When are you ready for Risk Capital?

by Taneli Tikka

A lot of startups think they are ready to receive venture capital, risk capital, or some sort of "real" financing. I recently had to count; how many rounds of financing have I "done?" (not solo, they are always teamwork) It took some plain old organic memory search, and if I have it right that would be a total of 9 rounds so far. (just as a remark: IRC-Galleria had zero rounds.)Based on that experience; When are you ready?

Here's my take on that:

1. You have the right attitude. You and your startup need to be very good at what you are doing. You need to have your act together. Know your stuff. Know your competition. Already have plenty of things done instead of "just planned". You need to be there to succeed and as part of that attitude you need to be humble enough, yet know that you are a "catch" for them to have; and that you are the client shopping for financing services for the price of equity.

2. Your materials are in good condition. Yesterday a highly competent venture capitalist (managing partner, none the less) said to me: "the good VCs know that the excellent companies probably don't have time to prepare a 50+ page business plan and perfect materials". Agreed. I think you do not and should not need a very long business plan and a beautiful polished power point. Many of the 9 rounds I have done have been done without the one of the other, sometimes without either.

What do you need then? You will need a very good executive summary. You will need to be ready to talk about your stuff at a "championship level". Solid financials are needed. And a good representation of your overall plans and goals. Specific roadmaps and such should not be so important - because they will change anyways, and the good VCs know this extremely well. Many VCs don't read plans. They only read summaries, 1 page or 2 pages. Even the legendary Sequoia Capital asks everyone to send a maximum of 15-20 slide summaries, as they say "all that's needed". What did Eran Davidson the CEO and Managing Partner of Hasso Plattner Ventures say on stage at SIME Helsinki? "I'm a VC and I don't read business plans". There you have it.

3. DD preparation is done or underway. Check my earlier post about the DD. Make sure that's at least in progress and you can answer questions about IPR and such in a very competent level and detail.

4. You have an investor plan. You have mapped out multiple investors. Actually found out about their investment focus, criteria, space, latest deals, terms, etc. You have schedules for the whole thing to progress, your team has divided the responsibilities of preparing everything, and you have created the most important thing: a shortlist of investors most likely to realistically invest into your startup. Where to find VCs? Check my previous post for a few ideas.

5. You have time to raise capital. It takes a while. In this economic climate it takes a while and then some. You need to have that time, no hurry. Sizeable startup rounds (a few Big MOs) can go through in as little as 2 months, but that is an extraordinary accomplishment that does not happen often - there needs to be a real match between the startup and the investor for a deal to move so fast. Angel rounds can be faster. Typically it takes at least 6 months, and now quite possibly more than that. This old comic from the Dot-Com era sums it up nicely.

6. You have already engaged customers and partners. One thing that will greatly speed up your VC deal will be real commercial traction. Especially if you are in a space like "Web 2.0" that’s sort of the requirement before you get any VC money. It helps significantly if you are already on a path towards growth and expansion, but would grow a lot faster with additional capital. One way to get there is to talk to your customers, partners, consumers etc as soon as possible, as much as possible. Hammer out your thing, what ever it is, in such a way that it is desired in the marketplace and has clear evidence of showing commercial traction. Score the deals. Close and sign them in. Then talk to VCs. Try to go for LOIs, non-binding contracts, MoUs, or even try to get upfront payments from the customers. Every name on the paper is tangible proof and will help you out. Try to get permissions to reference them and their interest when they sign.

7. You require money for growth. VCs don't really want to fund things like; proof of concept, product development, prototypes, "stage 1 development", "hiring a team", etc. The earlier in the game you are, the harder time you will have raising any VC money. They like to fund companies that need the financing for growth, not to build something risky that might quite likely fail. If you happen to be very early, then go for Angels or "Friends, Family and Fools".

8. Have a fallback plan. One indication of your readiness is your ability to come up with a fallback plan. If everything drags out and your startup is not picking up any interest (or just not enough of interest) from the VCs, then you need to have the famous plan B. And in this case I don't mean buying 5 years worth of green beans and a big gun.. You need to plan for extended periods without outside money, getting the company risk level and burn rate right etc. If its not VCs maybe its angels? or maybe its your own pockets? maybe its one good pilot customer? What ever it is, have the plan in place and expect having to go for it.

9. Have your own term sheet ready. It speeds things up and ends up in your benefit if you make your own term sheet before the VC gives you one. it helps you to have a clear sense of the kind of stuff that goes into it. You might not end up actually using it for anything else than comparing, but there might be situations where you can offer to propose the first set of terms to the VC. This is probably way more common with Angels, since most VCs have their "standard" terms sheet (with nothing really being standard or fixed in them). Preparing your own set of terms mainly helps you to think and that comes in rather handy when you actually have to negotiate the stuff - you'll understand it better and have thought through the meaning of different terms. Actually the smart VCs prefer this as well: they would rather have an entrepreneur signing with them who knows exactly what he signed, instead of a one that has no clue at all. VC terms can vary a lot. There's also a bit of a Gap between what the VCs say is "standard" and what they actually sign in the end. For example: many VCs claim liquidation preferences to be a standard term. Yet out of the 9 rounds of financing I have seen only two have actually had that term included. So in my book it's rather rare to be seen. Same goes for another classic "strict term": anti-dilution clause for the VC. Out of the 9 deals only one has had that. There's actually enough substance regarding this matter that I might write a separate blog entry on this alone..

10. Finally: know what you are doing, and research the investors. Partially this is a repeat of number 4 above there, but I want to separately underline this one. It is vitally important for your "VC readiness" to research the investors, really find out about them, use your contacts, talks to people etc. Talk to other VCs, talk to startups that have done deals with the VC, talk to angels, to Tekes, to who ever. Find out all the classic and generic details: "sweet spot" for investments, typical deal size, typical exit, typical terms, the likes and dislikes (and the backgrounds) of their partners, etc. Finding out this stuff will mostly help you to figure out are they the right investor for your. And if they are the info will help you in the talks. What to do if despite all of this you don't raise attention from the VCs? Then calm down. Leave it be for about 6 months. Get back in touch (with a revenge) and update them on all the fantastic progress you should have been making by then. Meanwhile go for the angels, or the FFF, or what ever keeps you focused on the Big Plan. Don't dwell too far into project services and selling the skin off your back, that may be a living, but its not going to be a venture backed startup any time soon. (sorry, it just rarely happens that way).

The VC's Customer

by Fred Wilson

Many of the people I know in the venture capital business think their customers are their investors, called LPs in the industry vernacular. I've always thought that was dead wrong.

The entrepreneur is the customer and the LP is the shareholder. That's the only way to think about the venture capital business that makes sense to me.

What makes this so hard to grok for many in the venture business is that much of the selling we have to do is when we raise money.  Once the money is raised, the entrepreneurs are the ones who come into our offices in "sell" mode.  And that dynamic warps many VC's perspective of the business.

I start with the value chain.  The entrepreneur creates the value, they are the "raw material" in the venture capital business.  If there were no entrepreneurs, there would be no venture capital business.  So the VCs who treat the entrepreneur like the customer and invest heavily in customer service will be rewarded with the loyalty of the most important component in the value chain.

Money on the other hand is a commodity, whether its in the hands of the LPs or the VCs. Money flows to the best returns and always will.

So if the VC does a good job of serving his customers well and generates superior returns as a result, the money will always be there as long as the price of his fund is reasonable.  That's why I am convinced that the LPs are the shareholders.  That is exactly the same dynamic that exists in company/shareholder relationships.

This "entrepreneur is the customer" mantra gets hard in a couple places in the venture capital process.

The first is the VC deal flow process.  Take our firm.  We are getting something like 30 new deals a week coming into our office that are generally in our area of interest and are at the stage we like to invest.  We will make investments in roughly four of them per year.  So we have approximately 1500 potential "customers" walk in our door a year and only take four of them.  It's natural that the other 1496 will leave our office unhappy at some level and may never return. That's a big customer relations problem.  We try really hard to be helpful, candid, and quick in our triage process, but at our best we might only make a third to a half of the rejected entrepreneurs comfortable with our process and eager to come back.

The second area where customer relations gets sorely tested, and where the "entrepreneur is the customer" mantra is the most difficult is when the entrepreneur is not doing a very good job of minding their own store. I believe that once the entrepreneur accepts an investment from the VC, the VC's customer set expands to include the company, its employees, and its customers.  The entrepreneur is still an important customer, probably the most important customer, but the entire stakeholder group in the entrepreneur's company comes into the equation once the investment closes. When the entrepreneur starts failing this expanded stakeholder group, it becomes the VC's job to help them by getting them to change or getting them out of the way.  Most entrepreneurs don't view that as help and therein lies the problem. 

But in a funny twist, this is exactly where the "entrepreneur is the customer" is the most helpful mantra.  If you really view the entrepreneur as your customer, when you walk into their office with the hard news that you aren't going to keep funding their company if it continues on its current path, or that you want them to step aside and bring in someone better suited to run the company, or that they need to get a coach and start behaving differently if they want to keep their job, you will deliver that news as a friend, a person who honestly cares about them and their dreams, and with compassion and understanding.  And that is the only way to get through those really hard discussions with a chance of coming out the other side with a relationship.

Entrepreneurs are really difficult customers to serve well.  It takes a significant investment of time, energy, money, and intellect to satisfy them.  But if you do it well, you will develop a reputation for great customer service that will keep the best ones lined up at your door.

And that is the best way to deliver exceptional returns that I know of.

Pitch Pet Peeves

by John Gannon

I spent the afternoon in Boston coaching entrepreneurs who are preparing investor pitches.  I provided some tips to the entrepreneurs and want to share a few of them here:

Quickly describe what your business does and how it will make money:  Within the first 30 seconds, it should be clear to your investor audience what your company does to make money.  Investors tend to have a short attention span and so you want to get their attention quickly during a pitch.  Another good guideline from Jon Karlen at Flybridge was to make sure you can get through your entire pitch, unrushed, in 1 hour.

Don't spend too much time on the market size of the opportunity if you're pitching investors who are intimately familiar with your market: If you are pitching a digital media firm who has made investments in the Internet advertising space, you don't need to spend time telling the firm about the growth potential of online advertising.  Use the time you'll save by cutting out the market size discussion and spend it fleshing out other areas of your business.

Make sure the margins in your financial projections are realistic: Several times I've seen business plans that indicate a company will achieve a net margin of 25%+ at scale.  There are not many businesses that I can think of that can achieve those margins.  The two that come to mind are Google and Microsoft.  Therefore, the logical assumption is that the author of the business plan thinks their business will be the next Google or Microsoft, but in actuality I think that people don't bother comparing their predicted margins with comparables from their industry.  It's never a bad idea to spend time researching public market comparables, so when you do, make sure you check some of the key ratios and margins to make sure you're relatively in line with the rest of your market.

Mark Davis spends a great deal of time discussing pitch do's and dont's on his blog if you'd like some more information on this topic.

The State Of Venture: The Ugly, The Bad And The Good

by Mark Davis

There is one topic on the minds of all entrepreneurs right now: the impact of the economy on their startups. The economy is the centerpiece of every networking event and panel, and it even consumed the Q&A session after my speech at VANJ last week on how to raise VC. It's inescapable.

The financial crisis has and will continue to effect the venture world. Despite how bad things have become, however, there is a silver lining for the best startups. Here are my thoughts on the good, the bad, and the ugly of the current economic environment.

The Ugly: Economy In Shambles
We all know how troubled the financial markets are right now. The public markets are in an irrational downward spiral, the gears of our credit machine haven't unlocked despite being greased by the government bailout and the exit environment is as slow as it has been anytime in the last 30 years . In a nutshell, our economy is undergoing a substantial realignment that is leaving the weakest to be killed off quickly by the consummate predator – the global financial community (Thomas Friedman's so-called "electronic herd”). The casualties have included most facets of the American economy, including financial institutions (Bear, Merrill Lynch, Lehman, WaMu), big corporations (Automakers, Linens 'N Things, Circuit City), millions of households and, yes, the government, which is watching corporate tax revenue evaporate while the cost of providing life support to the ailing economy is climbing.

The Bad: Venture Market – An Innocent Bystander
While the industries in which venture capital firms traditionally invest (IT, life sciences and, more recently, clean technology) are not directly in the line of fire of this economic downturn (as they were in 2000), the venture space has and will continue to be adversely affected.

An investment banker I know recently stated his view that it will take at least six months for our economic wizards to be able to quantify the size of the financial correction; we don't even know how bad it is yet. Uncertainty drives corporations and consumers alike to hedge all bets by cutting their spending on everything from advertising to autos. As pockets tighten, it becomes more difficult for companies (whether B2B or B2C) to generate revenue, creating the need to reduce costs or take more capital from investors.

Unfortunately, right when companies need the investment community's support, venture purse strings will be tightening. There are a few reasons for this conservatism. First, later stage investors (the growth stage venture firms) know that companies that they invest in today won't be able to exit as quickly as they once might have because the public markets are sick and the corporate buyers are conserving cash until they understand how bad things are going to get. An increased time to exit means lower effective returns.

Second, many VCs expect growth stage capital to become less accessible (for the reasons described above) and, as a result, are increasing their capital reserves for their portfolio companies.  VCs hope to fill part of the follow-on financing gap, enabling their companies to stay afloat while holding out for growth capital. While this is good for portfolio companies, it does mean fewer deals in the portfolio. VC funds are fixed in size, therefore allocating more to each company generally means fewer new investments.

Third, some limited partners (the investors in venture funds) are reducing their allocations to venture capital, despite the fact that venture capital traditionally performs well in recessionary market environments. With the net asset value of nearly all liquid assets devastated by the market crash, many limited partners are now experiencing what is being referred to as the "denominator problem." For example, if an institution had originally planned to have 10% of its assets in venture, the decline in value of the other 90% of its assets effectively increases the percentage of the portfolio that venture capital represents. An LP may have seen the percentage of his/her assets in venture capital increase from 10% to 14%, leading him to pull away from the very asset class that is likely to provide the best returns in this environment. The magic of this math is that it encourages LPs to invest more in the most troubled asset classes, not the healthiest. While some LPs will follow this logic and cease to make investment in venture until the value of their other holdings rebounds, others will invest more in venture because the fundamentals of the venture sector are even more attractive now. Without new commitments from LPs, there will be less fresh capital coming into venture funds. The net effect is likely to be fewer investments at all stages of the venture market.

In sum, revenues are going to be lower and less capital is going to be available. This of course leaves entrepreneurs with one option: reduce costs. Coincidentally, reducing costs often means making layoffs, exacerbating the downward spiral of consumer spending. It's hard to buy Christmas gifts without a job. Additionally, the decline in capital means that valuations will drop substantially–a trend that is already visibly taking hold in the market. Times in the venture world are challenging. As any good entrepreneur knows, however, change creates opportunity.

The Good: The Weak Will Die Quickly; The Strong Will Win Big
In this new economic environment, access to capital will become an increasingly important differentiator. If venture investing contracts substantially, a strong balance sheet will no longer simply be a means of staying with the pack, it will increasingly become a substantial advantage, enabling some companies to get way out in front of their competition. While many startups are deploying limited resources, trying to manage costs and weather the storm, the few well capitalized players in each market segment will be positioned to invest for the future, laying deep roots into their markets that can support rapid growth with the drought ends. Furthermore, as layoffs continue to take place at the corporate giants (such as American Express), startups that are well capitalized will have an opportunity to hire high caliber people now looking for work, increasing their advantage and mitigating the human capital constraint that traditionally plagues new ventures in booming economies.

This is a virtuous cycle for the winners. As competition becomes more polarized, the leaders will eat even more of the laggards' lunch making it even more difficult for the back of the pack to compete. Customers naturally gravitate towards the financial stability of the winners and in tight economic times the second tier players may not be able to reduce their margins to win over the more price sensitive buyers, limiting their means of catching up. These dynamics will likely kill the weak off more quickly, enabling the winners to more quickly separate themselves from the pack.

While I believe the frontrunners will come out of this downturn positioned to win big, the story isn't entirely bleak for the second and third tier players. Once the end of the downturn is in sight, corporations will likely exploit the financial woes of startups to make low cost acquisitions. The hunters will be coming. For some entrepreneurs this could yield decent (if not life altering) returns.

Conclusion
There is no doubt about it—times are tough for the overall economy and that has, and will continue to, impact the venture marketplace. The companies that are not going to succeed will likely discover their fate more quickly (a blessing in disguise), the companies that might have otherwise squeezed by in a better economy should be sure the corporate sharks smell their blood and the winners should be opportunistic and cautiously thinking big. In sum, I think it's a great environment for the best entrepreneurs. While at today's valuations it will likely cost founders a pound of flesh to acquire the capital they need to win, they'll be able to turn a pound of flesh into a mountain of gold.

How can a board decrease litigation risk in an insider-led down round or dilutive financing?

by Yokum Taku

The role of the participating inside investors in an insider-led down round financing, who have the ability both to set the investment terms and make the investment, creates tension between management and minority stockholders on one hand, and the participating inside investors on the other. In addition, former founders or early investors not participating in the financing may perceive that the participating inside investors are attempting to secure control of the company by diluting their equity position.

Furthermore, the directors affiliated with the participating inside investors are often regarded as having a conflict of interest with regard to their approval of the down round financing.  This conflict of interest creates a difficult legal environment surrounding the actions of the board members and the company.

The actions of the board of directors are governed under state law by the business judgment rule.  This rule creates a presumption that business decisions made by a board of directors will be given deference by the courts if the board's judgment is exercised diligently and in good faith.  Where the board's decision may be influenced by conflicting financial interests of the directors (a so-called interested transaction), as in a down round financing, the favorable presumption of the business judgment rule falls away.  In these situations, the transaction is voidable by the shareholders or the company. Under corporate statutes in both Delaware and California, the board may successfully avoid an attempt to void the transaction by showing that the transaction was approved by a vote of the disinterested board members or a special committee, or by a vote of the disinterested stockholders or by proving that the transaction was intrinsically fair and reasonable at the time it was authorized by the board.

If the members of the board were to be found to have breached their duties, state law provides that they may be personally liable for their actions.  Since most private companies don't carry directors' and officers' liability insurance and may not have the cash resources to engage in sustained litigation, the threat of personal liability can be serious.

Other theories of liability have been advanced based on the controlling influence that a venture fund or its general partners may have over the actions taken by a portfolio company.  These theories are based on facts which can demonstrate that a controlling stockholder has breached its fiduciary duty to minority stockholders, or that venture funds or their general partners have conspired with each other to aid and abet a breach of fiduciary duty owing to the stockholders.

There are a number of steps that a board of directors and the company can consider to reduce the risk of litigation from disenchanted stockholders when faced with a dilutive financing driven by inside investors.

• A compelling board record. Board minutes reflecting the board's thinking and analysis are important. Board members typically should meet in person or by conference telephone as opposed to taking action by written consent, and should devote more than a single meeting to decide to proceed with a down round financing. The minutes should reflect the board's rationale for considering a down round financing and its efforts to recruit potential third-party investors.

• Diligent assessment of alternatives. The board should attempt to demonstrate that it has considered all reasonable alternatives to the insider-led round. Although actual contacts and presentations with possible new investors are not legally required, if the company has not attempted to engage with new investors, there should be a plausible reason in the record for the board's decision.

• Approval by independent directors. Approval of the financing terms by the independent directors, or by a special independent committee of the board empowered to authorize the financing, may allow the board to take advantage of the business judgment rule.  Independent director approval may not be practical, however, in many circumstances.

• Disinterested stockholder approval. Down round financing structures typically require stockholder approval. Securing the approval of the stockholders who are disinterested helps the company defend against an attempt to void the transaction by disenchanted stockholders.

• Full disclosure of terms. Complete disclosure of financing terms is essential in a down round, with particular consideration of the benefits of the financing terms to the inside investors, the likelihood of replenishment of equity incentives to management and employees following completion of the financing, and factors that would adversely impact non-participating stockholders.

• Rights offering. Perhaps one of most important steps in an insider-led down round financing is a rights offering that accompanies or follows the financing. All stockholders of the company, and frequently including employees with vested options and warrant holders with "in the money" rights, should be permitted the right to participate in the financing on substantially the same terms as the inside investors. The disclosure or information statement provided to all stockholders of the company can serve to summarize the financing terms while soliciting the interest of potential investors. The rights offering should be structured in a manner to comply with applicable state and federal securities laws and should allow sufficient time to allow potential investors to respond to the offer.

Unfortunately, there is no single step or combination of steps that can completely remove the risk of legal exposure in a down round financing. Board members may be faced with the difficult decision of proceeding with a financing that may result in litigation or shutting down the company.

Why VCs invest in stupid companies

by Drama 2.0

I'm often highly critical of VCs and the investments they make. After all, there is no shortage of funding announcements that make you go "huh?"

So why do VCs make so many stupid investments? Since the world of venture capital is currently in a "crisis," I figured now was as good a time as any to detail why I think VCs so frequently make us scratch our heads in curiosity and disbelief.

VCs are really money managers - not investors

VCs really aren't "investors" in the traditional sense of the term. When raising a fund, VCs typically only contribute 1-2% of the total capital. The rest comes from limited partners.

VCs collect a management fee (typically 2% of committed capital) and carried interest (typically 20% of the fund's profits).

Thus, VCs are really fund managers in that they manage other people's money and have very little "skin in the game." While the vast majority of their opportunity comes from carried interest, if a VC firm has a $250m fund and earns a 2% management fee, that fund guarantees the general partners $5m annually.

Thus, just like mutual fund managers, most of whom underperform the market, VCs are in a position where they really can't lose. While they do have a profit motive, their primary responsibility is to put other people's money to work, not to risk their own.

This creates a dynamic in which VCs make decisions differently than they would if they were investing only their own money.

VCs are often clueless

I've argued before that "most VCs are little more than McKinsey types who know everything about building a business in theory, but couldn’t run a local pizza joint if you gave them a manual."

VCs often have little practical knowledge of the markets they invest in. For all of their "analysis" and "due diligence," I believe many are ignorant to the realities of those markets.

In other words, they may have a decent high-level understanding of these markets, but they simply don't understand the "situation on the ground" because they've actually never been on "the ground."

Much of the funding currently taking place in the cleantech market, for instance, demonstrates this quite well. Many VCs making investments in this space have fashioned themselves as energy industry "experts", yet they've ploughed billions of dollars into companies that look promising on paper but are clearly not commercially viable (at least for the foreseeable future).

This is because they can't be scaled, can't compete without government subsidies or are severely hampered by existing infrastructure limitations, amongst other things.

At the end of the day, I think a reasonable generalization is that VCs are usually book smart but not street smart.

VCs are often unrealistic

Because they're often clueless to the practical realities of the markets they make investments in, VCs are liable to place too much emphasis on theoretical potential instead of practical potential.

This is problematic for three reasons

First, potential is often overestimated. As I've noted before, research firms projecting the growth of nascent markets typically overestimate the speed at which these markets will grow and the total size they will grow to. When making investments in early-stage companies targeting these markets, overestimations can be disastrous for obvious reasons.

Second, a focus on potential often blinds one to the barriers new companies face in realizing that potential. VCs often fail to look at the challenges that face the startups competing in high-potential markets. In many cases, I see companies that receive funding yet will clearly find themselves struggling to gain traction simply because they don't realistically have what it takes to compete, regardless of how much potential exists in the markets they target.

Finally, potential is not as important as revenue, cashflow and profit. All the potential in the world cannot negate the fact that if a company can't generate sufficient revenue, cashflow and profit, it isn't going anywhere. Thus, VCs who don't consider how a startup is going to translate potential into these things are avoiding reality.

VCs overemphasize past successes & relationships

One doesn't need to look very hard to find startups that are funded by "serial entrepreneurs" and individuals who are well-known on Sand Hill Road.

This is because many VCs place a great emphasis on past successes and relationships. Unfortunately this isn't always a good thing.

Past success is never a guarantee of future success, and as successful "serial entrepreneur" Glen Kelman observes:

"...we still insist on believing in the serial entrepreneur with the Midas Touch. We make celebrities of our entrepreneurs because we’d rather believe in talent than luck. And we tend to overlook reasons why second-time entrepreneurs are actually worse, not better, for their experience."

This is despite the fact that:

"Every Silicon Valley colossus — Amazon, Apple, Dell, Ebay, Google, Microsoft, Oracle and Yahoo! — was started by a first-timer 30 or under. Facebook was founded by teenagers."

Past success, name recognition and personal relationships are nice "filters" in theory, but they delude VCs into thinking that they know who is most likely to create the "next big thing" and which startups have a higher probability of success.

They don't and these delusions don't result in better investments. If anything, they may limit VCs to poorer investments.

VCs are vulnerable to herd mentality

When a market is "hot," VCs usually fall victim to herd mentality.

One need look no further than online video to see this. With the rapid rise of YouTube and its $1.65bn acquisition by Google, many VCs felt compelled to throw money at online video startups without asking:

"Just how many highly-successful online video services can the market actually support?"

As one would expect from money managers, VCs instead say:

"We need exposure to the online video space in our portfolio. Let's invest in an online video startup!"

Of course, this often a foolish approach because even in the hottest markets, there are usually a few winners and a whole lot of losers.

The eonomics of Venture Capital suck
The economics of VC funding are not all that great, in my opinion, and this has only become more pronounced as the average VC fund size has increased.

If you run a $500m fund, for instance, you simply cannot invest that money in small chunks. You have to find companies that you can put larger amounts of money into.

Early-stage companies often don't need large amounts of money and later-stage companies may have more favorable financing options. Thus, I believe that many of the companies that do receive funding, especially early-stage startups, are overfunded.

In some cases, it is the amount of funding - not the funding itself - that makes an investment "stupid." After all, many funding announcements don't cause one to ask "Why did that company receive funding?" but do cause one to ask "Why does that company need that much money?"

As I've pointed out before, being overfunded can be just as destructive to a new company as being underfunded. Yet because the economics of venture capital often require VCs to overfund, stupid investments are made simply because VC economics encourage it.

The Survival Matrix

by Fred Wilson

As Brad Stone and Claire Cain Miller talked about in the New York Times piece about startups slimming down to survive, we are seeing many companies looking at their cash balances and burn rates and deciding to cut burn to increase runway. We've done an exercise with our own portfolio that I wanted to share with all of you. I am calling it the survival matrix.

First we create a table of our entire portfolio and chart current cash balance, burn rate, and runway (cash/burn). We leave out the profitable companies from this analysis unless we think the downturn will cause them to start burning cash. Here's a look at a theoretical runway table:

We then do a scatter plot of burn rate versus runway with runway in months on the x-axis. It looks like this:

When you do that, you'll get to four quadrants.

Where you want your company to be is in the upper right quadrant, which I call "the comfort zone". The comfort zone is a low burn rate combined with a long runway.

The upper left quadrant is not a bad place to be as well. I call that the "too small to fail" quadrant. While your runway is not long, your burn rate is so small that your investors can fund your company for a while without any new money showing up to join the party.

The lower right quadrant is also not a bad place to be. I call that the "betting on revenue" quadrant. These are the companies that are carrying high burn rates but also have long runways. They are betting on revenues to start coming in and lower their burn rates over time. One thing about this quadrant though, you don't stay here forever. Your runway will come down and you'll either go into one of the upper quadrants because your burn has come down, or you will go into the lower left quadrant.

The lower left quadrant is the "danger zone" - high burn combined with short runway. You don't want to be there.

We've done this analysis on our portfolio recently and we came away from the exercise feeling very good about where things stand. We'll keep doing this every couple months as one of several "macro screens" we do on our overall portfolio health.

If you are an entrepreneur, you should know where your company fits on the survival matrix and if you are a VC, then you probably are already doing this kind of analysis on your portfolio as well.

Piracy v. Private Equity: A Comparison

by Heidi N. Moore

While every kind of legal deal making is down this year, one practice is up: Piracy. Pirate hijackings of oil tankers have surged 75% during 2008, according to the International Maritime Bureau's weekly piracy report. (Who knew?) And they're making good money — better money, this year, than most of the beleaguered money men of Wall Street.

In these upside-down days of credit crisis (and in part because they just sound kind of similar) we got to thinking. What makes for better returns: Piracy or private-equity?

The answer says a lot about the state of the buyout business, which spent hundreds of billions of dollars on deals that are today deeply underwater.

Here's how the two compare.

Public Profile

Piracy: Treated with scorn in the past, as practitioners were called barbarians. Blamed for international wars such as the First Barbary War of 1801 to 1805. Illegal.

Private equity: Treated with scorn in the past. Famously dubbed Barbarians at the Gate in the 1988 book on KKR's takeover of RJR Nabisco. Currently skirmishing with Congress over carried interest, or the amount of taxes paid on investment gains. Legal.

Business model

Piracy: Seize assets; make money by causing distress; demand ransom; "all for one, one for all" partnership model.

Private equity: Seize assets; make money by reducing distress; dividend recap, then sale or IPO; "all for one, one for all" partnership model.

Compensation structure

Private equity: Management fees and carried interest. Average yearly salary of $885,000. Invest money, then divide booty when the effort is successful.

Pirates: Ransom. No taxes. Somali pirates earned $50 million last year. Hijack ships, then divide booty when the effort is successful.

Year-to-date performance

Private equity: Volume down. Returns abysmal. Expected annual return of about 15%, which is down significantly from the 28% to 30% return of previous years.

Piracy: Volume up. Returns rising. Target hit rate of nearly 100%, much to the chagrin of the chairman of the Joint Chiefs of Staff.

Investment horizon/lifespan

Piracy: Only the number of days it takes to receive a wire transfer for $500,000 to $2 million, which is the average ransom on an oil tanker. Investment lifespan ranges from several days to several weeks.

Private equity: Three to five years for each company purchased, on average. Given high asset prices and grim economic outlook, that could push the horizon even longer, seriously crimping returns. With a coming shakeout in the business, that is diminishing fund lifespans.

Geographical investment thesis

Private equity: Bullish on China.

Piracy: Opportunities on the coast of Africa.

Start-up costs

Piracy: Gun, boats, a handful of men, rocket-propelled grenades.

Private equity: Office on Park Avenue.

Jargon

Private equity: "Internal rate of return," called IRR.

Piracy: Eerily similar: "Aaar."

Insights on Web funding from Crunchbase

In my CFO & Business Development responsibilities at pearltrees, I'm interested in reliable Web specific funding data but it's hard to find. Usually, Web start-ups are included in broader categories.  Actually, I haven't found any comprehensive funding analysis focusing on Web only. Discussing about this with Nicolas Cynober - a semantic Web expert and R&D engineer at pearltrees - we decided to find a remedy: we extracted the entire CrunchBase database of funding rounds. Zooming on investments in Web start-ups exclusively (since 2004 to end of October 2008, series A to F), we ended-up with a database of 914 start-ups, 1307 investment rounds by 817 investors worth nearly $14bn. While CrunchBase may have some pitfalls (e.g., fewer deals prior to 2006, US bias), it is one of the most comprehensive publicly available database on Web start-ups funding. You'll find below some "Web specific" insights such as the Web VC ranking or overall data on investment stage, deal size and implied valuations (the tables below and detailed investments by VC are in Excel here Download Tables Crunchbase).

VC Web investment ranking

As table 1 below shows, the usual suspects are at the top of the ranking with DFJ, Sequoia and Accel trusting the first 3 places. These 3 funds invested in more than 40 Web start-ups with a total of 127 individual start-ups (w/o double counting for companies with several VCs) representing 14% of all funded companies. They are followed by Benchmark, Index, Intel Capital, First Round Capital and DAG Ventures who each invested in >20 companies. In total, these 8 VCs invested in 215 Web start-ups (24% of total). Another 36 VCs invested in more than 10 Web start-ups. In total, these 44 VCs invested in 490 Web companies (54% of total). Finally, another 770 investors complement the picture with investments in ~760 start-ups (83% of total financed companies - note that companies having several VCs, the percentage sum up to more than 100%).

Web investment stage

As tables 2 and 3 illustrate, series A funding represented on average 57% of investments rounds (39% in terms of amount invested). Series B, C and D & above represented respectively 31%, 9% and 3% (35%, 19% and 7% in terms of amount invested). Overtime, investments tended to move towards later stage rounds reflecting the advancement of the investment cycle. In 2008 (year to date), series A represented only 44% of funding rounds and 27% of dollars invested.

Web round size and implied pre-money valuations

The median round size was $~5m for series A, $9.5m for series B, $15m for series C and $20m for series D & above. There is however a large variance as table 4 illustrates. For example, there is a ratio of nearly 1 to 3 between third and first quartile series A size ($2.5m vs. $7m) or above 4 between 80th percentile and 20th percentile ($2m vs. $ 8.3). Series B tend to be in the range of $6-14m and series C $10-25m.

There is one step between round size and valuation... unfortunately this data is not available. However, by doing some rough assumptions (series A tend to go for 25-50% of capital, series B for 20-30%, series C & above for 10-25%), we can infer some estimates of pre-money valuations that should be directionally correct. Table 5 shows the resulting rough estimates (the implied step-ups tend to be in line with market data): taking the median estimates, series A could typically go for $5-15m, series B $20-40m and series C $45-135m. With this estimation "technique", bigger round size mechanically come up with higher figures. A recent study by SVB argues that larger round size have on average higher valuation levels.  Hence, one could infer that "very hot" Web start-ups may go for >$25m pre-money valuation for series A or >$60m for series B (20th percentile high estimates).

That's it. I'll try to extract some further insights from this database for future posts so keep... posted.

Time for Management BuyOuts of VC Companies?

by Suzanne Dingwall Williams

The numbers are clear: since 2007, hundreds of millions of dollars have been invested by VCs in new companies, or follow-on investments made in existing portfolio investees. Equally clear is that a number of VCs are in stasis; either they are not succeeding in raising new money, or they are winding down their current fund and shuttering operations to wait out the current market. Either way, the implications are clear: a number of portfolio companies must either grow organically without new funds, or find an entirely new investor syndicate to (a) support further growth, and (b) battle with incumbent VCs who will wish to retain their stake. In parallel, investees may find themselves with an entirely new set of investors if a retiring VC sells it sposition in the secondary markets - probably at a discount.
A question I am increasingly asked is whether, given the circumstances, it makes sense for management to pursue a buyout of a VC investment, rather than wait to see who shows up at the next board meeting. For later stage investees, I can understand the appeal. If a VC has limited follow-on funds to support its investment, management must slow growth and bridge the business through cost cutting and hardship. (This leads to what I've come to call the fundamental "Achievement Gap" between Canadian and American venture capital - backed businesses.) In this scenario, it makes more sense for management to perform if they own signficantly more of the business. Likewise, if a VC is discounting its equity position as part of a portfolio liquidation, managemetn may well want to offer the same money for better autonomy.

The key driver of any MBO is a belief that a placing more equity in the hands of management will drive more value in a business, through a combination of financial engineering (cost cutting) and strategic growth. At a thousand-foot level, it's easy to see how this might appeal. And, until teh market collapse this fall, the TSX Venture Exchange was a regular vehicle fo choice for achieving liquidity for VCs and increased holdings for management. Now, private debt might be necesssary. Certainly there are a number of companies that might have the early revenue, together with leverageable assets, that might attract the kind of debt that would finance an MBO. How will this play out? Something to watch.

The Venture Capital Deal Hype Cycle

by Healy Jones

If you are trying to raise early stage venture capital and are actively engaged with a VC or two, you may have noticed a funny variance in the VCs level of interest, excitement and mood. This is completely normal! As a startup's dialog with a VC matures the VC will go through a totally natural "Deal Hype Cycle." I've diagrammed the important stages in this venture capital deal hype cycle below and included some tips on how you can recognize these stages in your potential funding partner - and what you can do to help keep the process moving along. As a startup CEO, you don't have to be a passive participant on this roller coaster… you can positively influence the VC and keep your fund raise on track! Note also that this is the cycle for an investment that actually closes.* (You may also be interested in my previous post on the VC deal process.)

Stage 1: The Pitch

Hype Level: Pretty Good

If the VC took the meeting with you they must be at least decently interested. Most business plans introduced to venture capital firms never make it to this stage (i.e. are never met with), so your startup probably has something going for it.

What you can do: Deliver a good pitch. Answer the VCs questions as them come directly, but stay on message and get through the important parts of your business. Manage the time carefully! (At some point I'll do a post or two with simple tips for delivering a good VC pitch.)

Stage 2: Happy Thoughts

Hype Level: Elevated

If the pitch went well the venture capitalist is hopefully thinking through the ideas that you presented. He/she may talk to another member of the venture capital firm or make a phone call to a portfolio company CEO to answer some basic questions, such as "Hey, would you buy something like this? Are you having this pain point? Have you heard of this founder guy? Is this technically possible?" This stage is very important for the VC deciding to commit time and effort to digging into your startup. You need the VC to internalize your basic premise.

What you can do: If the VC asks you if he/she can discuss your idea with one of the venture capital fund's portfolio companies or with a friend of the firm, say yes. (VCs are usually pretty careful with portfolio company's time and often are careful using "favors" with experts in their networks. Taking the time to do these things is a good sign that the VC is trying to work up enough mojo to spend time on your company.) Follow up on open questions left from your initial meeting, usually with things like financial models or industry research reports. Make sure the investor knows you are willing to introduce him/her to other members of your team or key contacts such as initial customers.

Stage 3: Real Work (Diligence)

Hype Level: Varies from Good to Poor to Good

There is naturally a depressed/low point to the deal cycle. This is the point where reality sets in and the venture capitalist realizes that the startup's life is going to be more difficult than originally anticipated. It is totally normal, and it is the time where most VCs will do a serious bit of reflection and decide if they wish to continue trying to justify an investment in the company. Issues that contribute to this low point may include the VC deciding that the team needs additional management talent, that the overall market is too small, that the competition is too strong, the technology is going to be too hard to create, etc.

What you can do: You need to understand what the VCs real issues are and work to address them. Listen carefully to what the VC is saying, and try to match it up with their diligence requests/actions. There should be a method to their madness. For example, if they have conducted several meetings with their outside "experts" and your CTO, and continue to ask questions about the technology then they likely have serious fears that your technology isn't feasible. Figure out the roots of this issue and address it head on. VCs can be dense, so this may require several attempts. You need to get the VC off of the low point and thinking positively again about your company.

Stage 4: Confirmatory Work

Hype Level: Should be High and getting Higher!

The VC has answered the hard questions and is now tidying up their diligence process, making sure all of the easy questions have been answered. They also may be aggressively introducing you to potential customers, in the hopes that their investment thesis will be "agreed to."

What you can do: Responsiveness is key at this stage. The VC wants to know that you have an executive team that can "be worked with." This means that you've adjusted your plans based on what you as a company have learned from the diligence process (or maybe what the venture capitalist has "taught" you - be careful who you decide to work with!) If the VC has introduced you to potential members of the executive team you've gotten them to join your company or come on after the funding closes. Finally, keep abreast of changes in the market or competitive landscape.

Stage 5: The Close

Hype Level: Off the Charts

When the deal closes everyone should be wildly optimistic. This is pretty much just human nature and you should enjoy it. The optimism around the company can be offset by difficulty in negotiating the final stock purchase agreements and other legal minutiae.

What you can do: Keep on top of your lawyer and make sure they are responding quickly with changes to the legal documents. Believe it or not, I've seen good deals die here - always due to an inexperienced attorney representing the company. Make sure you've got a very experienced lawyer!

Wow, this got to be a long post. I hope you found it interesting and welcome your comments! 

*Keep in mind that very few potential venture capital investments become real venture capital investments. The hit rate for firms trying to raise venture is quite low. At any point along this cycle the process can grind to a halt and the venture capital firm can pass on investing in your startup.

The Pyramid Principle: Venture Investment in a Capital-Efficient World

by Roger Ehrenberg

Large venture firms are in trouble. The combination of too many dollars to deploy coupled with the rapidly declining costs of starting companies has largely rendered their models obsolete. While there are exceptions, e.g., Cleantech, most venture-stage companies require very little money to prove their viability, often less than $2 million (made up of an angel round or an angel plus a "light" Series A round from a small venture firm). So where does this leave the big firms running assets of, say $250 million and above? Either relegated to a dwindling number of later-stage deals where large amounts of capital are required or a concentration of capital-intensive sectors such as Cleantech and Biotech. As either a GP or an LP of these funds, this is not where I'd want to be.

But all is not lost for these funds, if they are willing to adapt and if their LPs are able to wake up and shake off their hidebound ways of thinking about venture investing. It will require a change in staffing, due diligence methods and capital allocation. Big stuff to be sure, but essential if the legacy leaders of venture want to stay relevant and on the cutting edge. The way forward is what I'm calling the Pyramid Principle. It contemplates a three-tiered approach to venture investing, but through a structure that is almost the inverse of what larger venture firms are doing today.

The base of the pyramid - where firms will spend the lion's share of their time - will be in true early-stage venture investment. It will involve leading rounds that are as small as $250,000 and up to $2 million. It will also include incubation, which will pair a small, high-performance, tightly-knit group of agile developers that can churn out rapid prototypes of entrepreneurs' ideas. The base is a bubbling cauldron of deals, experiments and innovation. Where will the ideas come from? Either internally by looking at gaps and trends across the investment portfolio, bringing on Entrepreneurs-in-Residence that have specific ideas they'd like to work on or by being approached by an entrepreneur with a compelling idea but would benefit from the structure of working within a venture firm. The goal of investments in the base is to assess viability, e.g., whether the product or platform can demonstrate commercial relevance and traction. I would expect the staffing of the base to be with wicked smart, young-ish entrepreneurs, who want to step back from working on a single idea and to develop their chops as investors. The more experienced venture professionals, the Mentors, could provide advice and counsel to these up-and-comers and, in the process, get mentored themselves in bleeding edge technologies, business models and development methods. Entrepreneurs would get carry for both bringing in deals and working with companies, and Mentors would get carry for bringing in deals, advising the Entrepreneurs and directly working with some of the young companies. Some companies out of the base will be sold early, generating super-high ROIs but not large absolute dollars. If it turns out that growth will either cost too much or take too long to achieve, then it might make sense to take the money and run. That will be ok under this model. It will require a culture that pushes rapid assessment and admission of mistakes, rewards innovation and compensates heavily for successes that can be broadly applied. Most large venture firms find this activity too time-consuming and capital inefficient to warrant much attention. In the future I believe that getting the base right will be the key to success in the large-scale venture field.

The middle of the pyramid - where less time but more capital will be deployed - will be in B-round  growth capital investments. These source of these growth-stage investments will largely emerge from the base, in companies that require $2-$5 million to aggressively go-to-market. Money will go towards bulked-up engineering and operations teams, key management roles and creation of a sales and account management infrastructure. This has been a very competitive stage in the venture world for the past 3-5 years, where plenty of funds are happy to write checks for $5 million to help a company grow. The problem is, there will be fewer of these companies requiring fewer dollars as bandwidth and storage costs approach zero, yet these larger VCs are traditionally reliant on these deals and even later-stage investments to put their bulging LP commitments to work. By cultivating and nurturing companies in the base, the new-age VC can hang onto their winners and build a strong stable of growth-stage companies in their portfolio.

The top of the pyramid - with a small number of deals consuming large amounts of capital - will be in C and D-round growth acceleration investments. These will be for those companies that are runaway successes which can benefit from large ($10-$100 million) investments to rapidly achieve scale and dominate the space. They will be graduates from the base and middle of the pyramid, and will have been nurtured from inception to explosion within the firm. These investments represent "venture firm nirvana" - winners that have been on the books from the beginning with the ability to put progressively larger dollars to work throughout its life cycle. This enables those C and D round returns to be augmented by cheap A and B round valuations, creating the optimal mix of ROI and capital consumption.

I imagine that making these changes will be very difficult for most large venture firms, as it requires an internal culture change and a different team coupled with an external shift in messaging. It may be that a number of brand-name VCs go into run-off mode, taking their chips off the table over time and focusing their efforts elsewhere. Perhaps some of these firms could segregate their businesses into a run-off book and a new fund, with the LP commitments at a fraction of their levels in the heyday. Maybe we'll see yesterday's $1 billion fund as today's $200 million fund, with a number of $75-$150 million funds started by the venture stars of the late 1990s/early 2000s. This would be a good thing for everybody except the old-line venture firm GPs, who will no longer be collecting management fees on mega-asset pools that are no longer necessary. That's ok; they'll get over it. But if the major VC players want to remain relevant and in the game, they will need to dramatically scale back assets and modify their approach to the investing business.

We Are Yet To Receive Slowdown In Businessplans We Receive

by SHRIJA AGARWAL

Prashant Prakash, Partner, Accel India, says only very high quality biz plans will get funded now.

Accel India, the new avtar of Erasmic Venture Fund, the Bangalore-based early and seed stage fund, recently closed their second fund with a corpus of $60 million. Erasmic earlier managed about $10 million and usually invested sub-$1 million in very eary stage companies. VCCircle's Shrija Agrawal caught up with Prashanth Prakash, Partner, Accel India, in an email interview post the fund closing announcement. 

Your fund has swelled from $10 million or so earlier to $60 million now. What new can we expect from Accel Partners now?
There will be a continued emphasis on the seed and early stage space as in our earlier fund. What will be new is our ability to leverage Accel's global platform: e.g., Accel's information network and worldwide network of relationships with key individuals, customers and market-leading companies. These networks and Accel's global brand will give our portfolio companies superior credibility and attractiveness in the marketplace, resulting in recruiting advantages, accelerated sales cycles with key customers, and enhanced ability to strike strategic deals with industry-leading companies.

What is the time horizon for investing this capital?
Four years.

Arent you happy that you raised the fund at the nick of time? By the time crisis became worse you were already home with fund.
Accel enjoys association with some of the very best LPs around the world. More than timing it illustrates the strong backing Accel's India initiative has received from our LPs in very turbulent financial times.

In the current economic climate, what kind of deals do you expect in early and seed stage?
We expect to see more startups that will target consumer and business opportunities for the domestic markets which at this point are relatively more stable and still growing. These will be across many high-growth sectors and not limited to tech products or services.

Dont you think an economic slowdown affects entrepreneurship or new ideas? People will usually be sceptical about leaving their secure job and starting up especially when you need staying power to tide over the crisis.
Historically some of the best innovations and ideas have come during economic down cycles. We are yet to see any slowdown in the number of business plans that we receive. That said, the bar for funding in these times will definitely be higher, we can expect only the highest quality teams and ideas to attract venture funding.

What is your advice to the startups you have funded so far on tiding over the current market slump? You have funded a few social media companies where the business models are not clear yet. They have a long, long way to go to see a revenue stream.
While there is much talk today on cash conservation, we have always emphasised the need to be capital efficient sometimes even at the cost of growth. Most of our companies are close to cash breakeven and a few are already very profitable. More specifically, our internet companies have focused very sharply on building revenue models that work in the Indian context, and several of them are in sight of being cash breakeven.

Do you see a shift in your investment strategy?
We do not expect any significant shift in our investment strategy.

What are your learnings from the Indian market in the last few years of your operation?
We have worked with more than 20 seed and early stage companies over the last few years. Our experiences suggest the following:
--Staged infusion of capital is the most efficient and beneficial to all parties in the long run
--A number of founding teams do not have prior company building experience, and, thus far, it has been hard to acquire senior management talent from outside
--Active involvement is required from us, particularly for the first 12-18 months post fundin
--Companies need support for strategic & operational help; and key contacts for sales or partnerships

The VC model is broken

by Matt Marshall

There more you talk with folks about Silicon Valley's venture capital industry these days, the more negative the message is becoming.

And for good reason. There's no more patience. Last time, circa 2001, the entire VC industry got a "get-out-jail-free card" after the Internet bubble burst. That's because the scores of new firms created in the late 1990s argued they should be forgiven for any poor performance — it was the bubble's fault, and everyone was affected. Their investors — chief among them, the elite university endowments –agreed, and gave the VC firms more money to invest again. With most VC funds lasting for ten years, this ensured the VCs a very long life indeed.

However, several things have changed. Adeo Ressi, founder of TheFunded, the site that lets people rate venture capitalists, is the latest to try to articulate the changes with a dour set of slides. He gets some things right, and some things wrong.

Ressi was invited to present his views to the finance and entrepreneurship faculty at Harvard Business School, a place that historically has produced a lot of venture capitalists. Ressi's message is that the venture capital industry is fundamentally broken.

Ironically, his audience (HBS) might be part of the problem: One of the shortcomings with the VC model, Ressi argues, is that venture capitalists rely on their network of friends. Of all networks, HBS is one of the tighter ones. Needless to say, Ressi's message wasn't very warmly received. In fact, while blasting the old boys network is a popular thing to do, I'd actually disagree with Ressi on this point. Increasingly, you're seeing diversity within the VC community, and they're pushing themselves hard to find great entrepreneurs of any kind. I disagree that the Google founders were outsiders. They were part of the Stanford engineering student machine, a source of Silicon Valley magic for years.

Where I do agree with Ressi is in the ugly economics overall. Most daunting is that there's more money being invested into venture firms than those same VC firms are generating from their investments in start-ups — in other words, Ressi argues, they're now having a net negative affect on the economy. You'd expect this lopsided dynamic to exist temporarily in a downturn. But the worrying thing is that this state of affairs may last for quite some time.

I'm not sure how long this negative balance will last, but for now it certainly contradicts the message traditionally propagated by the VC industry — that it, that VC is a net creator of value, namely of stock market growth and job creation. That positive impact was indisputable — until now.

There are a number of key reasons why things are so ugly:

1. The early successes in the valley (Intel, Cisco, Genentech, etc) attracted so much venture capital after the late 1990s that VC became an official asset class that money investors around the world sought to get a portion of. However, this is a niche industry, and should have stayed that way. Too much money has swept in, with too few deals to accommodate it. This has distorted the economics badly. Valuations are driven up for the good companies, making it prohibitively expensive for VCs to invest. Everyone loses.

2. Others have become smarter. Larger companies put startups on their radar much earlier. Yahoo, Microsoft, Google, Cisco have acquired startups very early in their life, taking them off the market for tens or hundreds of millions of dollars — but potentially keeping some startups from becoming billion-dollar companies. Amazon famously balked at buying Google for about $1 billion back in 2000. That may not happen today.

3. Greed. Pure and simple. Good venture capitalists have an incentive to raise ever larger funds, because the 2 percent they get in fees on the funds can bring them millions of dollars in cushy salary and expense accounts (including private jets, at least in the good old days). But to put all that money to work, the investor can't focus on early-stage companies, because those small companies can't absorb enough dollars. So greedy VCs turn to invest tens or even hundreds of millions of dollars into each company. That's why there was this rush to invest at the lastest stage possible, that is in private equity. There's major pain in that sector right now, because there's no way for anyobody to liquidate their investments. This is something we saw coming a while ago; we're surprised people supported the Blackstone IPO; it was so obviously set for failure.

Is it really so gloomy?

I remember meeting Draper Fisher Jurvetson partner Tim Draper in mid-2000, when it had first become clear that the first Internet bubble had permanently burst. At the time, to my surprise, he exhorted me to be positive in my reporting, that is, to show the good side of the valley and not dwell on the bad. Of course, I largely ignored him. I ended up writing about three years worth of aggressive, negative coverage of the industry and its fallout, and didn't make a lot of friends.

But I'll never forget how sanguine Draper was — and how in the end, his view proved to have merit even though it sounded so absurd at the time. While Benchmark's Bob Kagle predicted a huge shakeout in the industry — half of all firms would disappear in a few years, he said –that shakeout actually didn't happen. The number of VC firms actually grew through 2005 or so. DFJ itself thrived, making big money from companies like Skype and Baidu. Draper was only half right, of course. He said that venture investing would remain strong, and possibly even grow. VC investing dropped back down to where it was before the bubble, but it did remain solid and grew through last year.

It is noteworthy, then, that this week I found myself contacting Tim Draper again, upon hearing that his firm DFJ is raising a large $800 million fund. Again, like last time, the economy and overall investment environment had deteriorated badly. Limited partners (the institutions that give money to VC firms like Draper's) are panicking and some are actually having trouble making good on their existing commitments (not meeting capital calls). Why on earth would DFJ think it could raise a fresh big fund in this environment?

Draper declined to comment on his firm's fundraising efforts, but here's what he said:

It wouldn't be a bad idea to spread some VC good will around about now. Washington could stand to hear about Venture Capital job creation and wealth building. After all, ours is the asset class that may be able to pull the US out of this mess. You might also go on an anti-Sarbox rampage. That might be the regulation that has sucked the most value out of the entrepreneurial economy in the last 5 years.

In other words, we're back to where we were ten years ago. The bubble a decade ago inspired a new set of regulations — known as Sarbanes Oxley — that forced startups to be much more conservative with their reporting and which required more burdensome auditing. The VCs complained about it — until the IPO market opened up in 2005-2007. Now that's over, and again we're facing the possibility of an even more severe drought. That's because there will be less mercy for VC firms this time around. And thus the plea not to focus too much on all this negativity. For Draper, such positivity is his natural demeanor. DFJ is widely known as the most aggressive venture firm in the valley — offering much larger amounts of money for an ownership stake in start-ups than other VC firms offer.

However, a lot of VCs are likely to go under this time. This asset class significantly underperformed other asset classes between 1998 and 2006. A handful of firms — Sequoia, Kleiner, Benchmark, Accel and a handful of others — have pulled up the average performance somewhat, because they've produced an inordinate amount of the successes (a small group of homeruns, the eBays and the Googles, account for 25 percent of total VC returns over the past 20 years; see Ressi's slides). But if you invest in the average firm, you're doing very poorly. So limited partners will probably shift from endowments and foundations increasingly to fund-of-funds and sovereign wealth funds.

In other words, yes, the VC model is badly broken. This time, Bob Kagle's statement about half of all VCs going out of business is more likely to be true.

What Happens to Preferred Stock When Your Company is Sold

by Jay Parkhill

The phrase in the title of this blog showed up recently in my Lijit search results and it is a great question.  The way preferred stock clauses play out is not totally obvious, either, so here is my summary of the basic principles.  For simplicity, let's assume these basic facts:

*1M shares of common stock have been issued to founders; and
*A $1M investment at $1.00 per share, meaning 1M new shares are sold and investors own 50% of the company.

Liquidation Preference
Preferred stock has rights that stand ahead of common stock.  The most basic of these (and the only one I will focus on) is the liquidation preference, meaning the amount of money each share of preferred stock will receive if a company is sold or liquidated. This amount is paid to the preferred stock holders before the common stock (founders and employees) gets any money.

The amount of the preference can be negotiated.  At a minimum the preference will be the amount paid, $1 in our example, so that investors know they will get their money back before anything goes to holders of common stock.  i.e. if the company is sold for only $1M the investors get their money back (ignoring any debt, attorney fees, etc.) and common stock holders get nothing.

If investors think the deal is risky they may demand more than a 1x preference.  Liquidation multiples of 2x or more are more common when times are tough and money scarce.  With a 2x liquidation preference our investors would get paid $2.00 for every $1.00 they invested before any money goes to the common stock.  This means the company needs to sell for over $2M before the common stock gets anything out of it.

Participating Preferred
The next question is what happens after the preference amount is paid.  In our 1x preference scenario with a $2M sale the preferred stock gets the first $1M.  What happens to the other $1M?

It depends whether the preferred stock is "participating" or "non-participating".  Participating preferred splits the remaining $1M with the common stock and non-participating lets the common stock take the full amount.  Clearly, common stock holders would rather see the preferred not participate, while participation is a better deal for the investors.

But What Happens if the Company Sells for a Lot of Money?
These scenarios all assume our company is sold for a relatively small amount of money and show how investors would get their money back when the total payout is small.  What happens if a company hits a home run, e.g. if our company sells for $50M?

Following the rules above, here are some possible outcomes:

$1 preference, non-participating:  $1M to investors, $49M to common
$2 preference, non-participating:  $2M to investors, $48M to common
$1 preference, participating:  $1M preference + 1/2 of remainder = $25.5M investors, $24.5M common

The participation right makes a big difference, as we can see. (and note that the amount of participation can be limited as well, e.g. so that preferred stock gets its preference, $10M based on participation, and then the rest goes to common)

Conversion to Common Stock
The last thing to keep in mind is that preferred stock holders can always convert to common.  So for example, in the two non-participating examples just above the preferred stock would lose out if they only got paid their preference amounts.  Instead, they could forgo the preference, convert to common and share in the sale proceeds based on their percentage ownership of the company.  This would net the investors 50% of the sale proceeds in our example.

Which Leads to Percentage Ownership
The last (obvious) point is that percentage ownership matters.  A 10% owner nets a much lower return than a 50% owner.  This basic fact goes a long way toward explaining why valuations plummet in down markets- investors value the company lower so they can get a bigger percentage for the same amount of cash, and this lets them still make a decent return even if the company sells for a low price.

Wrapping Up
The bottom line is that in almost every situation there is a company sale amount below which the investors are better off staying as preferred stock (this is generally downside protection against low-sale price outcomes) and above which the investors are better off converting to common.  The main variables are the total sale price, amount of the preference, participation/non-participation (and any caps on participation) and the percentage of the company investors would own after conversion.  You can be sure your investors will be doing this math, so you should learn how to work through it as well.

And that's what happens to preferred stock when a company is sold.

Lessons From The Last Crash

by Furqan Nazeeri

It's pretty rare that during a crash and recession there are employees and managers with recent experience on how to handle the situation.  Well, the "good news" with the Great Depression 2.0 is that a whole bunch of us have relatively fresh experience.  Last time the financial grenade went off in our lap.  This time, we're collateral damage, which means it should be less painful assuming similar size crashes (which is looking less and less like a valid assumption).

In any event, here are some lessons I learned from the last time through this mess:

1. Cash is king.  In the startup world there is a giant "scale of justice" with capital on one side and ideas/execution on the other.  Depending upon the macro environment the relative value changes and right now cash is king and ideas/execution are cheap and getting cheaper.  Some investors will be faster than others to take advantage of this, but over time all will.  Valuation and terms will be far less favorable to entrepreneurs (here's a good article on what terms will deteriorate).  If the last bubble is any indication of how much, look for 50%+ decline or more that will come over the next 4 quarters.
2. Survival is relative.  The company may survive but the cap table is unlikely to.  That means that Common (mostly founders) are going to get squeezed out.  Employees that remain with the company will get refreshed.  Going forward, if founders stay with the company, they will get compensated as employees (via option refreshes after Draconian recap rounds).  As a founder, you have to go through your personal ROI...most will find that it's best to stay but some won't.
3. Cutting costs is a tactic, not a strategy.  Most of the venture world is ignoring the forest to focus on the needles on the branches of the trees. This is necessary but not sufficient.  Like they say, the first thing you do when you find yourself in a whole is to stop digging. Ok, fine. But that won't get you out of the whole. If you are burning money, quickly do your layoffs and and then get back to figuring out how to make money off this opportunity...how to get out of this hole.
4. It's darkest before it goes totally black.  Hope is around every corner.  Entrepreneurs by their nature are optimists and you have to sell hope, but don't do it if it's not grounded in reality.  Now more than ever is a time to be a pragmatist.  If that's not your constitution, find a colleague or board member who has it and use them as a sounding board.
5. Cost savings sell.  If the past is any clue, then what will really sell in the next couple of years is cost savings.  I was in a board meeting a couple weeks ago for a company that sells a solution which helps large companies cut their telecom expenses.  One of the board members is a a Fortune 500 CIO and his point was that the prospects of the company were never better...the world is clamoring for cost cutting and that's exactly what we're selling.  Forget pitching your value as better service or more revenue.  Eventually people will come around, but right now it's better to sell what people are buying and what folks are buying right now are cost savings.
6. There is no exit strategy.  Unfortunately the only exits in the next couple of years will be asset sales and wash outs that return pennies on the dollar to Preferred and little or nothing to Common.  So unless you have a deal that is closing tomorrow, plan on living off existing cash for the foreseeable future.

Most people will tell you that unless you already have angel or VC funding today, there's no chance of raising money in the short term.  They continue by saying that these angel- or VC-backed firms are the "lucky ones."  Maybe.  I actually think that the folks who have a business buy don't have the pressure of lots of shareholders, a big board and a high burn rate are the real lucky ones.  Remember that these venture backed companies may actually survivie, but the real question to ask is which companies are most likely to have a good return for Common.

Cash panic sweeping VC industry: The capital calls problem

by Matt Marshall

Reports are growing that the financial crisis is hurting big investors that have traditionally sustained the venture capital industry. Large institutions, such as pension funds, financial institutions (including some of the banks that are going bankrupt) and university endowments give money to venture firms, which turn around and make bets on startups.

Increasingly, though, some of these institutions (known as limited partners, or LPs) are having trouble meeting their commitments to VC firms.

The result is that everyone needs money, fast. Hedge funds like Galleon, and Silicon Valley companies like electric car manufacturer Tesla and social network Facebook, are now trying to raise money in the Middle East, according to sources. Meanwhile, many angel investors have disappeared and deal-making has slowed down to a feeble craw.

VC firms typically make "capital calls" to their LPs whenever they need more money to pump into their startups. However now rumors are circulating that Columbia University's endowment fund is illiquid — that is, it can't raise the cash it needs to fund current commitments. Harvard, meanwhile, is reportedly trying to sell a third of its private equity portfolio at a steep discount in a "secondary offering."

We've called Columbia for comment.

We've heard from other solid sources that Harvard is indeed selling some of its private equity positions in the secondary market. Others are too. California's largest pension fund, CalPERS, for one, has had issues, and we're investigating this to get more details.

This may be more serious than some realize, even with the gloom already out there. We just heard of a Silicon Valley company that couldn't raise a round because one of its VC backers attempted a capital call, but the firm's investors couldn't come through with the funds.

Hans Swildens, of Industry Ventures, a firm that specializes in helping take over commitments that Limited Partners can't make (see our early story about the growing capital call problem), says:

We're starting to also see all the later stage companies miss Q3 numbers and guiding down for Q4 and 2009, that makes the company's CEO/CFOs rebudget, do layoffs to adjust expenses and also has growth impacts (not investing for growth, but hunkering down). This will make valuations drop.

Apparently, this is one area where the U.S. has more problems than other countries. Institutions have generally been more active in devoting capital to private equity and venture capital. I talked this morning with Frank Boehnke, a general partner based in London for Wellington Venture Partners, who says Europe is seeing fewer capital calls problems. But he says the worst of the problems may not be seen for a few months. Many institutions rely on returns from previous commitments to fund their capital calls. Because they've been getting fewer returns from their investments lately, capital calls going forward become harder to fulfill.

Update: The large limited partner Alpinvest Partners is reportedly saying it's no longer interested in investing in venture firms that raise new funds because Alpinvest can simply buy ownership stakes in the VC firms for much cheaper on the secondary market, where they "can be had for 50 cents on the dollar," according to PE Hub. Alpinvest, which has more than $51 billion under management, is currently evaluating about $3 billion worth of secondaries "with a short fuse," PEHub reports.