‫Venture capital, part 3.
‫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,
‫meeting potential investors,
‫creating disruptive ideas, et cetera.
‫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 done with Sequoia yet,
‫we're still gonna deal with them,
‫but we're also dealing 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 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 gonna 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.
‫Okay, so let's move on.
‫Find your passion.
‫I'm gonna 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 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.
‫Okay so we talked about the jockey
‫being more important than the horse,
‫investing in the right management team is always
‫incredibly important.
‫As such, venture capital firms
‫tend to always want to bet
‫on the best athlete, okay?
‫The best athlete.
‫And so, we're gonna go through a case study.
‫And we're gonna deal with a baseball superstar,
‫I'm a huge baseball fan,
‫the Toronto Blue Jays is my team.
‫But we're gonna talk about the best player in baseball
‫right now, which is a guy named Giancarlo Stanton.
‫And Giancarlo Stanton plays for Miami.
‫And so he's the best athlete, I thought it'd be fun
‫to talk about it in these terms.
‫And Giancarlo also, hypothetically,
‫created a company called PayPal, right?
‫And PayPal, we all know what this brand is,
‫it's basically a way to pay for stuff online
‫instead of just using VISA, AMEX,
‫et cetera.
‫Okay, so, Giancarlo is the best athlete
‫there is out there, okay?
‫So what he did is he designed
‫a proof of concept,
‫or a sample product for a revolutionary new
‫payment terminal,
‫or what is referred to as a POS,
‫which is a piece of, I mean, sorry,
‫it's a proof of,
‫or point of sale product, point of sale product.
‫Okay so it's a payment terminal.
‫And there's the image of it right there,
‫it's kind of like Square, okay,
‫for this hypothetical example.
‫So he's got kind of a test version,
‫or a proof of concept version of this terminal.
‫Okay?
‫But he needs a million bucks to build a real version of it,
‫not just a prototype version,
‫a real version.
‫And so, here comes Sequoia.
‫And Sequoia is the best hedge capital firm in the world.
‫And they wanna back him.
‫Why?
‫Because,
‫they've been incredibly successful in the past
‫backing the best athletes or the best entrepreneurs.
‫And they think they're gonna make a 50% return
‫per year over five years.
‫So again, venture capital firms always invest
‫in the very best athlete,
‫Giancarlo Stanton is the best athlete in this example.
‫So when Giancarlo launched his payment company,
‫last year he had $10,000 in equity capital,
‫or of his own money, okay?
‫And he decided to launch the company then
‫last year with 2 million shares, okay?
‫Don't over think this, just accept,
‫2 million shares, right?
‫He needs to negotiate with Sequoia
‫on how many shares they are going to get in his company
‫in return for money that he can use to fund his growth.
‫So Sequoia and Giancarlo agree that
‫in 5 years his company is gonna make a million bucks
‫in net income, that's pretty good,
‫five years from now, he'll make a million bucks.
‫Okay, a competitor of Giancarlo's
‫just went public, just an initial public offering, okay?
‫And this competitor did this at a valuation
‫of 20 million dollars,
‫and this competitor had 2 million dollars in income.
‫That means the price range ratio
‫is 20 million valuation, the price,
‫divided by the earnings, 2 million,
‫10 times.
‫A 10 times p/e multiple,
‫a big competitor of Giancarlo's went public,
‫had a 10 times P multiple.
‫So in five years,
‫Giancarlo wants to go public as well, okay?
‫And so the valuation of his company in five years
‫should be as follows.
‫If the competitor of Giancarlo's firm is public,
‫and trades at 10 times earnings,
‫then his firm should trade
‫at 10 times earnings in five years.
‫So in five years,
‫Giancarlo's firm is gonna make a million bucks.
‫And that means a valuation
‫of 10 million bucks in five years.
‫In five years, his company will be worth 10 million dollars.
‫So what is his firm worth today?
‫Okay, what is his firm worth today?
‫So here's how we get there.
‫Sequoia expects to make 50% per year, okay?
‫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 gonna invest
‫if they can make 50% return every year, okay?
‫So, here's the math.
‫So we discount that 10 million bucks to today.
‫And the way you discount,
‫and we'll cover this during our DCF
‫or discounted cash flow portion,
‫in 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 one 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 the company in two years,
‫divided by, you know, one plus the expected return
‫to 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 it at Sequoia's expected rate of return,
‫which is 50%, okay?
‫And we're gonna do it discounted by five years,
‫meaning it's the power of 5.
‫If we were only discounting it by three years,
‫it'd be the power of three.
‫So we're gonna do that.
‫And that equals a valuation today
‫of 1.316872, okay?
‫So $1,316,872.
‫And so, that's how much the 10 million dollar company
‫in five years is worth today, okay?
‫So the value today is that
‫Sequoia owns a million bucks worth,
‫remember they're investing a million bucks?
‫Divided by 1.32 million,
‫so they own 76% of the company.
‫So that means we own
‫24%, okay?
‫Or Giancarlo owns 24%.
‫And he's got 2 million shares, right?
‫So total shares is 2 million divided his .24,
‫which equals 8.3 million shares,
‫it's just math.
‫That means Sequoia owns 6.3 million shares.
‫So what is a share price?
‫Well you take a million bucks, right?
‫Which is invested in the company divided by
‫6.3 million shares for Sequoia,
‫they put in a million bucks,
‫and they own 6.3 million shares.
‫So the share price is 15.8 cents per share.
‫That's what the share price is.
‫Right?
‫So how much does Giancarlo own?
‫Well he owns 2 million shares times 15.8 cents per share.
‫Right, which is $316,000 dollars.
‫This is called the pre money valuation
‫of his company, right?
‫And then the total valuation of the company
‫is 8.3 million shares.
‫You know, his 2 million plus Sequoia's 6.3,
‫time 15.8 cents, which equals 1.31 million dollars.
‫If this is complicated, stop this, rewind a little bit,
‫okay?
‫So the post money valuation,
‫the value of the company after the money was given
‫from Sequoia is 1.31 million dollars.
‫Okay?
‫Pre money valuation of the company before,
‫we get money from the venture capital firm,
‫divided the company afterwards
‫is after the million bucks,
‫or the venture capital firm invests.
‫Pre and post valuation.
‫So, in five years,
‫you know, his ownership,
‫his 24% ownership is gonna be worth 2.4 million bucks,
‫not bad, eh?
‫It's pretty good, pretty good.
‫He'll be worth 2.4 million dollars in five years,
‫unless something goes wrong.
‫So, we talked about valuation for Sequoia as well,
‫and we know it's gonna be at 10 million dollars
‫the value of the whole company in five years.
‫What was awesome about what we just did,
‫was we didn't build a financial statement.
‫We didn't build an income statement.
‫We didn't build any financial stuff, right?
‫Any statements, we just calculated it.
‫Which is pretty cool.
‫So Sequoia just led what's called
‫the A round, or the first round, okay?
‫Giancarlo just did an A round with Sequoia,
‫lucky him, Sequoia's awesome.
‫Uh oh, oh shoot.
‫Breaking news.
‫(laughing)
‫So, what happened was
‫Giancarlo got injured, right?
‫This is a bit of a setback,
‫he's gonna be okay, 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.
‫Okay, so something happened,
‫Giancarlo got hurt, his company got hurt.
‫Okay?
‫So now we're in year three and we need more money.
‫Shoot, we ran out of money faster than we thought we would.
‫Alright, so.
‫Cash is king, okay?
‫Cash rules, right?
‫So, we did the A round with Sequoia in year one, okay?
‫And in year five we wanna go public, right?
‫And then Kleiner is now,
‫the second venture capital firm,
‫and they're leading the B round, okay?
‫And they're gonna lead the series B.
‫So, we're in year three,
‫and we need another million bucks, yeesh.
‫We still wanna go public in year five
‫at a valuation of 10 million dollars,
‫but we hit a speed bump.
‫And so, here comes the dillution,
‫that basically means you're gonna less the company.
‫Or Giancarlo is gonna less the company.
‫Damn lawyers.
‫So Kleiner expects a 25% return for 2 years
‫until the company goes public.
‫How did they come up with the map?
‫To value their stake in the company?
‫Well Sequoia still expects a 50% annual return,
‫and unfortunately,
‫Kleiner Perkins,
‫which is a great firm and so is Sequoia,
‫and what they're doing in this hypothetical example
‫it's not their fault, it's the banner's fault.
‫But Kleiner Perkins needs shares, right?
‫And Sequoia's not giving them up.
‫Nor should they.
‫So Kleiner's expected return
‫is a million bucks,
‫investing a million bucks now
‫at 25% return over 2 years,
‫means that in 2 years,
‫their million dollar investment
‫is 1.85625 million dollars, okay?
‫So Kleiner's ownership
‫is 1.56 million dollars divided by 10 million bucks
‫or 15.6%, okay?
‫Sequoia's ownership remains at 76%.
‫Remember, they don't get dilluted.
‫So our ownership, or Giancarlo's ownership
‫goes from 24%,
‫to 8%.
‫Kleiner took that stake.
‫So now we only own 8% of the company, right?
‫But, it's at a higher valuation, right?
‫But we'll see anyway,
‫we'll cover that later.
‫So how many shares do you own now,
‫or how many shares does Giancarlo own now?
‫Right?
‫So, in total there's 24 million shares,
‫so in the A round we issued 24 million shares
‫to Sequoia, they own 18 million shares.
‫And the B round, 15% of the company
‫was given to Kleiner,
‫that's 3.7 million shares for them,
‫and before we got to the diluted,
‫we owned 24% in the A round,
‫after the B round we now own 8.4%.
‫Yeesh, we got diluted big time.
‫It actually gets worse because,
‫we as Giancarlo forgot about employee ownership
‫via stock options, remember,
‫you always want to incentivize employees, right?
‫By giving them options, right?
‫And these options only
‫vest or become valid
‫or you're allowed to cash them in every four years.
‫So it's the golden handcuffs keeping you in place
‫as an employee.
‫So, before we move on,
‫let's analyze a pie chart.
‫This is pie I've eaten,
‫and this is pie I've not yet eaten.
‫Not funny?
‫Okay, sorry,
‫my kids said that would crash and burn,
‫clearly it has.
‫Alright let's move on.
‫So, employees need shares too.
‫So, right now,
‫we had to give 6% of shares away to employees,
‫and remember we owned 8.4% of the company?
‫Well now that we have to give 6% of shares
‫away to employees because we forgot to include
‫that in our legal documents early on,
‫we only own 2.4% of the company now,
‫that's tragic, tragic.
‫It's not Sequoia's fault.
‫It's not Kleiner's fault.
‫It's my fault, I'm Giancarlo.
‫I should have accounted for that,
‫I should have hired a lawyer to do all the legal paperwork
‫early on.
‫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'm gonna give my employees part of the company.
‫It motivates everybody to work hard as a team,
‫and it's basically golden handcuffs.
‫And there's something called vesting,
‫which means,
‫you can't benefit from ownership
‫in stock options until you've held them
‫for four years, okay?
‫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 effect.
‫You'll get to sell and make money every four years.
‫And that basically is golden handcuffs.
‫It keeps you with me.
‫They vest.
‫Vest every four years.
‫Okay, so, now,
‫we only own 2.4% of the company,
‫how many shares are there?
‫And we just take 2 million dollars,
‫or 2 million shares divided by our percent ownership,
‫that 82 million shares, okay?
‫And the options are that many shares,
‫5 million shares, so,
‫we got diluted by 90%, yeesh.
‫So,
‫outside venture capital investors
‫are protected against dilution.
‫Why?
‫Because they own preferred shares, they're preferred.
‫We get common.
‫Giancarlo gets common.
‫Okay?
‫And 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 start a company.
‫It's not all that bad though,
‫because founders of companies
‫get massive option grants anyway,
‫and,
‫every year, like 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 a huge success.
‫Okay, you got it.
‫So, he could actually, hypothetically speaking,
‫be worth a heck of a lot more,
‫if the value of his company goes up
‫materially after the IPO.
‫It works out well.
‫But you do get diluted, just keep in mind,
‫if you deal with a venture capital firm,
‫or equity investors as opposed to banks,
‫you're gonna give up ownership of your company.
‫But hopefully your company's 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 Giancarlo,
‫you're done, you're done,
‫banks don't care.
‫If you miss one payment,
‫they'll screw you, they'll take everything.
‫But it's okay, because you're protected,
‫and so is your family,
‫because you have an LLC,
‫or a limited liability corporation structure set up.
‫So why do a B round?
‫You know, if we were tracking the 10 million bucks
‫in net income by year 5,
‫instead of a million bucks,
‫and we wanted to accelerate growth,
‫just grow a lot, lot faster,
‫then 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, okay?
‫So let's talk about,
‫a little more vc terminology,
‫we talked about unicorns in length,
‫the probability
‫is less than 0.07% of having a unicorn
‫or a billion dollar plus valuation company.
‫I wanna talk about black holes
‫or walking dead, okay?
‫So, a lot of deals end up just breaking even,
‫or a black hole.
‫So you just gotta know when to fold, you know?
‫If you worked a couple years,
‫and your venture is not going anywhere,
‫that's cool man, just shut it down and move on.
‫You know?
‫A lot of the 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 basketball player of history, of course,
‫in history, he said that,
‫"I failed many, many times in life,
‫"and that is why I succeeded."
‫So venture is very hard,
‫in order to return the capital
‫on a 400 million dollar fund,
‫you have to have 20% of your funds
‫or two unicorns in 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.
‫Because there are fewer investment opportunities,
‫because you have to invest big amounts
‫in companies like, I don't know, Uber,
‫or Air bnb, whatever it might be.
‫Okay, great, so.
‫We talked about unicorns,
‫it takes about seven years on average
‫from founding to IPO,
‫and San Francisco now, actually, interestingly enough,
‫and not the valley, meaning not the area
‫south of San Francisco,
‫is the new home of the unicorns.
‫And the average founder age is 34,
‫a lot of young people here.
‫And in terms of the number of founders per company,
‫there's usually a couple,
‫there aren't that many companies with
‫just one founder anymore, right?
‫We talked about the odds of
‫creating a billion dollar plus company,
‫it's tough, it's tough.
‫So, okay so, San Francisco
‫is now the home of all the cool companies,
‫okay?
‫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, I know.
‫Yahoo!, Oracle, EA.
‫And all the cool new companies
‫are up in San Francisco there,
‫like Airbnb, or Uber,
‫or Salesforce.
‫AppDirect, Udemy of course,
‫which is an awesome company by the way.
‫Square, Zynga,
‫yadda, yadda, you get it.
‫So, the new disruptive tech companies
‫are up in the city, San Francisco is seeing
‫a big renaissance.
‫And the old boring tech companies
‫are down in the valley.
‫Salesforce.com,
‫Mark Benioff's company,
‫is building the largest office tower
‫in the history of San Francisco.
‫It'll be up and ready within a couple years.
‫And just the landscape in San Francisco
‫has changed materially,
‫most people want to be in the city now,
‫and no longer in the valley.
‫Okay,
‫140 character class recap.
‫We discussed the first round, the A round,
‫we talked about valuation and dilution.
‫I know it seems a little bit complicated,
‫don't worry about that, okay?
‫We're gonna do an easier example later.
‫We talked about the B rounds.
‫We talked about option pools,
‫the importance of contracts, legal contracts.
‫We talked about unicorns again
‫very quickly,
‫and then just other VC terminology.