Business Models

by Dick Costolo

There's been some discussion in the tech blogosphere about startups and their need to have a clear business model, and some confusion from entrepreneurs about why it's ok for some businesses not to have known business models when they are expected to show three year pro-formas and be grilled about their model during any investor pitch.

I generally believe that for many technology companies, you need not necessarily have any idea how you will make money when you get started, and if you show good progress on the product and customer adoption, you need not make any commitments to a business model for some time. You do need to intimately understand where you sit in the proverbial value chain and what your position there means for your company, but you don't need to know precisely how you will extract value. In fact, I'll go farther and say that focusing on business model too early can hurt a company's prospects. When asked about Google's lack of a clear business model when he backed the company, John Doerr is said to have responded "With this kind of traffic, we'll figure it out". It's hard for some people to make sense of this when juxtaposed against their own experience pitching VC's, during which an obviously best-guess business model is grilled and questioned. What's going on here?

I have said before in this blog (or if not here, then certainly in my own mind) that I think all startups should think of the long road in front of them in three phases: during phase 1, you need to be passionate about the product (or service); during phase 2, you need to be passionate about your customers (*and* the product); during phase 3, you need to be passionate about revenue (*and* customers *and* the product). That may sound like some statement out of a "7 Habits of Highly Successful Startups" manual, but what does it really mean?

First, it's important to remember that you (you being the startup or entrepreneur) have limited resources. In the beginning, you are the most limited in terms of resources but the least limited in terms of range of motion. It's easier to innovate and change directions in the early days, but it's harder to do nine things at once. This is probably the founding team's favorite part of the lifecycle of the company. Everything is possible, and you can really focus on building the most awesome product/service possible, nimbly making changes in direction on the fly and rolling out different or new capabilities easily while simultaneously shutting down capabilities that seem to make no sense as part of the evolving vision. This is one reason I hate to see very early stage companies sign a big customer before the product is baked. You are encumbered by product commitments and customer support before you truly know what the market wanted. You have to be passionate about a customer and the product when you should be laser focused on the product. The customer's needs and your goals vis a vis the market may diverge. In an effort to show progress, however, the marquee customer is attractive in the belief it will help attract investment (and this may indeed be true). In a previous life before FeedBurner, my founders and I made the mistake of signing a big name customer to a paid monthly contract before we really knew what the product's place in the market should be. Won't ever do that again.

So, you grow, and the product gets to the point where it's usable and people start climbing in the bus, and if you're really lucky, it's growing like a weed and customer adoption is rampant. So, now we come to this curious world in which some people start to say "sure it's great, but what's the business model" while other people are saying "don't worry about the model right now, grow grow grow" (which is in turn interpreted by the first group as either "forgetting what happened in the bubble" or greedy or just stupid). I strongly believe that while you are growing in this phase, and expanding your initial team, you need only be passionate about the product and passionate about the customer. So, what does it mean to be passionate about the customer? Come closer and pay attention because I might not say what you think i'm going to say. If you ask a customer what being passionate about the customer means, you might generally hear "great customer service". This is not necessarily what I mean in the business sense. Passionate about the customer means that you are doing everything in your power to a) get more customers and b) make sure that your existing customers have little reason to want to stop using your product (what's referred to as "churn" in the antiseptic parlance that is preferred by some). Is great customer service one way to accomplish this? It can be, yes. What are some other mechanisms by which you can be passionate about the customer? Well, if you want to minimize churn, your product needs to be as usable and bug-free as possible. Nothing offers the competition an opportunity to show its stripes like your product not working. I think of response time, for example, as part of the passionate about the customer bucket, not the passionate about the product bucket. Slow response times can reduce new customer growth and give existing customers reason to try out a competitive offering.

It is absolutely critical, however, that you not make the fatal mistake of interpreting "passionate about the customer" with a mindset of being in reaction to a specific customer or customers. What the heck does "in reaction to a specific customer" mean? Ted Rheingold, the founder of Dogster and Catster, likes to say "the customer that emails you all the time is not all your customers". If you have a thousand customers, and you think that you are being passionate about the customer because you immediately respond to the two customers that repeatedly send emails like "YOUR SERVICE IS ACTING LIKE A *$#@! !!! PLEASE FIX THIS NOW. WHY CANT YOU PEOPLE GET A CLUE AND GROW THE !@#$! UP???", then you aren't being passionate about the customer, you're just feeding the raccoons. It is really really hard to get this through your head. You want to help everybody that's using your service. Here are a couple people that seem to want to use your service but repeatedly complain like this...if you are trying to help them, then you must be passionate about your customers. Instead, all you're really doing here is causing your team and company a lot of aggravation. I'll use a stupid analogy for those of you who play golf. When you make a bad shot, your inclination on the next shot is to think specifically about fixing that thing you just did wrong and think about making sure you don't do those two specific things wrong again. Of course, this is a recipe for disaster. The right way to play the game is to have a very consistent approach to every shot, irrespective of what just happened on the very last shot. So it is with an approach to being passionate about the customer. You need to understand what things you are going to do, how you are going to communicate with ALL your customers, etc. in order to maximize the number of new customers that will try your service, and at the same time minimize the number of people who you give a reason to try something else. Maybe this includes responding immediately to all caps emails that contain > 50% vulgarity, maybe it means ignoring those. Maybe it means being in reaction to every blog post you see, maybe it means never responding to any of those but frequently letting your community of customers know what's going on at HQ. Maybe it means using your constrained resources to do no communication at all and focus 100% on having the fastest and most highly available service. That's for you to figure out. We happened to be of the "hypercommunication with customers" mindset and practice at FeedBurner, but I know of wildly successful internet companies that had absolutely no customer feedback mechanism and yet almost never lost a customer because the service just worked.

So, we come to the point of the whole post: business model. Let's say you have 20 people in your company working with you. Let's say your initial product is a big hit, and people are adopting it with such enthusiasm that your growth rate is beyond your wildest dreams. The product is still in its relative infancy, but you're working out the kinks.
Is it critical that you figure out your business model as soon as possible? No.
Is it critical that you have enough cash to make sure you can grow the business? Yes.
Might it be the case that you can't get access to capital unless you have a sound business model? Yes.
Is life fair? No.
Don't you ultimately have to figure out how the heck you're going to make money? Of course, but....

You've got limited resources. It's still early. It is very likely the case that the first business model you try will not work (or will need to be amended or supplemented with other mechanisms). So, while you should be laser focused on having your company be passionate about product and passionate about customers, you don't need to be (and in fact you shouldn't be) passionate about revenue until the business model reveals itself. How the heck does a business model reveal itself? You try different things....the less you worry about fixating on a specific model, the more different things you can try. Maybe it's an ad model, maybe it's a free/premium model, maybe it's a private label model, maybe it's something else altogether. But leave yourself room to be in that quantum state of "it could be this or it could be that" until you figure out what works. Only then do you have to ramp up sales, finance, sales engineering, etc. and go out to the market with a very specific model. Announcing your model to the market before you really figure out what works forces you into multiple binds....the model may not scale, the model may be wrong, and you're now in a position where you have very limited resources and you are trying to get your company to be passionate about three things: product, customer, revenue. You also signal to the market and your investors that the clock is now ticking. Didn't hit your q1 revenue number? Uh oh, you're now going to be a lot more focused in q2 on figuring out how to hit that revenue target but you're also still in hyper-growth mode so the product and customer base require everybody's critical attention. Much better to be internally focused on fostering continued growth and innovation while tinkering around on the side with potential models, knowing that the ultimate model may not present itself for some time.

Conundrum: if this is true, then why do potential investors always drill you on your business model?! Because they want to understand how you think of the company and the business. It will ultimately have to go through these three phases. Does any of your thinking about business models sound even remotely plausible? Is it the case that you are starting a company in an area in which many others have tried and failed? If so, then why do you think yours will work? What you are hearing when potential investors ask you this question is not: "I don't see how that business model will make the 9 million in top line, with 39% margins that you show on page 10", instead you are hearing "help me understand how you see this ultimately functioning as a business". It may be that your answer is "look, we think there is a free/premium model here that works if X and Y are true. However, if A and B are true, and so far that appears to be the case, then it's more likely that we go go go on product innovation for the next year and then attack this as a private label model when enterprises follow consumers into the market". Bottom line: Investors are trying to see how you're thinking about this, not whether you have the right answer.

Conundrum Part II: Our service is free and because we don't have a business model, should we pursue charging for it as one of the potential models? Uh, I suppose you could, but why would you do that if it's going to impede growth? Look, there are plenty of great business models based on charging a subscription fee. It's also the case that we've all been burned by "now it's free, now it's not" services in the past (think ATM's, for example....it's free until we're all using it, at which point it's $2 per withdrawal). Nonetheless, it would appear that models in which revenue and earnings accrue to a company as an indirect function of its free use are the models that have the most powerful impact on the Internet today, and you work against that trend at your own peril. This is probably true even where specific industries continue not to admit it. When you add costs to using a product/service, you add friction to customer adoption (he said, stating the obvious). If somebody else comes along and figures out how to make money on such a service by providing it for free, then it's not so much fun to be you because your competitor's lack of friction is going to make life harder for you. And time and time again on the Internets, we see that somebody ultimately comes along and figures out how to make a lot of money by offering for free a service for which somebody else is charging.

When do you need to figure out your business model? Before you run out of cash. Sucks to read through that much text for such an unenlightening conclusion, but there you have it.

Due Diligence

by Marc Averitt

Top Ten Myths of Entrepreneurship

by GuyKawasaki

This is a guest post by Scott Shane as a follow up to his entrepreneurship test. He is the A. Malachi Mixon Professor of Entrepreneurial Studies at Case Western Reserve University. He is the author of seven books, the latest of which is The Illusions of Entrepreneurship: The Costly Myths That Entrepreneurs, Investors, and Policy Makers Live By. Many entrepreneurs believe a bunch of myths about entrepreneurship, so here are ten of the most common and the realities that bust them:

1. It takes a lot of money to finance a new business. Not true. The typical start-up only requires about $25,000 to get going. The successful entrepreneurs who don’t believe the myth design their businesses to work with little cash. They borrow instead of paying for things. They rent instead of buy. And they turn fixed costs into variable costs by, say, paying people commissions instead of salaries.

2. Venture capitalists are a good place to go for start-up money. Not unless you start a computer or biotech company. Computer hardware and software, semiconductors, communication, and biotechnology account for 81 percent of all venture capital dollars, and seventy-two percent of the companies that got VC money over the past fifteen or so years. VCs only fund about 3,000 companies per year and only about one quarter of those companies are in the seed or start-up stage. In fact, the odds that a start-up company will get VC money are about one in 4,000. That’s worse than the odds that you will die from a fall in the shower.

3. Most business angels are rich. If rich means being an accredited investor –a person with a net worth of more than $1 million or an annual income of $200,000 per year if single and $300,000 if married – then the answer is “no.” Almost three quarters of the people who provide capital to fund the start-ups of other people who are not friends, neighbors, co-workers, or family don’t meet SEC accreditation requirements. In fact, thirty-two percent have a household income of $40,000 per year or less and seventeen percent have a negative net worth.

4. Start-ups can’t be financed with debt. Actually, debt is more common than equity. According to the Federal Reserve’s Survey of Small Business Finances, fifty-three percent of the financing of companies that are two years old or younger comes from debt and only forty-seven percent comes from equity. So a lot of entrepreneurs out there are using debt rather than equity to fund their companies.

5. Banks don’t lend money to start-ups. This is another myth. Again, the Federal Reserve data shows that banks account for sixteen percent of all the financing provided to companies that are two years old or younger. While sixteen percent might not seem that high, it is three percent higher than the amount of money provided by the next highest source – trade creditors – and is higher than a bunch of other sources that everyone talks about going to: friends and family, business angels, venture capitalists, strategic investors, and government agencies.

6. Most entrepreneurs start businesses in attractive industries. Sadly, the opposite is true. Most entrepreneurs head right for the worst industries for start-ups. The correlation between the number of entrepreneurs starting businesses in an industry and the number of companies failing in the industry is 0.77. That means that most entrepreneurs are picking industries in which they are mostlikely to fail.

7. The growth of a start-up depends more on an entrepreneur’s talent than on the business he chooses. Sorry to deflate some egos here, but the industry you choose to start your company has a huge effect on the odds that it will grow. Over the past twenty years or so, about 4.2 percent of all start-ups in the computer and office equipment industry made the Inc 500 list of the fastest growing private companies in the U.S. 0.005 percent of start-ups in the hotel and motel industry and 0.007 percent of start-up eating and drinking establishments made the Inc. 500. That means the odds that you will make the Inc 500 are 840 times higher if you start a computer company than if you start a hotel or motel. There is nothing anyone has discovered about the effects of entrepreneurial talent that has a similar magnitude effect on the growth of new businesses.

8. Most entrepreneurs are successful financially. Sorry, this is another myth. Entrepreneurship creates a lot of wealth, but it is very unevenly distributed. The typical profit of an owner-managed business is $39,000 per year. Only the top ten percent of entrepreneurs earn more money than employees. And the typical entrepreneur earns less money than he otherwise would have earned working for someone else.

9. Many start-ups achieve the sales growth projections that equity investors are looking for. Not even close. Of the 590,000 or so new businesses with at least one employee founded in this country every year, data from the U.S. Census shows that less than 200 reach the $100 million in sales in six years that venture capitalists talk about looking for. About 500 firms reach the $50 million in sales that the sophisticated angels, like the ones at Tech Coast Angels and the Band of Angels talk about. In fact, only about 9,500 companies reach $5 million in sales in that amount of time.

10. Starting a business is easy. Actually it isn’t, and most people who begin the process of starting a company fail to get one up and running. Seven years after beginning the process of starting a business, only one-third of people have a new company with positive cash flow greater than the salary and expenses of the owner for more than three consecutive months.

The Science & Art of Term Sheet Negotiation

by Furqan Nazeeri

By the time I was in the 9th grade, I had been playing chess for a few years (as in I knew the rules) but I didn't play seriously and more often than not I lost.  Then one day at the library (remember, pre-internet) I happened to find a book on chess.  So I read the book and almost overnight I became one of the chess "stars" in high school.  In one of the funnier incidents, I started playing chess during lunch hour and was "hustling" money which on one occasion resulted in a kid pulling a knife on me after I relieved him of a few bucks.  True story.

What was it in that book that allowed me to take advantage of the situation?  Well, there was a lot of basic stuff, some general rules and even some strategy, however, the most useful bit of information, initially, was a table on the relative value of pieces.  You know, a pawn is worth 1, a knight/bishop 3, rook 5, a queen 9 and the king "infinite" unless it's the endgame then it's more like a 4. 

Experienced players have a "feel" for this from many games played and they can also break the "rules" by, for example, sacrificing a queen for a rook to get better position.  But these are all things learned from experience and best not tried by a novice.  If you are new to the game, you have no idea.  When you are starting out, having some rules of thumb can make all the difference between winning and getting hustled.

What does this have to do with negotiating term sheets?  Well, I think a lot of newbies get hustled when negotiating term sheets because they don't know the relative importance of the various terms.  Have you heard the joke about the VC who says, "I'll let you pick the pre money valuation if I get to pick the terms?"  My goal here is to provide a framework that gives relative value of various terms on a term sheet and allows you to compare them on two dimensions: economics and control (or as my friend Noam Wasserman likes to say, "rich" versus "king").  In the same way that a chess grand master doesn't need rules of thumb from someone else, if you're a seasoned negotiator of term sheets then this is probably equally useless.  And no, this is not based on any academic or scientific study.  It's based on my own experience and, more importantly, that of a few other experts like Dave Kimelberg (Softbank's GC). 

In my view there are 12 important terms on a typical Series A / B term sheet.  Yes there are other terms and yes sometimes they are important, but if you go with the thesis of keep it simple, then 12 is the magic number.  In terms of rating, the rich/king differentiation is important as different people are after different things so depending upon your motivation you may be inclined to pay more attention to one column than the other.  So without further adieu, below is a table showing them as well as the relative importance:

Here a 10 means it is really important to get as favorable a result as possible on this term, a 1 means it is not so important and a "-" means it doesn't apply (i.e. a zero).  The cool thing about having something like this is you can use it as a tool to compare term sheets (provided you can determine how favorable or unfavorable each individual term is...more on that below). 

The next part of this post is to provide a range of typical results for each term which will give you a means to rank each term in each term sheet with a "1,3 or 5" where 1 is "unfavorable", 3 is "fair" and 5 is "favorable."  If you aren't already familiar with the terms in a term sheet, you should check out the model term sheet (basically a template) put together by the National Venture Capital Association.  They have other model agreements too, but you will see with the term sheet that they include various options, some discussed here.  Below is a scale for each of the 12 key terms across the two dimensions:

1. Investment/price.  I think there are two ways you can rank price.  One is to rate it relative to your expectation and another is to rate it relative to similar companies (in terms of stage, geography, sector, etc.).  If you don't have comparables, you can fairly easily get them, for example Dow Jones puts out a quarterly survey of VC deal terms which includes pre-money valuation (send me an email if you want a copy).  If you're less than 80% of your benchmark, that's probably unfavorable, if you are within +/- 20% than that's fair and if you're over 120%, then it's favorable.
2. Board of directors.  This term comes down to simple math.  If you give up and don't have control of the board, that's unfavorable, if it's tied, call it fair and if you control it, that is quite favorable.  BTW, the reason I didn't rate the board control a "10" on the "king" scale is because even when you give up control, your board members are bound by fiduciary obligations to the firm, i.e. they can't do whatever they want.
3. Option pool refresh.  Often time this will show up as a separate term in the term sheet, however it is actually just another bite at the apple in terms of price.  Traditionally there is a refresh pre-deal so that after the round the company can execute on its hiring plan without needing to expand the pool for 12-18 months.  You will have to develop your hiring budget if you haven't already.  Given that benchmark and your hiring equity budget, I'd say less than 12 months is favorable, 12-18 months is fair and more than 18 months is unfavorable.
4. Preemptive rights.  As you know, preemptive rights give your investor the right to invest in future rounds.  This is of moderate economic value, however you are giving up some control of future financings.  There is remarkably little variation in how this term gets negotiated, probably because of its relatively low importance in the grand scheme.  I'm told the only area that gets negotiated is whether the investor has an "overallotment right" whereby they can take a portion or all of the pro rata of another investor in the same series who didn't participate.  That said, unless something unusual is in your term sheet, it's probably a 3 for both rich and king.
5. Anti-dilution protection.  Anti-dilution is a pretty important economic term.  In terms of the range of possibilities, no anti-dilution would be a 5, broad-based weighted average would be a 3 and full-ratchet would be a 1.  I think the vast majority of deals end up as broad-based weighted average.  Very few deals avoid it altogether, but it can be done, particularly in later stage or very hot deals.
6. Registration rights.  Reg rights have some economic value and in theory you do give up some control, but in reality they're close to worthless.  You can push on these and most investors will give in when pressed. You can negotiate when the right kicks in and cutbacks.  But bear in mind that investors will love it if you waste time negotiating this because it is not an important term.  Unless something unusual is going on, I'd rate this a 3 on both dimensions.
7. Drag along rights.  Most deals include drag along rights and like many of the other terms, the key is in the voting thresholds.  I rated this a 1/5 on the rich/king scale.  In terms of economics the issue is with regard to a sale of the company where the preferred stock, because of special rights, is indifferent to a deal that would be better for Common.  However, the bigger issue is on the control side of the equation where you could get dragged into a sale that you don't want to do.  So in terms of rating both the economic and control sides, I would say that if the thresholds are such that a single investor can unilateral drag along, that's a 1, if it takes 2 or more investors that's a 3 and if it takes investors plus either a neutral party or Common (you) then it's a 5.
8. Right of first refusal / co-sale.  I rated this a 5 because this is essentially a "lock-up" on the founders stock which seriously affects liquidity and thus value.  It doesn't really affect control issues.  If you read the actual section of the stock purchase agreement that describes this term it's several pages of bureaucratic procedures for a sale that in the real world you can't imagine ever occurring (which they don't).  As a result, the only real counter party for selling common stock is the other investors or the company with the investors approval and they're all quite likely to low ball.  Unfortunately, I've never heard of avoiding this term completely, so in terms of how to rate it, I'd say that if you can negotiate a right to sell some portion (say 20% on an annual basis) you're at a 5 otherwise if it's a standard lockup then you're at 3.
9. Dividend right.  I rate this a 5 on the economic scale.  In terms of the range, there is no dividend which is a 5, then there is a simple interest dividend which I'd say is a 3 and a 5 would be a compounding dividend.  For some reason, the dividend rate has been 8% ever since I've seen term sheets.  You can negotiate the rate, but the bigger battle is whether you pay a dividend and how the rate compounds. 
10. Liquidation preference.  This is a very important economic term that doesn't have any importance in terms of control.  The issue here is during a sale, how do investors get paid out.  I'd say about 1/3 of deals have a preference at 1X but no participation, another 1/3 have a preference with a cap and participation and the balance a preference with no cap plus participation and that's pretty much how I'd rate it, i.e. 5 for 1X preference/no participation, 3 if with a cap in the 2-4X range and 1 if with no cap and participation.
11. Protective provisions.  This is very important from a control perspective but not so economically.  While there are a ton of these protective provisions, the key ones relate to sale/merger of the company and future rounds of financing.  As with other control rights, the key is in the voting thresholds so I'd assess this the same as 7 (drag along rights).
12. Redemption.  Finally, we get to number twelve, redemption rights.  This is an almost worthless economic right.  I've never seen or heard of this being exercised and most investors will acquiesce if you push on this.  Unless you see something unusual, I'd rate this a 3.

Ultimately the individual rating combined with the overall importance of each term will allow you to create a weighted average total for each term sheet on both the rich and king dimensions.  While you wouldn't want to make a decision to take an investment on this alone, it will give you a basic idea of where the strengths and weaknesses of particular term sheets lie.  It also gives some tips for negotiating.  For example, you don't want to waste your time negotiating redemption rights and attorney's fees and instead, you want to go to the core of what's important to you on the rich/king scale.

Due Diligence Binder

by James Chen

The reason this topic is important to me is that more and more I am seeing entrepreneurs and start up companies who really don't have the first clue as to how to go about obtaining funding. They have piqued the interest of some investors, but they do not know what the next step is. They may have heard the term "Due Diligence" but they really don't know exactly what it means or how it is conducted. Every venture firm or angel investor will have (should have) his or her own protocol of conducting due diligence. I have seen as formal a process as a due diligence worksheet where the company is scored on various metrics. Or as informal as a group of partners giving a company the thumbs up or thumbs down. With angels, I have seen it as simple as a discussion over a cup of coffee.

If you had $5 to $10 mm to invest in the life of a startup company, how extensive would you want to check up on the company and its managers? There are only a few real life examples that I can think of that stress the importance of what due diligence really means. For example: when you go to hire your babysitter or live-in nanny, what kind of information would you want to find out to make sure they are a fit for your family? Surely this would include references, a biography, a resume, and some research about what this person is all about.

If you were a famous politician, what kind of due diligence would you do on your closest security personnel? I would imagine that it would be pretty stringent. If you are lucky enough to survive the treacherous Goldman Sachs interviews and get an offer for a job, they will basically do an FBI background check on you to make sure that you have not had any run ins with the law and that everything you say with regards to your criminal history is true (Don't ask me how I know this!)

An old school financially-minded venture institution will conduct due diligence on a company that will at the minimum include seeing audited and unaudited financials since inception,  all correspondence to investors, all versions of a business plan and its updates, background checks on key personnel, lease agreements, purchase or sale agreements, and employment contracts. There is a good chance that the firm has a due diligence team or will hire outside professional lawyers and accountants to make sure everything is OK. You have to remember that these firms have LPs and have a fiduciary duty to do what they can to make sure their investments are crisp and clean. They want to make sure there are no hidden liabilities or debts that they are going to become responsible for once they become attached to the company.

In short, if you are going to obtain serious venture financing, be ready to go to the Proctologist. They are going to make sure your financials are scrubbed squeaky clean. If they sense there is any misrepresentation, then get ready to start explaining.

What does this mean for you the entrepreneur? Well if you know you are going to the Proctologist, then you better start cleaning out your system and flushing yourself thoroughly. You don't want him to find out that you are full of SHIT!!! In ordinary terms this means keeping your accounting and financials clean, having a good reporting system in place, and most importantly, creating a DUE DILIGENCE BINDER!

You don't understand how happy I am when I am interested in a company and THEY send me a due diligence binder that pretty much has everything I want. This means I don't have to ask. I don't have to wait. I don't have to hear some lame excuses about why they don't have the information I want already accumulated. When I work with an entrepreneur who has already prepared one, I know I am dealing with someone highly sophisticated who has been through the drill before. Perhaps he or she has obtained financing before, has M & A experience, or investment banking experience. Anybody who has this prepared obviously knows that the venture financing drill can take a while and they want to make it as expedient as possible.

So if you are an entrepreneur, here is my advice. A good due diligence binder is a royal pain to make. The easiest thing to do is to find out what you want to include in your due diligence binder and make a template of the sections. Update these templates on a quarterly, semiannual, and annual basis - make it a standard part of your accounting and reporting procedures that you report to your shareholders. Some things to include are an update of your business metrics, financial performance, and budget. When it comes time for you to put out a due diligence binder you will already have in place what you need!

I believe a good entrepreneur will create a due diligence binder on a yearly basis even if he or she is not in the market for financing. Creating a due diligence binder forces an entrepreneur to analyze his company as a whole and see what holes are in it.  If he took a step back and looked at the company as an outsider, what weaknesses would he identify? If he is particularly sophisticated, he may realize that the process of updating and creating this binder and report is really a simulation of the rigorous reporting standards required to be on the public markets. If he is very sophisticated, he may take advantage of key advisors and consultants and send this binder out for free feedback that would serve his company well. By having one of these binders in hand, he will be prepared if there is an unexpected event and his company needs financing. If he is having a great day, a potential suitor for his company may come knocking on the door with interest in buying his company....voila! he has a package for them that they can look over and he won't be disrupted from day to day activities scrambling for all this information and potentially turning away an acquirer.

If you haven't figured it out yet, a due diligence binder is far more than just a binder - it is the hard copy that represents a faithful process of reporting, updating, and analyzing your whole business.

You want to provide your investor adequate information for them to research you and your company. The more you provide, the better they can evaluate you. While some entrepreneurs may be leery at providing this kind of proprietary information to outsiders, you must understand that your investors will be spending money to investigate you - take this as a sign that they are serious about your company. If you desire, you can make them sign non-disclosure. If you are paranoid, you might go as far as setting up a clean and confidential room such as may be used in an M & A process. One easy alternative is to create a truncated DD binder and leave out key pieces that may be requested as appendices.

So here is what I like to see in a solid DD binder:

1. Background of company since inception
2. Background of key personnel
3. Business plan and all previous versions, including exit strategy
4. All correspondence to previous investors
5. All audited and unaudited financials since inception
6. Discussion of performance
7. Capitalization Table
7. Lease agreements
8. Employment agreements
9. Purchase or sale agreements
10. Previous letters of intent

If you are just starting up, you want to have reporting processes in place that make it easy to update this DD binder on a quarterly basis. You want to be able to get this out to people immediately if they request it. If you are an established startup and are now just putting together a DD binder, your investor will probably be able to see that you are not that organized and that you really haven't done this before. This may or may not pose a problem, but if your financials and accounting are crisp and clean and you have a nice reporting system in place already then your investor will surely know that accountability and reporting are not going to be an issue.

In this day and age of electronic networks, there are various on-line reporting systems that are used by private companies or investment companies to deliver correspondence. Many open-minded institutions post all of this information that might be included in a DD binder on this network and make it available to potential investors. I will admit that this is somewhat rare, but I have done due diligence before on a firm that gave us access to their intranet that contained all correspondence and reports for all of their previous and current funds. Suffice it to say that we found no holes in any of their documents and reporting and they have one of the cleanest books that would make any LP sleep comfortable at night.

As you can imagine, this is a generic list of items that will need to be tailored according to industry or type of company. For example if your startup is an investment company or private equity firm, you will want to focus more on track record and perhaps investment strategy. You may want to include a list of previous investors or key LP relationships or even letters of "soft" commitments from LPs to shows that you will not have problems raising investment funds. Because investment firms tend to rely on key personnel, one thing I do like to see is a discussion of exit strategy of the key principals including how long they plan on being with the company and what their personal investment in the firm has been to date.

Feel free to let me know if you have any additions or questions.

作者：桂曙光

（本文删节版已在《创业邦 www.cyzone.cn》杂志第三期，2008年1月发表。转载请注明来源及作者！！！）

风险投资人对某公司进行投资时，通常是购买公司某类优先股（A、B、C…系列），这些优先股在一定条件下可以按照约定的转换价格（conversion price）转换成普通股。为了防止其手中的股份贬值，投资人一般会在投资协议中加入防稀释条款（anti-dilution provision）。

防稀释条款，或者叫价格保护机制，已经成为大多数VC的Term Sheet中的标准条款了。这个条款其实就是为优先股确定一个新的转换价格，并没有增发更多的优先股股份。因此，“防稀释条款”导致“转换价格调整”，这两个说法通常是一个意思。

防稀释条款主要可以分成两类：一类是在股权结构上防止股份价值被稀释，另一类是在后续融资过程中防止股份价值被稀释。（下文以A系列优先股为例讲解）

结构性防稀释条款（Structural anti-dilution）

结构性防稀释条款包括两个条款：转换权和优先购买权。

（1）转换权（Conversion）

这个条款是指在公司股份发生送股、股份分拆、合并等股份重组情况时，转换价格作相应调整。这个条款是很普通而且是很合理的条款，也完全公平，通常企业家都能够接受。Term Sheet中的描述如下：

Conversion: The Series A Preferred initially converts 1:1 to Common Stock at any time at option of holder, subject to adjustments for stock dividends, splits, combinations and similar events and as described below under “Anti-dilution Provisions.”

转换权：A系列优先股股东可以在任何时候将其股份转换成普通股，初始转换比例为1:1，此比例在发生股份红利、股份分拆、股份合并及类似事件以及“防稀释条款”中规定的情况时做相应调整。

举例来说：优先股按照$2/股的价格发行给投资人，初始转换价格为$2/股。后来公司决定按照每1股拆分为4股的方式进行股份拆分，则新的转换价格调整成$0.5/每股，对应每1股优先股可以转为4股普通股。

（2）优先购买权（Right of first refusal）

这个条款要求公司在进行B轮融资时，目前的A轮投资人有权选择继续投资获得至少与其当前股权比例相应数量的新股，以使A轮投资人在公司中的股权比例不会因为B轮融资的新股发行而降低。另外，优先购买权也可能包括当前股东的股份转让，投资人拥有按比例优先受让的权利。

这也是一个很常见且合理的条款，Term Sheet中的描述如下：

Right of First Refusal: Investors shall have the right in the event the Company proposes to offer equity securities to any person (other than the shares reserved as employee shares described under “Employee Pool” and other customary exceptions) to purchase their pro rata portion of such shares (based on the number of shares then outstanding on an as-converted and as-exercised basis).

优先购买权：投资人有权在公司发行权益证券的时候（发行“期权池”股份及其他惯例情况出外）按其股份比例（完全稀释）购买相应数量的股份。

 

降价融资的防稀释保护权（Anti-dilution protection in Down Round）

公司在其成长过程中，往往需要多次融资，但谁也无法保证每次融资时发行股份的价格都是上涨的，风险投资人往往会担心由于下一轮降价融资（Down Round），股份的发行价格比自己当前的转换价格低，而导致自己手中的股份贬值，因此要求获得保护条款。

防稀释条款通常是一个公式，它决定优先股在转换成普通股时的数量。大部分的公式基于优先股的“转换价格”，而最开始的转换价格就是投资人购买优先股的价格（Initial Purchase Price）。在公司以低于本轮的价格进行了后续融资之后，转换价格就会降低。

所以，如果没有以更低价格进行发行股份（后续融资），初始的购买价格跟转换价格就是一样的（假定没有结构性稀释），优先股也将按1:1转换成普通股。如果后续以更低价格发行了1次或多次股份，转换价格就会比初始购买价格低，优先股能转换成更多的普通股。根据保护程度的不同，优先股的转换价格保护主要分为“完全棘轮”调整以及“加权平均”调整两种方式。

Term Sheet中的描述如下：

Anti-dilution Provisions: The conversion price of the Series A Preferred will be subject to a broad-based weighted average adjustment to reduce dilution in the event that the Company issues additional equity securities at a purchase price less than the applicable conversion price.

防稀释条款：如果公司发行新的权益证券的价格低于当时适用的A系列优先股转化价格，则A系列优先股的转换价格将按照广义加权平均的方式进行调整以减少投资人的稀释。

（1）完全棘轮条款（Full-ratchet anti-dilution protection）

完全棘轮条款就是说如果公司后续发行的股份价格低于A轮投资人当时适用的转换价格，那么A轮的投资人的实际转化价格也要降低到新的发行价格。这种方式仅仅考虑低价发行股份时的价格，而不考虑发行股份的规模。在完全棘轮条款下，哪怕公司以低于A系列优先股的转换价格只发行了一股股份，所有的A系列优先股的转化价格也都要调整跟新的发行价一致。

举例来说，如果A轮融资$200万，按每股优先股$1的初始价格共发行200万股A系列优先股。由于公司发展不如预想中那么好，在B轮融资时，B系列优先股的发行价跌为每股$0.5，则根据完全棘轮条款的规定，A系列优先股的转换价格也调整为$0.5，则A轮投资人的200万优先股可以转换为400万股普通股，而不再是原来的200万股。

完全棘轮条款是对优先股投资人最有利的方式，使得公司经营不利的风险很大程度上完全由企业家来承担了，对普通股股东有重大的稀释影响。为了使这种方式不至于太过严厉，有几种修正方式：（1）只在后续第一次融资（B轮）才适用；（2）在本轮投资后的某个时间期限内（比如1年）融资时才适用；（3）采用“部分棘轮（Partial ratchet）”的方式，比如“半棘轮”或者“2/3棘轮”，但这样的条款都很少见。

（2）加权平均条款（Weighted average anti-dilution protection）

尽管完全棘轮条款曾经很流行，现在也常常出现在投资人的Term Sheet里，但最常见的防稀释条款还是基于加权平均的。

在加权平均条款下，如果后续发行的股份价格低于A轮的转换价格，那么新的转换价格就会降低为A轮转换价格和后续融资发行价格的加权平均值，即：给A系列优先股重新确定转换价格时不仅要考虑低价发行的股份价格，还要考虑其权重（发行的股份数量）。

这种转换价格调整方式相对而言较为公平，计算公式如下（作为Term Sheet的附件或置于条款之中）：

NCP = A系列优先股的调整后新转换价格

CP = A系列优先股在后续融资前的实际转换价格

OS = 后续融资前完全稀释（full dilution）时的股份数量或已发行优先股转换后的股份数量

NS = 后续融资实际发行的股份数

SNS = 后续融资额应该能购买的股份（假定按当时实际转化价格发行）

IC = 后续融资现金额（不包括从后续认股权和期权执行中收到的资金）

加权平均条款有两种细分形式：广义加权平均（broad-based weighted average）和狭义加权平均（narrow-based weighted average），区别在于对后轮融资时的已发行股份（outstanding shares，即上面公式中的OS）及其数量的定义。（a）广义加权平均条款是按完全稀释方式（full diluted）定义，即包括已发行的普通股、优先股可转换成的普通股、可以通过执行期权、认股权、有价证券等获得普通股数量，计算时将后续融资前所有发行在外的普通股（完全稀释时）认为是按当时转换价格发行；（b）狭义加权平均只计算已发行的可转换优先股能够转换的普通股数量，不计算普通股和其他可转换证券。

广义加权平均时，完全稀释的股份数量很重要，即包括所有已发行和将发行的股份（优先股转换、执行期权和认股权、债转股、等），企业家要确认跟投资人的定义是一致的。相对而言，狭义加权平均方式对投资人更为有利，公式中不把普通股、期权及可转换证券计算在内，因此会使转换价格降低更多，导致在转换成普通股时，投资人获得的股份数量更多。

仍拿上例来说，如果已发行普通股为800万股，新融资额为$300万，按$0.5的价格发行600万B系列优先股。则广义加权平均时新的转换价格为：

而狭义加权平均时新的转换价格为：

A轮投资人投资的$200万分别可以转换为246万和320万股，相对前面的400万股，要公平一些。

防稀释条款的谈判要点

企业家和投资人通常对结构性防稀释条款不会有什么争议，主要谈判内容是针对后续降价融资的防稀释保护条款。

（1）企业家要争取“继续参与”（pay-to-play）条款

这个条款要求，优先股股东要想获得转换价格调整的好处（不管是运用加权平均还是棘轮条款），前提是他必须参与后续的降价融资，购买等比例的股份。如果某优先股股东不愿意参与，他的优先股将失去防稀释权利，其转换价格将不会根据后降价续融资进行调整。

Term Sheet中的描述如下：

Pay-to-Play: On any subsequent down round all Investors are required to participate to the full extent of their participation rights, unless the participation requirement is waived for all Investors by the Board. All shares of Series A Preferred of any Investor failing to do so will automatically lose anti-dilution rights.

继续参与：所有投资人都要完全参与后续可能的降价融资，除非董事会允许所有投资人都放弃参与，任何没有参与的投资人的A系列优先股将自动失去防稀释权利。

（2）列举例外事项

通常，在某些特殊情况下，低价发行股份也不应该引发防稀释调整，我们称这些情况为例外事项（exceptions）。显然，对公司或企业家而言，例外事项越多越好，所以这通常是双方谈判的焦点。Term Sheet中的描述如下：

The following issuances shall not trigger anti-dilution adjustment: (i) reserved as employee shares described under the Company’s option pool, (ii) … (iii) …

发行下列股份不引发防稀释调整：(1)公司期权池为员工预留的期权，(2)… (3)…

通常的例外情况有（防稀释调整将不包括下列情况下的股份发行）：

（a）任何债券、认股权、期权、或其他可转换证券在转换和执行时所发行的股份；

（b）董事会批准的公司合并、收购、或类似的业务事件，用于代替现金支付的股份；

（c）按照董事会批准的债权融资、设备租赁或不动产租赁协议，给银行、设备出租方发行的或计划发行的股份；

（d）在股份分拆、股份红利、或任何其他普通股股份分拆时发行的股份；

（e）按照董事会批准的计划，给公司员工、董事、顾问发行的或计划发行的股份（或期权）；

（f）持大多数已发行A类优先股的股东放弃其防稀释权利；

需要注意的是最后一条（f），跟上面的“继续参与”条款类似。在有些投资案例中，后续低价融资时，大多数A系列优先股股东放弃其防稀释权利，同意继续投资。可能有少数投资人不打算继续投资下一轮，他们想通过防稀释条款来增加他们转换后的股份比例。那根据这个例外事项，这些少数投资人是不能执行防稀释条款的。这一条会迫使少数投资人继续参与下一轮投资，以便维持股份比例。

（3）降低防稀释条款的不利后果

首先，不到迫不得已，企业家永远不要接受完全棘轮条款；其次，要争取一些降低对创业者股份影响的办法，比如：

（a）设置一个底价，只有后续融资价格低于某个设定价格时，防稀释条款才执行；

（b）设定在A轮融资后某个时间段之内的低价融资，防稀释条款才执行；

（c）要求在公司达到设定经营目标时，去掉防稀释条款或对防稀释条款引起的股份稀释进行补偿。

（4）企业家可能获得的防稀释条款

企业家在跟VC就防稀释条款谈判时，根据双方的谈判能力，公司受投资人追捧的程度、市场及经济状况等等因素，可能得到不同的谈判结果，如下表：

本人编制了一个Excel表格帮助企业家模拟在不同的后续融资估值情况下，不同的防稀释条款对转换价格、转换后股份数量及股份比例的影响。下载地址是：http://www.esnips.com/doc/d8fd42c9-bb51-4733-8dac-5879c4f454e7/Anti-dilution-Calculation-(English-Version)

防稀释条款背后的道理

第一，有了防稀释条款，能够激励公司以更高的价格进行后续融资，否则防稀释条款会损害普通股股东的利益。防稀释条款要求企业家及管理团队对商业计划负责任，并对承担因为执行不力而导致的后果。

大部分创业者接受这个条款，如果他们对公司的管理不善，导致后续融资价格低于本轮融资的话，他们的股份会被稀释，所以在有些情况下，企业家可能会放弃较低价格的后续融资。

第二，投资人如果没有防稀释条款保护，他们可能会被“淘汰”出局。比如，如果没有防稀释条款，企业家可以进行一轮“淘汰”融资（比如$0.01/股，而当前投资人的购买价格是$2/股），使当前的投资人严重稀释而出局，然后给管理团队授予新期权以拿回公司控制权。

另外，VC也可以通过这个条款来保护他们面对市场和经济的萎靡，比如2000年左右的互联网泡沫。

一个防稀释条款案例

假设某公司已给创始人发行了1,000,000股普通股，给员工发行了200,000股普通股的期权，A轮融资时以$1.00的价格给VC发行了1,000,000股A系列优先股（融资$1M）。B轮融资时，以$0.75的价格发行了1,000,000股B系列优先股（融资$0.75M）。

下表给出在广义加权平均、狭义加权平均和棘轮降低三种情况下，A系列优先股股东在B轮融资后的转换价格，以及1,000,000股A系列优先股能够转换成普通股的数量。

从上表可以看出，不同防稀释条款，导致的股份转换数量的差异，以及对创始人和当前股东的影响。

总结

防稀释条款通常是精明的投资人为了在后续低价融资时，保护自己的利益一种方式。对创始人来说，防稀释条款通常是融资中的一部分，理解其中的细微差异和了解谈判的要点是创业者很重要的创业技能。

尽管偶尔A轮融资的Term Sheet中不包括防稀释条款，但如果有的话，不要试图要求VC去掉防稀释条款，所以在谈判之前多些了解总是有好处的。另外，只要企业家把公司经营好，在融资后为公司创造价值，让防稀释条款不会被激活实施，这比什么都强。(桂曙光 Sam GUI)