When Bad Acquisitions Happen to Good Startups

by Suzanne Dingwall Williams

Hard to believe it’s almost Christmas, but I know I’m looking forward to the break. A woman jostled me on the street the other day and I called her names I would ordinarily only use if I was talking about her behind her back.

Name-calling is the least of the problems startups can face if they don’t do some due diligence of their own on potential acquirers. Many founders feel they know their buyer well enough after the rigors of integration planning. But integration due diligence is all about rainbows and unicorns and how well you’ll all dance in the land of happily-ever-after-closing. It doesn’t help assess the risks associated with the payment terms offered by the buyer. Is an earn-out acceptable? Should future payments be placed in escrowed accounts by the buyer? Should the startup insist that it receive a security interest over its assets, in case there are payment disputes down the road?

Consider these true stories:

1. Startup A (not its real name) is sold to a competitor, who agrees to pay the purchase price as certain "earn-out" targets are met by the startup (now a division of the purchaser). When the first target is achieved, instead of making the agreed-to payment, the buyer admits that all profits generated by the division were used to pay off other company loans, and that there is no cash on hand.

2. Startup B is bought by a venture-backed business for a combination of cash and shares. Its shareholders believe that the combined firepower of the two startups, together with the backing of this VC, will make the shares they receive more profitable than an all-cash purchase price today. Turns out, the VC is having its own issues and is struggling with its current LPs/struggling to raise its next fund. Since it holds shares and secured convertible debentures, the VC decides to shutter the business and sell of the technology. As a secured creditor, it takes all of the proceeds from sale, leaving the shareholders with nothing.

Lawyers reading this will tell you that these kinds of risks can be mitigated against in a number of ways – restrictive covenants, secured interests, putting funds in escrow for example. But startups need to consider these possibilities at the letter of intent stage, and factor them into the deal. Post merger and technical integration, it’s very hard to undo a bad deal, and take your technology and go home.

If you'll excuse me, I have to go to a high-end electronics store and jostle other wives out of the way while I look for a piece of equipment which, far as I can tell, does nothing but look flat and have a wood-grain finish on its casement. (Open letter to trademark goddess Jessica Stone Levy: who let some boys name their company "Nad Electronics"? And then compounded the problem by adding the tag line "Powered by Passion"? I'd like to send him/her a note)

The Valuation Trap

Should I pay my investor's legal fees?

Should I shop around?

"We took the approach of wanting to get to know the different partners and the different possibilities and to see where there was the best fit. Partnerships take a lot of work—you want to go out on a few dates before you get married. Yes, we dated a few people but didn’t get married… and so there were a few unhappy girlfriends out there. The choice wasn't an economic choice, it was a customer choice."

— Steve Jobs

Summary: A deal is only as good as its best alternative. Keep improving your alternatives until you have a signed term sheet. And keep developing your current offers or they will die. Finally, don't say "shopping around", it puts investors off their stroke.

A reader asks:

"I have spoken to only one person regarding an investment, and they immediately said they would back my company. Should I contact more than one potential investor, i.e. shop around for someone who has experience in this space, and might be capable of injecting more capital for bigger goals? The product looks good, so I'm confident I can successfully engage other potential investors."

In your mother's womb, you learned that a chain is as strong as its weakest link. Now, in the awesome womb of Venture Hacks, you learn that,

A deal is as good as its best alternative.

Receiving a term sheet is a significant milestone. Receiving a verbal offer or an indication of interest is also a significant milestone.

But you should keep engaging alternative investors until you sign a term sheet. Sometimes, you should keep engaging alternative investors until you close (assuming the term sheet you signed doesn't have a no-shop).

Improve your alternatives to get a better deal.

Create a market that is filled with alternative buyers. Without alternatives, you will be stuck in a hostage negotiation with a single prospective investor. With alternatives, you will do well. In Bargaining for Advantage, G. Richard Shell writes,

"Research has shown that, with leverage, even an average negotiator will do pretty well while, without leverage, only highly skilled bargainers achieve their goals."

Spending time developing alternatives is as good as spending time developing your current offer. It increases the chances of closing your current offer. It closes your current offer faster. And it improves the terms of your current offer. Keep this in mind if you "don't have time" to develop alternatives.

Develop your current offers or they will die.

Keep developing your current and pending term sheets while you engage alternative investors. If you sit on a term sheet for 2+ weeks, there's a good chance, say 33%-50%, that the offer will disappear because the investor will move on to a shiny new company and his enthusiasm for your company will wane. Not to mention that most term sheets expire after a couple weeks.

Don't let offers cool while while you warm up alternatives. Shopping around for Gucci underwear is effective as long as stores have it in stock. It's not effective if each store runs out of inventory while you're visiting its competitors.

The best way to keep investors warm is to focus on fund-raising so you can (1) get all your offers at once and (2) pick the best one before any of them cool down.

Buy a little time after your first offer.

When you receive your first offer, you can buy 1-2 weeks of time by saying,

"We've promised to close out conversations with a few investors and we need to honor our promise."

"We've committed to a partner's meeting next week and we need to honor our commitment."

No investor is going to ask you to break your previous commitments. This little tactic buys you time and increases your social proof and scarcity.

You only need a few offers to clear the market.

How do you know if you've cleared the market? You need two or three offers from investors who make it a habit to invest in startups at your stage. These investors should create enough demand, social proof, and scarcity among themselves to improve your terms and clear the market.

Finally, receiving more than two or three offers means you will have to disappoint more investors. Turning down investors is surprisingly hard.

You're not "shopping around".

Finally, don't use the words "shopping around" or "auction" with investors. Their reaction to these terms is,

"What am I, a bag of money? I can only get in this deal if I pay the most?"

You're not "shopping around", you're "looking for the right partner". While you're talking to investors, you can define the right partner in terms of domain experience, or someone who wants to invest more/less money, or someone who has a history of backing the founders, or anything but: the guy who will pay the most.

Choose Your Investors Wisely

by James Chen

I wanted to take a moment to congratulate Andy Klein and his team at Spotzer. Spotzer recently announced a Euro 10 million investment from Sierra Ventures and European Directories. I must disclose that we invested in the angel round at Spotzer.

Spotzer is an exciting company working in the white hot space of highly targeted and affordable advertising. Spotzer is based in Amsterdam with offices in the UK, San Francisco, and New York. They hope to become the first truly global advertising company in the highly targeted video space.

In thinking about Spotzer's new investment, it reminds me of the importance of taking on investors strategically for reasons besides money.  Often it is not the best "deal" that you should chase, but the most doors a potential investor can open.

Spotzer's list of strategic investors:

Dutchview BV - Holland's largest  post production company serving the Dutch population.
Cyrte Investments - media investment firm with deep relationships in the Netherlands
European Directories - pan-European directories service group with strong marketing holds in most of Europe
Sierra Ventures - California based firm with a strong record in the United States

In any area, it is important to get strategic investors. In the space of global media advertising, it is essential. Without those investors to open doors to get into media networks and get national creative agencies to sign on to your product, you face a huge uphill battle.

Let's briefly take a look at Spotzer's largest competitor, Spotrunner, based in the US. Spotrunner's investors:

CBS Corporation
WPP - huge multinational advertising agency
Interpublic Group - huge multinational advertising agency
Battery Ventures - blue chip VC firm
Index Ventures - young global VC firm that backed Skype

As you can see, strategic investment is the key to thriving in any sector, particularly advertising media.

I expect this space to flourish over the next few years with a few possible public offerings on US or global markets. As more and more of these types of companies continue to receive funding, there will also be a nice wave of acquisition and consolidation.

作者：桂曙光

注：本文删节版已在创业邦杂志（www.cyzone.cn）第二期（2007年11月）正式出版

情景一：假如你是第一次创业，你正在寻找风险投资（VC），在经过跟风险投资人漫长的商业计划演示和交流之后，突然有一天，投资人对你的公司产生了投资兴趣，于是给你出了一份所谓“投资协议条款清单”（Term Sheet）。但是，包括你的团队、你的董事会、你周围的朋友在内，都没有人曾经看到过一份Term Sheet，里面的某个“清算优先权”条款是这样写的（通常是英文）：

Series A Preferred shall be entitled to receive in preference to the holders of the Common Stock a per share amount equal to 2x the Original Purchase Price…

A系列优先股有权优先于普通股股东每股获得初始购买价格2倍的回报…

你完全搞不懂这是什么意思。

情景二：假如你接受了上面那份Term Sheet，投资人跟你投资了$2M，给你的投资前估值（Pre-money valuation）是$3M，投资后（Post-money）估值$5M，于是投资人拥有你公司40%的股份。经过1年，公司运营不是很好，被人以$5M的价格并购。你认为你手上60%的股份可以分得$2.5M的现金，也还满意。但是投资人突然告诉你，根据协议，他要拿走$4M（投资额的2倍），留给你的只有$1M。你又糊涂了。

什么是清算优先权（Liquidation Preference）?

几乎所有的VC选择可转换优先股（Convertible preferred stock）的投资方式，而可转换优先股的最重要的一个特性就是拥有清算优先权。

优先清算权是Term sheet中一个非常重要的条款，决定公司在清算后蛋糕怎么分配，即资金如何优先分配给持有公司某特定系列股份的股东，然后分配给其他股东。例如，A轮（Series A）融资的Term sheet中，规定A轮投资人，即A系列优先股股东（Series A preferred shareholders）能在普通股（Common）股东之前获得多少回报。同样道理，后续发行的优先股（B/C/D等系列）优先于A系列和普通股。也就是说投资人在创业者和团队之前收回他们的资金。

通常所说的清算优先权有两个组成部分：优先权（Preference）和参与分配权（Participation）。参与分配权，或者叫双重分配权（Double Dip）有三种：无参与权（Non participation）、完全参与分配权（Full participation）、附上限参与分配权(Capped participation)，相应的就有三种清算优先权：

（1）不参与分配优先清算权（Non-participating liquidation preference）

参考下面实例：

Liquidation Preference: In the event of any liquidation or winding up of the Company, the holders of the Series A Preferred shall be entitled to receive in preference to the holders of the Common Stock a per share amount equal to [x] the Original Purchase Price plus any declared but unpaid dividends (the Liquidation Preference).

清算优先权：在公司清算或结束业务时，A系列优先股股东有权优先于普通股股东获得每股[x]倍于原始购买价格的回报以及宣布但尚未发放的股利（清算优先权）。

这就是实际的清算优先权，退出回报如下图。

（1）当公司退出价值（Exit Value）低于优先清算回报时，投资人拿走全部清算资金；

（2）当公司退出价值按投资人股份比例分配的数额高于优先清算回报时，投资人将优先股转换成普通股，跟普通股股东按比例分配；

（3）当公司退出价值介于两者之间时，投资人拿走约定的优先清算回报额。

在普通股股东获得利益分配之前，投资人要获得原始投资一个确定倍数的回报。在过去很长时间里，标准的是“1倍（1X）”清算优先权。目前现在大部分情况是1倍（1X）至2倍（2X）。

（2）完全参与分配优先清算权（Full-participating liquidation preference）

完全参与分配权的股份在获得清算优先权的回报之后，还要跟普通股按比例分配剩余清算资金。在优先权条款后还会附加以下条款：

Participation: After the payment of the Liquidation Preference to the holders of the Series A Preferred, the remaining assets shall be distributed ratably to the holders of the Common Stock and the Series A Preferred on a common equivalent basis.

参与权：在支付给A系列优先股股东清算优先权回报之后，剩余资产由普通股股东与A系列优先股股东按相当于转换后股份比例进行分配。

退出回报如下图所示：

当公司退出价值低于优先清算回报时，投资人拿走全部清算资金。超过优先清算回报部分，投资人和普通股股东按股权比例分配。

（3）附上限参与分配优先清算权（Capped-participating liquidation preference）

附上限参与分配权表示优先股按比例参与分配剩余清算资金，直到获得特定回报上限。在优先权条款后会附加以下条款：

Participation: After the payment of the Liquidation Preference to the holders of the Series A Preferred, the remaining assets shall be distributed ratably to the holders of the Common Stock and the Series A Preferred on a common equivalent basis; provided that the holders of Series A Preferred will stop participating once they have received a total liquidation amount per share equal to [X] times the Original Purchase Price, plus any declared but unpaid dividends. Thereafter, the remaining assets shall be distributed ratably to the holders of the Common Stock.

参与权：在支付给A系列优先股股东清算优先权回报之后，剩余资产由普通股股东与A系列优先股股东按相当于转换后股份比例进行分配；但A系列优先股股东将停止参与分配，一旦其获得的回报达到[x]倍于原始购买价格以及宣布但尚未发放的股利。之后，剩余的资产将由普通股股东按比例分配。

退出回报如下图所示：

（1）当公司退出价值低于优先清算回报时，投资人拿走全部清算资金；

（2）当公司退出价值按投资人股份比例分配的数额高于回报上限时，投资人将优先股转换成普通股，跟普通股股东按比例分配；

（3）当公司退出价值介于两者之间时，投资人先拿走优先清算回报，然后按转换后股份比例跟普通股股东分配剩余清算资金，直到获得回报上限。

这里一个有意思的问题是原始购买价格倍数（[X]）的真实含义。如果参与分配倍数是3（3X）（3倍的初始购买价格），表示一旦获得300%的初始购买价格的回报（包括优先清算的回报），优先股股东将停止参与分配剩余资产。如果清算优先权是1倍（1X）回报的话，参与分配权的回报不是额外的3倍，而是额外的2倍！也许是因为参与权跟优先权的这种关系，清算优先权条款通常同时包含优先权和参与分配权的内容。

清算优先权激活：清算事件（Liquidation Event）

谈清算优先权，那明确什么是“清算”事件就很重要。通常，企业家认为清算事件是一件“坏”事，比如破产或倒闭。对VC而言，清算就是“资产变现事件”，即股东出让公司权益而获得资金，包括合并、被收购、或公司控制权变更。结果是，清算优先权条款决定无论公司在好坏情况下，资金的分配方式。标准条款如下：

A merger, acquisition, sale of voting control or sale of substantially all of the assets of the Company in which the shareholders of the Company do not own a majority of the outstanding shares of the surviving corporation shall be deemed to be a liquidation.

公司合并、被收购、出售控股股权、以及出售主要资产，从而导致公司现有股东在占有续存公司已发行股份的比例不高于50%，以上事件可以被视为清算。

所以这个条款是确定在任何非IPO退出时的资金分配（IPO之前，优先股要自动转换成普通股，清算优先权问题就不存在了），而大部分的公司最后可能的退出方式也不会是IPO，所以不管创业者对自己和公司是否有信心，都应该详细了解这个条款。

清算优先权背后的逻辑

很多VC采用有参与权优先股，一方面是因为他们基金的出资人－有限合伙人（Limited Partner, LP）也是这样向他们收取回报的。VC的普通合伙人（General Partner, GP）向LP募集资金，成立一个基金（Fund），LP出资（GP也可能会出1%），GP运营，到基金存续期结束清算的时候，LP拿走出资额外及基金盈利的80%，GP获得盈利的20%。比如：一个$100M的VC基金，LP实际上是借给VC公司$100M，LP需要拿回他们的$100M，外加80%的利润。

另外一方面，为了避免创业者从投资人那里不当获利，让VC基金蒙受损失。比如：你从投资人那里获得$10M投资，出让50%股份。然后在VC的资金到账后立刻关闭公司（没有其它资产），那投资人只有得到企业价值（$10M）的50%，这样你就从投资人那里欺骗到$5M。要是真的这样，以后你的基金就很难募到资金了。为了避免出现这种情况，也因为投资人一贯的贪婪本质，他们会要求最少1倍（1X）的清算优先权，这样在公司发展到退出价值超过投资人的投资额之前，你是不会关闭公司的。

创业者如何理解清算优先权

（1）优先股是债权（Liability）还是权益（Equity）

优先股是企业的债权或是权益，参与分配权的优先股既是债权也是权益。“优先权”表示债权，“参与分配权”表示权益；

参与分配的优先股股东，不需要决定是拿走优先清算额，还是转换成普通股按比例参与分配，他们两者都要。根据上文不同情形下的退出分配图，仔细分析就会发现，参与分配的优先股只有在退出价值较小时才合理，以保护投资人的利益。如果公司运营非常好，投资人不应该按照优先清算的方式参与分配，他们会转换成普通股。

（2）投资人与创业者存在退出利益不一致

在不参与分配和附上限参与分配的清算优先权情况下，会出现一个非常奇怪的回报情形：通常投资人在某个退出价值区间的回报保持不变，比如，在退出价值X和X+a之间，投资人的回报没有区别（维持优先清算额或回报上限）。但是创业者的回报在退出价值X和X+a之间是不断升高的，此时出现双方利益不一致。如果此时公司有机会被收购，出价范围刚好在X和X+a之间，为了促成交易，投资人当然愿意接受一个底价。

（3）了解投资人要求清算优先倍数的动因

创业者要了解给你投资的VC基金，这个基金其它投资案例运营得怎么样，因为绝大多数情况下，这些投资案例的情况会决定VC如何看待你的公司。如果某个基金的其他投资案例都表现糟糕，那基金的策略会更为保守，要求的清算优先倍数会高一些，并通过投资你的公司来提升基金的整体回报水平，这样他们才能继续运作这个基金，并募集新的基金。如果某个基金投资了很多好项目，那么他们可能表现得激进一些，只想着做个大的（IPO），在清算优先倍数上不太在意。不同的VC根据你的公司在他的基金中的地位会有不同的风险/回报判断。

（4）要仔细研究并跟投资人谈判

没有一个VC打算在你没有看过并且没有给你的律师看之前，跟你签署任何东西。想一想：我打算给你能够买20或30部宝时捷汽车的资金，因为我相信你是个聪明的商人，能够让我搭顺风车一起赚钱。我会把这些真金白银给一个没有看过合同就签约的家伙吗？VC不愿意把钱给一个草率得甚至都不愿意花点时间来理解Term Sheet的家伙。最好还是找个律师或财务顾问来帮你研究一下。

我编制了一个Excel表格帮助创业者模拟融资条款中不同的清算权和参与分配权的退出回报情况。你可以改变稀释比例、优先股的参与分配权、优先清算倍数、回报上限、退出的价值范围、等。改变模型中的这些变量，就可以看到管理层和投资者的回报情况。下载地址是：http://www.esnips.com/doc/bac52507-7009-49b4-9b18-bed3b3a638d4/Liquidation-Preference-Calculation-(Chinese-Version)

后续融资的清算优先权

在谈判A轮融资的Term Sheet时，清算优先权通常比较容易理解和评估。但是随着公司发展，后续的股权融资将使得不同系列股份之间清算优先权在数量上和结构上发生变化，清算优先权也会变得更为复杂和难于理解。跟很多VC相关问题一样，处理不同系列股份清算优先权的方式也不是一成不变。通常有两种基本方式：（1）后轮投资人将会把他们的优先权置于前轮投资人之上，比如B轮投资人先获得回报，然后A轮投资人。（2）所有投资人股份平等，比如A轮和B轮投资人按比例获得优先回报。运用那种方法是一个黑箱艺术，是不同系列优先股之间的事情，通常不会影响创业者，因为创业者的普通股优先级最低！

一个清算优先权案例

假设ABC公司的投资前估值$10M，投资额$5M，投资人要求参与分配的清算优先权倍数为2倍（2x），清算回报上限是4倍（4X）。

根据以上数据，投资人的股份（可转换优先股）比例为33%（$5M/($10 M +$5M)），优先清算额为$10M（$5M*2），清算回报上限是$20M（$5M*4）：

（1）如果公司清算时的价值低于投资人的优先清算额，即$10M，那么投资人拿走全部；

（2）如果公司清算时的价值高于$60M，那么投资人会将优先股转换为普通股，与普通股股东按股份比例（33%）分配清算价值，投资人获得的回报将大于$20M（$60M*33%），而不受优先股清算回报上限（$20M）的限制；

（3）如果公司清算时的价值介于$10M至$60M之间，投资人先获得优先清算额（$10M），然后按股份比例跟普通股股东分配剩余的清算价值。此时会有一个有趣的情况：当清算价值介于$40M至$60M之间时，投资人拿走优先清算额之后，剩余的清算价值为$30-50M，投资人按股份比例理论上可以分配的金额为$10-16.7M，两项相加投资人获得的回报为$10-26.7M，突破了清算回报上限$20M了，因此，按照约定，此时投资人仍然只能获得$20M，多于的部分由普通股股东分配。

具体回报如下图所示。

谈判后可能的清算优先权条款

创业者在跟VC就清算优先权谈判时，根据双方的谈判能力，公司受投资人追捧的程度，公司的发展阶段，等等因素，可能或得到不同的谈判结果：

（1）有利于投资人的条款：1倍（1X）或几倍清算优先权，附带无上限的参与分配权。

在公司清算或结束业务时，A系列优先股股东有权优先于普通股股东获得每股[1]倍于原始购买价格的回报以及宣布但尚未发放的股利（清算优先权）。在支付给A系列优先股股东清算优先权回报之后，剩余资产由普通股股东与A系列优先股股东按相当于转换后股份比例进行分配。

在这个条款下，投资人不但可以获得优先清算回报，还可以不用转换成普通股就能跟普通股股东按比例分配剩余清算资金。只能说这个投资人太贪婪了。

（2）相对中立的条款：1倍（1X）或几倍的清算优先权，附带有上限的参与分配权。

在公司清算或结束业务时，A系列优先股股东有权优先于普通股股东获得每股[1]倍于原始购买价格的回报以及宣布但尚未发放的股利（清算优先权）。在支付给A系列优先股股东清算优先权回报之后，剩余资产由普通股股东与A系列优先股股东按相当于转换后股份比例进行分配；但是一旦A系列优先股股东获得的每股回报达到[3]倍于原始购买价格（除宣布但尚未发放的股利外）后将停止参与分配。之后，剩余的资产将由普通股股东按比例分配。

这个条款通常双方都愿意接受，但需要在清算优先倍数和回报上限倍数达成一致。通常的清算优先权倍数是1-2倍（1-2X），回报上限倍数通常是2-3倍（2-3X）。

（3）有利于创业者的条款：1倍（1X）清算优先权，无参与分配权。

在公司清算或结束业务时，A系列优先股股东有权优先于普通股股东获得每股[1]倍于原始购买价格的回报以及宣布但尚未发放的股利（清算优先权）。在支付给A系列优先股股东清算优先权回报之后，剩余资产由普通股股东按股份比例进行分配。

这是标准的1倍（1X）不参与分配的清算优先权（Non-participating liquidation preference）条款。意思是退出时，A系列优先股投资人可以选择要么在其他任何人之前拿回自己的投资额（仅仅是投资额），要么转换成普通股之后跟其他人按比例分配资金。没有比这个对创业者更友好的条款了，如果在你的Term sheet中出现了，恭喜你。这完全决定于你目前业绩、经济环境、第几轮融资、项目受追捧情况、等。如果创业者没有令人激动的创业经历或者项目没有太多投资人关注，通常在A轮Term sheet中不会看到这样的条款。

总结

大部分专业的、理性的投资人并不愿意榨取企业过高的清算优先权。优先于管理层和员工的清算优先回报越高，管理层和员工权益的潜在价值越低。每个案例的情况不同，但有一个最佳的平衡点，理性的投资人希望获得“最佳价格”的同时保证对管理层和员工“最大的激励”。很明显，最后的结果需要谈判，并决定于公司的阶段、议价能力、当前资本结构、等，但通常大部分创业者和投资人会根据以上条件达到一个合理的妥协。

Failure Rates In Early Stage Venture Deals & Why They Fail

By Fred Wilson

Failure Rates

My friend Jeff Jarvis invited me to talk to his class yesterday. Jeff is doing something really cool. He's teaching graduate students in journalism school how to be entrepreneurs. So these students graduate with the understanding that they have another option, they don't have to go work for a media company. If they are so inclined, they can try to start a media company instead.

We had a pretty far ranging conversation but the most interesting part of it was in response to the question "why do startups fail?"

I have seen my share of failure over the years, it's part of the venture capital business. When we raised our first Union Square Ventures fund, I told prospective investors to expect 1/3 of our investments to fail. I always like the 1/3 rule, which is that 1/3 of the investments will fail, 1/3 will under-perform expectations, and 1/3 will meet expectations. Meeting expectations means 5x to 10x on our money. If you are into math, you can look at it this way:

1/3 average 7.5x – 2.5x
1/3 average 2x – 0.667x
1/3 average 0x – 0x
Total result – 3.2x

The important part of that equation is that you have to have high expectations going into an investment. If your expectations going into a deal are 3x on an average investment, you will fail in the venture business.

In reality, I've been able to do better than this over the years. But when talking to investors, it helps to set achievable expectations.

I went back over the past 17 years during which I have been doing deals by myself. During that time period, I have originated, led, and managed 32 investments, about 2 deals per year. I find that is pretty standard in the early stage venture capital business, 2 new deals per year per partner.

Here are the stats:

5x or greater – 11 deals – average 10.2x
1x to 5x – 7 deals – average 2.6x
Failures – 5 deals
Unrealized – 9 deals

Three of the unrealized deals are 1999 vintage Flatiron investments which will almost certainly end up in the 1x to 5x category so if I add them to that category and leave out the six unrealized Union Square investments that I manage, the distribution looks like this:

5x or greater – 11 deals
1x to 5x – 10 deals
Failures – 5 deals

That is decidedly not 1/3, 1/3, 1/3.

It is more like 40%, 40%, 20%.

I doubt that is sustainable going forward. If I take out the six investments I made in the "golden years" of 1996 to 1998, then the numbers look like this.

5x or better – 7 deals – average 7.1x
1x to 5x – 9 deals – average 2.5x (on the 6 realized investments)
Failures – 4 deals

That is 35%, 45%, 20%, which is more like what I'd expect to see from a good early stage investor's track record.

Why they Fail

I've made 32 direct investments (the deals I've sourced, led, and managed myself) over the past 17 years. Of those 32 investments, 5 of them have been failures. Those 32 investments includes 6 unrealized Union Square investments I am currently managing and 3 that we've sold. If we assume that at least one and possibly two of the unrealized Union Square investments will fail (hopefully not!), then something like 20% of the investments I've made are going to be failures. That's a pretty low failure rate and I am proud of it. I am also proud of the fact that I've lost money on investments because until you do, you really aren't a "seasoned" venture investor. It's almost a requirement in our business to have lost money. It's a rite of passage, but also one you want to do very infrequently.

So why do venture investments fail? Well if I look at the ones I've been involved in (including deals my partners led but where I shared the pain of loss) there are two primary reasons.

1) It was a dumb idea and we realized it early on and killed the investment. I've only been involved in one investment in this category personally although I've lived through a bunch like this over the years in the partnerships I've been in.
2) It was a decent idea but directionally incorrect, it was hugely overfunded, the burn rate was taken to levels way beyond reason, and it became impossible to adapt the business in a financially viable manner.

Four of the five failures I've been involved in fit into this second category and probably 2/3 of all the failures I've seen "up close ad personal" fit into this category. I don't blame the entrepreneurs and managers entirely for these failures. The investors and the boards of these companies (ie me) are responsible for failures like this. Entrepreneurs may not have the experience to know the folly of taking burn rates to levels which make "figuring it out" impossible. But we as investors know how high burn rates kill companies and we have a responsibility to fight them at every turn.

This is a lesson that is etched into my brain and into my back with the scars of $20mm losses, bankruptcy filings, and mass layoffs. It's ugly, painful, and totally and completely avoidable.

My friend Dick Costolo, co-founder of FeedBurner, describes a startup as the process of going down lots of dark alleys only to find that they are dead ends. Dick describes the art of a successful deal as figuring out they are dead ends quickly and trying another and another until you find the one paved with gold.

I like that analogy a lot. Of the 26 companies that I consider realized or effectively realized in my personal track record, 17 of them made complete transformations or partial transformations of their businesses between the time we invested and the time we sold. That means there a 2/3 chance you'll have to significantly reinvent your business between the time you take a venture capital investment and when you exit your business.

Here's an interesting breakdown of the "transformers" versus the "stick to our plan" investments in my personal track record.

Greater than 5x – 11 total investments – 7 transformed, 4 did not
1x to 5x – 10 total investments – 6 transformed, 4 did not
Failures – 5 total investments, 1 transformed, 4 did not
Unrealized Union Square investments – 6 total, 3 transformed, 3 have not

You might think that the home runs had their plan figured out right out of the box and the deals that were less successful were mostly transformers. That's not the case with the investments I've been personally been involved in. It’s about the same ratio for both categories.

But where you really see the value of being nimble is in the failures. All but one failed to transform their business and all but one were unable to do that because of the large unsustainable burn rates they had built up. Even the one business that did transform itself, it went from a low cost business model to a high cost business model and they put themselves in a pickle when the transformation didn't pan out.

To go back to Dick's analogy, you can go down lots of blind alleys if the cost of doing so is low. But if you are spending a million dollars on each blind alley, you'll be out of business in no time.

So it's pretty clear to me that most venture backed investments don't fail because the business plan was flawed. In my experience at least 2/3 of all business plans we back are flawed.

Most venture backed investments fail because the venture capital is used to scale the business before the correct business plan is discovered. That scale/burn rate becomes the cancer that kills the business.

I should also say that for businesses that don't have the benefit of venture capital backing, the reverse is probably true. Almost certainly non-venture backed businesses will not have the ability to get too big too fast. They will mostly fail because they have the wrong business plan and they don't have the wherewithal to survive for the period of time it takes to figure out the correct one.

Regardless of whether you have taken venture capital or not, capital efficiency and bootstrapping are critical values. You must keep your burn rate low until you can show without a shadow of a doubt that you have a business model that works, can be operated profitably and is ready to be scaled. Then and only then should you step on the gas.