A hierarchy of pitches

by Eric Ries

Every company will need to pitch itself from time to time. Usually we think of pitches in the context of raising money, but that is only one of many pitch situations. We pitch to potential partners, vendors, publishers, conferences, employees, and even lawyers.

Pitching is different from selling a product, because it is not part of our regular business practice, is not something that relates to our core competence, and tends not to happen in a repeatable and scalable way. (I'll exclude those non-lean startups who basically exist for the purpose of raising bigger and bigger sums of money. You're not one of those are you?)

Pitches usually fail because they answer the wrong questions.

Most of the times I have seen pitches fail, it is not because they are poorly written, or that the entrepreneur lacks passion. It is because they don't answer the right question.

My favorite example of all time comes from students in an entrepreneurship class. Their idea was to build a next-generation autonomous robot, that could be used by defense and security agencies around the world. The whole pitch was about how valuable robots could be in the future. They even included a slide with The Transformers on it.

Now there was nothing wrong with their analysis: anyone who invents a technology as sophisticated as The Transformers is definitely going to make a lot of money. But these students completely failed to address the one and only question on their audience's mind: can you three guys really build the robots of the future? (Turns out, they were incredibly well-credentialed graduate students who had, in fact, developed some interesting new robotics technology. But you wouldn't have known that from their pitch.)

The right questions depend on your business’ stage.

I have come to believe that there is a hierarchy of pitches, and that understanding where your pitch falls on this spectrum can assist in making decisions about what information to highlight. Pitches higher in the hierarchy tend to be more successful, and so if you can fit your company into one of those categories, you can get better results or better terms.

Now, just because you can do a thing, doesn't mean you should - and there are plenty of other great resources out there that can help you think through whether and when to raise money (or do other kinds of deals).

With that disclaimer out of the way, here's how I order the hierarchy of pitches:

1. Printing money
   Key questions: are those numbers real? how big is the market? can your team execute the growth plan?
   Most important slide: valuation
2. Promising results
   Key questions: can you monetize that traffic? (or drive traffic to that profitable destination?) do you know why you've achieved those results?
   Most important slide: hockey stick
3. Micro-scale results
   Key questions: who is the customer, and how do you know? what is the potential market size? what are the business economics?
   Most important slide: lessons learned
4. Working product
   Key questions: what does the product do? what's the launch plan? who's on the marketing team?
   Most important slide: live demo
5. Prototype product
   Key questions: what will it take to ship a working product? how do you know anyone would want it? who's on the engineering team?
   Most important slide: demo (if the product solves an obvious problem), engineering resumes (if the product is nearly impossible to build), "day in the life of a customer" (if neither of the above)
6. Breakthrough technology
   Key questions: who owns the patents? can we make a product out of this technology? are there any good substitutes?
   Most important slide: barriers to entry
7. All-star team
   Key questions: has the team made money for their investors in the past? are they domain experts? are they committed to an idea in their domain of expertise?
   Most important slide: problem we are trying to solve
8. Good product idea
   Key questions: what kinds of risk does this company need to mitigate (technology risk, market risk, team risk, funding risk)? is it a revolutionary and novel idea? is this team the one to back? can the team bring the product to market? who is the customer? who is the competition? will they fail fast?
   Most important slide: about the founders

Focus your pitch on the key questions.

In a pitch meeting, try to spend as much time as possible talking about the key questions for your pitch. If you find yourself getting asked non-key questions, try to use your answers to steer the conversation back to the key questions.

But here's the most important part: if you keep getting non-key questions over and over again, something is wrong with your pitch. Either you misunderstand where your pitch fits into the hierarchy, or you are not using the early part of your pitch to establish it. Don't keep banging your head against the wall - if you can't convince your potential partners that your startup is printing money, try to figure out why. Experiment with different narratives. If you still can't do it, move one level down the hierarchy and see if you can make that story stick.

One last piece of advice: don't forget that potential partners are evaluating the strength of your pitch, not you. It's not true that companies with pitches further up the hierarchy are better, in some absolute sense, than companies further down. It's just that they have an easier time closing these kinds of deals. If you can't close the deal, maybe your company is at the wrong stage of its development, and it's time to try a different tack.

Venture Capital deal syndication - Why it ought to take two to tango

by Healy Jones

One of the more important venture fund raising decisions a startup entrepreneur has to make is around their Series A VC deal syndication strategy. Specifically, an entrepreneur needs to decide if he or she wants to raise capital from a single venture capital firm or "syndicate" the investment with two or more funds at once. VC deal syndication is a pretty funny dance, with the entrepreneur trying to get VCs to converge, and venture capitalists trying to feel out each other and the company to see how/where/when an investment might come together. Given the added complexity of getting two VCs at once, many entrepreneurs consider raising capital from a single fund and screwing the whole "syndication" thing.

Venture funds of the size of Atlas (my employer), about $400 million in the current fund (Atlas Venture VII), can easily cut the check for most reasonable Series A rounds. However, most Series A rounds are syndicated. I would postulate that startups with two strong Series A VCs are in a much better position than firms that raised capital with only one VC, and have outlined some of the reasons for and against syndication at the Series A. Some of these reasons are magnified given the difficulty in the current capital markets.

(While I think most people coming to this blog are familiar with basic VC terminology, as a reminder the first institutional investment in a startup is usually called a "Series A" investment, the second is called the "Series B," etc. Also, when I say first institutional fund raise I am specifically talking about the first investment in the startup where a formally organized venture capital firm provides some of the cash invested.)

Reasons to Syndicate:

1. More potential capital for your business. There is a limit to the amount of capital that a venture fund can commit to any given startup. If your company has two VCs invested in the Series A, the theoretical amount of capital available to your startup is greater.
2. Protection. Your startup's chances of having an existing Series A investor participate in the Series B is doubled if you have two VCs from your first financing round. This is a critical point. If an outside investor is to join the Series B they look to the Series A investor for continued support of the company - if the original investor, who has worked with the management team for months, no longer wants to support the company then the assumption is that there is something very wrong with the company. If you only had a single Series A investor and that fund or partner is no longer in the business then your startup could be in serious trouble. Venture funds DO implode and partners ARE poached (or pushed out ) from top tier venture firms more often than you'd think. Orphaned startups - good ones too - can be sometimes left to die. The best defense is to have two initial venture firms.
3. Easier Series B #1. Some VCs have a reputation of keeping their good deals 100% to themselves, so if they encourage a portfolio company to seek capital from other VCs then the company in question is assumed to be a dud. 
4. Easier Series B #2. It is often easier to get a difficult Series B done internally (without an external investor participating) if you have two syndicate partners vs. a startup with only one. The basic explanation for this is that neither of the original syndicate partners will want to get their initial stake washed out by the other. If one puts money in the B then the other often ends up participating. I've seen this happen, and it is pretty slick from the entrepreneur's perspective, but not so much from the VCs. So much for the "wisdom of crowds." Or maybe it's just a commentary on VCs.
5. More contacts/introductions. Pretty obvious, the more connected investors you have looking out for you the better.
6. More smart people on your board. Ditto.

Reasons against Syndication:

1. Harder. Getting a single VC to close is difficult. It could be even more difficult to get two firms interested at the same time. Additionally, if two firms start to work closely together and one backs out the other can get spooked - "what did they see that I didn't??" The only defense against this is to work with VCs who aren't sheep (easier said than done…)
2. Loss of deal competition. If you had two venture funds competiting on investment terms you very well may be able to work your deal terms to a more favorable spot. In a perfect world you'd have a couple of syndicates circling your startup, but obviously that's not the easiest thing in the world.
3. Investor dynamics. Venture capital firms are a bit like chickens, always concerned with their pecking order and social status. Some VCs don't want to syndicate with certain other funds, or worry about who the "lead" investor is or who gets mentioned first in the press release, etc. Thankfully, I'm not a chicken, and did I mention cock-a-doodle doo.
4. Board dynamics. With a syndicate you'll have to vet two board members. Chemistry is ridicously important, and you'll have to worry about it with two people and two funds.

I'm sure I forgot things, so welcome comments.

Venture capital earnings fall

By Scott Duke Harris

Months before a blizzard of bad news put a freeze on Wall Street, the venture capital industry was seeing a steep downward skid in its investment returns. Now it may be headed for negative territory for the first time since 2002, the doldrums of the tech crash.

A report by Thomson Reuters and the National Venture Capital Association on Monday showed that returns for the VC industry, calculated over a one-year horizon, had slipped to a 5.1 percent gain as of June 30 — one-fifth of the robust 25.5 percent gain reported one year earlier.

Those returns, the association emphasized, still handily outperformed key benchmarks over the same period, during which the Nasdaq composite index lost 11.1 percent of its value and the Standard & Poor's 500 index dropped 13.8 percent.

But the latest VC report is one of many signs pointing to tougher times ahead for the industry that financed such Silicon Valley icons as Intel, eBay and Google, as well as hundreds of start-ups. "It could certainly turn these numbers negative," said John S. Taylor, research and financial analysis executive for the NVCA.

Venture capital is perceived in some quarters as an oasis of hope amid the parched financial landscape, because VCs invest cash for equity stakes and are only indirectly affected by the credit crisis. Several VCs have called upon leaders of portfolio companies to save money and prepare for a prolonged recession, but funding has continued.

One-year investment horizons, Taylor cautioned, are highly volatile and greatly influenced by the stock markets, especially the Nasdaq. During the dot-com bubble, returns peaked at 184 percent in 1999, and crashed down to minus 34 percent in 2001 and minus 29.5 percent in 2002.

The most recent NVCA investment return numbers reflected the performance of $257.1 billion under the industry's management, averaging out a wide variance in the performance of individual firms and funds.

Over long-term horizons, Taylor pointed out, the VC performance remained relatively healthy, with a 16.6 percent average annual return over 10 years and 16.9 percent over 20 years. Over the past 20 years, the Nasdaq's average annual return was 9.2 percent and the S&P 500's was 8 percent.

The NVCA spotlighted the most recent one-year horizon number because it included the first quarter without a venture-backed initial public stock offering (IPO) in 30 years.

Renaissance Capital, a firm that tracks the IPO market, described how Wall Street's fears are now exacerbating the "ice jam": "Institutional investors are largely focused on the day-to-day drama of routs, liquidations, margin calls and the Treasury/Fed/FDIC bombshell du jour. They are rightly concerning themselves with survival."

Financial turmoil is also playing havoc with the opportunities for start-ups to pursue mergers and acquisitions. The venture industry relies on IPOs and acquisitions as the financial "exits" that enable them to earn money and deliver returns to the pension funds, university endowments and institutional investors who invest in the funds.

While the near-term investment returns appear grim, Taylor emphasized that VCs are still raising money and seeing good "deal flow" from a parade of entrepreneurs presenting business ideas.

Renaissance Capital, meanwhile, suggests that VCs will have no choice but to lower expectations for IPOs. "Venture capitalists must capitulate to the need to heavily discount prices to move merchandise," its report said.

Raising VC$ - Go for the "No"!

by Mark MacLeod

Raising venture capital is tough at any time, but especially these days. With stock markets down, going public is even less viable an exit path (already - only 1 in 10 startups exit via IPO. This will go down). The drop in stock prices also makes acquirers less eager to buy - especially if they buy companies using stock. A depressed stock price makes acquisitions more expensive since they need to issue more shares in order to buy you.

This new reality raises the bar even higher if you're looking for VC$. Only the best companies will get funded. As Jeff Bussgang explains, VCs will take a look at everything, but only invest in a tiny fraction of the deals they see. Knowing this, when I fundraise, I go for the "no" just as quickly as VCs do.
Here's my process:

Level 1: 1st pass e-mail teaser (3-4 slides) with a call to action (letting them know I will call to follow up on a specific day). What you want to know here is - Do they like this space? Team? Is the deal size and timing right? If they are not very enthusiastic, they goto the back of the pile. If they are excited then we move to the next level.

Level 2: Webex presentation remotely - before hopping on a plane, qualify some more. Give the pitch by video conference. Make sure to leave lots of time at the end to get them to talk and ask questions. Make sure you have a tangible and timely next step - i.e. meeting in person with one or more partners. This is the only relevant outcome from level 2.

Level 3: Onsite - Go onsite and pitch one or more partners (push for more). At this stage, they're already pretty well qualified. They've had time to dig around. At the end of this meeting you should know if they are ready to roll up their sleeves and do some serious diligence.

Anything other than active diligence means that they are not serious. They may be curious, even mildly positive, but this is not a current top priority deal for them. Treat them accordingly (i.e. keep them warm, but move on. Don't be fooled into thinking that these discussions are serious).

Level 4: All partners meeting: This is the go/ no go for the fund. You present to all the partners. If this goes well, they may come and see you, if they haven't already, but either way the next step after this is...

Level 5: Term sheet. As I mentioned in a previous post, not all term sheets are created equal. For some funds, this means that they have made their decision and barring a major surprise - they're in. For others, it only means that they are serious about getting serious. Make sure you know what kind of offer you have before you accept it.
The bottom line is that startups burning $ do not have the luxury of time. You can't waste cycles with funds who are not serious and excited about you. If it's not love at first sight, the chances of them investing are low. So, be just as ruthless in going for the "no" as they are. Only focus on the funds that love you. To find them you will need to contact MANY funds. Make sure you do that in parallel, not one at a time.

Finding venture capital in a time of crisis

From the Current-Argus

In the wake of a financial crisis that spread quickly from Wall Street to the rest of the world, many small businesses are finding traditional funding sources, including debt financing, harder to secure. Many entrepreneurs are consequently turning to venture capitalists to finance the growth of their businesses.

The decision to seek venture capital is a strategic one that requires thought and planning. Venture capitalists generally invest in high-growth companies that have potential to create a sizable return. Venture capital isn't for everyone, but it's ideal for companies aiming to acquire a large market share in their industries until they can be acquired by a bigger player or go public.

When looking for venture capital, it's critical to target a firm whose mission and goals align with your own and to understand the firm's economics and investment patterns. Doing this important legwork before seeking venture-capital funding will allow you to be more efficient and successful in achieving your funding goals.

Sizing up the venture-capital alternatives: The first step is to qualify the firms you plan to approach, beginning with fund size, the clearest indicator of a firm's investment strategy. A firm that operates a $50 million fund might make investments between $2 million and $5 million, while a $500 million fund might make investments in the range of $15 million to $20 million. Understanding the amount of capital a firm is willing to invest helps you determine if it can meet your funding needs.

Identify an investment pattern: Aligning your goals with a venture capitalist's investment pattern means understanding the stage at which the firm invests, the pace of investments and the market sectors in which the firm invests. Be clear about the type of capital you need — capital for research and development, for initial product rollout or to help you enhance an existing revenue stream.

The pace at which a firm invests is crucial because some venture capitalists like to invest a lot of money up front to allow for dilution, while others prefer to make smaller, incremental investments, usually tied to the business reaching specific milestones. Your strategy for building the company and your funding needs determine which pace is best for you.

Make sure your company is in the market sector in which the venture-capital firm invests. Venture capitalists can and do offer their expertise to help your company grow, so it's advantageous for you to work with someone who has expertise in your business sector.

Closing the deal: Many resources exist to help you understand a firm's economics and investment patterns. You can review the firm's Web site and see what types of companies it has funded. Social networking sites such as Linked-in and Facebook can provide useful information on the types of investments a firm typically makes.

Once you have qualified and decided to approach a venture-capital firm, your goal should be to get a "warm" introduction from someone who has a relationship with the firm so you can stand out from the crowd. While persistence is necessary, be prepared for rejection. If the firm expresses interest in your venture, establish a meaningful relationship quickly. Ask hard questions about difficult topics early in order to avoid wasting time.

VC funding is an excellent option for companies that want to grow, and taking the time to target compatible firms will make it more likely that funds will flow your way.

What deal terms appear in down round and highly dilutive financings?

by Yoichiro Taku

[This is the first of a series of posts on down round and dilutive financings.]

I don't want to add to the "sky is falling" in Silicon Valley theme that I've read on various blogs, but given recent economic conditions, a review of how venture financing deal terms may change seems warranted.

Existing investors generally want new investors to set valuations and deal terms in subsequent rounds of financing for a company. However, these deal terms typically become more investor favorable as raising money becomes more difficult. In many cases, existing investors are left to fund the company as new investors are unwilling to invest.

Unlike conventional, "up-round" financings which have a fairly predictable range of terms, the structures and terms of down round financings are variable.  A "down round" financing typically occurs when a company issues securities to investors at a purchase price less than that paid by prior investors.  Absent anti-dilution protection, a down round financing will dilute both the economic and voting interests of the prior stockholders.  A "washout" or highly dilutive financing, is an extreme form of down round financing that significantly reduces the percentage ownership of prior stockholders.

Below are some features of down round and highly dilutive financings.

• Valuation.  Obviously, valuations may decrease as the financing environment becomes more difficult.

• Liquidation preference.  Liquidation preferences are also typically more investor favorable than previous rounds.  These financings may involve the issuance of participating preferred stock with senior liquidation preferences at multiples of the purchase price.  Please keep in mind that the liquidation preference may be the most important right of the preferred stock, as the percentage ownership that the preferred stock represents upon conversion into common may become meaningless from a practical perspective if the common stock is worthless (see below).

• Full ratchet anti-dilution protection. Investors in risky financings may request full ratchet anti-dilution protection to protect against future down round financings.

• Aggressive convertible debt terms.  Many investors in highly risky financings will prefer senior secured convertible debt over equity securities in the event the company has to file for bankruptcy. These financings may involve the issuance of secured convertible debt (sometimes coupled with warrants) senior to other debt with a payment of a multiple of the principal amount on a sale of company (or conversion into equity securities at a multiple of the principal amount). 5x multiples were not shocking during the post-dot com bust 2001 era. In these situations, voting control, as reflected by percentage ownership and affected by valuation, is a secondary concern to the return on a sale of company and protection in bankruptcy.

• Milestone-based or tranched financings. Investors may be reluctant to invest large amounts of money in a risky financing.  Instead, they may provide enough money for a company to find someone willing to buy them or achieve a particular milestone that decreases investment risk.  These "IV drip" bridge financings may provide a couple to a few months of operating cash and are typically structured as secured convertible debt with a multiple X return upon a sale of company.

• Conversion of preferred stock. Some financings involve a conversion of previous series of preferred stock into common stock in order to decrease the aggregate liquidation preference.  In some companies, previous financings may have resulted in an aggregate amount of liquidation preferences that may render the common stock worthless.  For example, due to multiple X liquidation preferences or raising multiple rounds of financing, a company that has raised $50M in financing may have $100M in liquidation preferences.  However, the company may realistically have a problem getting sold for greater than $100M in poor economic conditions where company valuations are low.

• Pay to play.  Many dilutive financings implement a pay to play mechanism where stockholders not participating in the financing are penalized by being forced to convert into common stock. Absent a pay to play mechanism, stockholders may not have an incentive to risk additional investment into a company due to a free rider problem.

• Enhanced rights for participating investors.  In some financings, existing stockholders that participate in the financing may receive additional benefits over non-participating stockholders.  This is similar to pay to play provisions that penalize existing stockholders for not participating in the financing. For example, existing stockholders that participate in a financing may have their preferred stock repriced via an adjustment to the conversion ratio, which would effectively give them the benefit of a lower valuation for their original investment. Alternatively, participating stockholders may have the opportunity to exchange their existing preferred stock for new preferred stock with more favorable rights, such as a senior liquidation preference.

• Expanded investor protections.  Some investors may request more extensive representations and warranties, broader indemnification protection, D&O insurance, and other similar investor-favorable protections.

• Drag-along rights.  Investors may require drag-along provisions that require existing investors to vote in favor of a future sale of company or an amendment of the certificate of incorporation to create a new series of preferred stock to facilitate a future financing (even before the terms of the preferred stock have been established).

• Employee retention plans.  Some financings may involve large stock option grants to offset the dilutive effects of the financing to employees.  In some companies, aggregate liquidation preferences or multiple X returns on convertible debt may render the common stock worthless.  In these situations, stock options may not be adequate to hire and retain employees.  Instead, companies may implement retention plans where employees receive a certain percentage of sale proceeds upon a sale of company.

Be Careful Who You Deal With

by Matt McCall

As these markets continue their chaotic path downward, people's true colors come out. Some people show increasing amounts of fairness and consideration. Others will self-optimize and use every bit of leverage that they can get their hands on.

Two entrepreneur friends of mine recently had a very negative experience with an investor who has a reputation for being Machiavellian and it really, really has incensed me.  These slimy bottom suckers use the changing market conditions to test how low they can retrade an existing deal.  Here is the standard game plan for these kinds of assholes. When they sense a dramatic change in the market, they pull away their term sheet siting "policy" changes. However, instead of walking away from the deal, they mention in passing that they might reconsider under "different terms". If the entrepreneur bites, they know that they have leverage and they proceed to throw down absolutely egregious terms (multiple liquidation preference, half the original price, etc). If the entrepreneur bites on this, they know they really have them and continue to ratchet down the terms until things break and they back off.

Entrepreneurs who have a retrade occur, must first figure out how badly they need the money. If they can get the runway from expense cuts or manage to breakeven, then they should tell the investor to pound sand as soon as they mention "different terms". Remember, even if you get this round done, you will be stuck with this scum for years to come and any time things go the wrong way, they will use their leverage to take another pound of flesh. This falls into my category of "Life is too short to deal with Assholes". If you have to take the money, negotiate as hard as you can, realizing that they will continue the downward ratchet. Try to drag out discussions and aggressively start talking to any other possible sources, even if under the same terms (if you think they are decent people, at least the match won't burn twice).

Before dealing with someone, especially an investor, find out what their reputation is in ugly situations. Did they roll up their sleeves and help the CEO or did they use the situation for leverage to self-optimize. Animals don't change stripes so assume you will see more of the same with yourself.

If I wasn't concerned about liable issues, I would list a couple of these known predators (with details) such as the one pimping my friends. I can only hope that the Laws of Karma eventually return the favor...

Why Venture Firms Tighten the Purse Strings in a Down Market

by Stuart Ellman /Eric Wiesen

Anyone who has raised money during a down cycle like this one has noticed two significant changes in the fundraising climate.

1. Valuations come down
2. VCs make fewer investments

The first is probably fairly straightforward even to those entrepreneurs who don’t like it. When we’re in boom times (like the late 90s, 2005-6 for Web 2.0 or today for Cleantech), deals get bid up and investors pay high prices to get into great and even not-so-great deals. The inverse is also true - in tough times, the leverage shifts and investors hold the upper hand, often getting better terms and lower prices for good companies. That’s just the operation of what is, at the end of the day, a capital market.

The second of these is probably counterintuitive to some and deserves some attention. There is reasonably good evidence that firms are best-served by investing when prices are low and there is less competition for deals. It’s classic contrarianism. Well, aside from the basic truth that most people aren’t contrarians (by the definition of the word), there is another force at play here: When things are good, VC funds invest their funds as quickly as they can and go out and raise another (typically larger) fund. When things slow down, however, venture funds also slow their pace.

Why? Because it’s harder to raise that next fund. Venture funds are hit by an indirect consequence of problematic public markets.

Here’s how it works: Let’s say that you are an institutional investor (like a pension fund) with a $1 billion fund. Part of your fund is invested in venture capital funds. Your allocation to venture capital and private equity is set at 20% (for example). Now further imagine that the other 90% of your portfolio (equities, fixed income, real estate, etc…) goes down by 20%.

So prior to the market going down, you were invested like this:

Equities/Bonds/Real Estate             $900 million 90%
Private Equity/Venture Capital        $100 million 10%

Now, however, you are invested like this:

Equities/Bonds/Real Estate             $720 million 87.5%
Private Equity/Venture Capital        $100 million 12.5%

You are now over-allocated to PE/VC. The problem is that your public-market investments are “marked to market”, meaning that their value changes as the market provides a signal as to a new price. With a publicly-traded security, those signals are provided every business day via price quotations. Venture capital investments, by contrast, are marked to the most recent valuation, and that typically only comes with a new round of financing. There is a significant delay in the marking-to-market of these investments. They will eventually be marked down in this kind of environment, but it takes longer.

The way that most institutional investors respond to this situation is simple and devastating - they stop investing in new funds until their allocation returns to plan. Sure, if a top-tier VC fund comes calling, they’ll find allocation for them, but newer funds raising their first or second fund, funds that haven’t performed particularly well, and other less well-known investors will have a hard time raising capital.

In addition, there is a reduction in the velocity of money that flows through a portion of the Limited Partner base for venture funds. Many wealthy individuals, family foundations and other potential investors in funds use the distributions they receive from successful exits to fund their participation in new funds. In an environment where there are fewer and smaller exits, these investors’ money is locked up in their existing funds, and hence unavailable for new funds. To compound the problem, many of these individuals are technology founders and CEOs who make substantial money from big technology exits, typically IPOs or large acquisitions by public companies. When these types of transactions aren’t taking place, these individuals aren’t potential players as VCs look to raise new funds.

All of this combines to compel venture firms to be more patient and slower-paced with funds, because the bar is set higher for us as well, and we want to make sure that in a climate where fewer venture funds are getting funded, we’ve done only the very best deals that fit closest to our firm’s capabilities.

We know you need the money more than ever in times like this. It’s not personal.

Why won't VCs return my phone call?

by Jason Mendelson

Q: We pitched to a venture group 3 times in July and August. They kept telling us that they were very interested and wanted to learn more about our venture so we shared complete details of our venture hoping that they would invest.

Now for last 6 weeks they have gone completely silent. They used to respond to our emails within hours but now...no response to emails or phone calls. Once we got one of their partner on the phone and he promised to call back and hasn't yet. We would like to move-on. Are we nuts? Why would they spend so much time then behave like this? Why won' they just say "NO" to us?

A: (Jason)  To answer your first question, no, you aren't nuts and yes, you should move on.  Clearly they aren't interested in funding your company.

The bigger questions is "why do some VCs act this way?"  I really don't know or understand this behavior, but it's not uncommon.  We hear on a regular basis from entrepreneurs that VCs frustrate them this way.

What's probably happening is that they have other companies in their pipeline that are sorting higher in interest than yours, but they'd like to keep you as a potential option if their other opportunities disappear.  That being said, I've never heard of a situation where a VC lead goes completely cold and then becomes hot again.  Think of this similarly to any romantic relationship that you've ever had.

We think it's really important to say "no" quickly.  While it's not always easy to say no (see Brad's post on "Why am I passing?"), it really is the most fair thing to the entrepreneur, even if hard to hear.  Dragging the process along does no one any good.  Sorry to hear about your experience - not all VCs are this way. 

作者：桂曙光

一、风险投资基金的组织形式

风险投资（Venture Capital，简称“VC”或“创投”）是私募股权（Private Equity，PE）投资中的一种，专注于投资早期、高潜力、高成长的公司，以现金换取被投资公司的股权，通过被投资公司的上市或出售，股权变现后获得投资回报。

风险投资基金（Venture Capital Fund，简称“VC基金”）是一种集合的投资工具，通常是有限合伙（Limited Partnership）或有限责任公司（Limited Liability Company）的组织形式，将第三方出资人/投资者（Investor）的资金聚集起来，并投资给众多目标公司。

风险投资公司（Venture Capital Firm，简称“VC公司”）是VC基金的管理者，负责基金的募集和投资。VC公司的专业人士称为风险投资人（Venture Capitalist，也简称“VC”），他们将管理经验、技术力量、外部资源以及资金等带给被投资公司。

对于采取有限合伙形式的VC基金，基金的出资人/投资者是有限合伙人（Limited Partner，LP），风险投资公司是普通合伙人（General Partner，GP）。

具体如下图所示：

二、VC基金的生命周期

有限合伙形式的VC基金存续期限一般是10年（有时会延期1年），VC公司通常在基金的前3-5年会将全部资金投资出去。一个VC公司可以管理多只独立的VC基金，所以为了维持其持续运营，VC公司通常每3-5年就会募集一个新的基金。

在VC基金的后几年，甚至延期1年，VC公司会将投资目标进行变现，使VC基金获得投资回报。

VC基金的生命周期如下图所示：

三、VC基金的资金来源

在美国，VC基金的资金通常来源于公共养老基金、公司养老基金、保险公司、富裕个人、捐赠基金/基金会、等，通过VC公司集合投资。

根据美国风险投资协会（NVCA，National Venture Capital Association），加州公共雇员退休系统（CalPERS）年度报告（2006），耶鲁大学捐赠报告（2006），VC基金的资金来源比例如下表所示：

从上表还可以看到，机构投资者的资产配置中，都偏向于上市公司的股权投资或者债权投资，而私募股权投资的比例都很小，给予VC基金的就更少了。

四、VC基金的投资回报计算

（1）简单模型

VC基金与对冲基金（Hedge Fund）、共同基金（Mutual Fund）等形式投资基金的运作模式类似，都是从投资人那里募集资金，由基金管理公司进行投资运作，投资收益分配给投资人。如下图：

但与其他形式基金的不同的是，VC基金的资金是所谓的承诺资金（Committed Capital），这些承诺资金在VC基金存续期内逐步分期到账，并不是设立时一次性全部到位。比如，如果某出资人（LP）承诺给一个VC基金出资$100M，出资人会在特定的时候收到VC公司（GP）的一些出资请求（Capital Call），每个请求的金额为其出资总额的3%至10%不等。

这是因为VC公司的投资需要周期，他们是在基金的存续期内，经过3至5年逐步投资，而且，对单一项目的投资可能也是分期投资、分期到账，所以，VC的资金流出比较慢。因此，出资人的钱投入到VC基金是比较慢的。

当一个被VC投资的公司实现退出后（IPO、出售、等），VC获得投资收益。由于投资持有期通常需要5-7年，因此，VC在5-7年之后才进行第一次给出资人分配投资收益是很正常的。通常VC给出资人分配也是逐年逐步分配，而不是在基金结束时一次性分配。

假设一支$100M的VC基金设立之初所有资金就全部一次性到账，10年之后出资人被分配了出资额的2倍，那这个回报倍数（2倍）对出资人而言就不太好，准确说IRR只有8%而已，这个回报率对于投资人进行10年流动性较差的股权投资是不可接受的。

而事实上，如上所述，出资人的资金流出是比较慢的，而资金也是提前逐步分配收回的，假设如下表模型所示，那出资人的IRR就是14.8%，而不是8%，比上面的算法有大幅提高，这是因为$100M的资金持有量不是贯穿基金的整个10年周期，同时，收益也不是基金到期后才分配。

上述案例模型假设：

• 出资人5前年完成全部出资；
• VC从第6年开始实现投资案例退出，并给出资人回报。

以上假设需要稍作解释：第一，出资人拿回2倍的资金是很低的、但可接受的投资表现。第二，这样的现金流出是保守的。有些基金在前4年只到位了60%-70%的承诺资金，而上例是80%。因此，真实的资金到位常常比这个案例更慢。另外，上例在第5年才开始分配收益也是非常保守的，有些基金在第3年就开始分配。如果VC投资的企业比较成熟的话，可以在基金的早期就出售，这种事现在也比较常见。

如果上述的模型中，资金到位更慢，而收益分配更早，出资人同样只收回2倍于承诺资金，也可以获得40%的年回报率。

（2）考虑管理费及分成

上述出资人从投资中获得的回报可以成为“净回报”（Net Return），是出资人的投资业绩考核指标。而VC的投资能力，即从投资中获得的回报，可以称之为“毛回报”（Gross Return）。两者之间的差异在于：VC的管理费和投资利润分成。

首先，VC公司管理VC基金要收取管理费（Management Fee），用于VC公司日常运营及人员薪酬。管理费是基金总额的一个比例，对于大规模基金约1.5%，小规模基金约2.5%左右。管理费在基金存续其每年收取，但比例在基金成立5年后会逐渐下降，因为基金投资工作大部分已经完成。由于存在管理费，所以VC能够用于投资的资金是会小于基金总额的。

其次，如果投资有利润，VC公司要获得利润分成（Carry），大部分VC要求20%，也有要求25%甚至30%的，有人认为越好的VC要求的比例越高，但事实并不一定都是如此。分成是针对利润，如果VC基金没有投资利润，就不需要支付分成。就是说只有在VC给出资人分配的收益超过出资人承诺的基金总额之后，VC才跟出资人一起分配投资收益。

比如上述$100M规模、10年期的基金，假设管理费为每年2%，利润分成比例为20%，则10年的管理费合计为$20M，可供VC投资的资金总额只有$80M。一旦VC有退出案例，获得的投资收益先分配给出资人，只有在出资人累积获得的收益超过$100M之后，后续的退出案例收益，VC将会分配20%，剩下的80%仍要分配给出资人。

将上述案例模型进一步细化，如下表：

上述案例模型补充假设：

• 管理费率从2.50%逐年下降至1.00%；
• VC前7年完成全部投资；
• VC从第6年开始实现投资案例退出；
• 利润分成比例为20%。

如上表，此$100M基金的运营情况如下：

• 基金总额：$100M
• 管理费合计：$20M
• 投资总额：$80M
• 投资收益（退出价值）：$225M
• 基金投资利润：$125M （$225M-$100M）
• 收益分成：$25M（$125M*20%）
• VC的毛回报：2.81倍（$225M/$80M）
• VC的毛IRR：22.4%
• LP的净回报：2.00倍（$225M-$25M）/$100M）
• LP的毛IRR：14.8%

可以看到，VC获得2.81倍回报，而LP的回报则只有2倍。

（3）考虑最低回报率

上述案例中，是假设出资人在收回基金总额之后，就跟VC分配剩余的收益，但很多出资人会要求一个最低回报率（Hurdle Rate），即只有在收回基金总额，并获得最低回报之后，才跟VC分配剩余的收益。假定出资人要求的最低回报率是20%，那么上表就变为：

从上表可知，最低回报率不会改变VC投资的回报，但出资人的回报率会提高。

五、LP违约

通常，LP需要在10个工作日之内按VC公司的出资请求，投入所需资金。如果LP没有投入，他们就构成违约。这也是在当前金融危机的情况下，很多创业者担心的问题。因为很多机构投资者的资产在严重缩水，他们是否还会如约向VC基金投资呢？

首先，由上文可知，VC基金的来源大部分是机构投资者，而这些投资者的资产配置中，只有很少的份额是VC基金。

其次，有些基金，比如Kleiner、Sequioa、August、Accel、等，实际上对投资人非常有吸引力，有很多投资机构挤破脑袋想投资给他们，因为他们的投资回报一贯很好，LP不会轻易违约的。而且，LP有优先认购权（Right of First Refusal，ROFR），即有权在此VC的下一只基金中优先获得投资份额。所以，对于好的VC基金，有LP违约也不用担心，有很多投资者等着接手他们LP的投资承诺。投资承诺及相关权益的转让在VC二级市场（VC Secondaries）中进行。

第三，LP与VC公司签署合伙协议（Partnership Agreement），同意在基金需要的时候投入约定数额的资金。一旦LP违约，VC公司可以根据合伙协议，采取相应的措施。

比如，对违约的LP，对其分红比例进行重大打折（比如50%）。要是某LP承诺投资$4M，在投资了$2M后，不继续投资了。那么，基金在分红时，将按此LP只投资$1M（50%）与其他LP按投资金额的比例分配。违约的数额（$2M）按比例由不违约的LP承担。

另外，基金可以将违约LP的分红延迟到基金到期的时候才支付。这种处理方式的好处是：

• 自动执行，不需要花费GP的时间和费用；
• 对分红进行打折会迫使LP不选择违约；
• 对于没有违约的投资人有好处。

但是，如果在基金设立的早期就有LP违约，这种方式就显示不出好处了，因为LP可能还没有投入什么资金。

如果LP在基金的早期就违约，而且在VC二级市场没有买家接手，GP可以起诉此LP，强制其投入承诺资金。这种方式当然不太好，会花费一定的时间和费用，尤其是如果此LP在基金中的份额比较小，就更没有价值了。

也有些合伙协议中规定允许违约LP继续留在基金中，不予惩罚，但其基金份额只以已经投入的资金计算。这种方式的不利之处在于会鼓励其他LP违约，并且VC基金可能无法募集到全部的承诺资金，基金规模就减小了。

Due Diligence Reveals All - To The VC

by Jeff Bussgang

Earlier this year, I wrote a blog about how to prepare for the financing process, focusing in particular on follow-on financings.  Some readers have pointed out to me that I left out a very key element of the due diligence process:  what the process itself reveals about the nature of the entrepreneur to the VC.  Many entrepreneurs I know underestimate the importance of their small and large actions during due diligence and the signals their behavior send to the VCs.  In truth, the due diligence process itself is a gauntlet that tests the entrepreneur and informs the VC about their mettle and whether they have the character and skills to build a great company.

VCs don't typically enter a true due diligence process until after the 2nd or 3rd meeting.  That's when they start talking to experts in the field, customers, management team members, conducting technical reviews and combing through financial models.  Broadly speaking, there are three stages to the process:

1) Sniffing around.  During the "sniffing around" phase, the VC has decided they like the company enough to make it one of their top 3-5 "new deal" priorities, spending proactive time on the company squeezed in alongside the time they spend on their portfolio.  This typically involves the following activities:

• Conducting follow-up meetings with the team to identify and probe on the key issues
• Putting the team in front of "friends of the firm" who have expertise and can provide insight into the opportunity
• Making 3-5 reference calls with analysts, customers or management team members to get an initial read.

In addition to the substantive questions around market size, competitive advantage, technology and team qualifications, the VC will ask themselves a few key questions about the entrepreneur during this phase:

• Is the entrepreneur defensive when I probe on important questions or are they thoughtful, earnest, insightful and authentic in their answers?
• Is the entrepreneur on top of the details of the business or do they appear to be flying by the seat of their pants?
• Has the entrepreneur done their homework about the market and really researched deeply the customer need and competitive set or do they appear naïve and uninformed about the challenges ahead?

2) Digging deep.  During the next phase, the lead VC partner has decided to make the company a top 1 or 2 priority and begins thinking deeply about the company and the opportunity during shower time and drive time.  For the VC, this typically involves the following activities:

• Briefing their partners in some detail on the pros and cons of the investment opportunity and the important financial terms of the deal
• Mapping out a detailed due diligence plan to probe on the key diligence issues and risks
• Exposing some if not all of their partners to the company to get other informed opinions around the table
• Making 15-20 reference calls with customers, management team references, perhaps even competitors and others who can provide insight into the market

During this process, the VC will ask themselves the following questions about the entrepreneur:

• Are they open in revealing customer references and management team references or are they hesitant and defensive?
• Do they provide thoughtful, detailed responses to the key diligence questions promptly or do they appear to take the posture that the VC simply "doesn't get it"?
• Does good news and momentum continue to build as the process wanes on or do they seem frozen in time?

3) Making the case and negotiating the deal.  Once the lead VC has decided he or she is convinced, they now have the obligation to convince their partners, or "make the case".  The entrepreneur must answer whatever the hot buttons of the other partners are as well as make it through the dreaded Monday morning partners meeting, where the fate of the deal is decided based on their performance in a tight 60 minute presentation.  In parallel, the lead VC partner will typically be negotiating the main business terms of the deal with the entrepreneur.  Again, you learn a lot from someone during this process.  In particular:

• Is the entrepreneur cool, thoughtful and confident in how they present to the partnership or do they seem nervous and anxious in a "step up" moment?
• Is the entrepreneur persuasive and mature in making the case for their important business points during negotiations or do they seem immature and irrational as they make their arguments?
• Is the entrepreneur quick to pick up on sophisticated deal terms by bringing in good advisors or do they seem commercially naïve and unable or unwilling to bring in helpful expertise?
• Finally, do you complete the process and still say to yourself:  "I'm excited to do business with this person and jump into the roller coaster with them for the next 5-7 years” or "boy am I glad that's done, I can't wait to get to the next deal!"?

In these trying economic times, entrepreneur should expect that the due diligence process will become more rigorous.  Further, the competitive power has shifted to the sources of capital (i.e., VCs), which means deals will likely move slower and more deliberately than in the past.  Remember, the deal isn't done until the money is wired and the VC will be evaluating you and your actions all along the way. 

Why You Might Want a Lower Valuation for your Startup

by Stuart Ellman, Eric Wiesen

The most obvious point of negotiation in any venture financing is the valuation of the company. The first-order logic is pretty simple: Founders want the highest possible valuation and investors want the lowest. Pretty straightforward. Founders want to go high because it minimizes dilution. Investors want to go low because they get a higher ownership percentage.

For those who aren't familiar with this math, it works pretty simply. Investors are going to put money into a company. More accurately, they are going to buy shares of stock from the company at a certain price. The higher the price of the company, the fewer shares the investors get for a given number of dollars.

What this winds up meaning is that at a higher price (price = valuation), the money put in by investors (let's say $5 million) buys a lower percentage of the company. If you say that the company's valuation walking in the door is $10 million (the "pre-money valuation"), the $5 million put in by the investors buys one third of the company (because the company will then have the $10 million of presumed value plus $5 million of cash in the bank, resulting in a $15 million "post-money valuation"). If, on the other hand, you say that the pre-money valuation is $20 million, the new money will only buy 20% ($5M out of $25M) of the company rather than 33%.

Just to do the simple arithmetic, if you assume this is the first money into the company, the outcome of these two scenarios looks quite different for the founders. In the first scenario, the founders own 66% of a $15 million company. They are worth $10 million on paper. In the second scenario, they own 80% of a $25M company and are worth $20 million on paper. In both cases their company ends the financing with $5 million of cash to grow the business.

So you are now asking why I'm suggesting that you might not want to raise the round at the highest valuation you can possibly get. And a good many of you are rolling your eyes at the obvious self-interest we as investors have in this negotiation (which is undoubtedly true - we are interested, but bear with me).

There are at least two very good reasons why you might not want to go for the highest possible valuation.

1. You are probably going to have to raise money again.

2. The valuation you get today impacts your exit possibilities.

The first is critical, and many first-time entrepreneurs miss this. When you raise money, you should have it in the back of your mind that you will probably be raising money a second time. While most companies (especially web companies) come in with the idea that the raise being done today gets them to cash-flow positive, realistically it often doesn't turn out that way. We understand this and it's ok that you will need more money, but you should understand this too. When you go out to raise that next round, recognize that your current investors are going to want a step-up in valuation and so will you. Secondly, new investors are going to want to see momentum in the business.

The critical point is this: If you raise money at too high a valuation, you are going to have a very hard time raising money the next time around. Your current investors are going to balk at taking a flat or marked-down valuation, and they will almost assuredly have anti-dilution protection that will keep them whole while diluting YOU, the founder (and your team). New investors are going to be wary of investing in a company that has to be marked down from its previous price. Either way, your overpriced first round is going to be a huge headache when you go back out to raise money, and new investors are likely going to re-price the company anyway.

The second reason is equally important. Simply put, if you raise money at a high valuation it will be very difficult to sell your company for anything less than a significant multiple of that valuation. When your investors purchase a portion of your company, they do so with the hope and expectation that they will earn a multiple on their money when you eventually sell the business or take it public. Put in more concrete terms, if you raise money at a given valuation, you should assume that in the near term and in a success situation, you will be expected to get more than 4x that valuation in an exit.

So when you go to raise money, think about both of these factors. Think about what proof points you will likely reach when you go out to raise more money, and be wary of a valuation that puts you in a difficult position when that time comes. And try to be mindful of what constitutes a successful outcome for you. If you raise money at $50M post-money valuation, you are implicitly saying you can build a very large business and you are taking a good (but not huge) outcome off the table for yourself. Make sure this is a decision you make consciously.

Expect to see start-ups and VCs hit standoff over valuations

by Matt Marshall

When the stock market goes into the dumps, it takes a while for the effects to trickle down to start-ups. That's because start-ups are often are working away on a project that's isolated from the larger market — and if they're lucky, they have money from venture capitalists.

For the start-ups with no angel or VC backing, forget about raising money. They're going to have trouble immediately. VCs are paying too much attention to their existing companies. But what about those lucky ones — those who already have a venture backer? The conventional wisdom is those companies will have an easier time getting money again when they need it, because VCs want to make sure the companies survive long enough so that they can earn a profit on the investment.

But it comes at a price. When the entrepreneur returns to the VC, an epic battle ensues over valuations. In a climate of fear, the power pendulum swings back to the VCs. The VC knows that an entrepreneur won't be as likely to get money elsewhere, so he plays hardball. The entrepreneur is more ready to cave in on the valuation. That means when a VC gives the entrepreneur money, the VC can claim more ownership of the company with a given amount of investment (because the company is worth less.) Tension rises, and boardroom fights begin. I saw it all unfold last time, when I started covering venture capital in 2001.

Let's take a look at the valuations of start-ups during the last boom, and how they trended in subsequent years. The National Venture Capital Association's statistics are about as good as we're going to get. They aren't perfect, because they rely on valuations as voluntarily provided by the NVCA's member venture capital firms, so the sample size may be too small to be completely reliable. But with that caveat, they do show that from 2000 through 2003, valuations fell pretty hard. You can see it took a while for the valuations to hit bottom, even though the market crash took place in mid 2000.

What does that mean for today? Well, the market's crash these past two weeks is too fresh to have worked itself through the system. Companies are in the middle of tension-filled negotiations with their venture backers, but we don't have any stats yet.

Now lets take a look at some recent valuations at one of the most aggressive venture capital firms in Silicon Valley: New Enterprise Associates. That firm has demonstrated how it has offered very rosy terms to entrepreneurs in recent years, bidding up value levels of companies like SolFocus and SugarCRM by offering large amounts of cash for relatively small ownership stakes. It did so because it believed: 1) the deals were competitive and NEA wanted to participate, and so outbid other venture firms to do so, and 2) because it has more money than other venture firms, and so was mandated to put its money to work.

That's a decent strategy when you've got a robust economy. But when the market turns negative, NEA will have difficulty justifying these valuations. They and other investors are more likely to negotiate tougher. In some cases, the dreaded "down round" will emerge, which is where a VC invests at a valuation lower than the company's previous ones — a particularly brutal snub because it suggests the company has lost value since it raised its last round.

NEA is the leading VC firms this year (so far) in the amount invested. The firm is second in the total number of deals (again, so far this year) to Draper Fisher Jurvetson. I don't mean to pick on NEA. But the folks at PE Data Center have provided three examples of the firm's investments, and they’re good for illustrative purposes:

SiBeam (formerly Silicon Microwave Systems) — The Sunnyvale, Calif. company is a developer of chips for the wireless industry. In March, the company closed a third round of funding (Series C) totaling approximately $40 million, alongside U.S. Venture Partners and Foundation Capital. The post-money valuation was $138 million, or exactly in line with the most recent average valuation of late-stage private companies, as provided by the NVCA (see chart). However, as you can see from the last boom-bust, late stage valuations came down significantly. That's not to say we're going to see exactly the same scenario play out this time (last time, it was a tech bust, this time it is a credit bust, and companies are generally on much sounder footing). But with the market closed for new IPOs and companies slamming the breaks on acquisitions (they feel poorer, because their lower stock prices are their main currency), there's no doubt that late-stage companies are going to get seriously slammed on the valuation side if they raise money this year.

CVRx –  The Minneapolis, Minnesota, company develops implantable devices designed to control hypertension. The company has raised several rounds of financing and New Enterprise Associates has participated in all of them. Other investors in the company include ABS Ventures, Kearny Venture Partners, SightLine Partners, and InterWest Partners. The company raised a third round $30 million in May 2006, at a valuation of $95 million, and then raised $65 million fourth round in April 2007 at a valuation of $267 million, and then a fifth round of $84 million in July year at a valuation of $424M valuation. Needless to say, those recent valuations are extremely high. Who knows, the company may be good enough to justify it. But expect them to come down, especially in light of the general decline in valuations for the health-care sector in general (see the chart below, courtesy of Dow Jones VentureSource).

DreamFactory Software – The Mountain View, Calif. company offers on-demand software, and raised a first round of $5.8 million at post-money valuation of $16 million in 2006. Then it raised $3 million more in March 2008, at a post valuation of $24 million. New Enterprise Associates led both rounds financing. As you can see from the charts, the valuations of the earlier rounds didn't drop as significantly during the last bust. Earlier stage companies will have it slightly easier than later stage private companies. They're more protected from the market, because they're not searching for an IPO just yet. However, that's not to say that investors won't fight to hard to lower valuations even at this level.

Third quarter statistics on valuations won't be out for another couple of months. And even then, those stats won't reflect what happened in the current fourth quarter, which is when the real pain will be felt.  It may be next year before we can give a serious assessment of the true fallout for start-ups. Expect to see more companies go out of business too, as VCs in some cases decide not to invest at all.

VCs to Entrepreneurs: Seed-Stage Startups OK. Others? Not So Much

by  Rob Hof

Just for fun tonight, and hoping to view a potentially entertaining mass freakout over the market, I decided to attend one of those ubiquitous Silicon Valley panels where entrepreneurs can ask venture capitalists questions. Nobody broke down or waved dangerous weapons or anything at the VC Connect event held in Palo Alto and hosted by VC Taskforce, a group that brings together entrepreneurs and VCs in a series of regular events. But I noticed that, even before the event started, more people than usual were happy to partake of the wine, even one of the VC panelists.

Anyway, given the ugly turn of the markets lately, not to mention news of grim meetings by VCs with their portfolios companies and scary emails by angel investors, I was surprised VCs weren't even more bearish than they sounded. All of them said they don't plan to slow their pace of investing. I'm not sure I believe them, especially if the market continues tanking, but venture capital is funny that way. I mean, even the rather muted returns of venture investments in recent years now must look appealing to institutional and other investors next to the train wreck that is conventional stocks.

In particular, the VCs were surprisingly positive about the prospects for very early-stage startups, which after all don't have to worry about paying customers for a little while.

"I'm very bullish about the seed stage," said Jorge Calderon of Launch Capital, a new, small VC firm in Palo Alto that has funded eight companies so far this year, including two consumer Web firms. Why? "There's going to be a lot of new talent" to hire, he said.

"That's a very gentle way of saying there's going to be a lot of people out of work," shot back the moderator, Bill Reichert of early-stage VC Garage Technology Ventures.

"There's going to be a lot of smart people out of work," replied Calderon with a smile. But the news isn't all good, he said (as if layoffs are good news). "You gotta hunker down and be very efficient with your dollars," because it's unclear when the next funding will come, if ever.

One downside for early-stage companies, however, is that later-stage companies will have to change course to focus on revenue more than simply growth, and that's going to draw the full attention of many VCs, who simply won't have time to look at many new ventures for at least the next six months.

What's more, entrepreneurs who hope to get money from angel investors will have a tougher time, said Ed Esber of the small Halo Fund. Esber, who is also part of the Angels' Forum, a group of angel investors, said some of them are starting to refuse to write more checks for investments until their portfolios improve--and that could be a good, long while. "Angel money is very, very tight right now," he said.

But the challenges of newly minted startups will pale next to those later-stage ones, especially those ready to go to market. "The biggest problem in the next 12 to 18 months is if you expect your customer to write a check," said Saurabh Srivastava of Artiman Ventures. which manages $350 million in two funds. "You're in for some pain."

All that said, the VCs said that for savvy entrepreneurs with good ideas, these are potentially the best of times. "In bad times, the accidental entrepreneurs leave," said Srivastava. "Some of the best companies are born in times of stress."

Who Will Be The Biggest Loser: 1999 VC Funds or 2006 PE Funds?

by Bill Burnham

1999 vintage Venture Capital funds are infamous for being some of the worst performing private investment funds of recent memory with the average 1999 Venture Capital fund returning only about $0.95 on the dollar through 6/30/08.  The poor returns of these 1999 funds are a result of two main factors:

1. These funds were raised at or near the height of the tech bubble.
2. These funds were often fully invested within 12 months of closing.

The result was a ton of money invested very quickly at very high valuations.

During the 3 year market correction that followed the tech bubble, venture capital lost favor with many institutional investors.  Many of these same investors instead plowed their investment dollars into private equity funds.  These funds enjoyed huge returns early in the decade as an extremely loose credit market combined with very low risk premiums and declining loan underwriting standards gave rise to such as wonders as dividend recaps, PIK toggles, and covenant light loans.  By late 2006, private equity firms were raising absolutely gigantic funds with terms and fees that would make many VCs blush.  Part of the private equity pitch at the time was that because they were buying well established firms with ample cash flows and "fundamental value", private equity would never see the same kind of market collapse that cratered 1999 and 2000 vintage VC funds.  LPs generally lapped up the pitch and as a result during 2006 and early 2007 there was a ton of money raised and invested very quickly at relatively high valuations.  Sound familar?

Fast forward to today's market and the "fundamental value" of many private equity funds appears highly suspect thanks to two main developments:

1. The credit markets have completely imploded effectively making it impossible for private equity firms to refinance existing debt.
2. The recession is impacting earnings and cash flow which in turn is increasing the likelihood of loan defaults.

Against this backdrop, the massive leverage that enabled private equity firms to put up such huge numbers in the 2002-2005 time frame now looks like it has the potential to absolutely decimate 2006-2007 returns.

But don't take my word for it, just look at the market.  Unlike VC investments for which no reliable daily market values exist, most private equity deals issue publicly traded debt and that debt provides an immediate window into the health of the deals themselves.  Just how healthy are those deals?  Not very healthy at all.

Even after today's big rally, the kind of senior bank loans often issued against private equity deals are trading at or near all time lows with some of the highest profile private equity deals trading at discounts of 25-30% from par.  What's more, many closed end mutual funds that specialize in such loans are themselves trading at 20-30% discounts to their Net Asset Values which strongly suggests that senior loans have even further to fall.  Clearly the market is anticipating some major defaults in private equity land in the near future.

Defaults are bad news for PE funds because they are generally catastrophic for the equity holders in a deal and the equity holders in these deals are, you guessed it, the 2006-7 private funds.  Thus, if the market is to be believed, a lot of private equity funds are going to see catastrophic losses on their equity investments in the next couple years.

Private equity LPs, like many homeowners these days, are about to learn a lesson in the downside of leverage.  They may end up wishing they put all their money into 1999 VC funds instead.  Imagine that!

Do You Know What Your VC Is Doing?

By Brad Feld

A well worn tradition of most venture capital firms is the Monday Meeting.  While there are several variations of it, including having it the meeting on Tuesday or Friday in an effort to be counter-cultural, most venture capital firms gather on Monday's to review their portfolios, have companies come in and present for follow-on rounds or new investments, and ponder the state of the universe.

I expect there will be a lot of pondering today.  Given that it's only 1:23pm and I've already received several missives commenting on the Sequoia RIP article (including a skeptical email from someone forwarding the VentureBeat article stating that Sequoia raised the largest new fund in Q3), it's clear that many VC firms are sitting around today discussing ways they can "help" their portfolio companies in these "uncertain times."

Get ready for a flurry of two things from your VC.  (1) Questions.  (2) Advice.  Not necessarily in that order.  Occasionally you'll get a demand here and there. 

If you are a first time entrepreneur, be forewarned that this is normal.  The questions and advice usually start on Monday afternoon or Tuesday morning (due to the timing of a partners meeting) a few weeks (or months) after the environment has changed.  Of course, a cynic could (appropriately) ask "where were these questions last week."  Welcome to the world of VC-backed companies.

Given that you now know this is coming, my recommendation regarding the questions is to actively engage your VC(s) rather than simply either (a) answer them or (b) dismiss them.  The questions - while often annoying, redundant, or nonsensical - will cause you to think about things you might not otherwise be thinking about.  Just make sure you've got the whole question, think, analyze, discuss, decide loop on a short cycle so you can iterate quickly as the environment changes again (either for the better or for the worse.)

With regard to the advice, my recommendation advice is different.  "Think before you act."  This doesn't mean sit around with your thumb up your ass.  This also doesn't mean the advice is wrong.  But it definitely means you should apply your (and your team's) brain(s) to the advice and see if it matches your view of reality.  This is especially true when the advice is second or third hand (e.g. I read the Sequoia presentation and here's what you need to do.)

Don't forget to bring your towel to work tomorrow.

Stuff to establish with your angel investor BEFORE the investment

by Healy Jones

Ah, angel investors. With a name like that, you'd think angel investors would be everything venture capitalists are not - warm, forgiving, easy going, free flowing with their cash… I'm sure there are some angel investors who have those qualities. However, most of the angels I've interacted with have been smart business people looking to generate significant returns - not so different from venture capitalists. As your startup searches for funding you will likely be introduced to angel investors. Here are a few things you ought to think about while you interact with angels:

• Friends and family can be angels… but you'd better treat them right. Make sure your f&f realize that the investment is risky; clearly tell them they could easily lose their entire investment. It's probably a bad idea to let them invest their entire life savings. Make it clear that the investment will not be liquid, so they will not be able to ask for the return of their money at a specific time. Make sure they know that their investment could be diluted to no value by future financing rounds. Don't make the mistake of relying on a handshake or legal investment documents downloaded off the internet. Hire an experienced lawyer and make sure everything is clearly explained to your f&f.
• Don't confuse smart business person with experienced investor. Just because someone has made money somewhere else does not make them an experienced angel investor. Ask them how many other angel investments they have made. Do some diligence on them if they are going to have any sort of an advisory/board/active role in the business - if they've invested in other startups talk to those CEOs/founders. Again, hire an experienced lawyer. 
• Don't confuse smart business person with someone who automatically knows everything about the industry you are attacking. Success in the automobile dealership industry does not translate into knowledge in the Web 2.0 space. If you need industry advice and you are not going to get it from your angel investors it makes sense to create an advisory board with people with the right experience. A smart angel investor will probably ask for that anyways. This leads to the next point:
• Establish their role in the business. Board member or whatever, just make sure you won't have to spend 30 minutes on the phone with them before every strategic decision if you don't want their advice. Aligned your expectations of their role with theirs.
• Understand their exit/return expectations and make sure they align with yours. Angels can be great because they might be very content with a $10 million exit that would be considered a failure at a large venture capital firm. This assumes you've found an angel who would be content with such an exit. Other angels really want to go big. Figure this out, then ask yourself the next question:
• Get a legitimate feel for the amount of capital you need to get to cash flow breakeven or exit. Ask how much money the angel has to invest and make sure it is clear how the rest of the company's growth will be financed. If it is clear that you will need venture capital or additional funding down the road establish this expectation ahead of time. Find out if the angel investor will continue to invest in the business in future financing rounds. If you are expectign to raise venture funding in the future, you are a bit like Goldilocks - you want your angel investors to invest just the right amount in future funding rounds: enough to reasonably defend their position but not so much that they crowd out venture investors or don't allow the VC to get their desired ownership position. Several years ago I was with a VC who was unable to invest in a startup because the original angel investors exercised their "blocking right." The angels were not happy with the dilution they were going to recieve in the financing round, and decided it was better for them to have a big piece of a small pie over a small piece of a large pie. This may or may not have been the best financial decision for the angel investors, but it really screwed the management team. Set expectations early on the capital required and make sure the angels will do what you think is right for the company.
• If you need VC later structure the deal right. Actually, just make sure you structure the deal correctly. Hire and experienced lawyer.

This post is getting pretty long, so I'll stop there… however, if others have good suggestions I'll add them in. 

Angel investors can be very valuable to the growth of your startup. Just make sure you AND they know what you are getting into together.

VCs, LPs, startups and money

by Healy Jones

Recent conversations with startup founders and their questions on VC's ability to invest given the current market conditions have reminded me that many technologists do not realize how venture capitalists manage their funds. Unlike mutual funds, VCs should be able to invest regardless of the market's state. 

Many people tend to think of VCs as mutual funds that invest in private companies, but this analogy is wrong on several levels. Many mutual funds take money from investors on a rolling basis and begin investing in the market as they get these funds. Unless the fund gets additional investors' money (or sells current holdings) it does not have capital to place in new investments (that is a generalization, but let's go with it). Also, if current investors wish to withdraw capital from the fund they usually can do so on a daily basis. This results in the fund either using existing cash or selling assets to raise cash for these redemptions. Again, this is done on a rolling basis.

Venture capital funds are raised and redeemed differently. First, they are not raised on a rolling basis. Rather, a group of Limited Partners (LPs). These LPs sign an agreement with the venture capital firm agreeing to provide a specific amount of capital to the venture firm as needed. The summation of these LPs commitments is the size of the fund. If a VC has 50 investors who each commit, on average, $10 million then the VC has a $500 million fund. 

It is important to realize that the VC has not actually taken possession of this $500 million. Instead, the LPs agree to send the VC capital for investments as they are required. This is very different than the mutual fund, where the fund has the investors' capital in hand and is investing it right away. It is also different in that the LPs can not (under almost all circumstances) pull their commitments or investments out of the fund. 

If a venture fund has a committed fund with unallocated/invested capital then it should be able to make new investments, regardless of the market conditions. Again, different than a mutual fund. In a bad market, a mutual fund may have difficulty making new investments if investors are pulling their capital out - there just won't be cash to use for investments. All cash on hand will be used to redeem the mutual fund investors as they exit the fund.

However, there is a scenario where venture capitalists with legitimate, committed, unallocated funds may have problems making new investments - when their Limited Partners default. Charlie O'Donnell has a good post on LP defaults and the VC industry. I haven't heard of this happening in the current downturn but it probably will. When this happens some VCs may have problems closing new deals or supporting their existing portfolio companies in follow on rounds. 

Startups seeking venture funding should not be discouraged at this point. VCs are still making investments and looking for companies who can innovate through any market.

What Will the Crisis Mean for Venture Capital?

The financial crisis is sure to hit Silicon Valley startups hard, but even the VCs that funded them may find themselves on shaky ground

by Sarah Lacy

In the lingo familiar to the kids toiling away at Web startups, the U.S. financial system is on the verge of an epic fail. The same may soon be said of many of the firms whose investments are the lifeblood of those Silicon Valley entrepreneurs.

There's been plenty of discussion about the impact of Wall Street's woes on emerging tech businesses. Web entrepreneur Jason Calacanis wrote late last month that as many as 80% would go under in 18 months. Early-stage investor Ron Conway advised entrepreneurs not to quit their day jobs unless they could get a year's worth of funding in advance. According to Om Malik, Sequoia Capital recently told its portfolio companies to hunker down for a long economic downturn. At a recent dinner party, an entrepreneur told me that his startup had about six months to pull a business model out of thin, recessionary air or it was toast.

Startups get funded in bunches, and in a downturn, the strong survive and the weak get sold for cheap or shuttered. We get it.

But what's in store for the venture capitalists who pump billions into these fledgling companies? My growing concern is that the financial crisis gripping the globe might cause some firms to close their doors and leave many VCs looking for a new line of work. Returns for plenty of firms are tapering off, particularly in recent years. And before long, even looking back a decade will indicate that venture capital didn't yield much more than the stock market and other less risky places to park cash. Think that won't be lost on the institutional investors, university endowments, and other limited partners that look to Sand Hill Road for returns? Think again.

Venture Capital's Lasting Power

To understand why, take a look back almost a decade ago. Even after the air came hissing out of the tech bubble, venture capital kept attracting investment (BusinessWeek.com, 10/3/07). Sure, a few firms retrenched, and a handful of reckless partners lost their jobs. But even more money poured into the asset class. That's because the last few decades have created such a surge of wealth in pension funds and endowments, and they all have to invest in what are commonly referred to as "alternative assets"—a category that includes VC funds. Even with a huge crash, venture capital was still a better long-term investment than the broader markets.

Limited partners look at industry returns in three-year, five-year, and 10-year increments. And in the early part of this decade, by those measures, VC returns could still be plotted upward and to the right. VC firms had little trouble raising new funds.

In fact, many took in more than they knew what to do with. Only two of the last eight years—from the end of 2005 through the end of 2007—have had any decent market for initial public offerings and acquisitions. Even during this window, the companies that went public or got acquired went for smaller amounts of money, and took longer than ever to get there.

No matter. On a 10-year time horizon that includes 1999, VCs returned 32.83%, according to Cambridge Associates, compared with a meager 3.5% for the Standard & Poor's 500-stock index. On that basis, who wouldn't look past the risk associated with shaky startups?

Regulation Fallout Ahead

But check your calendar. We're closing in on 2009. And even if the financial system on which VCs depend for returns averts collapse, it's still in for a few years of serious wound-licking and stepped-up government regulation. Ask anyone in Silicon Valley whether Sarbanes-Oxley had a chill on IPOs.

This realization hit me like a ton of bricks during a recent trip to Boston, coincidentally the same day Lehman Brothers (LEHMQ) filed for Chapter 11. I was sitting down with Tom Crotty, of the venerable Battery Ventures, which had a unique approach to the tech meltdown. Battery, full as it is with more financial gurus than Valley-style engineers, responded by diversifying from traditional startup investments into so-called Private Investments in Public Stocks (PIPEs). Battery also capitalized on the consolidation of cash-rich but fragmented industries.

Crotty hopes the atypical investment approach will insulate Battery, but he nonetheless sees a reckoning coming—specifically toward the end of 2010. He points to 2000 as the "last really good year" for venture capital. Looking back, "the one-year, three-year, and five-year indexes are all going to be terrible," Crotty says. "And once 1999 and 2000 fall off, the 10-year will be, too. It's going to be painful."

More Realistic Numbers

Data from Cambridge show why. Aggregate VC returns for the 12-month period before the crash of the Nasdaq stock market were greater than 300%—far better than any period since. Once that period is no longer captured by historical data, 10-year returns for many firms—even ones that had great years in the interim—won't look nearly as good. The fear is numbers will show that many won't have returned much more than the S&P even with a decent 2010.

If the 10-year investment period hits at or below the S&P 500, portfolio managers are going to wonder why they're investing in such a risky asset class. Crotty estimates that 20% to 30% of the money going into venture will go elsewhere, and that is going to be bad. A lot of firms will go under.

You know what else? That won't be such a bad thing. After a painful period of forced reckoning with bad past decisions, VC will emerge stronger. Entrepreneurs and the larger U.S. economy will still need venture capital. Some venture capitalists will engineer a new way to make venture-style returns, like Battery Ventures did eight years ago. Many will turn to emerging markets such as India and China. There will be even fewer Google-like (GOOG) home runs. Then again, a leaner, smarter industry may not need as many.

I predict a wave of superstar partners just quitting and becoming angels, the way Vinod Khosla did in the wake of the last downturn, bringing the industry back to its roots.

Why LP defaults isn't an issue for good VC firms

by Charlie O'Donnell

Amazing. In the blink of an eye we've come from Web 2.0 mania to Limited Partner commitment defaults in VC funds. Wow... who turned on the lights in the club? Party's over, I guess.

"You don't have to go home, but ya can't stay here."

Anyway, Doomsday aside, the way venture capital works is that high net worth individuals and institutions (pension funds, endowments, insurance companies) make commitments to VC funds. Unlike hedge funds, however, they don't hand the money over day one--it gets drawn down as VCs find and fund deals. Some funds, like Accel, draw down chunks of their fund 5% at a time, just in case a deal needs some quick cash. Otherwise, Limited Partners generally have 10 business days from the day VCs request their money to pay up. If they don't, they can be in default, and lose their stake in the fund. If you really don't have the money, though, I guess that's not such a bad scenario.

From '00-'03, many dot com entrepreneurs and even some institutions (like banks) realized that, as a % of their shrinking wealth, they had overcommited to VC funds and either couldn't keep up with the capital calls or just didn't want half their savings tied up in VC funds.

Some of them had pieces of VC funds that had already been fully invested, others had relatively new commitments. Eiither way, they wanted out and that's where the VC secondaries market came into play.

How do I know this? When I was on the VC investment team at the GM Pension Fund (now PEQM), we were a major investor in secondaries. Not only did we back secondary funds, like Lexington Parters, who bought these commitments from others, but we did a number of transactions on our own, buying direct. One of our major purchases was a portfolio of VC funds sold after the crash, when VC funds seemed to b devaluing their portfolio and shutting down companies every quarter. It was a bloodbath and those who were newbie investors went running--right into the arms of long term institutional investors like ourselves that had been doing venture since 1979.

The most interesting portfolios we saw were the mostly unfunded ones, where investors had made big commitments to newly raised VC funds only to realize that they'd never be able to follow through.

So what's the going rate for an empty VC fund that has yet to draw down any capital? More than you think!

Some funds, like Kleiner, Sequioa, August, Accel, were seen as so attractive to investors and so difficult to get into, that people were paying money for completely unfunded commitments--just to get into the fund. The idea is that if you target a 15% return and you think a given fun will return 25%, then risks being equal, you'd actually pay up to put your money into it if you were limited in your access to other similar funds.

That was the exception, though. Most funds were sold at heavy discounts for the existing assets. The point is, there was never a shortage of investors looking for access to these funds. The idea was that if you bought in, made nice with the VC firm, and proved to be a stable source of capital, you could hopefully get into their next fund as well, plus make some money with your "value" bet on the existing assets.

Therefore, good firms with good LPs will always have someone waiting in the wings to take over their commitment. Also, some existing LPs have "ROFRs", which stands for right of first refusal. That means that before you think you're going to pick up a few pieces of the next Sequoia fund on the cheap, the existing investors will get a shot at it before you do.

If you do have a commitment to a top tier fund and you're looking to get out, drop me a line and I'll put you in touch with some folks who would be willing to take it off your hands. Just remember, when I say top tier, I don't mean Joe's Auto Body Shop and VC Fund.