13 7 / 2012
Here is an essay version of my class notes from Class 7 of CS183: Startup. Errors and omissions are mine.
Roelof Botha, partner at Sequoia Capital and former CFO of PayPal, and Paul Graham, partner and co-founder of Y Combinator, joined this class as guest speakers. Credit for good stuff goes to them and Peter. I have tried to be accurate. But note that this is not a transcript of the conversation.
Class 7 Notes Essay—Follow the Money
I. Venture Capital and You
Many people who start businesses never deal with venture capitalists. Founders who do interact with VCs don’t necessarily do that early on. First you get your founders together and get working. Then maybe you get friends, family, or angels to invest. If you do end up needing to raise a larger amount of capital, you need to know how VC works. Understanding how VCs think about money—or, in some cases, how they don’t think about it and thus lose it—is important.
VC started in late 1940s. Before that, wealthy individuals and families were investing in new ventures quite frequently. But the idea of pooling funds that professionals would invest in early stage companies was a product of the ‘40s. The Sand Hill road, Silicon Valley version came in the late 1960s, with Sequoia, Kleiner Perkins, and Mayfield leading the field.
Venture basically works like this: you pool a bunch of money that you get from people called limited partners. Then you take money from that pool and invest it in portfolio companies that you think are promising. Hopefully those companies become more valuable over time and everybody makes money. So VCs have the dual role of encouraging LPs to give them money and then finding (hopefully) successful companies to back.
Most of the profits go back to LPs as returns on their investment. VCs, of course, take a cut. The typical model is called 2-and-20, which means that the VC firm charges an annual management fee of 2% of the fund and then gets 20% of the gains beyond the original investment. The 2% management fee is theoretically just enough to allow the VC firm to continue to operate. In practice, it can end up being a lot more than that; a $200m fund would earn $4m in management fees under a 2-and-20 structure. But it’s certainly true that the real payout that VCs look for come with the 20% cut of the gains, which is called the carry.
VC funds last for several years, because it usually takes years for the companies you invest in to grow in value. Many of the investments in a given fund either don’t make money or go to zero. But the idea is that the companies that do well get you all your money back and then some; you end up with more money in the fund at the end than LPs put in to begin with.
There are many dimensions to being a good VC. You have to be skilled at coming up with reasonable valuations, identifying great entrepreneurs, etc. But there’s one dimension that is particularly important, yet surprisingly poorly understood. It is far and away the most important structural element of venture capital: exponential power. This may seem odd because it’s just basic math. But just as 3rd grade arithmetic—knowing not just how many shares you get, but dividing that by the shares outstanding—was crucial to understand equity, 7th grade math—understanding exponents—is necessary to understand VC.
16 6 / 2012
I needed to post considered one of my favored pictures from a recent trip to Dubai, planning to Atmosphere in the Burj Khalifa, the globe’s tallest making. We decided to possess afternoon tea in the Burj Khalifa, formerly the Burj Dubai, rather than paying out to go to the observation deck. Notice the selection of stages while from the elevator. In the 123rd ground, we could see the Burj Al Arab, The World Islands, as well as the new Downtown. Below the engineering is phenomenal. There are still cranes littering the desert sands making aside at this time. When I say the world’s tallest constructing is substantial, this can be an understatement. The Dubai Mall underneath from our vantage point appears to get appropriate underneath us. Nevertheless it will take 5 minutes to stroll for the Dubai Mall. The worlds tallest constructing, the Burj Khalifa, would be the pinnacle for every single individual inside building market.
18 5 / 2012
It seems like using all of the different methods of creating energy, together would be the best approach to alternative energy. I know so many people are now scared of nuclear power because of what happened in Japan, but that was multiple massive failures happening all together, causing the worst possible scenario. Solar energy doesn’t seem to be the complete answer as the technology in itself is expensive and not 100% there yet. Wind power has similar issues. Though since these are such new technologies, there is a lot more that we have yet to gain from the research and development that will continue finding better methods of extracting our existing natural resources. Hopefully the world will see that the solution is to use many types of energies together.
17 5 / 2012
Solar energy seems to slowly be catching on out here in Los Angeles. I have noticed more solar cells on top of single family residences. I have been looking to buy a house and it seems like even some of the smaller houses are starting to get in on the benefits. We are looking at Highland Park, and when you drive up the 110 North from Downtown Los Angeles you can see a huge array of solar panels. Very cool stuff.