Responding to a popular request, we are now sharing transcripts of our investor podcast interviews in this new series. The following interview with Heidi Roizen, DFJ was recorded in March 2016.
Heidi Roizen, Operating Partner at DFJ, discusses her important article, “How to Build a Unicorn From Scratch – and Walk Away with Nothing,” and imparts crucial lessons to entrepreneurs on how to look at terms in a venture financing situation.
Sramana Mitra: We have been living in world of unicorn mania. We have tried to put some perspective on this issue. There are good sides to the unicorn mania. There are bad sides to the unicorn mania. Let’s start with one
particular piece that you wrote, which I thought was very well-analyzed. The piece was titled How to Build a Unicorn From Scratch – and Walk Away with Nothing.
Heidi Roizen: I’ve been doing this for a long time and I’ve seen cycles come and go. There are two things every entrepreneur should be aware of that they really aren’t aware of. One is, not everything goes well all the time. If you’re an entrepreneur, you fully believe that everything is going to go great for you. The reality is, that is almost never the case. The second thing is, our economy moves in cycles. The macroeconomic conditions will affect your ability to raise money and prosper.
If you take those two things in mind, what has happened and what created this unicorn problem is, entrepreneurs got very fixated on raising very large amounts of money on high valuation. First of all, money in a war chest seems like a good thing to have. Second of all, being able to talk about your billion-dollar valuation makes it feel like it’s a very solid company.
There’s a falseness under that because at the end of the day, venture capital is still debt. It is money you have to pay back in, pretty much, every circumstance. It’s preferred shares, and preferred shares, in essence, are debts that must be paid back first in any but a terrible outcome or an IPO where everything goes common. We can count the number of IPOs in the last year on not too many toes and fingers, so let’s not go that direction.
The reality is, the entrepreneurs have made this sort of deal with the devil. I guess I shouldn’t say that because it makes it sound like investors are devils. The entrepreneur says, “I want a really high valuation and I want to raise venture money. If I raise venture money at a high valuation, I don’t get diluted.” The investors says, “Okay but I want some downside protection. It’s hard for me to imagine your company is worth a billion dollars today. I’m going to put in preferred liquidation preferences and a bunch of terms.”
Entrepreneurs need to worry about that, because the terms are more important than the valuation. Here’s a fun example. I went to a party once and said, “I will make anyone a unicorn tonight. I will give anyone a billion-dollar valuation.” I had a term sheet and it was printed on my business card. It said, “I’m going to invest a dollar in you. I want a 100x on my money and I’ll give you a billion-dollar valuation.”
If you got to pay me $100 as return on my money, that’s not a very good deal for you. If you’re raising $200 million and there are ratchets and multiple guarantees on that money, you are in a very different place. This is why it’s taking me so long to answer the question. It’s actually very complicated. Particularly when there are multiple rounds of financing, everybody around the table starts to have different economics.
If your company sells for a billion versus half a billion, they’re still going to get double their money and then you have another person who doesn’t make a penny until after you sell for a billion. Those people are going to have very different economics. The one thing entrepreneurs should remember is, unless you are in a highly unusual situation, you sit at the bottom of the stack. You sit below everyone else who has invested money on whatever terms in your company. I just think entrepreneurs need to keep that in mind. I really believe that clean and simple terms at rational valuations are the best healthy hygiene for any normal company that is out there to raise money.