Venture capital part three.
And we're covering a lot of venture capital topics because a lot of the topics within the venture capital
industry are relevant to starting a company starting a new division working at a large corporation raising
money.
Meaning potential investors creating disruptive ideas etc..
Okay great.
So let's move on.
So now we're in the third section here we talked about getting funded by Sequoia.
We're not quite yet we're still going to deal with them but we're also dealing with with Kleiner Perkins
in this round.
So we're now in years 3 to 4 on our journey in terms of what's next after this after this eventually
we'll we'll get ready to go public and then we'll work on maybe breaking up the company or filing for
Chapter 11 or selling the company.
I'm not going to ruin the surprise for you though.
But needless to say moving through this entire life cycle of a company covers all of the most important
topics that you can possibly cover in business education.
OK.
Let's move on.
Find your passion.
OK I want to repeat this over and over again.
If you get out of bed in the morning and you tell yourself you're going to work then you're doing it
wrong.
I want you to find out what you're most passionate about in life and go after your goals and we'll do
a goal setting workshop later on which will help you to kind of refine and crystallize what it is you
want to accomplish.
OK so we talked about the jockey being more important than the horse and thing in the right management
team is always incredibly important.
As such venture capital firms tend to always want to bet on the best athlete the best athlete.
And so we're going to go through a case study and we're going to deal with a baseball superstar.
I'm a huge baseball fan.
Bluejays is my team.
But we're going to talk about the best player in baseball right now which is a guy named Giancarlo Stanton
and Carlos Stanford tent sand plays for Miami and so he's the best athlete I thought would be fun to
talk about in these terms.
And Jock Harlow also hypothetically created a company called PIPA.
Right.
And Pay-Pal we all know what this brand is it's basically a way to pay for stuff online instead of just
using Visa Amex etc..
OK so John Karlo is the best athlete there is out there.
OK.
So what he did is he designed a proof of concept or a sample product for revolutionary new payment terminal
or what is referred to as POS which is a piece of I mean sorry it's proof of or point of sale product
point of sale.
OK so it's a payment terminal and there's the image right there is kind of like Square.
OK for this hypothetical example.
So he's got kind of a test version or proof of concept version of this terminal.
But he needs a million bucks to build a version of it not just an on just not just a prototype machine
a real version.
And so here comes the question Sequoyah is the best venture capital firm in the room and they want to
ask why.
Because they've been incredibly successful in the past backing the best athletes or the best entrepreneurs
and they think they're going to make a 50 percent return per year over five years.
OK.
So again venture capital firms always invest in the very best athlete.
John Carlos Dan is is the best athlete in this example.
So when John Karlo launched his payment company last year he had $10000 in equity capital of his or
his own money.
And he decided to launch the company then last year with two million shares.
OK.
Don't overthink this.
Just accept 2 million shares right.
He needs to negotiate with Sequoyah on how many shares they're going to get in his company in return
for money that they can use to fund this growth.
OK.
So Sequoyah and John Karlo agree that in five years his company is going to make a million bucks in
net income that's pretty good.
Five years now make a million bucks OK.
A competitor John Carlos just went public just in initial public offering today when the stock market
and its competitor did this at a valuation of $20 billion.
And this competitor had $2 billion in income.
That means the price earnings ratio is 20 million or valuation.
The price that I buy the earnings two million ten times ten times P E multiple cable big.
Was in public had a 10 times p.
So in five years Jhankaar the wants go public as well.
OK and so the valuation of his company in five years should be as follows.
If the competitor of of John Carlos firm is public and trades at 10 times earnings then his firm Sheetrit
ten times earnings in five years so in five years Charles firm is going to make a million bucks and
that means evaluation of 10 million bucks in five years in five years his company will be worth ten
million dollars.
So what is his firm worth today.
OK what is his sperm worth today.
So here's how he get there.
Sequoyah expects to make 50 per cent per year.
OK.
So we have to calculate what his company in five years is worth today.
So again in five years his company is worth 10 million bucks.
And Sequoia is only going to invest if they can make 50 percent return every year.
So here's the math.
So we discount that 10 million bucks to today.
And then we discount and we'll cover this during or after discount a cashable portion and the finance
and accounting section of this course and it won't be dull I promise you the way you discount something
is.
You divide it by 1 plus the interest rate or the expected return.
Right.
And if you do it over two years then you divide it.
You know the valuation of a company in two years divided by you know one plus the expected return the
power of two.
But in this case we're discounting that 10 million bucks the value of his company in five years to today
and we're doing yet at Sequoia is expected rate of return which is 50 percent.
And we're going to do it this kind of by five years means that.
If we were only discounting it by three years.
Maybe the power of three.
So we're into that and that equals a valuation today of 1.3 1 6 8 7 2.
OK so one billion three or sixteen thousand dollars and seventy two bucks.
And so that's how much the 10 million dollar company in five years is worth today.
The value today is that Sequoia owns a million bucks worth investing million bucks divided by 1.3 million.
So they are seventy six percent of the company.
So that means we own 24 percent.
OK.
Or Giancarlo owns 24 percent.
Right.
And he's got 2 million shares right.
So total shares is 2 million divided by his point two for which equals eight point three million shares.
This is just not right.
I mean Sequoia owns 6.3 lien shares so what is the share price.
Well it's like really bucks right.
Which is invested in the company divided by 6.3 million shares per Sequoyah.
They put in a million bucks and they own 6.3 million shares.
So the share price is fifteen point eight cents per share.
That's what the share price is right.
So how much has John Carloman while he wants 2 million shares times fifteen point eight cents per share.
Right.
Which is three hundred sixteen thousand dollars.
This is called the pre-money valuation of his company.
Right.
And then the total valuation of the company is a point three million shares.
You know his 2 million plus sequoias 6.3 times fifteen point eight cents which equals 1.3 million dollars.
If this is complicated stop this rewind it a little bit to so the post now.
The money valuation the value of the company after the money was given from this cap is 1.3 one million
dollars.
Kay pre-money valuation of the companies before we get money from venture capital for the value the
company afterwards is after a million bucks or the venture capital firm index pre and post by your.
So in five years you know his ownership is 24 percent ownership is when we were 2.4 million bucks not
bad.
It's pretty good.
Pretty good.
He'll be worth $2.4 billion in five years unless something goes wrong.
So we talked about valuation for Sequoyah as well and we know it's going to be 10 leaders to the whole
company.
That was awesome.
But what we just did was we didn't build the financial statement we are building committee.
We didn't build any financial stuff write any statements we just calculate which is pretty cool.
So Sequoyah just left lead what's called the a round or the first round.
Okay.
Sean Carlo just did an a round with Sequoyah.
Lucky him sequoias.
Awesome.
Oh shoot.
Breaking news.
So what happened was John Karlo got injured.
Right.
This is a bit of a setback.
He's going to be OK.
He got injured.
And so this is kind of an analogy for forecasts are often wrong.
We tend in business to overestimate what we can accomplish in a year.
But we always underestimate what we can accomplish in a decade in case something happened.
Carl got got her company got her.
OK.
So now we're we're in year three and we need more money.
Shoot we ran out of money fast and we thought we would.
All right.
So cash is king.
Cash rules.
Right.
So we did the a round with Sequoia in year one and in year five we're going to go public.
Right.
And then Kleiner is now the second venture capital firm and they're leading to be.
In the series B.
So we're in year three and we need another million bucks we still want to go public in your five had
evaluation of 10 million dollars but we see Bob and so here comes the dilution that basically means
you're going on unless the company or Jon Karl is going to test company Daimler's.
So Kleiner expects a 25 percent return for two years until the company goes public.
How do they cope with the math to value their stake in the company will score still expects that 50
percent return.
And unfortunately Kleiner Perkins which is a great firm and so Sequoia and what they're doing in this
hypothetical example.
It's not their fault it's the founders fault.
But Kleiner Perkins needs shares right and he's not giving them up.
Nor should they.
So Kleiner is expected return is a million bucks Betsie million bucks now a 25 percent return over two
years means that in two years there are a million dollar investment is one point five six to five billion
dollars.
So cloners ownership is one point five six million dollars to buy about ten bucks or fifteen point six
percent cash squeeze ownership remains at 76 percent member they won't get to so our ownership has not
Karlos ownership goes from 24 percent to 8 percent.
Kleiner took that stake.
Ok so now we only own upset the company.
Right.
But it's at a higher valuation.
Right.
But we'll see anyway.
But what will come later.
So how many shares do you own now or how he shares zonk Harlow now.
Right.
So in total there's 24 million shares.
So in the round we issued 24 million shares.
A coin.
They own 80 million shares to be around fifteen point six percent of the company was given the Kleiner.
That's three million shares for them.
And before we got diluted we own 24 percent in the a round after the B ran.
We now own 8.4 percent each.
We got to lose it big time it actually gets worse because we saw Karlov forgot about employee ownership
your stock options.
Remember you always want to incentivize employees right.
By giving them options.
Right.
And these options only are only vest or become valid or you're allowed to cash them in every four years.
Right.
So it's called first place as an employee.
OK.
So before we move on this analyze a pie chart.
This is pie Eden and this is pie.
I have not yet.
Not funny.
OK.
Sorry.
My kids said that would crash and burn.
Clearly it has.
All right let's move on.
So employees need chairs too.
OK so right now we had to give six percent shares away to employees.
Remember we own 8.4 percent the company.
Well now that we had to give six percent of shares away to employees because we forgot to include that
in our legal documents early on.
We only own 2.4 percent of the company now.
It's tragic tragic it's not quite as well.
It's not Clara's fault.
It's my fault.
I'm Sean Karlo.
I should have accounted for that.
I should have hired a lawyer to do all the legal paperwork early on to.
So why do we issue stock options.
Well it's cheaper than paying a salary because we don't have that much money.
Right.
So I had to give my employees part of the company and rates everybody worked hard as a team and it's
basically a golden handcuffs.
And there's something called vesting which means you can't you can't benefit from ownership in stock
options until you've held them for four years.
OK.
So if you work for me you're an engineer and I give you stock options.
You're not allowed to cash in those stock options or use them for four years and I give you options
every year.
So it's like a waterfall that you'll get to.
You'll get to sell them and make money every four years.
And that basically is gold handcuffs.
It keeps you with me the best best.
Every four years.
OK.
So now we only 2.4 percent the company.
How many shares are there.
And we just take two million dollars or two million shares divided by parks and ownership it's a 2 million
shares.
And the options are that many shares.
Five million shares.
So we got to live by 90 percent.
So outside or venture capital investors are protected I guess solution.
OK.
Why.
Because they own preferred shares preferred.
We a comment.
Chuck Harlow gets calm.
OK.
So you need lawyers you need lawyers and founders of companies really need to understand dilution before
dealing with venture capital firms which is why you need to hire a lawyer.
When you started coming.
It's not all that bad though because founders of companies get massive option grants anyway.
And every year Larry Ellison would get a lot of options every year.
He's the founder of Oracle and you can pay yourself incredibly well through stock options over the years.
So Giancarlo no longer injured.
He hit the ball out of the park.
Especially if his IPO was it was a huge success.
OK.
You get it so he can actually hypothetically speaking be worth a heck of a lot more if his company goes
up materially after after the IPO.
It works out well.
But you do get to.
Just keep in mind if you deal with a venture capital firm or equity investors as opposed to banks you're
going to give up ownership in your company.
Right.
But hopefully your is worth a lot more money over time.
So it becomes a moot point.
But don't don't do debt if you're an early stage company.
Because if you have one little hiccup like we just did here with Shawn Karlo you're done you're done.
I don't care if you miss one payment they'll they'll screw you.
They'll take everything.
OK.
But it's OK because you're protected and so's your family because you have an LLC or limited liability
corporation structure.
So why be it.
Why do a big round the over your track in 10 million bucks indebting can buy your five and seven million
bucks.
And we want to accelerate growth just grow a lot lot faster than we can raise a certain amount of money
at a much higher valuation in the series B.
Right.
And we can grow instead of just domestically we can get enough money to grow overseas.
That's called leverage.
So let's talk about a little bit more VC terminology.
We talked about about unicorns in lag.
The probability is is is less than point zero seven percent of having a unicorn or a billion dollar
plus value company.
I want to talk about black holes or walking dead.
OK.
So a lot of deals end up just breaking even or a black hole.
You just gotta know when to fold.
You know if if you worked couple of years in your venture it's not going anywhere.
That's cool.
And just just shut it down and move on.
You know a lot of most successful entrepreneurs in the world have failed many many times before they
succeeded.
Michael Jordan once had this great quote.
He's the best baseball player of history course history said that I feel I've failed many many times
in life and that is why I succeed.
So venture is very hard in order to return the capital on a 400 million dollar fund.
You have to have 20 percent of your funds or to unicorn's and your fund.
It's really really tough especially when you get bigger funds bigger funds it's harder to make a lot
of money on it because there are fewer investment opportunities because you have to invest big amounts
in companies like a Hoover or B A B whatever it might be.
Okay great.
So we talked about unicorns.
It takes about seven years on average from founding to IPO in San Francisco.
Now actually interestingly enough and not the Valley not the area south of San Francisco is the new
home of unicorn's and the average founder age is 34 a lot of young people here.
And in terms of number founders per company it is usually a couple.
There aren't that many companies with just one founder anymore.
Right.
And we talk about the odds of of of creating a billion plus company.
It's tough.
So OK so San Francisco is now the hub of all the cool companies.
OK so the valley which is on that graphic south of that little green square airport logo.
The valley is where all the old school companies are right by Stanford.
Ebay Google old school and Yahoo Oracle and all the cool new companies are up in San Francisco.
They're like Airbnb or Uber or sales force app direct you to me of course which is an awesome company
by way squares.
How do you get it.
So the new disruptive tech companies are up in the city.
San Francisco is seeing it the Renaissance and the old boring tech companies are down in the valley.
And so sales force dot com mark ups
sales force dot com.
Marc Benioff s company is building the largest office tower in the history of San Francisco.
It'll be up and ready within a couple of years and just the landscape in San Francisco is changing materially
most people want to be in the city now and no longer valid.
OK.
140 character class recap.
We discussed the first round the rounds we talked about valuation and dilution.
I know it seems a little bit complicated Don't worry about that.
Rhyd do an easier example later.
We talked about about the B routes.
We talked about option pools but the importance of contracts legal contracts and we talked about unicorn's
again very quickly.
And then just just other VC terminology.