massive amounts of porn from a prospective customer’s servers – but Pied Piper miraculously wins the lawsuit.
But then another Partner at Peter Gregory’s firm, impressed by the technology but not by Richard’s leadership, buys out Russ Hanneman’s stake, wins 3 out of 5 Board seats, and then uses control of the Board to fire Richard.
So how much of this is plausible, and how much is pure fantasy?
Plot Point #1: Quitting Your Job, Starting a File-Compression Company, and Raising $5+ Million from Investors
Leaving your job is plausible, but the particular product here is not: a compression algorithm to improve the quality of streaming video and music and file storage.
Venture capitalists would be highly unlikely to invest in this company because it’s just an algorithm – a complex set of instructions – and is not defensible.
Investors typically want to see traction with users or customers before committing money to a venture – especially on the consumer side, where “hits” are much less predictable.
You could argue that this case is more plausible because Pied Piper’s $200K of funding was a seed round and the additional $5 million came from one individual, but even that is a bit of a stretch.
Reality Verdict: You’d be unlikely to raise $5 million for an unreleased product with no users, but $200K of seed funding is possible, especially in frothy times.
Plot Point #2: Making Enemies with the CEO of “Hooli” (Google) and Getting Into a Giant Battle with the Company
In the show, Hooli CEO Gavin Belson – similar to Marc Benioff of Salesforce – takes a personal interest in destroying Pied Piper. Among other tactics, he initiates development of Hooli’s own copycat product and starts a frivolous lawsuit.
Big companies such as Google do sometimes force startups out of business with competitive products.
One example is Kiko, a promising web-based calendar… that died in 2006, right as Google released its own version of what became Google Calendar.
Opinions vary on whether or not Google Calendar “killed” Kiko, but it made an impact.
The unrealistic part is that in most cases, the CEO of a $100+ billion company will not take a personal interest in killing a tiny startup founded by a former employee.
Sometimes C-level executives do get heavily involved in product development – Larry Page leading the Android acquisition and development efforts at Google is one example – but this particular scenario is unlikely.
Reality Verdict: Plausible, but exaggerated.
Plot Point #3: Getting Sued for Copyright Infringement and Not Being Able to Raise VC Funding as a Result
Hooli’s CEO, incredulous over Pied Piper’s initial success, initiates a copyright infringement lawsuit against the company, claiming that Richard used their computers to test the product.
As a result, Pied Piper goes from being a Silicon Valley darling to being completely unable to raise funds.
This one is very realistic because I saw the same thing happen firsthand a few years ago.
In 2011, a few friends from university started Egraphs, which let fans request autographs from athletes and celebrities and receive them on their tablets, along with personalized audio messages.
It was a great idea.
Even though the lawsuit was frivolous, VCs completely shut down and refused to talk to the company anymore because it represented too much risk.
The company later shut down because it couldn’t raise enough funding to continue.
Most venture-capital funds are structured as Limited Partnerships, which, in theory, protect the General Partners and Limited Partners from lawsuits against portfolio companies.
However, this structure does not protect the companies themselves, and most firms will stay far, far away from any company with legal troubles.
Reality Verdict: Very plausible.
Plot Point #4: Winning Higher and Higher Valuations by “Negging” VCs
Right after Pied Piper wins TechCrunch Disrupt, all venture capitalists immediately wanted to invest at extremely high valuations ($50 – $100 million for a pre-revenue company with no usable product… right).
What rings most true, however, is how the company bid its valuation up by going around to different VCs and acting as if it did not need funding at all.
If you think about the stage that most companies are at when VCs invest, you can see why this strategy works so well: there is no real financial analysis to be done because the companies have no real financials yet.
As a result, the fundraising environment is more like a high-school popularity contest: as soon as one VC thinks you’re “cool,” everyone else will as well.
As far as insulting VCs to get better terms, it can work if you’re a hot commodity and everyone wants in (similar to how “negging” actually works for pickup artists if they do it correctly).
In The Facebook Effect, author David Kirkpatrick details how Facebook used a similar strategy to solicit higher and higher bids until Accel “won” in 2005.
I don’t think Mark Zuckerberg walked in and told a VC his muffins smelled bad, but there was that story about his old business card…
Reality Verdict: Plausible, minus the muffin-related and sexual insults.
Plot Point #5: Negotiating Down a Higher Valuation to Avoid a “Down Round” in the Future
At the start of the second season, Pied Piper receives a “blowout” investment offer valuing the company at $100 million and offering $20 million in cash for 20% of the company.
Then, an underling from the same VC firm visits and encourages the company to decline the offer because the valuation is too high and might lead to a “down round” in the future.
So the CEO, Richard, negotiates down and pushes for $10 million in funding at a $50 million valuation instead.
To explain this scenario and what a “down round” is, I’ll use Facebook as an example.
Normally, as a startup grows and develops, its value increases at each stage.
For example, Facebook was valued at $5 million pre-money when Peter Thiel invested, and then at $84 million when Accel invested in 2005, and then at $525 million when Greylock invested in its Series B in 2006, and then at $15 billion when Microsoft invested in 2007.
At each stage, Facebook had more users, more revenue, more profit, and more traction, so it made sense that its value increased.
Also at each stage, investors were paying more and getting a lower percentage of the company.
Angels and early-stage VCs invest when the outcome is far less certain, and so they are rewarded with a higher stake in the firm.
However, their percentage ownership in the business decreases at each stage because of the new investors.
For example, Peter Thiel’s stake dropped from 10% in 2005 to ~7% in 2007.
But then in 2009, Yuri Milner came along and invested $200 million for a 2% stake in Facebook, valuing it at $10 billion.
This scenario is known as a “down round,” because the company’s valuation has decreased from one round of funding to the next.
In Facebook’s case, this made no real difference because the company shortly became worth $50 billion, then $100 billion, and then even more.
But for regular companies, a down round can create many negative effects:
- Existing owners and founders get diluted and own less of the company because someone else just came in and bought more of the company for less.
Even with Facebook, Mark Zuckerberg’s stake dropped by ~1% in the “down round.”
It still would have declined even if the valuation had stayed the same in that round, but it would have been a smaller drop.
- Employees often lose morale because their stock and options are worth less. It might also become harder to hire new employees.
- Sometimes customers might even become more reluctant to buy the company’s products and services – but that’s more of an issue when the customers are tech-savvy.
Existing VCs sometimes protect themselves in a “down round” by demanding additional shares to reduce dilution.
But Founders and early employees rarely have such tools, so they often bear the brunt of the damage.
So going back to Silicon Valley: yes, a company may want to avoid a very high valuation because of the risk of a future down round.
However, it’s still extremely unlikely that the Founder would negotiate for a lower valuation from the same firm. Down rounds are just not that grave a threat.
There are cases where a company has several financing offers and then accepts one with a lower valuation because of other factors: one investor can add more value, one firm has a better reputation, and so on.
But I cannot imagine a scenario where a Founder gets a $20 million offer at a $100 million valuation and then pushes for $10 at $50 to avoid “setting expectations too high.”
Reality Verdict: Unlikely; elements of truth.
Plot Point #6: Screwing Yourself Over by Picking the Wrong Investors or Using the Wrong Terms
After Pied Piper is forced to accept funding from Mark Cuban / Sean Parker-wannabe Russ Hanneman, various disasters occur: Hanneman starts interfering with daily operations, he “accidentally” deletes a porn company’s files, and eventually he sells his stake to a VC firm that takes control of Pied Piper’s Board of Directors.
The specific examples are exaggerated, but the principle of getting screwed by the wrong investors or by unfavorable deal terms is very plausible.
The Founder of Get Satisfaction experienced something quite similar: the company raised $10 million at a $50 million valuation in 2011, and then the company sold itself in “a fire sale” in 2015 and he received exactly $0.00.
This scenario could easily happen with an unfavorable liquidation preference.
It’s easiest to explain with an example, so I’ll use the $182 million Google / Slide deal.
Around 2.5 years before Slide was acquired for $182 million, it had raised $50 million in a Series D financing from Fidelity and T. Rowe Price at a $500 million valuation.
Without a liquidation preference, those late-stage investors would have earned roughly 10% * $182 million, or $18.2 million, from Google’s acquisition.
In other words, it would have been a complete disaster for them since they invested $50 million and would have earned only $18.2 million 2.5 years later (that’s a negative 29% IRR).
With a 1x liquidation preference, though, they were guaranteed to receive back at least 1x their investment in a “liquidity” event (i.e., an M&A deal).
As a result, they earned back $50 million and avoided losing money on the deal.
Of course, that additional $31.8 million had to come from somewhere.
In this case, the Founder, Max Levchin, earned $39 million instead of a potentially much higher figure ($100+ million?) since there were other investors also with liquidation preferences.
A 1x liquidation preference is quite common on venture deals, but Founders can end up with nothing when you get into 2x, 3x, or even higher preferences (which were common in the dot-com bust).
So it is plausible to get screwed by your investors, but it usually happens via financial means rather than by deleting massive amounts of porn.
Reality Verdict: Plausible, but exaggerated.
Plot Point #7: Losing Control of the Board and Getting Fired
At the end of Season 2, Russ Hanneman sells his stake in Pied Piper back to Peter Gregory’s firm, giving them control of 3 out of 5 Board seats.
A firm with majority control of the Board can fire the CEO – which, of course, they did immediately.
Once again, parts of this are plausible while others stretch credibility.
Yes, the Board can fire the CEO even if the CEO is the Founder of the company. This move is less likely if the CEO owns over 50% of the shares because he/she should, in theory, control the Board, but it is possible.
Firing executives is just one of the duties of the Board of Directors: it has the authority to set compensation, review executive performance, and hire/fire anyone else in the company.
What’s unusual here is how outside investors had 3 out of 5 Board Seats – that is not normally the case after only 1-2 rounds of financing.
A typical startup might begin with a 3-seat Board, often composed of the Founders.
Then, after a Series A financing, they might add one VC Partner to the Board. And then in the next round of funding, they might add another outside investor, and so on.
They rarely give up the majority of their Board seats to outsiders until they’ve raised significantly more capital.
So I don’t understand how two outside investors, combined, could have won majority control of the Board in this situation.
It is possible to lose control of the Board, but not in this way, and not this early on.
Reality Verdict: Got Steve Jobs?
When in Silicon Valley…
So if you’re suddenly interested in tech and you want to find out all about startups and venture capitalists, check out Silicon Valley.
Not everything is realistic or plausible, but it gives a better sense of that world than any other show or movie I’ve seen.
It can’t top The Wolf of Wall Street for drugs and strippers, but it comes out far ahead in educational value.
So get started watching right away, and remember: avoid that down round at all costs.
For Further Reading:
- Business Insider – What Down Rounds Do to Startups
- Pando Daily – What Silicon Valley Gets Right and Wrong About Negotiating a Lower Valuation
- Business Insider – How Liquidation Preferences Work
- Funders and Founders – How Startup Valuation Works
- Business Insider – A Guide to Silicon Valley‘s Jokes
- AVC – How to Select a Board of Directors
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