The a16z Show - a16z Podcast: How To Get The Most From Your Board

Starting point is 00:00:00 The content here is for informational purposes only, should not be taken as legal business, tax, or investment advice, or be used to evaluate any investment or security, and is not directed at any investors or potential investors in any A16Z fund. For more details, please see A16Z.com slash disclosures. I'm Frank Chen. Today I'm here with Scott Cooper, and we are now in part three of three of our demystifying Silicon Valley. This part is all about living with you. investor. As Scott will point out, the average length of time that you will work with a venture investor, 8, 10, 12 years is longer than the average marriage. Terrifying statistic. And so you want to make sure that you understand how to work and pick with an investor that you can live with over a long

Starting point is 00:00:48 period of time. And so we're going to talk about ways that you can think about getting the most out of your venture investor and board member and how to handle situations from the bad situations where you have to wind down the company, to the awesome situations where we hope you find yourself, which is you're doing an IPO for your company. So let's dig right into it. Let's talk a little bit about fundamentally, what do I want from my investor?

Starting point is 00:01:13 And usually they'll live basically as my board member. Yeah, right? Like what are the big things I'm working for? Yeah, so look, I think, you know, certainly you want a board member and all the things that a board member entails, which is hopefully they are a good coach, a good mentor, a good sounding board for you.

Starting point is 00:01:26 Hopefully they're good stewards of corporate governance and help you kind of think through important strategic decisions for the company. But then I think more importantly, you know, and this extends beyond often just a general partner who's sitting on your board, you want some, you know, you want some value from them that allows you to help you accelerate the growth of the business. I mean, ultimately, you know, you and the venture capitalists are along for the same ride, which is you're both trying to achieve an outcome that yields a very important, longstanding, hopefully independent and publicly traded company. And so, you know, whatever the venture

Starting point is 00:01:54 capitalist can do to help you with that, whether it's making customer introductions or helping you understand how and when to add a CFO or a head of sales or how best to kind of navigate the PR and marketing world and who are the right press relationships to have. All those things are, I think, fair game where, you know, kind of good VCs find ways in which they can be valuable to entrepreneurs in that regard. Yeah. So one of the jobs of the board is that they can fire me as the CEO. Okay. So now I've got this weird incentive, which is on the one hand, I want that partnership. I want to get great advice. And on the other hand, like if I share too much or like I'm too open about my vulnerabilities or my shortcomings,

Starting point is 00:02:34 like I could get fired. And so how should I think about transparency, trust? Exactly, right. It's a little bit like the relationship, you know, probably your youngest has with you as a parent, right? Which is, okay, I want to be truthful. Right. I want to tell them when I've wrong, but I know there's consequences for doing that, right? So that's exactly right. Yeah, look, I think, so you're absolutely right, which is, look, the fundamental power the board does, of course, is to be able to hire the CEO. Now, we talked about this in a different session. It's also changing these days, which is often the boards are not controlled by the venture capitalists, but controlled by the CEO and, you know, kind of, you know, other common shareholders, in which

Starting point is 00:03:06 case the board really can't, you know, the venture capitalists can't unilaterally do anything. They would have to actually really generate consensus with a much broader set of folks. So I think, I think some of those risks of kind of, you know, a VC being, you know, kind of random or, you know, kind of, you know, not thinking through these things and, you know, and doing that is much, that risk is much lessened today. Technically, they can't outvote me. That's exactly right, right. they would have to kind of co-op other members of your kind of constituents to do so.

Starting point is 00:03:32 But that notwithstanding, I think even in the scenario where that's not the case, I think you're right. I think what it means is, look, you have to – you still have to build a relationship, though, where you are willing to share enough information to kind of get their advice and get their help. Yeah, in some cases, maybe that means you're vulnerable. But I think in most cases, I think most VCs would say, hey, look, if you can tell us stuff and we can help you fix it and help you address it, then there's no reason, it doesn't necessarily mean

Starting point is 00:04:00 that every time you do something wrong, you get punished and you basically find yourself out of a job. So I think most people are pretty rational about this, but you're right. There is this kind of strange dichotomy of having somebody who's also your boss essentially be your concedularia as well. And then sort of as I build the company,

Starting point is 00:04:19 I'm going to basically grow the board from people who invested money. So I have a Series A investor who takes a board seed, then the B investor takes a board seat. So now I've got like a whole cat-herding exercise to go through. And there are situations in which the economic interest of my investors, A's and B's and C's, can diverge. Absolutely. Like I might get into a situation where somebody's heading into a fundraise. They need a liquidity event. Yeah, yeah, yeah. They need to put up some dollars and so like now they're pressuring me to sell the company. Yeah, yeah, yeah. Right,

Starting point is 00:04:48 whereas the A and B investors might be like, no, no, no, we're like, let's go for a bigger outcome. Yeah, so how do I manage these situations? Those are tough situations in management managed. I think, again, as a CEO, it's really important for you to kind of understand exactly what those incentives are. And, you know, you mentioned it, hey, maybe I, maybe I, as the VC, need to go fundraise a new fund, and so I need to show my LPs that I'm smart and I'm making some money. And we get an acquisition offer for your company. And for me, it's a good outcome, but maybe it's not a good outcome for you and others. Now, the good news is, you know, as a board member, you know, you are a fiduciary to those shareholders. And so, you know, you do have

Starting point is 00:05:21 legal constraints on your ability to be completely self-serving, but still even within that, you have to think about it. And so this is, you know, oftentimes you'll see, you may have heard of this term called a waterfall analysis, which is oftentimes, it's a mechanism by which often the lawyers will do it for you for the company. They'll say, hey, look, if you sell the company at this price, here's what the A people will get, here's what the B people get, here's what you and your employees get. And it's good in those situations to look at that because that will help you understand if you do have this kind of divergence of interests among folks. Again, I think, as with all things, look, the best thing you can do is hopefully you've

Starting point is 00:05:55 stacked your board with good people who are rational and who respect things like fiduciary duties, and you can have a meaningful conversation around that. In theory, the board is supposed to be exercising duty of care. In theory, they're not supposed to put their own interests. That's right, yes. Right, all of the, but there are situations where you will get this sort of self-serving behavior. Yeah, where you kind of find this weird situation and is oftentimes when company, we talked about liquidation preference in one of our prior sessions, where a company is getting sold for at or around the liquidation preference, this is where you tend to kind of get these issues that come up, right? Because the VCs are, you know, if they've got $30 million of liquidation preference, they're probably indifferent between a $30 million sale and a $30 million sale and a $3 million.

Starting point is 00:06:42 $35 million sale and a $40 million sale because, you know, I'm just making up these numbers, but let's assume in those cases they're still going to get the same amount of their liquidation preference because the price isn't high enough to actually cause them to convert and take their normal equity ownership. And so you do get these weird scenarios. Now, again, as I said, the good news is most of the time, you know, people still act rationally. There are a couple cases, though, that we've seen where the courts have kind of said, hey, we don't like the behavior we're seeing from D.C. is because you kind of didn't take care of the common shareholders, which is really your main job here.

Starting point is 00:07:12 And so, you know, I don't want to put everybody to sleep on this webcast here. But, you know, there's a whole chapter on this of the book, which kind of helps you understand how we got there. And then importantly, what are the kinds of things that you can do to make sure that you don't run afoul of those problems? So the take-home message for me as the startup CEO is like, I need to understand all of the incentives. That's right.

Starting point is 00:07:32 And the timeframes of the people who are on my board. That's exactly right. So I can try to understand why are you saying what you're saying. That's exactly right. Yeah, and look, it goes, again, it goes back to where we started the conversation in our first session, when we started talking, was, you know, incentives drive behavior for better or worse, right? You know, we, again, you and I spent time in the enterprise world where, look, if you want to change the way you sell your product, the best thing to do is change the quota structure for your sales reps, right?

Starting point is 00:07:57 And that's not, you know, a denigrating statement. It's just the way that, look, incentives may matter, and people respond to incentives. And just like that, you know, venture capitalists are people too. And so they respond to the incentive structure they have. And the more you understand that, the more I think you can finally cut through and actually have a rational dialogue. Great. Now I want to do some sort of play acting with you on three scenarios. So scenario one is things aren't going well.

Starting point is 00:08:22 We're going to have to do something tough like raise a down round or a bridge. And then a scenario where, hey, yay, we're getting acquired and we're going to clear the liquidation preferences. It's going to be happy. And then the super happy scenario where we're going public. So advice for each one of those. All right. Tough times. It's not going the way I expect.

Starting point is 00:08:40 I have to raise a bridge. Maybe I have to raise a down round. How should I think about this? Yeah, so this is hard. I talk about this in the book a lot, but I'd say the most important thing I think to think about there is, and this is where I do think having good relationship with your VC is critically important, is having a real open, honest discussion, right?

Starting point is 00:08:55 So sometimes, unfortunately, despite your best efforts and, you know, despite our best efforts, hopefully to be supportive of you, maybe the market's just not there or the product's not taking. You know, for whatever reason, you know, look, you gave it 110%. and it's just not there. And it's interesting, when I've had those conversations with entrepreneurs, I was kind of, I was dreading going into that conversation because I was worried that it was going to be a contentious discussion.

Starting point is 00:09:18 And more times than not, they actually come out and they say, you know what, I'm kind of relieved because I was thinking the same thing you were, which is I was doing this because I thought my job to you as the VC was to just run through walls no matter what. And honestly, I don't know that spending another three, four years doing this is likely to yield a better outcome. It doesn't always happen that way. More often than not, I'd say that happens.

Starting point is 00:09:38 And so I think in those cases, look, it's perfectly respectable to say, hey, look, we all gave it our best and it didn't work. And the right thing to do is let's wind it down in a reasonable fashion so that we can hopefully, you know, take care of our employees and take care of our vendors and do all the things we can. If you still feel like, you know, the alternative is true, which is, hey, yes, maybe we got the product wrong or maybe the markets developed more slowly. But you know what? Like, I'm committed as an entrepreneur and I really believe this market is still here and this is a viable business. then, you know, kind of, I talk about this in the book, but things like what you call like a recapitalization, which is kind of almost a reset, right, which is we say, hey, look, we raised a bunch of money, we spent it, it didn't yield what we want, but we're all still believe in this thing,

Starting point is 00:10:17 and I want to go spend the next 10 years of my life trying to do this. Then let's set the company up for success, right? And it's unpleasant. The word recap is obviously has such a negative commentation. But in that respect, it's actually a positive thing, which is we're going to figure out, okay, how do we kind of make the company attractive for potentially new investors to come back in by cleaning up some of these things like liquidation preference we've talked about, resetting the price to a point that actually reflects the progress of the business.

Starting point is 00:10:41 But importantly, and this is where I think entrepreneurs need to make sure they're aligned with their VCs, for you as an entrepreneur and your employees to also make sure that you get reset as well. So there's no sense in any of us putting more money in the company if it turns out all of your stock options are underwater and you've got no financial incentive and then tomorrow everybody's going to walk away from the business. So this requires kind of give and take on both sides, which is, you know, the VCs will give up a lot of the rights that they otherwise had. But importantly, the give that the VCs, you know, need to do to make this successful is to kind of reincent the team as well and make sure that you all are, you know, shooting for the same ultimate outcome. So there's a lot of emotional freedom just sort of listening to you talk, right? Because even if we have to wind it down, we can have the conversation and then realizing that like half your portfolio is going to go belly up anyway.

Starting point is 00:11:28 Right. Right. I don't have to feel like, oh, my God. on like the world's biggest failure, right? Right, right. You're kind of expecting this. I think that's right, yeah. I mean, look, yeah, look, it's more, obviously, look,

Starting point is 00:11:38 it's more emotional and more personal for you as the entrepreneur, of course, right? Because you've, you know, this has been your life's dream. But you're right, so you shouldn't feel sorry for the VCs, right? And I certainly never, would never suggest that you should feel sorry for the VCs, because you're right, we expect that that kind of risk

Starting point is 00:11:53 is what's inherent the business. The more important question is really, do you still believe in the market, do you still want to pursue this, or also do you feel like, hey, it was a good idea, but just for a variety of reasons, didn't materialize the way we thought, and the more rational thing to do is go do something else. Got it. Great.

Starting point is 00:12:09 Let's move on to scenario, too. So we're getting an acquired and an attractive price. Yay. It's not quite an IPO, but it's not a windown. It's not a recap. So what are things that are important to think about as we're going through this process? So maybe let's start with sort of how are we getting value. Is it cash or private stock or public stock?

Starting point is 00:12:27 Yeah. So there's lots of things to think about, right? One is you're right, which is, look, what's the economic interest we're getting here? And sometimes, as you said, that can be, you might be getting paid in cash. Sometimes you might get stock of the other acquirer. And so, depending on the scenario, right, you may want to do some homework if you're getting stock to understand what do I think about that stock, what do I think about the prospects of that company because your economic future is now going to be tied to the success of that

Starting point is 00:12:49 business as well. I think the most important thing, though, to think about, obviously price is important, so I don't want to belittle that. But the next most important thing to think about is what is the go-forward business going to look like, right? So are you being acquired because they really love your product and love your vision? And now you're going to go be the general manager of some new unit in the company and have the ability to affect the vision that you had hoped you would affect as a standalone company, but now inside of a bigger, you know, better resource, better capitalized company?

Starting point is 00:13:16 That's wonderful. Obviously, if you're signed up to do that and your employees are signed up for that. Or are they saying, hey, you know what, we really like those engineers, but all these sales guys, all these product guys, we don't need them. And so, like, we're going to incent the engineers to stick around. But quite frankly, we want you to lay off everybody else before you kind of come over.

Starting point is 00:13:34 So I think those are the most important things, which is kind of, you know, what is going to happen to the employees? What does the go-forward business look like? And, you know, again, I know we all get excited and we like to talk about the price because, of course, it's a lot more fun and sexy to talk about money. But it's, I think, you know, managers and CEOs

Starting point is 00:13:49 make their reputations, quite frankly, in these types of situations where, you know, they are thinking first and foremost about kind of the prospects for their employees and their team members, you know, kind of, you know, not secondary to the actual, you know, value of the company. Right. So who's getting a job, who's not getting a job? That's right. What are the terms of the stock options? That's exactly right. What's the financial setup going to look like, right? Are they going to give you new stock options in the new company? Are they just going to take the ones you had and move them over? Sometimes people do what are called retention bonuses, right? Where they say, you know what, like for the first two or three years of the deal on each of the one year anniversaries of the deal, if you're If you're still here, we're going to give you maybe a cash bonus or we're going to give you a stock bonus. So all those things that allow you to kind of get a better sense of what is that go-forward structure going to look like?

Starting point is 00:14:31 And is that something that you as the CEO believe you can sell to your employees to say, hey, look, we gave it a shot, we did well. And now here's an opportunity for you to both enjoy financial reward as well as feel like you're enjoying the reward of being in a bigger company and having access to more resources. I hear that sometimes in these cases and also with the recamps or the down rounds, there are these things, called management carve-outs. Yes. What are they? Should I be looking for one? Is that a good thing, a bad thing?

Starting point is 00:14:58 Yeah, sometimes you'll see, yeah, management carve-out, management buyout, MBO sometimes is what they're called. Yeah, so the basic idea is typically sometimes what happens is, and it goes back a little bit to this liquidation preference discussion we're having, is the company might be doing well, but there may be so much money invested in the company that even in a nice acquisition, a lot of that money ends up going towards people like me, the VCs, as opposed to you and the people who can actually go have to run this business now. And so oftentimes what the VCs will do is say, hey, look, we want to incent you to kind of,

Starting point is 00:15:26 be motivated to try to find a buyer for this business if we all agree that that's the right outcome for the company. And so essentially, the VCs will say, look, let's carve out some of the money that might have otherwise gone to the VCs or in some cases other common shareholders and make a pool that effectively becomes a bonus pool for the executives and or the people who are responsible for the acquisition. And that's a perfectly fair and a reasonable thing to do. We do it in many cases in that scenario.

Starting point is 00:15:51 And then in addition, on top of that, sometimes the acquirer themselves will also put an additional incentive pool in place and say, okay, as we talked about post the acquisition, maybe on the first and second and third year anniversaries or something, we will also contribute to a pool that will incent longer-term retention for people. Got it. So the management carve out pre-the-transaction is about, look, this is the way the waterfall would have worked. That's right.

Starting point is 00:16:17 But we're actually taking a portion of it and basically getting into the managers. That's exactly right. Yeah. So think of the just time periods, right, which is kind of, you know, let's reallocate some of the dollars to the existing shareholders, you know, and then post and post, you know, acquisition as we talked about. It's just an incentive structure to kind of create a long term. It's like new options. That's exactly right, yeah. Yeah.

Starting point is 00:16:35 Got it. Good. Well, let's talk about the happy scenario. We're going public. Yay. We don't want to end on a depressing note. Of course. Exactly.

Starting point is 00:16:42 Here we go. This is what Silicon Valley does is create IPOs. So maybe talk a little bit about picking an investment bank. and what are some of the incentives they have and they bring to bear. And are they always aligned with my existing investors or can they be? Yeah. Yeah. So, yeah, the investment banks, you know, you've heard of these names, Goldman Sachs,

Starting point is 00:17:03 JP Morgan, Morgan Stanley. You know, their main job is to kind of, you know, help you prepare for the IPO and make sure all the documentation everything's ready. And then to basically kind of shepherd you through the process by introducing you to all the relevant institutional investors who will hopefully go on to kind of, you know, be the, you know, long-term shareholders for your business. And so, you know, they do that. They're professionals.

Starting point is 00:17:21 They do this all the time. So, you know, you certainly generally don't go through that process without it, without an investment banker. Where the conflicts potentially come up is, you know, they've got kind of two clients, right, which is you're their client for this transaction, but, you know, a firm like Fidelity or T. Row Price or BlackRock, who is a institutional investor who buys shares all the time in lots of IPOs and also trade shares through the deaths that the firms have. They're also a client of the bank, right?

Starting point is 00:17:48 And so there's this tension. You see this in the pricing for when IPOs are priced, where your incentive as the entrepreneur is I want the price to be as high as possible because that means I raise more money for less dilution, right? But I don't want to be too high where obviously the stock trades, you know, kind of poorly the next day. And, you know, the financial investor has the opposite incentive, of course, which is I'd like to buy it as cheap as possible so that I have the maximum amount of upside in the stock. And so this is where I think sometimes, you know, sometimes fairly and sometimes unfairly, I think the bankers, you know, are accused of potentially kind of favoring the institutional investors because they are the repeat

Starting point is 00:18:22 players for the business at the expense sometimes of the company. Having done this once, I was a banker earlier in my career and having seen the process, there's always some, I think, true to that, but I think more likely these are just more art than science, quite frankly, and it's really hard to know based on the demand signals that they get exactly where to price the stock. And so sometimes they get it right. Sometimes they don't. I think it's probably a little bit unfair to assume that there's all a kind of nefarious, you know, activity at work here. And what do I want to get out of my board in this situation? Are they basically sort of at this point not that important? Yeah, the board really starts to shift as you go public from being kind of,

Starting point is 00:19:00 you know, more active and probably more, you know, in some cases more valuable in the business, to more of, quite frankly, a governance and a legal board in that sense, right, which is making sure that the process is good, making sure that you're doing your audit committee and all the other things. So it's not that boards are irrelevant as a public company, but I would say that The nature of where boards spend their time starts to shift towards more compliance-related activities versus kind of, you know, potentially forward business-looking activities. Great. Fantastic.

Starting point is 00:19:25 Well, Scott, thank you for spending so much time demystifying this entire process. I appreciate it and I hope this is helpful and I hope people will find, you know, that they can go by the book and, you know, dig deeper into a lot of these topics. If there's one big takeaway from having written the book and then been on the circuit promoting it, like what's the big takeaway you would want entrepreneurs to take? Yeah, look, I think the biggest thing, and we hit on a lot of this is, you know, know, look, understand who your partner is, as I mentioned, you know, somewhat facetiously, but it's true, you know, these are marriages, right? You're going to be with these companies

Starting point is 00:19:52 for eight, 10, 12 years. And so, you know, I don't want to overstraining the analogy, but the concept of dating and understanding them really is relevant here, which is, you know, you wouldn't get married without really understanding your spouse and who they are and what makes them tick. And I think in many respects, that is the equivalent of the dating process in the venture capital game is know what their incentives are, know what they're interested in and, you know, make sure you're aligned. Great. All right, congratulations. You've made it to the very end of part three of our three parts series with Scott Cooper. Hopefully you've got a really good sense of what goes on inside our heads when you meet with us

Starting point is 00:20:25 because you understand what our incentives are, how we work, and how we're trying to help you build a big, great, durable software business. We hope that this encourages you to continue your entrepreneurial journey, that it demystifies part of the process. Look, we're in this together. Entrepreneurs and investors are here to change the whole. world together and yeah there's going to be tension on the line there's going to be times when we disagree but fundamentally we need to be about being side by side entrepreneur and investor because that's the way that we get to change the world so we encourage you on your entrepreneurial journey and if you've got a company that you're building that seems like a good fit for the

Starting point is 00:21:06 types of investments we make the house is open and we'd love to meet

The a16z Show - a16z Podcast: How To Get The Most From Your Board

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