What HBOs Silicon Valley Can Teach Us About Tech Start-Ups

It's Pop Culture Week on Industry Focus

Listen in to find out how venture capitalist start-up funding actually works, what a down round is and why it's so scary for new private companies, why a company's founder is not necessarily always its best CEO, how well the show nails Silicon Valley culture, and why you should really watch this series if you're even a little interested in the premise.

A full transcript follows the video.

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This podcast was recorded on Aug. 5, 2016.

Dylan Lewis:Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, August 5th, and we're talking tech and wrapping up Pop Culture Week with a chat aboutHBO'sSilicon Valley. I'm your host, Dylan Lewis, and I'm joined in the studio by the voice of The Motley Fool, Mr. Podcast himself, Chris Hill. How's it going?

Chris Hill: It's weird, it's weird to be a guest.

Lewis: Well, you're sitting in the seat you normally sit in.

Hill: Yes.

Lewis: But you're not sitting in the proverbial host's seat.

Hill: I was going to say, yeah, you're the host, I'm the guest, so you do all the driving.

Lewis: I'm pretty psyched about that, it's nice to have that power. This is the first time we've ever done anything together, I think.

Hill: You know, we did an episode of Market Foolery when we were in Austin, Texas.

Lewis: Yeah, that was on the couch in the convention center.

Hill: The South By Southwest Podcast Center. It was great. And now we need to figure out if we're going to go back next year. But, that's not what we're here to talk about.

Lewis: No. We are here to talk about HBO's Silicon Valley, and some of the ties into the tech world. I was very excited, I was actually the one who proposed Pop Culture Week among the IF cast. Because, at some point, I wanted to do this dissection. It's such a brilliant show, and they do a really great job of detailing some of the finer points of the start-up world out there on the West Coast.

Hill: As a listener, I've really been enjoying Pop Culture Week on Industry Focus. I was very happy that you asked me to do this. We've talked about this before -- Silicon Valley is not just a very funny show, it's a very smart show, and one of the ways that it's smart is, Mike Judge and Alec Berg, who are the creators of the show, work very hard to make sure the show is real, authentic. That goes for everything, from the equations that you see on whiteboards -- they have consultants to make sure those things are correct -- to the overall culture of Silicon Valley, which I know we'll get to.

Lewis: Some background here, for listeners who may have never seen the show before -- it's a comedy show, like you said, from Mike Judge, known for Office Space, Beavis and Butthead, King of the Hill. He has quite the resume there. Basically, it follows this Silicon Valley computer programmer as he tries to take this software that he's built and create a legitimate business, some start-up that people actually want to invest in, maybe eventually hit that Unicorn Club. We'll see.If you've never seen it, you can think of it the same way as Entourage, How to Make It In America. HBO seems to have all these shows that are about the little guy trying to rise in this really tough industry. It falls into that same category as those other ones.

Hill:Absolutely. Maybe a housekeeping note is in order, because it's an HBO show, there is some profanity. It's not Game of Thrones, by the way. There's no violence. But there is some profanity. But it's such a great show -- and an easy show to binge-watch -- because every season is like eight or 10 episodes.

Lewis: And they're half an hour.

Hill: Half an hour. So you can knock it out in a weekend.

Lewis: Yeah. So, I wouldn't watch it at work or with your kids. But, it's a fantastic show. Also, if you're midway through the series, this might be a little spoiler-heavy at times, because we're going to use the show as a vehicle to talk about some things in the tech space, and the venture capital world. You can always hit pause and come back to this episode of the podcast, maybe when you finish the series. But I figure it's worth throwing out there. I don't want to ruin the show for you.

I think one of the things they do very well on the series is give a sense of how start ups actually get funded, and that process. Most investors see theTwitters orFacebooks of the world pretty much from IPO on. They don't see the guts of what gets them into, "You have $X million in funding, you're working with that, how do you get to the next stage, and the one after that?" Very early on, the first episode, the founder of Pied Piper, this fictional company, Richard Hendricks, accidentally gets thrown into this seed funding opportunity. He pitches this music search app to this venture capitalist, Peter Gregory, who is the quirky venture capitalist that I think everyone imagines.

Hill: Quirky billionaire who, among other things, is building his own island in the show.

Lewis: With automated robots, yeah. There's some background there. [Laughs.] And he shows some programmers at his office -- he works at thisGoogle-type place -- this program as well, and ultimately, both the people at this VC firm and the people at Hooli, the Google-esque company, think that while his search app is very dumb and kind of useless, it's powered by this incredible data compression algorithm that is brilliant and potentially revolutionary. So, he faces two offers here: $4 million as an absolute buyout from the company that he currently works for, Hooli; or, $200,000 for a 5% equity in the company from this venture capitalist, Peter Gregory. And those deals shake out to the same valuation, the difference is, Richard actually owns the business in the equity option from the venture capitalist, whereas he would just be getting a $4 million paycheck from Hooli.

The $200,000 for 5% equity is what we would call a seed investment, or seed money. The reason they call them that is, it comes extremely early on in the process. Maybe some semblance of a business, very loose idea, a vision, but you basically have something incredible from the tech side, and the application isn't wholly there yet, but there's clearly a lot there under the hood and a lot of different ways you can use it. So, before a company can really generate any of its own cash, it needs some financing to get off the ground. That's where you see these investors come in.

Hill: One of the little points that comes up in the first season is -- and this is, of course, very much how the VC world operates -- that this venture capitalist, he's made his $200,000 investment in this data compression company. He's also made similar investments in other data investment companies.

Lewis: Like eight other ones.

Hill: Right. AndRichard, the protagonist on the show,is sort of hurt by that, like, "What do you mean?" It's like, "That's how VCs work." VCs workbecause they placed all of these small investments, and they know one out of 15 or so will hit it big and pay for all the others.

Lewis: And they can afford to do that because,what you typically see, especially in the seed funding round, is that the stakes ten to run somewhere between $10,000, and maybe $1 million. That would be a very large seed funding,you don't see that too often. But,to your point, these are a lot of small bets that venture capitalists are making. We use VC a lot here in this discussion, seed money can come from other places. Founders can take out loans, raise money from family. There are also options like angel investors. Some people go the crowdfunding route with Kickstarters and things like that to get off the ground. I don't want to limit it to just VCs, but that's how you see it portrayed in the show,and that's how most people are familiar with it.

Early in season two, after they've been seed funded and had this successful TechCrunch appearance -- TechCrunchis a very well-known tech convention where people show off some of the very fantastic stuff that's going on in the tech space, some of these early stage companies that are looking for more money. Pied Piper wins TechCrunch Disrupt, andmultiple venture capital firms approach them aboutfinancing the company's series A round.

A series A round is what follows the seed investment. Basically,businesses go on to get financing through this round. Itgenerally happens as the company has some proof of concept, and they need someadditional funding to keep things going. Generally, this comes in exchange for preferred stock in the business. Typically,what you'll see in terms of funds being raised in this round, it'll be a lot higher than what you see in the seed rounds,typically somewhere between $2-10 million, and they'll have a couple different firms involved.

There are a couple different reasons you see the higher amount of money being thrown at thesebusinesses at this point. One, they've had some sign of success, they've gained some traction, there's a more fully formed idea ofwhat's going on with the business. Two, the VCs wantsome significant skin in the game. For them to invest $10,000 or $50,000 in something, that'snot going to meaningfully boost returns for them. They need to be throwing $1 million to be picking up a significant portion of these companies. That's why you see some of these investments start to scale out.

Just togive you an idea of one of these very successful publicly traded companies that went through their series A round, early on, Facebook (NASDAQ: FB)raised $12.7 million from five different investors in their series A. That gave them an implied valuation, at the time, of $88 million.

Hill: Isn't that adorable to think about? [Laughs.]

Lewis: Yeah, they're now ...I can't even do the math on how much higher they are now.

Hill: Yeah. Now it's the fifth or sixthmost valuable public company in the world, something like that.

Lewis: Hundreds of billions of dollars.

Hill: Just pastBerkshire Hathaway(NYSE: BRK-A)(NYSE: BRK-B) in market cap.

Lewis: Yeah. That'sabsolutely incredible. And the way that you get to that implied valuation is, you take the equity stake that's being offered up in the round andmultiply it by the total funding raised during the round, and that gets you to the total valuation implied.

In the show, you seeRichard and his colleagues go from meeting to meetingon Sand Hill Road. In real life,this is where a cluster of some of the biggestand mostinfluential venture capital firms are in the Valley. This is where yourAndreessen Horowitzare,anything that's getting backed that's really worth something is getting some financing.

Hill:I have been to Sand Hill Road.

Lewis: Oh, you have?

Hill: I have. Because,once upon a time, The Motley Fool took on some venture cap financing. I wasn't sitting in the room, I was sort of there with David and Tom Gardner and a couple other folks. I was along for the ride. I was not in the meetings, but I've been in those buildings before, and it's yet another greatrepresentation, a capturing of what it looks like in the real world.

Lewis: Yeah. I'm guessing high-priced art up on the walls.

Hill: Yes.

Lewis: Some nice distilled water, some sort of fancy snacks, things like that?

Hill: Absolutely. It's the kind of thing where you look around and say, "Yep, these people are doing well." [Laughs.]

Lewis: So,assuming everything goes successfully with the series A, you then work your way through series B, C, D, etc.,as long as the company continues to seek financing through the VC side and opts not to go public. Togive you an idea of how many different rounds this can go through,Twitter(NYSE: TWTR) actually went from series A through G. They decided to stick around for a while, some companies don't go through that many, they do four or something like that,maybe they seek out some debtat some point and eventually go public. But, there's no real standard there, it kind of justdepends on the company's needs and what management wants to do.

One of the big things they touch upon in the show, Richard meets with a friend who had his own start-up, things didn't really goparticularly well for him, is the idea of a down round, and the fear of a down round. Chris,do you want to touch on that a little bit?

Hill: Yeah. It'syet another thing they do that they get right on the show. A down round is simply, you do your series A financing,you have an implied valuation of X. If you do another follow-up round,and the valuation of your private company drops,first of all, it's such a catastrophic sign. You can just tell,in the scene where they're having that conversation,it's the worst possible thing that can happenoutside of a tragic accident of some sort.

Part of what's exciting forcompanies at this stage, when they're private, when they're growing, is the excitement around it. It's a great scene where they're going toall the meetings on Sand Hill Road, and you can just see that Richard andEhrlich are the two characters of the show, the two main drivers of the business -- and we'll get to business leadership in a second -- you can see, they have this strut in their step,because they know they're in the driver's seat. Everybody wants to invest in their company. If you have a down round, it's the exact opposite. You're going hat in hand to all these VC firms, trying toconvince them that you're still worth investing in,and you have no leverage whatsoever.

Lewis: Yeah. It'skind of the kiss of death in a lot of ways. Youthink about a publicly traded company that has areally poor earnings report. It's like, OK,they've had years of success. There's an ebb and flowwith that business, but we know in general,things are going pretty well, and they're on the up-and-up. A down round is like, this is the second time we've gotten a glimpse at this company's valuation, and some of their growth metrics, and they look terrible. You don't have that nice, steady backlog of success that you can point to. It's much morevolatile and much more disruptive, and that's whyit can be particularly difficult for companies in that space. That's why you want to see that nice, steady climb up. In the show, they even allude to, "I could have taken less money and set my expectations a lot lower." And that's ultimately what they wind up doing -- they shun anincredibly high valuation for the same amount of equity but less money so they can give themselves more realistic growth targets. That wasactually a suggestion that came from Marc Andreessen. We talk aboutsome of the research they do on the trips they go on before each season to get ideas for the writers' room. That's something he proposed, like, "Yeah, someone could do that, if they wanted to." I've never seen itin the world, but I think it's kind of interesting.

Hill: It'sgot to be pretty heady. It's got to be really hardto be sitting across the table from someone who is saying not only, "Here'show much money we're going to give you, and,by the way, this means, the companythat you have built is now worth $100 million, $200 million." It'shard not to be seduced by that,and to walk away and say, "You know, it's actually better for us in the long run to take a breath, go slow, get greater control over the company, and pass up a huge amount of money."

Lewis: Yeah.I wonder if that's something that might happen, reality and fiction blending together. Maybe someentrepreneurs will take that advice.

Listeners,if you're interested in the pre-IPOprocess and seeing some of the stages thatcompanies go through,I think you would be smart to check out some of the sites like CrunchBase and TechCrunch. They doa really good job of reporting on the early stage investments that a lot of these private companies go through. They do a great jobbreaking it down round by round,some of the people that are participating in these rounds, the total value, implied valuation, all that stuff. That's out of our realm on Fool.com, but those two outlets do a really great job with that.

Chris,one of the other things we wanted to touch on with this show andhow it plays out in reality is the idea of the founder, the person who came up with this brilliant tech idea,not always being the best suited to actually run the business.

Hill: Yeah. It's one of those things that seems obvious, but at the same time, is easy to miss --the idea that you need balance at a business,you need more than one way of thinking. We've talked about Google (NASDAQ: GOOGL)(NASDAQ GOOG) a little bit today because Google is the fictional huge company Hooli. By the way,that's one of my favorite things about this show -- the names they come up with for the fake companies. I read in an interview with Mike Judge that that wasone of the more challenging things that they run up against, when they're jotting down some fake names,and then they go and do the research and realize, "Oh wait, some of these are actual companies."

Lewis: Yeah,you don't want to get in trouble there.

Hill: If youthink about Google before it went public,you have Larry Page and Sergey Brin, who are the guys who come up with Google, they come up with the search algorithm. Along the way, it is clear that they need "adult supervision." That's where Eric Schmidt enters the picture in 2001. He's an experienced older business manager with a background in tech, but Schmidt is really the business manager of the three of them, and he's the one who shepherds them through the IPO process, and through, really, the first decade of Google being a public company. It's interesting, when he left in 2014, Larry Page takes over, there'sall these stories about Eric Schmidtgiving him lots of credit, and rightly so, and saying, "Well, Larry Page has grown up, and now he's going to take the reigns of the company." But pretty early on in Larry Page's tenure as CEO, I would argue that he brings in another smart, experienced "adult" who has a skill set that is not really his forte, and that's Ruth Porat.

Lewis: Yeah, CFO.

Hill: Yeah. Bringing inRuth Porat was a masterstroke.I remember when the story broke that Google's CFO, a guy who's nameI don't even remember, previous CEO, left.I remember we talked about it on Market Foolery, and I said, "Idon't know who Google is going to hire,but I'm pretty sure it's going to be whoever the hell they want." You know? (laughs) They're just going to look out across the entire world and say, "Who's the single best CFO who can help us the most? Let's go make that person a Godfather offer," and they did that with Ruth Porat.

Lewis: Andyou look at what the company has done since then ... Ruth Porat has, I think, steered them in a more Wall Street-friendly direction. They've also announced plans for share buy backs, and they have anauthorization there, so they can opportunistically buy back shares. That'ssomething that old Google probably wouldn't have done. Theydidn't really care much for what Wall Street wanted to do,they were off doing their own thing and experimenting and changing the world, which is awesome. But, as an investor,it's always nice to see them making some of these more shareholder-friendly moves.

In the show, venture capitalist Laurie Breen says to Richard, "You'vecreated a company that is too valuable for you to run. You should be proud."

Hill: (laughs)

Lewis: Which is excellent, and it really embodies this idea of--

Hill: It'ssuch a backhanded compliment.

Lewis: Yeah, "If you have the technical skills for this brilliant, brilliant algorithm, and you're going to change the world ... we need someone else to handle it."

Hill: Exactly. Andpart of the fun of the show is seeinga character like Erlich Bachman, who's played by T.J. Miller, who is very full of himself, a little bit of a buffoon, but he does have his moments throughout all three seasons of Silicon Valley where he demonstrates that he has a skill set that is valuable and helpful to Richard and Pied Piper.

Lewis: Yeah, and in the show, they allude quite a bit to the Jobs and theWozniak, needing both sides of the business brain,and not just relying heavily on the technical skill set. It is not very often that you get afounder and visionary like Mark Zuckerberg who also gets the business. And even with Zuckerberg, he brought in some great talent tofacilitate them becoming this immensely successful company.

Hill: He's aphenomenal CEO,but I think he would be the first to saythat Sheryl Sandberg, bringing in Sheryl Sandbergas Chief Operating Officer ...if you look at what she did before Facebook,very much a traditional management background, and this steady hand. And,not the companies need to go out of their wayto cater to Wall Street,because there have certainly been a lot of great businesses over time that havelargely ignored Wall Street and the wishes of Wall Street analysts,but I think it does send a positive signal to analysts, to investment banks, etc., when they see that type of hire, when they see Ruth Porat, who was hired away from Wall Street, orSheryl Sandberg, with her background, or anEric Schmidt.

Lewis: And,I'm going to play devil's advocate here --it doesn't always work. Look at what happened with Twitter.Twitter plays out very similarly towhat happens in the show with Pied Piper. You have Ev Williams running the show, he goes onpaternity leave, they bring in COO Dick Costolo, who had been hired in, he was not part of the founding team there, and he runs the company for four or five years. He brings them public to debatable success. The vision hasn't been clear, theresults have not been great, and now you have Jack Dorsey, a founder, back at the helm. That's not all that different from what plays out in the show, where you have Richard Hendricks get unseated because they want a CEO-for-hire type person, someone who went to business school, has written case studies all of this stuff. His name in the show is Action Jack Barker.

Hill: Jack Barker!

Lewis: Excellent character. Andthey disagree on pretty much everything. He's very growth-focused, very "what's going to improve the bottom line and raise the share price and valuation of the business," and Richard is obsessed with the product, and wants to make the best technical specs. And they fight and fight and fight, and eventually, it plays out well for Richard. He gets his way, and they wind up,maybe begrudgingly, giving him back his CEO seat.But, another art imitating life imitating art kind of workaround there.

One last thing I wanted to touch on with the show is the Valley culture, and the way they present that on the show. One of the best quotes from the entire series is from the Google-esque Hooli CEO and founder, Gavin Belson: "I don't want to live in a world where someone else makes the world a better place better than we do."

Hill: Right. And this is one of those things that comes up time and again in the show that is very much fueled from real life. When we were in Austin, Texas, at South By Southwest earlier this year, there was a breakout session with Mike Judge, Alec Berg, and a few of those stars of Silicon Valley, that I went to. One of the first questions that Mike Judge got was, "Now that you're just about to launch season three, how is this show perceived in Silicon Valley?" And he said, "It's interesting, because in general, people really like it. We're very well-received. People are still willing to talk to us. But one of the things we run into now is, we'll meet with a company, and the people there will say, 'Oh, we think it's great how, on the show, you make fun of how we all say that we're going to make the world a better place,' and in the next breath, they'll say, 'but here, at this company, we actually are, and here's how ... '"

There really is this sense of self-importance. It's like, you know, it's fine that you're a tech company that just makes a great widget. There's nothing wrong with that. Please stop pretending that you're having this transformative effect on planet Earth. Zach Woods, who is one of the actors on that show, in that same panel session, talked about work that he did to learn about Silicon Valley, and going somewhere ... I think he might have gone to some type of pitch, it might have even been TechCrunch Disrupt, where someone stood up and was pitching their idea, and literally said, "Our app" -- he didn't even say what the app did -- "is the Ghandi of apps."

Lewis:[Laughs.]

Hill:It's like, what?! What in the world does that even mean?! Are you kidding?

Lewis: Yeah, sometimes the Valley can be a little bit myopic in its altruism, and maybe lacks some self-awareness.

Hill: Yeah. Another thing they do really well on Silicon Valley, and this shows up in real life, is the notion of how quickly word travels in a company town. Silicon Valley is a company town, and the business is tech. Washington, D.C. is a company town, and the business is politics. L.A., Hollywood, is entertainment. In all three of those cities, in real life, word does travel very quickly. It can be very positive, or it can be very negative, as we talked about earlier, with the whole notion of a down round.

Lewis: Yeah. Another testament to that, another example of that in the show, they're looking to hire some talent, and word gets out that Erlich Bachman, who has a 10% stake in the company, is shopping that 10% stake. The reason he's selling it is he made some very poor investments with his other money, and he needs to cover his own liabilities. But people in the Valley don't know that, they only know that, word is, he's shopping shares, and that must not be good for business. That's just another example of how that plays out.

I think one of the other things that's a real treat for someone who enjoys the tech world with the show is the cameos you see, and some of the people that they get on stage. Some of it can be a little self-aggrandizing, some of it can be self-effacing. I think they do a good job of striking that balance. But one of my favorite moments was when they had Evan Spiegel, the co-founder ofSnapchat, speaking at the funeral of Peter Gregory.

Hill: Spoiler alert, Peter Gregory dies.

Lewis: Yeah, that's how it starts out in season two. He says, "I'm sure if Peter Gregory were here, he would say he was not disappointed in Snapchat as an investment." But, you get these guys that are revered in the space to come on and just be little characters in this larger show.

Hill: Playing themselves.

Lewis:Playing themselves. Other people who have been on the show -- Eric Schmidt, who we talked about before, Tyler and Cameron Winklevoss from the Facebook, allegedly, and Dick Costolo, former CEO of Twitter, who we talked about. It's always fun to spot who's coming into the scenes, because oftentimes it's a very famous face.

Hill: Yeah. If nothing else, this is a show definitely worth checking out, beyond the real-life applications that you can take away as investors. But again, as you touched on, those very much exist, and it's a great indication of a world that leads to the world that is right in the sweet spot of The Motley Fool. We focus almost exclusively on public companies. It doesn't mean we're not looking at the private companies, and eager for the S-1 to come out. But if you look at what's happened since Silicon Valley first went on the air, one of the things we've seen in the real world of investing is pulling back the reigns a little, tightening the reigns on the rush to go public.

Becauseyou mentioned unicorns -- for those unfamiliar, a unicorn is a private company with a valuation of $1 billion. There was a quote going around last year from someone on Wall Street saying, "I think this year, we might see some dead unicorns." And that certainly has played out. I think we've seen, I would argue, with Twitter, but certainly with other companies as well, going public isn't always the greatest thing in the world. It's much harder to be a public company than a private company. That's why I think you see a company likeUber-- which, if it were a public company today, would very easily have a valuation of somewhere between $75 billion and $100 billion. But, that's a company that's not looking to go public.

Lewis: Yeah. And you've seen that with the cadence of IPOs recently. I can only think of two really big tech IPOs off the top of my head,Twilio (NYSE: TWLO)being one, and that was the largest of the year. That was about two months ago. But there was kind of a drought there for a while. I do think, looking at the private space, it's always interesting to see what's getting VC money, and also what private companies are getting scooped up by public companies. It's kind of a signal for where these companies are looking to position themselves, where they want to play, and some of the big tech trends to watch in the coming time.

Hill: I'm really excited for season four, because I have no idea where they're going to go. I would be curious to see if they actually look to take Pied Piper public.

Lewis: We'll just have to wait and see.

Hill: I'll be there.

Lewis: Listeners, that does it for Pop Culture Week and this episode of Industry Focus. If you have any questions, or just want to reach out and say hey, shoot us an email at IndustryFocus@Fool.comFool.com/podcasts

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Chris HillDylan Lewisfree for 30 daysconsidering a diverse range of insightsdisclosure policy