Walking through a Fundraising Process with a Veteran Investor | Morgan Stanley Investor, Andy Chase

So if you were to start a business, first, and I'm not gonna make— well, I will take one comment. Everyone here should take at least 1 or 2 accounting classes. You don't need to be an accountant, but you have to understand sources and uses of cash. You have to understand sources, for a person, your source of cash is your salary. And your uses, I gotta live, I got capital expenditures, which could be cars, payments, house rents, these kinds of things. But if you're a business, if you're a business, what are your sources of cash?

Investment.

Sales. Simple. What do venture capitalists do? They finance the losses that your sources and uses of cash don't— when those ends don't meet, right? That's what a venture guy is doing. When you start a business, and I'll just do a hypothetical here because I don't know how your plans— look like. But the first year, you've got sales. That's your source of cash. Your uses of cash, and down here is the balance sheet. And whatever is left over, as I said before, if you're making money, whatever is left over is going down to the balance sheet. If you're losing money, balance sheet's losses are getting bigger, bigger, bigger, and if you're the owner of that business, then you just—

You're screwed.

lost a bunch of money. So your uses, you got salaries, you got capital expenditures. CapEx are more like one-time deals. You got rents, you got benefits, you got capital expenditures that get to buy the people the computers, I mean, Xerox machine, there's stuff when you start a business, there's cost of goods sold. When you're doing software, the cost of goods sold may not be that great, but then you're paying smart engineers a lot of money. If you're making t-shirts or you're making— Hardware, I mean, there's cost to build and buy stuff, do stuff. So you have cost of goods sold, COGS. But big one here, let's talk about salaries. So let's just— we're gonna go through a hypothetical case for this wonder business. First year you just start, you're writing your code, you're doing software, you're doing no sales. Now what's your burn rate? How many employees you got in your company? 2, 3, just you? What do you have?

2.

5, 2. What do you think an engineer costs these days fully loaded?

$200,000.

What's that?

$100,000.

Yeah, but I say fully loaded because most people don't appreciate the cost of benefits these days, which is why Uber's having fights, you know, employees, non-employees. So there's the cash compensation. You can almost add another $15,000 to $20,000 per person on top of whatever you're paying them cash for benefits. A little less than $200,000. And there's a trade-off between salary compensation versus equity compensation. Okay, I'll tell you right now, before you give anyone any equity, you want to really think twice about it. Biggest mistake a lot of people make, because if they don't work out, you fire them. You can fire them without the salary, but you start the equity and they're going to argue, I wanted to vest it, didn't— I mean, it— Well, let's go through this thing. So you got, let's say the first year you got 3 employees, At $100 apiece, you know, it's $300K minus, plus you got, there's other stuff going on here, so you're out $500 grand. You get zero sales in this, and in this example we do zero sales the first year, you do $500K, $1 mil, $2 mil, $4 mil, $8 mil, $16 mil, and then we slow down, we're only doing $24 million in whatever year that is. Well, this is 1, 2, 3, 4, 5, 6, 7, in year 8. 8-year, and I will tell you right now, if you were to talk to any venture person and you were to double your sales every year, 7 years in a row, they will take that business plan. Most people are pretty happy with that math if you're an investor. Now let's go through your burn rate.

Okay.

First year you paid 3 people $300 grand, you're out $500 grand, you had to buy $200 grand worth of something. Software, computers, Xerox machines, rental space. Once again, you gotta rent, you gotta live somewhere, or the business has to live somewhere. Not everyone does it in a garage. So let's assume down here the net is you're out $500K first year. Now you're doing sales, you got $500 grand. It's not the same 3 employees. Did you hire a sales guy?

2.

Girl, 3, 4? I don't know. I'll guarantee your burn rate went up. If you're a SaaS company, I guarantee it went up. I mean, you got these big companies, these SaaS companies, they're doing $400 or $500 million in sales, they're still not making money because they're plowing it all back into more engineers, more salespeople. They just kind of keep growing it big. So let's assume your burn rate here is now, it goes from $500,000 to $1 million because you now got an office admin, you got a CFO, you had to hire a rent-a-controller, Something, you got more people going on. So you're down $1 million here and somewhere in here you have to raise your first round of venture because you just lost, you did $500,000 but you spent $1 million, you're down $500,000 again. You had to raise at least $1 to $2 million and in this example let's assume you gave up 50% of your company.

50%?

50%. Well, You're at risk of your time. The venture guy's at risk of his money. Your time, you're getting, you probably might be drawing a salary. You're not at risk. People don't get that. Oh, we're taking all this risk and we're entrepreneurs. That's BS. You're still probably paying yourself $100 grand. That's not a risk, it's just time. You could have gone to work at IBM too. The venture guy put money in. If this deal doesn't work out, he's out the money.

You're taking 50% of people first round for a million bucks?

Well, it's a negotiation. I'm just telling you. Ask Tim.

People raise money for way less than that.

What's that?

People raise money for way less than that.

You can raise $100 grand. You can do whatever you want, but I'm just saying if you needed $1 million, it's a negotiation. And so this is where pre-money and post-money is. So you raise $1 million at a $2 million post. So on day 1, you're saying for writing my business plan and for my intellect, my company's worth $2 million. $1 million, is the investors putting it in, they own 50%, and myself and my employees own 50% for the other $1 million, which you didn't put any money in for it. That's for you writing the business plan and saying you're going to work for it. Okay, that's how— I mean, I'm just saying this is hypothetical. What's that?

25%, maybe max 30% in one round.

Good luck. So if you need $1 million here, you need $1 million to $2 million to get going. In year 1, and you're saying the day you write your business plan, because you come out of here, it's worth $4 million?

No, you've got to put rounds in, but if they're—

Oh, okay. $50 grand will last you a month.

No, you've got to return on that. You raise $500 and make valuation of $1 million, so you give up maybe 30%.

Well, $500 to $1 million is 50% again.

$500,000 and then pre-money.

You could go that route. You could go that route. And that will last you the first year. And then what you hope to do is raise another round the next year and another round the next year as you improve. That's great, but it basically means as a CEO, you're on the treadmill raising money every— because you don't close the day you go out and raise money. I mean, it takes a while. And maybe you do the first round at $500,000. A third of the money, so you raise $500K at 33%. I mean, I could do a lot of iterations of this, but to make my math easier, I'll just say you're gonna give it 50% of your money on these rounds. But let me tell you how it's gonna go down. You're gonna, 'cause I gotta wrap this up here in 5 or 10, your headcount's going from 3 to 5 to 10 to 15.

20.

To 20, I don't know what the headcount is. When you're down here, if you're a SaaS company, you got about 100 employees here, something like that. And every year or 2, or every 6 months, whatever you wanna do, you're gonna be raising some money from the venture guys. And every time it's a negotiation, but let's assume for this case every single round, 'cause you're losing money. And as I said, The balance sheet, which is a negative number every year because you don't make— you're not making money yet. And somebody is going to look at you and say, okay, you're 20-whatever and you're hiring employees. I'm taking liquidity risk. I'm taking every risk I can know to mankind. You've never been a CEO before and I want 50% of the company for this. Now maybe several VCs combining for 50% and you employees own the other 50%, which really means as a founder maybe you own 10% You got to keep 25% for the employee option pool if you're giving people equity compensation.

Question?

What's the equation for valuation? There's no— it's a negotiation. The valuation is— If you get an investment, let's say you get like $10K for like 5%, what does that mean? Well, $10K, 5% means you— yeah, multiply it out, right? 20 times 20, so it's $200,000 valuation on your business. But in this example, You probably raised $1 million here, you probably raised $2 million here, you might have raised $4 million here, maybe $10 million, something like that. Now people are seeing evidence your sales are taking off, you're going $4 million, $8 million, $16 million, $24 million. You raised $10 million at a $20 million valuation, so everyone would assume it's 50%. We're going to assume that you as entrepreneurs don't get diluted. Which is an absolutely false thing, that you will get out to year 8 and still own 50% of your company. Not a chance. But I'm just telling you. And you shouldn't, because these guys have been investing money. So they're out $1 million, $2 million, $10 million. Somebody's invested $13 million here into this business. And finally here in year 8, it breaks even. I'm just making this up. It finally breaks even in year 8 when you do $24 million in sales 'cause you're a great SaaS software company. Most SaaS software companies are not breaking even until they get over $100 million in sales. So I'm giving you guys the benefit of the doubt, trust me on this, on the 50% on these things and breaking even. Some investor gave you $13 million and they own 50% of a company that's still not making money. Now call me stupid, I like to make 10% of my money, for example. If I'm going to take an equity risk, just as I said stocks, I wanted 10% if I was buying a liquid stock. I want a higher IRR if I'm in a venture deal. But I spent $13 million, I'm out in year 8, and I'm trying to think, wait a minute, have I made money? Well, I own— and let's assume in The company finally makes $500K. They finally make money in that year. They make $500K. As a shareholder, half of that's mine because the CEO and the board can determine when the— I don't care if you own a gas station. When the company makes money, they can either plow that money back into the business or they can distribute it out in a dividend. And if you own 50% of the company, $250,000 of that is mine. If I'm an investor in the company and $250,000 is the other shareholders and you collectively make a decision whether you're going to leave in the business or not. So I'm like, wait a minute, I just made $250,000, that's pretty cool. But I made $250,000 in year 8 on $13 million. And we're going to calculate what's that rate of return. I made a one-time yield of $250,000 on $13 million in 8 years, and I took a risk on you guys. If I bought the General Motors bond, the Johnson Johnson bond, this is why I went through that. If I had $13 million at 5%, that's $650,000 a year, every year, if I just bought a boring bond. If I bought a stock and I was making 10% a year, 10% a year, I'm making $1.3 million. So I'm sitting here, wait a minute, I'm out all this money, I should have been earning $500,000 to $1 million a year, I finally make $250,000 in year 8, and everything went as well as it possibly could have. You didn't have any down rounds, you didn't screw up and hire the wrong employee where equity— there's a big argument with litigation costs, you didn't mis-size your company on the real estate. Where you took down too much space so your rents were big and then the company hit a down patch because businesses go like this and you overbought your real estate and you got to pay the rents. And if you don't pay the rents, that landlord can foreclose on you, which means you need to either raise more venture company or you're out of business. We restart the company. There's all kinds of things that can go wrong here, all kinds of things. That is a crappy return. for any investor. And I like to go through these things because when you go to raise money from somebody, you better show how you can make them money. And if you can't answer the question as to why earning $250 grand on $13 million in the 8th year is a good investment, then you shouldn't even be an entrepreneur. You can't, you can't do it. Just because the sales are growing Sales don't mean diddly. There's a lot of companies out there that do a lot of sales. If you make a widget for a buck, but you sell it for 90 cents, not a great business. Not a great business. That is— I see a lot of these things. We're going to keep growing. We're going to make the money on advertising down the road, whatever it is. You better figure out how you can make money. So I'm gonna pause there, questions. Do you get that? 'Cause that's— you walk into a VC's office and you pitch me or you pitch Tim or something like that on investing money, I'm gonna look at it like, wait a minute. I mean, I used to— there was an old— Tim knows him. There was a guy back when pi was on the calculator. He always hit— whenever he'd see the revenue line, he would hit divide by pi. 'Cause entrepreneurs are always optimistic and they never— I mean, they're always—

Optimistic.

They're way off. They're way off in their revenue assumptions. Usually they're under on their costs, they're way over on their revenue. They assume— and people forget that it's not like Facebook— you do an app company, it's not like Facebook and Google aren't developing their own apps. You gotta compete with their own internal versions of what they're doing at the same time. And so when I see these app things, I'm like, wait a minute, are you that unique that they have to buy you as opposed to just incorporating a little feature set of one of what you're already doing on one of their own apps, kind of a thing. It's very difficult to come up with something new. It's very difficult in the SaaS space. SaaS, by definition, is always evolving. And there's only so many things a business needs to run. They need to do some sales. They need to do some supply chain management. How many critical apps are there? And there's a lot of big companies, Oracle, Salesforce, Workday, HR, kind of thing, and they're all starting to encroach upon each other now. Because they're trying to do more business with the same customer and that's kind of— it is what it is. So just, there's lots of ideas. I don't want to burst all your bubbles, but that is the problem that people have. The good news is with rates down so low, it doesn't make earning $250,000 on $13 million 8 years from now look as bad as it used to. It used to look horrible when rates were higher. and you can get 5% or 10% by buying a Treasury, but I get 6.5% by buying a Treasury? Are you kidding me? I'm going to make, you know, on $13 million, I'm sitting here making, you know, $700 grand in a Treasury, and you're telling me I'm going to get $250,000 back in year 8 from you guys? Somebody who's never run a business before? You've got to be joshing me. So, I mean, what's the point of even talking about making like sales revenue?

Because they would never make that sort of amount.

You do and you can. If this thing keeps going, 24, 40, 60, 100, I mean, at some point in time these fractions flip and you start dropping more to the bottom line. And that's why I was saying the venture guys are financing these losses the entire time and betting on the come. And going back to your comment, if I'm betting on a 20-something-year-old kid who's never been a CEO, who's never sized a company, who's never had to hire engineers, A lot of it comes down to can they hire the right people at the right time kind of thing. And I'm like, whoa, they've never done this before. And I'm betting my money. And you say, well, I'm— you're risking 2 or 3, 4 years of your life. That's not the same as somebody's out— you won't know that this is a complete failure until somebody's put in 1 plus probably $3 million. And they lost all their money. It's gone. You're going to sell the IP? It's not worth anything. Question? I'm just What's curious, your personal opinion on Amazon? The stock or the company? I guess their philosophy of putting money into what enables growth. They are a very important company, I'll just say that, and it's hard to bet against Bezos. I mean, I never understood the math on something like that, because they're a huge valuation, they don't make much money, but they're very, very critical. I always, when I think Amazon, I mean, because it's almost 2 businesses, you got the retailing side and you got the server side. And the good news for you guys is you guys can rent, you can start companies much cheaper than you used to because you can rent all this stuff. You don't need to pay for your own server farms and data, you just rent it, which keeps your burn rate down. That's why these numbers are so low. I mean, people used to be raising $5 or $10 million in seed rounds and now people can do it with $500 grand, $1 million because they can just kind of pay as you go a little bit, hopefully. Mathematically, they're too expensive for me to kind of understand. They don't make money yet. But the other flip side is it makes it awful hard to buy at Walmart or something like that too, 'cause I almost guarantee you that they'll keep a lid on profit margins of any other retailer. They're the ultimate store, but they don't have a store. How much cheaper is that to run? It's like Uber is a car company without owning a car. These are big companies without overowning a hotel, Airbnb, you just go on and on and on and on. Amazon, I mean, that's a lot cheaper than being Costco or Walmart to do what they do. Question? So would you consider Amazon a success or Twitter a success? Oh yeah, of course. Yeah, yeah, but they're not profitable. Well, Twitter's having— I mean, their stock's coming down because people are trying to figure out— I mean, they were a hype deal. And a lot of these companies were going to make money on advertising down the road. And at some point in time, that bubble's coming to roost right now. Stock's been under pressure because they haven't figured out how to make money yet. And I come back to it. When I hear WhatsApp, and there's always one story, one company or something like that Instagram, that in the hands of a Facebook, they're worth a lot of money. Only in the hands of Facebook or Google are they worth money because they can monetize those eyeballs. Yahoo has been able to monetize— they're getting criticized. They haven't monetized things. I can go on and on and on. AOL, Time Warner, all the other acquisitions haven't worked out for other people. Apple. None of these guys have made these things work out.

necessarily.

And there are, in pretty much every vertical, there's like 50 companies vying to be the one company, all very well venture-backed, vying to be the one company that Facebook and Google buy out in one of their verticals, right, in their little silos. Yeah, question? Are there any finance programs or books you'd recommend for people who haven't had finance training? No, I don't know who's in college, and I joke about it when I used to I mean, I went to Stanford, but I was teaching some stuff at Stanford, and I was shocked at how many people never ever had one accounting class. Just go into a junior college and take an accounting class on sources and uses of cash, because it's pretty simple. Sources and uses are not that hard. The actual— you don't worry about the footnotes. I mean, there's formal accounting, but understanding— I joke about it. You can be a doctor, but unless you understand basic accounting, you'll never run the doctor clinic. You have to understand the business, 'cause what's left over is either added or subtracted to the balance sheet. And you get it on a personal level, 'cause if you spend money you don't have, you're building up debt, student loan debt or car debt or whatever. And sometimes you gotta pay it off at some point in time.

Yeah.

So going along with that example and also with the example What do you think or what's your perspective on investors thinking about more exits or IPOs rather than a return of 3.25% in that case instead of—

Oh, well generally what happens—

It's valued at like $75 million, so that's probably—

Generally what will happen in something like this, they won't distribute the— they could distribute the $500 grand, Half goes to the shareholders, half goes to the investors. You don't know what that company is worth. I would say it's not worth a whole hell of a lot, unless I— I mean, personally, because as I said, I can't do much, but I can divide by 10, and I want to make 10% of my money. If I'm going to invest— so this thing's worth— people say, well, the thing's worth $50 million. I'm like, the hell it is. I mean, you know, 'cause I'm sitting here, it gives me $500 grand. If I had $50 million, I'm Bill Gates, I'm gonna buy a company, I'd wanna make $5 million profit. I wanna make 10% of my money. This company's making $500 grand. And even if the earnings go $500 grand, $1 million, $2 million, $4 million, I mean, I'd like to make it this year. I don't wanna wait 5 years to make my $5 million on $50 million, something like that. That's what's so skewed about some of the numbers Facebook and Google have paid me. Facebook didn't used to make money. Everyone kind of assumed— I'm a managing director at Morgan Stanley. We took them public. We got sued because they weren't making money. People said, oh, we ripped them off, and that kind of thing. Of course, the stock's tripled since then or something like that because it didn't make money originally, but you knew they would. If they know your birthday, I knew they'd start delivering flowers or candies on birthdays. Okay, FTD gets $15, we'll skim $10. There's all kinds of ways they're going to monetize, and they are. They're figuring it out. But they still don't make as— but they will make money. And investors will be patient to a point. I can wait a little while as long as I think there's light on the end of the tunnel. Waiting 8 years, taking a risk on you guys to make $250,000 on $13 million of mine feels a little risky. And I would hope you'd realize If you had $13 million in your pocket, would you do that deal?

No.

And that's my point, is you better have a pretty good answer when you sit down with somebody to say why this is not for social good, because that guy's gonna be looking and say, wait a minute, how am I gonna make money on this deal? Yeah?

I was gonna ask about how much of a role do you think moral hazard has in the city, for example?

How much what?

Moral hazard in the city.

Moral hazard?

Yeah, because people are using other people's money. They're a bit more risky in how they spend that investment time. So how much of a factor does that play in investors and VCs actually distributing their money to startups?

It goes back to 10%, 15% of it is the idea. Most of it comes down to does he trust the entrepreneur not to spend his money stupidly. Ask Tim about his first foray into China. Sometime. I'll tell you the story. They started the hedge fund, started investing in some Chinese businesses, and they don't— the CEOs over there didn't really understand shareholder ownership rights. They were taking the corporate money that was invested and bought a car. I need it to get back and forth to work, I'll buy the car. I need a Mercedes. I need an apartment across the street, makes me more efficient so I can work more. Tim refused to even put more money into any Chinese companies until he hired, literally from San Jose State, he hired junior accounting people that would have to co-sign every check of his CEO because they wouldn't do it. So you better understand how your CEO is going to spend the money and that CEO better be cheap. And if the CEO is not cheap, one time the CEO can get away with something like that, but the second time, if they've spent the first million bucks here on round 1, then it's gone. So you're saying that the and it hasn't been progress, do they ever get this round? The answer is no, they're gone. Because the first thing the next investor will do is they'll call the last investor. What happened? What was your experience? How did that CEO do? You're not gonna raise another round. You're out of business. Yeah, question?

Can you talk about any actual valuations you've seen? Give us a few examples of how much percentage they actually gave up for how much cash.

It's all over the place. You go to Adam, Adam puts in $50,000 for 6% of every company. But it's self-selecting because that's how you get in there. So $50,000, it's a $3 million valuation, is that right? 6%, $50,000 for 6% of the company puts this company valued at $3 million. Seems high to me, I mean, for an idea, but I mean, they've worked for a while in companies like that. I think it's that thing. What's that?

I think it's around $900,000.

$50,000 for 6% of the company, yeah. No?

$650,000.

Yeah, you're right. Yeah, no, yeah. So it's a negotiation. And it'll be a negotiation based on, the venture guys will look at what they think you need to raise. The first thing I always think about, okay, how far is this, what's this money gonna get me? I put $1 million in my business, Does that get me to the million-dollar sales? Does it get me to 8 employees? I mean, how much money am I gonna raise the next round? What's my risk that that round has to come in more money than I thought? 'Cause I'm not gonna keep funding this whole thing. What'll happen is this will be 1 investor, this will be 2, 3, by here you might have 3 or 4 investors and they'll all be negotiating for who owns what percent of the company, as will you be trying to protect your employees and yourself. Right.