Naval Ravikant (@naval) is the Chairman and a cofounder of AngelList. He previously cofounded Epinions (which went public as part of Shopping.com) and Vast.com. He is an active angel investor, and has invested in dozens of companies, including Twitter, Uber, Yammer, Stack Overflow and others.
As one of Silicon Valley’s most respected angel investors and entrepreneurs, a veteran of some of the Valley’s biggest startup success stories, and an investor in many others, Naval has a uniquely broad perspective on startups.
In this second part of our interview, Naval and I spoke about late stage funding.
Elad Gil:There is a lot published (including on venturehacks.com) about early stage funding, but very little about later stage rounds. What are some of the key hacks for a late stage funding round?
First I don’t think all companies need large rounds anymore. The internet makes it possible for many kinds of companies to be built a lot more cheaply. Obviously that’s not true when you’re doing hardware or when you have local expansion issues. But overall, I think you can build companies a lot more cheaply than people used to.
But if you’re going to raise a late-stage round, what are the hacks? Frankly, late-stage rounds used to be done by venture capitalists. And now they’re done more and more by mutual funds, by other companies in the space, strategic players, even family offices often want to go direct. In those kinds of situations, I think companies can create custom bundles where they can keep control and can even sell common stock—which is the ultimate hack. They can make sure they don’t give up board seats, they don’t give up vetoes on M&A and option pool issuances and future fundraising. (On non-arm’slength transactions, or insider self-dealing, though, you always do want investors to have the veto.)
We used to have a saying at Venture Hacks: “Valuation is temporary. Control is forever.” Whoever has control can effectively end up controlling your valuation later. Never give up control. And control is given up in subtle ways: A lot of term sheets will have so-called protective provisions that originally existed to protect the preferred shareholders, because they were minority shareholders. But effectively they give those shareholders control over the company. So, for example, if your preferred investor has the right to veto future fundraising, they effectively have a lock on your company. If you ever need more money, you have to get them to agree, which means they run the place. Same for expanding your option pool and issuing more shares to new employees, or to keep existing people. Same with M&A. That’s probably the big one, where the biggest fights happen. Sometimes the founders want to sell or don’t want to sell the company, and then the preferred shareholders try to control them for an opposite outcome.
“Valuation is temporary. Control is forever.”
– Naval Ravikant
So, in my ideal world, if I had a hot, late-stage, high-growth company, I would essentially sell common stock.
Elad: What would be the argument? A lot of times the investors are saying, “I really need the preference in order to protect my investment on the downside scenario.”
Naval: The preference is there for a very specific reason: Imagine that my company was raising at a pre-money valuation of $9 million. And then you came in and you invested $1 million in the company, so the post-money valuation is $10 million. And now you own 10% of the company. Suppose I try to take the million dollars and say, “Hey, we’re just going to divvy up the million dollars to all the shareholders.” Well, if you didn’t have a preference, I would get $900,000, and you would get $100,000 back. Not what you expected.
Elad: I see, so it’s really to protect in a distribution, versus to protect against some future downside.
Naval: Correct. That was the original theory behind liquidation preference. But as it’s gotten stacked on later and later, it’s become this giant freebie. And the easiest way to see that it doesn’t make sense for later-stage rounds is by seeing that it doesn’t exist in the public markets. The public markets are all common stock. Why? For exactly that reason—it doesn’t make sense anymore. If I have a $900 million company, and you come in and invest $100 million, well, presumably a $900 million company is really a $900 million company. I’m not going to turn around, shut the company down, and distribute the $100 million, because I’d be throwing away $900 million of real value.
The preference is really, really important at the early stages. You’d be a fool to do a seed round buying common stock. But it makes no sense at the later stages. And at the public stages, it’s gone.
If I had a high-growth, high-performance company with multiple bidders— and obviously these kinds of negotiations are only possible when there are multiple bidders—I would be selling common stock. Or, if that opportunity wasn’t available to me, I would be selling common plus liquidation preference. That’s it. I would be leaving out all the other junk.
Elad: I see. So they still get the liquidation preference, but they don’t get the protective provisions, they don’t get all the control provisions.
Naval: Right, that’s all left with the earlier rounds. Then the next hack you can do—suppose you can’t even get that—is to give them the protective provisions, but only for non-arm’s-length transactions. That means transactions that are not happening at a distance with other people. So if I’m issuing myself more stock, sure, I need your approval. If I’m issuing stock to a friend of mine or if I’m selling the company to my brother, then I need your approval. But if it’s an arm’s-length, bona fide transaction, I do not need your approval.
The next hack down from there is, okay, I need your approval, you have the veto, but the veto belongs to the preferred class as a whole. It doesn’t belong to each series individually. Because that way, if I can get the other investors to go along, then you have to go along. Presumably my earlier-stage investors are people that I trust more. I’ve worked with them longer, they’re friendlier, I chose them more carefully. They’re more understanding of how startups work. Whereas my later-stage investors are more likely to be people who just showed up yesterday into the business. So that’s the series of strategies that you would fall back on.
Another thing that entrepreneurs obviously do is create founder shares, which have extra voting power. That works up to a point. There are rights that preferred shareholders have that you can’t take away from them legally, no matter what contract they sign, under Delaware law and California law. So you always have to be aware of that.
Elad: What are some examples of that?
Naval: I believe that under California law, for example—this was true in 2003 when it was relevant for me—every series has to separately approve an M&A, even if it says that preferred as a class can do it. That’s one example. Another one is inspection rights. So when you have a shareholder on the books and you’re a Delaware company, they can demand your financials. Even a small shareholder can, which a lot of people don’t realize.
Elad: How do you think about the secondary component of late-stage rounds? When should founders do it, should they not do it, how should they think about it, how should they think about other early investors relative to secondary? At what stage does it become okay?
Naval: It’s becoming more and more common. As the markets become more liquid, the industry becomes more hit-driven. So the odds of your thing working out all the way get lower. The incentives of founders and investors are starting to diverge more and more. You can have a $100 million exit as a founder and you’re really happy, but your investors may not be, because their funds are getting larger and larger. The incentives are diverging more and more, so it makes more sense to do early founder liquidity.
Maybe in 1999, if you started a venture-backed business, your odds of success were 1 in 10. Today they might be 1 in 50.
Elad: Just because there are that many more companies?
Naval: There’s a lot more companies. We’re going after hugely winner-take-all markets. The new entrants keep coming up, the platforms keep shifting faster and faster, the half-life of the winners is shorter. It’s becoming a much more competitive atmosphere.
A friend of mine described incubator graduates as the locust swarm of startups. And you just don’t know—with every graduating class, here’s another hundred locusts. And who knows which one is coming after you and what tack they’re taking? So every business is constantly under more and more sustained assault.
As a founder, you get a couple of shots on goal in your life. And you might even only have one for that thing you’re really super passionate about. I think good VCs now realize that if they’re going to ask you to go for the billion-dollar exit, then they have to be willing to let you take some off the table along the way. So I think the secondary component is becoming more and more common, and it will become more and more liquid. Secondary markets are here to stay.
Elad: Is there a specific valuation before which you don’t think a founder should ask for liquidity? Or alternatively, is a founder unwise for not diversifying before a certain point?
Naval: The situation you don’t want to be in is one in which you took substantial liquidity but your investors lost all their money. Once you’re convinced— almost beyond a shadow of a doubt—that the value of your company is greater than the stack liquidation preferences of your company, then I think it’s legit to start asking for a secondary. You want to know that you’re generating enough revenue or cash flow, or that you’ve built something that’s getting acquisition offers at a price that exceeds the liquidation preference value of your company and will make the investors some money (and they want you to keep going).
The most common way the secondary conversation starts internally is with an acquisition offer. The investors want you to turn down that acquisition offer, and you probably want to also—but you’re tempted. And a smart investor at that point will say, well, let’s let you take something off the table.
That’s why secondaries probably shouldn’t happen for seed and A and B companies. But generally it’s C and up now where you’re starting to see it quite commonly. Even in B-round cases, you’ll see it if the company’s made substantial progress.
Related to that, I think the single most important elephant in the room is that companies don’t need that much money anymore. It’s become a lot cheaper to build a company. All your software is open source. All your hardware is sitting at Amazon, in Amazon Web Services. All your marketing’s done on Google, Twitter, Facebook, Snapchat, App Store, contact lists. Even the people that you need—you need mostly engineers, and even half of them are outsourced. A lot of your customer service is happening through the community.
So, companies just don’t need that much money. Slack is a great example right now. Slack is raising money, but I don’t even know what they’re doing with it—probably secondary. Stewart famously said in the last round that he had, what did he say? Fifty or something?
Elad: Fifty or a hundred years.
Naval: Yeah, fifty or a hundred years of money, and he’s still raising more. Why? Because these funds have a lot of money and they can just put it in. You can raise it for acquisitions, which might be a good reason, and you can raise it for founder liquidity. But these are not the classic reasons.
Our heroes today as entrepreneurs should be [Bitcoin creator] Satoshi Nakamoto, who built a multibillion-dollar enterprise single-handedly, or just two people, whoever he or they are, anonymously. Or WhatsApp, 50 or so people, bought for $19 billion. YouTube, when it was bought, was probably under 60 people. And most of those people were working in datacenters and doing servers. In an AWS world, I’m not even sure they would have needed that many people. Instagram, when it was bought, was just a few people. So it’s possible to build something of huge value today with very few people.
Elad: I think the commonalities of all the things that you mentioned, except for Bitcoin, is that those were large, network-based consumer applications. But in general, when you’re thinking about an enterprise company—and there are some counterexamples, like Atlassian—people still believe that you should build a sales force, they still believe that you need some scale in other areas beyond the engineering side.
Naval: Although I think that Slack doesn’t really have much of a sales force.
Elad: Yeah, that’s fair. And that feels very much like a consumer model.
Naval: Exactly. Even the enterprise companies are starting to head that way. So yes, a company like a Slack or an Uber is going to need a lot more resources. But it’s still going to need less resources than the five-year-older version of it would have. And that’s less than the ten-year-older version would have. So the trend line is very, very clear.
Elad: Do you think people are raising too much money? And if so, why?
Naval: I think they’re raising money because money is cheap and available. The Federal Reserve and central banks of the world are printing money like crazy to fight deflation. Money is just cheap. Money is available. So why not? It’s insurance. It’s a scorecard. It’s a tool that you can use for acquisitions. You can hire a few more people. It’s brutally competitive to hire people, so you can pay them better—Google and Facebook are paying through the nose.
But the downside, the subtle difficulty of raising money, is that when you raise more money you do spend more money. There’s just no way around that, no matter how disciplined you are.
And what’s worse is you move slower. You get less stuff done. The meetings are bigger, the groups of stakeholders that have to be coordinated are larger. You’re less focused as a company; you take on too many projects because you have all these resources.
So it’s just human nature that when you have money you will spend it, and not always for the better. I think it takes your eye off the ball. In that sense, it is true that companies that are at least somewhat cash-constrained do better.
Pierre Omidyar is a famous example—this is back in the old days, from eBay. He had a lot of competitors, and he actually credited his success to being the only one who didn’t have much outside financing for a long time. So when people were trading on his site, doing auctions, he came up with a rating system, which was very novel at the time. It seems obvious in hindsight, but his was one of the first sites to have automated ratings. Everybody else wanted to have a better customer experience, so they had individuals getting in the middle of every transaction. Which meant that as the whole thing spiked, he scaled much, much, faster than them and ran away with the market. By not having the headcount, he was forced to build scalable processes from day one.
Elad: There are all these different types of new investors who have come into the market or whose presence has grown: family offices, hedge funds, private equity firms, foreign funds, either sovereign funds or alternatively pools of capital that are raised externally. How should people think about those new sources of capital, and what do you think are the trade-offs?
Naval: I actually think it’s a positive development for entrepreneurs. I know VCs like to bash on them as dumb money. But you have to keep in mind that that’s like your local laundromat owner getting angry that a new laundromat opened up down the street. They don’t like competition. So you always have to filter venture advice through venture incentives.
As far as an entrepreneur’s concerned, more people vying to give them capital is good. More competition for something that they have to buy that’s normally expensive and painful is good.
Fundamentally, venture capital is a bundle—it’s a bundle of advice, control, and money. The more options you have, the more you can unbundle those three things, and get the advice from the people you want and the money from the cheapest source of money, and leave the control behind. So I think it’s good.
Now that said, a lot of these people who are newcomers—what are the downsides? The downsides are that these new types of investors are hot money, so they might not support you in a future round. They may not be smart money. What that means is not that they’re not going to add value, because almost nobody adds value as an investor in a later-stage company. It’s just that they might screw you up in a future round by not doing their pro-rata, by trying to veto something they shouldn’t. The way you solve that is by not giving them control in the first place, and not expecting more money out of them in the future.
And then finally, money has karma too. You cannot take someone’s money without having a moral, ethical obligation to them. You can’t do it without committing your time. And you don’t want to get sued by them, because that makes you untouchable later on. So you do want to make sure that you have a good relationship with the people you’re getting the money from.
“You cannot take someone’s money without having a moral, ethical obligation to them. ”
– Naval Ravikant
Especially with a lot of these later-stage players, they tend to swap people out a lot more. Venture capitalists are very stable—they raise money in ten-year partnerships, they own and run their partnerships. It’s very unlikely that your venture investor is going to get switched out on you, and if they do it will probably be with somebody else who’s an experienced venture investor. But if you take money from a corporate investor and whoever is the head of corporate development gets sacked the next day, the company’s CEO’s brother comes in and might be a nightmare.
If you give them a board seat or there’s a relationship person, you do want to have some control over who that person is. But I think more options are good, more choices are good.
Elad: Yeah, I’ve seen good and bad situations—and this is from either my own company or companies I’m involved with. The bad has been that some of those sources of capital are a little bit jumpier. Some are not. Some are very stable and smart. But every once in a while you’ll have the random billionaire who’s never invested in tech and then freaks out. Or I should say their office freaks out, because the people who manage their money may or may not be savvy about tech.
The positive for my startup has been working with people who come from finance backgrounds or from the New York network. And they’ve been amazingly helpful in a variety of ways. They’re very good strategic thinkers; they’re at the top of their game. But they also just have a different network from the traditional Silicon Valley group.
Naval: Yeah, it used to be that you would go to a VC for their network. But most entrepreneurs these days are much better networked than they used to be, thanks to accelerators, thanks to blogs, thanks to just being savvier about it. Different investors can be good for bringing out-of-market networks.
But exactly as you said, you want to interview your investors. And you really want to look for the subtle signals—I think people’s true motivations and behavior are revealed, not said. If somebody spends ten minutes telling you how honest they are, I can guarantee you that’s a dishonest person.
You should reference-check the hell out of them, you spend time with them, and you see how they treat you during the negotiation process. If they’re relatively easy during the term sheet negotiation process, if they’re quick to respond, if they’re no hassle, if they say smart things, they’re probably going to be good people to work with. If they give you an exploding term sheet, if they’re difficult to work with, if they’re inflexible, intransigent, they’re going to be ten times worse once the money is in.
By the way, that’s true of VCs too. You can learn everything you need to know about a VC during the term sheet process before the close. And don’t be afraid to call off the close if you’re getting negative signals. I’ve done it and I’ve never regretted it. The moment you know that you’re working with someone that you would not work with for the rest of your life, stop working with them right there. Save your time. Because you get married to investors, with almost no possibility of divorce. And your dating period with them ranges from a week to a year. A year if you’re really lucky, but it’s usually just a few weeks. So you really have to look for the subtle signals.
This is actually where your early-stage investors can be super helpful, because they’ve seen it all. So you can use the nose that your early-stage investors have developed to help pick out later-stage investors. You do have to be a little careful, because early-stage investors can be brand obsessed— either they want to get a big markup, or they want to get a markup from Sequoia, so they’ll say or do whatever just to ingratiate themselves. But you will have somebody within your circle who has a good nose, has a high bar, and speaks truth. You’ll know it from the way they say it; they’ll say the unpopular thing. Get that person to make an assessment for you.
Elad: I want to get back to your earlier point, about how companies today don’t need to be as large as they used to. How do you know when to stop hiring? Because there’s always that impulse, if you have the capital and you want to keep going.
Naval: The nature of human beings is that you come into a company, you work like a dog, you work really hard, and then you get tired and hire someone to do your job. And it always takes two new hires to do your job. Just repeat that ad nauseam, and you end up with five thousand people sitting around at a web app company. And everyone from the outside is like, “What are all these people doing?” That’s a simple web app. Why do you need thousands of people to do it?
Then, sure enough, the new CEO comes in and knows that they have to fire half these people, but they don’t know which half. That’s the dilemma that everybody faces, because they’re all politicking, so nobody knows who’s actually doing the work. And once you’re in that situation, you’re in trouble.
So I think you should hire extremely slowly. Hire only after there’s a burning need for that person. I think you have to be ruthless about firing and trimming the ranks. And I know that’s not popular—I know people don’t like that model—but it’s worked well for me and for us. The founder just has to keep a very, very tight eye on waste. And there’s always waste.
Elad: Do you think the granting of stock to people is an outdated model?
Naval: I think it’s better than the other model, which was no stock. But I do believe it’s outdated. So we do six-year vests. Venture capital firms do ten-year vests. So I think in a rational model you would not only do longer vests, but you would also probably not have permanent issuances of value. Maybe you would have stock for the early people, because they’re creating scaffolding that then turns into a big company. But the older a company gets, the further along it gets, the more your grants should shift to profit sharing.
Elad: I guess RSUs don’t quite capture what you’re saying.
Naval: RSUs are basically a tax-efficient way to give out more compensation that’s somehow lightly tied to the overall performance of the company. If you’re a multi-thousand-person company, though, one person can’t affect performance that much. So I view it as a very diffuse kind of thing. When you look at true “eat what you can kill” kinds of businesses, where the human capital is really important—like go to Wall Street, where it’s kind of cutthroat—those are all bonus-based.
Profit sharing can be very tax inefficient. AngelList is set up as an LLC, so for us it’s actually more efficient to do that because we only have one layer of taxation. But I just think that as companies get larger and larger, and get further and further along—you can hack it even before you’re profitable— you can do revenue sharing. Or you can give very outsize grants. So you do small grants for everybody starting out, a standard grant that everybody gets. But then next year you either increase a person’s grant substantially or you let them go.
Elad: It almost reminds me of McKinsey’s “up or out” model, where it’s a partnership and people either advance and get more and more pay or they’re out.
Naval: Exactly. Peter Thiel put this well in Zero to One: how are you going to sell your 21st employee? Because you can’t give them enough stock that they own 5% of the company. So at that point you have to be on track to building a huge company. Or, I would argue, you can build a great company with a very small number of people, and you can incent them heavily.
Right now is the lowest-risk time ever to be a founder. You can go into an accelerator and roll the dice, see where it goes. You can get some money, see where it goes. There’s very little risk to being a founder. But early employees are asked to take founder-level risk, because the companies often don’t have product/market fit, without getting founder-level equity.
Elad: Well, I don’t think that they end up working as hard as founders, or dealing with the stress and the bad issues most employees never hear about.
Naval: Absolutely true. But there used to be a very steep decline, where the founder would own 40% and the first employee would own like 0.15% or 0.25%. I think those days are ending.
I think future companies, especially those that haven’t raised money yet or haven’t raised substantial capital or haven’t gotten product/market fit even loosely, when they’re hiring early employees, they’re really just hiring late founders. And so they should be giving 1, 2, 3, 4% of the company, instead of giving 0.1, 0.2, 0.3, 0.4%.
The issue with hiring engineers into early-stage companies today is not that there’s a shortage of engineers, it’s that there’s a surplus of founders. And so you have to basically treat them more like founders, because there’s opportunity cost for these early engineers who could go start a company, join YC, whatever.
Elad: Although I think that the one thing that people tend to both overestimate and underestimate is the risk associated with a startup. There’s a whole class of people that think startups are incredibly risky, and if they blow up your career is over—which is of course false. But on the flip side, too many people assume that 90% of startups have an exit of some sort. Which is also not true. Most startups completely fail. Their founders have lived on very low salaries, and they make nothing after that.
Naval: And they’ve been so stressed beyond belief that they’ve lost their health and sacrificed their family.
Elad: Yeah, they’re ten years older than they should be in some sense. And they haven’t made salary for three, four years.
Naval: Yeah, actually the most successful class of people in Silicon Valley on a consistent basis are either the venture capitalists—because they get to be diversified, and at least used to control a scarce resource, although it’s currently not a scarce resource—or people who are very good at identifying companies that have just hit product/market fit. They have the background, expertise, and references that those companies really want them to help scale. And then those people go into the latest Dropbox, they go into the latest Airbnb.
Elad: It’s the people who were at Google, and then joined Facebook when it was a hundred people, and then joined Stripe when it was a hundred people.
Naval: When Zuckerberg is just starting to scale his company and panics, he’s like, “I don’t know how to do this.” And he calls Jim Breyer. And Jim Breyer says, “Well, I have this really great head of product at this other company, and you need this person.” Those people tend to do the best risk-adjusted over a long period of time, other than the venture investors themselves.
This interview has been edited for clarity and length.