Introducing the new VC blacklist: 217 and counting

by Georges van Hoegaerden

Retail store decorations reminded me that easter is approaching and that set off the memory of an easter egg chart (on the right) I received from an early stage entrepreneur who had been trying to raise money over the past 12 months. In many ways the chart indicates how the Venture Capital (VC) world is filled with the wrong operators (not a lack of money), incapable of assessing risk; I will clarify later.

The enclosed chart includes the names of every investor (VC and Angels) the entrepreneur has spoken to face-to-face (in dark green), conversed through e-mail (in light green) and is scheduled to connect with (in orange).

Needless to say the 217 investors (whom I will not disclose yet, to protect the entrepreneur) that bothered to meet face-to-face include pretty much anyone who means anything in the VC business.

Helped by a tiny amount of seed money and introductions from a well known and respected investor, most investors responded enthusiastically (according to the entrepreneur), yet virtually none have bothered to provide the valuable feedback (or responded back with a decent no) that could lead to a line-of-sight of a term-sheet.

So, we conclude from this painstaking process the entrepreneur went through the following:

- Fundraising takes time, a lot of time

Even with the introduction from a well known VC, carve out one year of your life to raise virtually nothing (a million or so). Most entrepreneurs chase a dream that is chiseled from years of experience dealing with inefficiencies, only to discover that at fundraising time they don't understand (and don't want to understand) the VC microcosm that holds "innovations" hostage. We recommend entrepreneurs to start socializing the idea with VCs the minute they start writing code, to establish a clear target list of investors that can and should do the deal 9 months to a year later. One year ago I would have recommended the entrepreneur to sell his house and raise money that way, easier and better retention of control in the company.

- Investors don't treat entrepreneurs with the respect they deserve

Not responding to the entrepreneur (even when they share valuable connections together) as the majority of the investors on the enclosed chart did is the lowest form of disrespect imaginable. I have written about obnoxious VCs in this blog many times before (reinventing VC, subprime VC, LPs fooled, curse of subprime VC, investors to avoid) and would tell you that those over-inflated personalities contribute that I have no interest to belong to the current VC club (I have been asked). Clearly not everyone was raised by a grandfather (and co-founder of the Mentos candy) who taught us early on that you can be hard-nosed, respectful and successful all at the same time.

- The current crop of early-stage investors are numb

As you notice from the linkages in the chart (hard to see at 6% of original size), many investors have provided referrals to others. But referrals only happen when investors believe "there is something there" (one of their favorite phrases) and pass it along to another investor who may better understand the proposition. In an effective investor ecosystem and regardless of their belief in the proposition, the chart would never grow to be as large as it is. When investors don't like the proposition they will not pass it on, and when they do they will keep it to themselves and work out a deal. So, the sheer size of this chart communicates really well how clueless our current VC microcosm is.

- The current crop of early-stage investors simply don't understand the technology business

The fact that this entrepreneur is thrown around like a rag-doll by some of the biggest "experts" in the VC business says it all. The investor's indecisiveness is an indication of their lack of knowledge and vision that has earned them such a prominent role in the innovation of our industry. But, the best investors weigh risk, they do not need to deliver vision. Experienced entrepreneurs do not need investors to hold their hands in understanding the technology business and just need their investors to get out of the way.

- The current crop of early-stage investors are cowards

There is nothing, I repeat, nothing wrong with a VC saying no, whatever the investor's rational. But this chart shows how none of them can decide on their own - either way. These investor cannot stand to lose a deal they may miss out on (and not saying no will keep that door open), and don't have the guts to take the risk if they thought otherwise. It takes a strong character to be a VC, not an insecure and arrogant one.

- The current crop of early-stage investors are lemmings in rudeness

We knew that they were lemmings already, but now we know they will not only decide to jump off the cliff together but also share incredible rudeness. A sad state of being. No entrepreneur should sign any of these people on to their boards, because if they were not rude to them yet, that behavior will undoubtedly pop up when they least expect it.

- Entrepreneurs need a professional agent

Talking to this many investors and not yielding any takers is creating the smell of a dead fish in the venture community. While great successes like Skype required talks with reportedly about 40 investors and I did 20 on one of mine, the entrepreneur should have forced an early feedback loop with some investors before proceeding to talk to any more. The entrepreneur should pick an advisor or agent that does not allow this to go on for so long. It is sad that we are beginning to look an awful lot like Hollywood to become effective.

Now, notice that I have not discussed the specific proposition of the entrepreneur here and we may actually side with the VCs unable to extract razor-sharp focus from this entrepreneur's broad tale (but we will have the courtesy to tell him that directly). But the validity of the proposition is beside the point made here. Entrepreneurs, while they eat away their family's life savings and make considerable personal sacrifices, deserve the straight talk to help them plan their resources.

It is even more appalling that without any serious feedback the only response from a few VCs is to come back later, build the base technology first (which the entrepreneur has done) and get a critical number of customers. As if at that time the entrepreneur is in need of any fair-weather friends. The true character of thesub-prime VC is shining through again, but I am surprised it includes so many investors I thought better of. No wonder people like Umair Haque become even more enraged, describing VCs asleep at the wheel of creative destruction.

I would suggest the LPs (Limited Partners) to pull back from 80% of their current VC commitment (that are not producing returns anyway) and re-allocate the majority of that money to the creation of new VC firms that target more fundamental diversification in the technology asset class. I hereby offer my services to the LPs that want to take a hard look at that. And I would love to see the remainder of the current "prime VCs" be forced to re-invent themselves by this new influx in the same way entrepreneurs are all the time.

The only way to grow technology innovation is to force the VC business out of its current sub-prime mode and challenge the behavior of the crypt-keepers by making them highly accountable for their performance.

In the words of Ron Conway (a prominent angel investor) who recently stated "it is time for a new crop of entrepreneurs", we surmise "it is time for a new crop of investors" that attracts better innovation.

What Should I Know Before Using a "Money Finder" to Raise Capital?

By Ben Hendricks

A "Money Finder" is an individual or company who, for a fee, finds willing investors interested to invest in growing companies. The Finder formally links the Investors and Entrepreneurs with the purpose of creating a mutually beneficial financial arrangement.

Terms

Some terms used here may be unfamiliar. "Intermediary" and "Money Broker", as used here, are other terms with the same meaning as "Finder." "Entrepreneur" is an individual who seeks and assumes the risk of business growth, usually through direct ownership and management. "Angel Investor" is an individual with high net worth willing to take the risk of lending money to an Entrepreneur.

How does a Finder find willing Investors?

Finders spend many years building a reliable network of investors. The network is built through business contacts, successful business deals, and the personal reputation of the Finder. The Finder's network is the heart and foundation of his own entrepreneurial business.

There are many types of Investors, including Institutional Investors, individual or Angel Investors, Venture Capital firm and Private Equity groups. New Investors are added to the Finder's network on a regular basis, but not without considerable scrutiny, thought and analysis.

How does a Finder find worthy Entrepreneurs?

Many entrepreneurial businesses are ready and worthy of funding, but not all need the services of a Finder. Usually businesses using a Finder 1) need at least $1 million, 2) have a strong management team, 3) have a proven track record of growth and potential to continue, and 4) has the ability to generate revenue. Therefore, the Finder usually asks potential clients for information and documentation about their businesses. These include biographies and resumes of the management team, business plans, and financial statements. The Finder evaluates and analyzes the information to propose the best solution for the client.

How are Finders paid?

Finder's fees are based on the amount of capital received. Usually, the fees are paid in cash or company stock or a combination. In general, the Finders fees are 5 - 10 percent of the amount of capital received with the higher percentage paid for smaller amounts raised. The Finder's fees are often negotiable and always agreed upon before any services are provided.

Does a Finder need to be licensed?

The SEC, which regulates money-raising activities, sees a Finder as someone who's acting as a promoter of the sale of securities and thus is required to have a Broker Dealer license. Ben Hendricks from Annacore Business Capital, LLC says" If they don't have the proper license, then (a) they're acting illegally and (b) any contract they sign with you is unenforceable, and therefore any portion of their fee that's based on a percentage of the money raised is not collectable"

If you are an Entrepreneur looking for capital, take the time to ask the right questions before you hire any Finder.

Are you overqualified for your startup?

by Alexander Muse

This afternoon I heard a pitch from a team of three co-founders who have developed a very cool device sold through stores like Sears and Home Depot.  The three engineers developed the device a couple of years ago as they held down regular day jobs.  Device sales have been growing steadily and it looks like they will each earn a $100,000 this year as a result.  Next year they might earn more than $200,000 if the device continues to sell.  Everything sounds great, right?

The engineers want to raise a million dollars so they can quit their jobs and work on the project full-time.  These guys are easily earning $200,000 each in their high-powered engineering positions today.  The funds will help them cover their salaries as well as finance their receivables.  Based on my analysis of their numbers they would almost run out of money in 13 months if everything goes as planned.  I think this plan is a mistake primarily because the startup can't afford to pay these highly skilled engineers.

For example, lets assume you and three buddies buy a McDonald's franchise, each putting up the money necessary to fund the operation until break even.  One of you quits his job to run the restaurant, while the other two keep their day jobs.  The goal is not for each of you to quit your high paying jobs to come work with your buddy in the restaurant - instead the goal is for you all to be able to hire a manager to run the restaurant creating side income for each of you.

Many times it is unlikely that your startup can afford multiple high powered executives or founders.  In this case I suggested that the engineers all keep their day jobs and hire a manager to run the day-to-day.  The manager would earn around $50,000 and could be paid a performance bonus.  They also need to secure purchase order financing of around $250,000 to fund their business plan for the next year or two.  They will own 100% of their business and each earn $300,000 (job + startup) this year and $400,000 next year instead of losing almost half of their company and a million dollars.  Not every startup is your next job - maybe it is just your next income stream.

Investors weigh public stocks versus Venture Capital

by Don Dodge

Venture Capital has been a great business and has provided solid returns for investors over the past 20 years. As an asset class Venture Capital has outperformed publicly traded stocks over all time horizons. Yet, the New York Times shouts "Angels Flee From Tech Startups" and  "Venture Capital Returns Dip Below Zero."  True, perhaps, but VC still outperformed stocks and most other asset classes. Venture Capital is a long term investment, typically 10 years in a fund, so I'm not sure how Thomson Reuters calculates the one year return, but there is no doubt that all asset classes suffered in 2008.

Fred Wilson points out that one year returns are irrelevant for VC, but are required by accounting rules. Fred says "The thing that really bugs me is if not for FAS157, which I posted about a few weeks back, we wouldn't even see negative returns for VC in the past year. FAS157 is an accounting ruling which requires venture capital firms to mark their investments up in good markets and mark their investments down in bad markets. I am not sure if this was an intended consequence or not, but FAS157 is going to make venture returns more highly correlated with public market returns than they have been in the past."

The question going forward is "with publicly traded stocks trading at historically low valuations will venture capital continue to outperform stocks?" Limited Partners, the investors who supply capital to the VC firms, will be making those choices over the next several years. Publicly traded stocks with low P/Es and high dividends look very tempting compared to a 10 year commitment to venture capital in uncertain times. But, these are very sophisticated investors. They will consider two things; current valuations, and future exits.

Current valuations of startups seeking capital have declined, and will probably continue to decline commensurate with the public market valuations. This levels the playing field for professional investors when deciding between public stocks and private VC investments. It is an imperfect comparison but valuations for startups need to be low enough that it doesn't become a glaring issue with investors.

Future Exit potential is another concern. Here the story is grim. At least with public stocks an investor can cash out on any day, take their losses, and move on. Venture Capital investors rely on IPOs or M&A transactions for liquidity. The Technology IPO market has been essentially dead in 2008. There were no Tech IPOs in Q2 or Q4 of this year, and just 6 for the whole year. 2008 was the worst year for IPOs in 33 years.

Mergers and Acquisitions have been the bright spot for investors, but even M&A is down about 50% to $2.1B for the 4^th quarter. This chart shows VC investments compared to M&A and IPO returns for the past 8 years. All amounts in $ Billions.

Entrepreneurs need to keep these numbers in mind when raising money from VCs and Angels. Investors have lots of other options for their money, many of them much less risky. With potential exit valuations uncertain, the entry "pre-money" valuations need to be attractive.

Why Stock Option Compensation Will Kill Your Company

by Anne-Marie Fink

Anne-Marie Fink is the author of "The Moneymakers: How Extraordinary Managers Win in a World Turned Upside Down" and runs the Money Makers site. Here's an excerpt from the book:

Paying as many employees as possible in stock is an article of faith to both corporate leaders and people in the investing community. I risk being branded as a heretic, therefore, when I say:

Don't pay employees in stock except those at the highest levels.

Investors advocate paying in stock, because we want employees to share our pain when their stocks are not doing well. A shareholder revolt ousted CEO Bob Nardelli from The Home Depot in 2007 due to his indifference to the stock price, which had been stagnant for years. Those at the most senior levels of an organization, the top five to ten folks, certainly need to be responsive to shareholders, and receiving a large piece of their compensation in stock or options ensures that they will pay attention when the stock isn't doing well.

However, to pay anyone else in the organization in stock or options separates pay from performance. Over the long term, stock prices are determined by the earnings and returns that employees generate, but in the short and intermediate terms stocks can move for reasons entirely unrelated to a company's performance. Nothing makes investors cringe more than when a CEO or CFO predicts how high a company's stock price is going. As people paid to forecast where stocks are going to go, we know how inherently unpredictable the stock price for any one company is; too many exogenous factors influence prices.

These influences disconnect pay from performance. Throughout the 1990s, many CEOs and other option holders enjoyed huge increases in their compensation despite mediocre or poor performance. They benefited as the stock market rose more than fourfold over the course of the decade. As interest rates fell and risk tolerance rose, investors paid higher price/earnings multiples for stocks. This rising tide lifted all stock prices, even those of poor performers. In 2007–08 executives have seen the reverse impact as the global credit crisis has taken down all stock prices, even for those companies with no exposure to the subprime mortgage market meltdown that precipitated the crisis.

Changes in market conditions decouple the performance of stocks from underlying companies' earnings and return results. For employees below the upper echelon, the disconnection between stock price and individual performance is even larger. These folks not only don't impact the multiple of earnings that their stock trades at, they don't impact the overall earnings. Just as rewarding employees on companywide metrics doesn't work because most employees can't impact the whole, so too rewarding employees with stock is in effective.

The United Airlines debacle with its employee stock ownership plan should serve as a warning to any corporate executive who thinks freely awarded options or ownership will align the interests of his or her employees. In 1994, UAL Corporation, the parent of United Airlines, signed a historic deal with its pilots' and mechanics' unions, giving them majority ownership in the company in exchange for wage and work- rule concessions. United represented the perfect test case of aligning employees' and shareholders’ interests through stock ownership.

Instead, they proved to be woefully misaligned. The original deal had the pi lots, mechanics, and some nonunion employees taking an average 15 percent cut in wages for six years in exchange for a 55 percent stake in the holding company. The deal enabled UAL to stave off bankruptcy and expand at a time when other major carriers were saddled with higher costs. The deal worked reasonably well until the wage snapback approached. Then it became clear that as owners of the airline, pilots and mechanics felt they could set their pay as high as they wanted. They demonstrated little concern for other shareholders. The results were disastrous. When senior management didn't immediately accede to their wage demands, the pi lots staged a disruptive, but effective, work slowdown in the summer of 2000. Management caved and the pi lots received significant pay increases just as the industry went into a cyclical downturn. With higher costs, customers annoyed by the job actions, and less revenue, UAL filed for bankruptcy protection in 2002. It was a tragedy not only for the in de pen dent shareholders but also for the pi lots and mechanics, who saw the value of their stock wiped out.

Theres another flaw in employee stock ownership plans:

Reward people with stock, and you'll hurt long- term productivity.

This may seem counterintuitive; after all, stock ownership would seem to give employees a reason to work harder and better than ever before, but it has other effects that negate this owner mentality. When employees have much of their net worth tied up in a company's stock price, it's often detrimental to the longterm interests of outside investors. Many option- heavy Silicon Valley firms see significant brain drains when their stocks do well; their employees can afford to retire. The problem becomes even worse when a company's stock stops rising (as all stocks inevitably do, because eventually a company's growth prospects get priced in). Intel, the premier semiconductor maker, experienced a 17 percent increase in employee turnover in 2004, when its stock stagnated after almost doubling in 2003. It's no coincidence that after this brain drain the company struggled and two years later had to lay off 10 percent of its employees as its results sagged.

I'm not arguing that you shouldn't reward people for good performance, but you should:

Pay your people, whenever possible, with cash.

Though some professional investors talk a good game about stock being the best reward, most will admit that to really motivate people, cash is king. I remember speaking with a top equity analyst who told me that one of the most important things he looked for in potential investments was shareholdings by employees. Yet minutes later, he lauded the advantages of working for a hedge fund versus a bank- affiliated money manager because hedge funds pay bonuses in cash whereas banks pay in stock. On a personal level, he was acknowledging that he much preferred receiving cash rather than stock. Your employees will feel the same. A dollar is always worth a dollar (more or less), while a stock's value can plummet through no fault of one's own.

On a company level, too, I have seen greater long- term success in companies that pay their people with cash. Jefferies, a midsize brokerage firm, has succeeded in a field dominated by much larger players because it has tapped into the motivating effects of cash. Unlike other big brokerage houses, where much of employees' compensation is in restricted stock or options paid out over three- year vesting periods, Jefferies pays its employees their commissions monthly and in cash. Traders and salespeople see a direct connection between their efforts and their spendable paychecks. This compensation system has worked for Jefferies; its stock price almost doubled from the end of 2003 to the end of 2006, and it avoided most of the problems other brokerages faced in 2007–08. Moreover, even though it does not lock employees in with restricted stock, the company's turnover is lower than at other brokerage firms; Jefferies' employees stay because they like working in an environment where they see concrete rewards for their efforts.

When awarding cash bonuses, you need to calibrate reward cycles based on the time required to judge success, given your employees’ tasks, as well as your business’s sales or product cycle. In brokerage firms, employees oversee dozens of profit generating transactions daily, so monthly rewards are appropriate. In longer- lead- time businesses, annual bonuses may be more appropriate.

The primary exception to the rule against paying in stock is start- ups; here, paying in stock makes more sense. Start- ups rarely have the cash to pay employees, so stock is often the only option. The firms are small, so interests are more readily aligned through personal contact. Plus, the upside is much greater if a company survives, so the motivational impact of the stock is more powerful. At the same time, paying in stock creates sanctions for failure. If a company doesn't survive, the stock is worthless; naturally, stock compensation results in high turnover in start- ups. But this unfortunate repercussion is tolerable given the constraints. Leaders of start- ups also need to remain aware that they can't stick with stock compensation for too long. As a company gets bigger and more established, the potential upside in the stock value will decline and the negative impact of stock's inherent disconnect between pay and performance will overwhelm the benefits.

Inside Information

• Never forget that cash is king. Payments in stock and options divorce pay from performance.
• Pay rewards based on your business cycle. They should be frequent but still allow you enough time to assess the effectiveness of employees' efforts.
• Use stock as compensation in a start- up, if necessary, but transition to cash rewards once your business gets on its feet.

Reprinted from The Moneymakers by Anne-Marie Fink.  Copyright © 2009 Anne-Marie Fink.  Published by Crown Business/Publishers, a division of Random House, Inc.

Avoid Unnecessary VC Bashing

by Mark Peter Davis

In my post VCs Are Setup To Be Bad Guys, I address the reality that VCs need to reject the vast majority of entrepreneurs that submit plans in order to do their job well. Nobody likes this - not the entrepreneur and not the VC (especially VCs with entrepreneurial DNA). It's just part of the job.

While being rejected by a VC can be frustrating for entrepreneurs who passionately believe in their vision, it is important to handle the situation gracefully. The first step toward the right response is not to take the decision personally. VCs pass on investment opportunities for a variety of reasons, many of which are not a reflection of the concept or the entrepreneur.

Regardless of how you feel about the outcome of your fundraising process with an investor, it is important not to attempt to seek revenge by sullying the reputation of the VC without good reason. I write "without good reason" since I am not attempting to advise entrepreneurs who have dealt with a VC that has done something truly inappropriate or unethical, such as lying or otherwise. In the absence of extreme situations, however, it behooves entrepreneurs to avoid saying bad things about VCs verbally or digitally.

At first read this post might appear self-interested or bias to help out VCs. To be clear this hasn't happened to me. While I have seen it happen to others, the reason why I am offering this advice is not to protect VCs from a little criticism; I writing this to help entrepreneurs avoid an unnecessary pitfall.

Yes, saying bad things about VCs can hurt entrepreneurs. Here's why. In order to be a successful, a VC needs to know and meet with lots of entrepreneurs and other members of the venture community. As a result, VCs are generally relatively integrated across the seemingly large and disparate entrepreneurial community. What is six degrees of separation to many is just two or three degrees for VCs. Since they are typically well networked VCs hear lots of the rumors in the market; if word gets around it usually gets to investors.

This could potentially create two problems for an entrepreneur. First, if word gets back to the VC it might create bad blood, and they might return the favor of giving an entrepreneur a negative recommendation. Second, other VCs might hear about this, making them wary of interacting with the entrepreneur.

At the end of the day, the same rules that applied in high school apply in the venture community. Avoiding pettiness and unnecessary negativity is generally the best approach. Bad karma has a way of finding its way back to its creator.

Rookie Mistake #2: Why is DEBT often considered a BAD thing by investors?

by JGARCIA

The Mistake

So, in the frenzy to build your company, you've done what we read all entrepreneurs do - you've run up
you credit cards, taken out a second on your house and pleaded for you vendors to take partial payments.

Now, you're looking for money and your little company has managed to accrue a sizable debt burden. In fact, part of your reason for raising money may be to pay off this debt so the company can breath again.

Sounds logical, doesn't it? Well, not to most investors. As a general rule, investors HATE debt and will often pass on deals where the debt issue cannot be resolved. If you don't know the difference between what constitutes "good debt" and "bad debt" in the eyes of an investor, you could be making a Rookie Mistake.

Why is this viewed as a Problem?

Basically, investors prefer to invest in the FORWARD progress of a company and not to cover the debts of the PAST. In general, an investor will see debt in the following way:

• Possibly Acceptable Debt: Any debt incurred to advance the development of the principal product of the company may be viewed as acceptable. However, not all debt in this category is good. Automatically remove any salaries paid (or accrued) to any member of the team.

What an investor may be willing to accept is:

1). The cost of parts needed to build the product.
2). Legitimate vendor costs to do work that would not be possible by the team.
3). Patent attorney fees (but only for a provisional patent)

There is a context in which these expenses will be viewed that will have a significant impact on whether or not they would be accepted. IF the entrepreneur has made what the investors deem to be a reasonable "hard cash" investment in their company, then expenses in excess of that amount may be acceptable. But, there is a flip side to this "2-edged sword." If the entrepreneur has not been prudent in how they spent the money and, as a result, has created a mountain of "frivolous" debt the investor will be very concerned. This not only creates a debt issue for the investor, but it also goes to how the entrepreneur manages money.

• Not Acceptable Debt: Generally, any accrued salary debt is disallowed automatically. Why? Because, that's what "sweat equity" is all about. In an early stage investment, the entrepreneur's team most likely has not (yet) quit their jobs. Thus, paying them a salary during this period is incremental to their day-job salary. Investors tend to frown on that.

Sometimes, in an effort to be fair, a team will set compensation guidelines according to what each team member states is their "minimum survival level." The idea is to pay each member only enough to cover their basic living expenses and then accrue the difference toward a "fair" salary for all members. This is an admirable goal, but one that is rarely accepted by investors.

Again, an investor does not want to pay for the past, so these well-intentioned strategies rarely work.

Finally, another major source of debt rejected by investors is that created by loans from "Friends, Family & Fools." Often, that friend or relative you finally persuade to "invest" in your company does so as a loan for which they expect to be repaid. This sends a poor message to your potential investor on two fronts: (a) you couldn't even persuade a close friend or relative to invest in your company without a guaranteed return of their capital and (b) once again, this is another example of paying for the past.

The Solution

The easiest solution is - DON'T INCUR DEBT! Unfortunately, that may not be possible. So, choose your debt wisely. Here's some simple rules of thumb:

1. Founder Salaries: NEVER accrue salaries as debt. If you believe in what you are doing, demonstrate your belief by distributing a reward that reflects your belief — STOCK! Once you have decided on an initial stock allocation (based on what each person brings to the party INCLUDING their initial cash contribution), set aside at least 20% of the companies stock as an employee option pool. Then decide on how you will compensate each other for (a) any
discrepancies in salary and/or (b) any "above and beyond" contributions.

2. Loan Debt: If someone is willing to loan you the money, but is unwilling to invest it outright, ask them if they would be willing to convert their loan to equity when a significant investor is found. By having their agreement written into the loan, you will mitigate any investors concerns. Often, it is considered entirely acceptable to provide special incentives and/or discounts at their conversion. After all, they did provide you with money when no one else
would.

3. Debt in Excess on the Founder's Investment: Suppose you and your team of three partners made a collective investment of $10,000 each for a total of $40,000. You've been working on this project for eight (8) months and have incurred a debt in excess of capital of $20,000. You now want to raise $500,000 to accelerate the growth of your company and take advantage of some market opportunities. Here's how an investor might evaluate your potential:

a. View from the PAST: Your "burn" for the first eight months was $7,500/mo ($60,000 divided by 8 months). None of these expenses included any salary, just hard expenses to get product prototypes made and trips to line up potential buyers. Upon examination, all expenses look reasonable and well managed.

b. Debt to Investment Ratio: Roughly one-third of the company's "burn" is debt. Ordinarily, this would be deemed high, but the economic status of the founders suggests they could not put up much more than they have and they have been very frugal with how they have spent the money.

c. Amount and Use of Capital: $500,000 is about the minimum amount most investors feel is needed to help a company advance to the next significant level. The use of capital has been carefully laid out over a 6-9 month period with clear milestones attached to specific expenditures. Although salaries are included in the use of funds (after all, this investment will require the founder's to "quit their day-jobs" and devote full-time to this project), they are modest and will reflect a true sacrifice by the founders.

d. Valuation: Suppose everyone agrees to a $2MM valuation (Typical for a seed stage investment). The $500,000 will buy 20% of the company. And, since there is a $20,000 debt to be paid off, only 4% of the investment is going to pay off the past.

Typically, any investment where the amount of legitimate debts that cannot be resolved into equity exceeds 10% the investors may walk. It's just too much money going to resolve past events vs. promoting future opportunities.

Rookie Mistake #1: Who Absolutely Must Invest in Your Company

by JGARCIA

Mistakes. They happen. Watch below:

In the investment arena, mistakes also can occur.

The Mistake

Before investors inject capital into your company, they make sure that two distinct groups have put "hard cash" into the venture:

• The Founding Team
• Members of the Board of Directors

Failure to uncover such activity can raise serious concerns that will prevent or delay an investment.

Why is this viewed as a problem?

If you want an investor to put skin in your company, you first have to put skin in your own company. Simple.

Here's how I see it: the founders want me to put my money into their company, yet they haven't put any  money in themselves? For an entrepreneur, the counter-argument (which seems perfectly logical at the time) is, "Hey I came up with the idea and I'm putting in tons of sweat equity; so therefore, an actual cash investment is unnecessary."

Unfortunately, most investors don't see it that way. Ideas are considered either worthless or suspect until proven (i.e profitable). In brief, most investors want YOU to be the first to demonstrate a financial commitment to your idea.

Next question: Why is sweat equity not considered a comparable swap for a cash investment?

This is a very good question and one that is difficult to explain. Think of it this way: Most investors like to look at being on an "equal footing" with the entrepreneur. To them, the best way for this to happen is for both parties to have "cash in the deal." To them, sweat equity is the minimum of what is expected. Hard cash is the above and beyond commitment they are looking for in the deal.

For Members of the Board, Investors are very interested in seeing board members that are true believers in your concept. It's too easy to get someone to "lend their name" and then have zero commitment to the success of the company. When an investor sees that the board has invested, it adds to your credibility as a company. It shows that someone else believes in your idea besides you. Naturally, the more credible your board, the more impressed will be your potential investor.

The Solution

For The Founding Team, the first question everyone asks is, "How much do I need to invest to convince an investor I'm serious?" The answer is, "It depends." First, if you have taken investments from prior investors AND you have not invested yourself AND you are taking a salary (even if it is a low one) THIS combination is the most lethal one to present to an investor.

Granted, consideration is always given to your economic state. In other words, if your residence or resume says that you could not afford to contribute much, a token investment of $5,000 to $10,000 would be fine (roughly equal to the minimum investment we'd expect in a "Seed" funding). However, those whose net worth would allow more are expected to contribute more. The only real exception to this rule is those very rare instances when the entrepreneur has developed something so amazing that investors are literally "beating a path to their door."

For Members of the Board, There is a subtle balance to strike between attracting top quality people to join your board and then asking them to invest. All board members should be encouraged to do their own due diligence prior to joining your board.

Why is reverse due diligence important?

Simply put, anyone who does not insist on doing due diligence on you is not taking their responsibility seriously. Once they become believers, and are willing to make a commitment, discuss with them the idea of making an investment. Often, the best solution is to agree on a set of milestones (some for you and some for them) that, when reached, will result in an investment.

This gives everyone something to shoot for and, if you share this with an investor, they should respect the arrangement.

Again, how much is believable?

For a board member, something as little as $2,500 to $4,000 is acceptable. The best is when they make an investment that is at least at the minimum of what an investor would expect to see in the first round of funding (~$5,000 to $10,000).

Top Ten Ways The Best Entrepreneurs Interact With VCs

by Mark Peter Davis

In a prior post I wrote about How The Best VCs Interact With Entrepreneurs. I am now turning the tables and offering some thoughts about the best practices for entrepreneurs.

While the following list is not complete, perfect or without exception, these ten rules should serve as strong guidelines for entrepreneurs who want to create enduring relationships with VCs.

Top Ten Ways The Best Entrepreneurs Interact With VCs

1. Only contact VCs that invest in your type of company (e.g., sector, stage, etc.)
2. Be honest about your intentions
3. Be patient with VCs
4. Actively share information
5. Do not take rejection personally
6. Do not harass VCs (they’re people too)
7. Focus on the success of the company; check your ego at the door
8. Be open to feedback and new ideas
9. Do not sully the reputation of a VC simply because you did not like their decision
10. Build relationships with VCs

Additional color about these guidelines:

1. Only contact VCs that invest in your type of company (e.g., sector, stage, etc.): Living by this rule will save you time and prevent you from looking clueless.
   Related Post: Types Of Risks VCs Take
2. Be honest about your intentions: I’m a firm believer that the best approach to business is the honest one. Be up front with your potential investors about your expectations, needs and level of interest in them.
   Related Post: Give Straight Talk
3. Be patient with VCs: VCs are extremely busy and therefore your patience with them is appreciated. No, this isn’t a cry for pity – it’s just the nature of the job. While a busy schedule isn’t an excuse (in my opinion) for not responding to appropriate emails, it does suggest that a bit more patience than average is warranted.
   Related Post: Why VCs Might Be Slow To Respond
4. Actively share information: It is important to maintain momentum with investors to keep them interested. In order to do this you should openly provide information about your company and respond quickly to requests.
   Related Posts: Why You Should Facilitate Due Diligence, Creating Momentum
5. Do not take rejection personally: There are a lot of reasons why you might not receive funding from a VC – some of which are entirely unrelated to your company. As a result, you shouldn’t take it personally. Don’t let a rejection affect your ego.
   Related Posts: Why You Might Not Get The Meeting, Another Reason You May Be Rejected: Portfolio Concentration
6. Do not harass VCs (they’re people too): Enough said.
   Related Post: If You Can’t Create Interest Move On
7. Focus on the success of the company; check your ego at the door: This point should work both ways; both VCs and entrepreneurs should focus on making decisions that maximize shareholder value.
   Related Post: Check Your Ego
8. Be open to feedback and new ideas: Enough said.
   Related Posts: Hear Feedback, Evolve
9. Do not sully the reputation of a VC simply because you did not like their decision: Bad karma has a way of making its way back to its creator. It’s a small world and VCs talk to each other. Seeking undue vengeance can create challenges for entrepreneurs in their current and future fundraising efforts.
10. Build relationships with VCs: It seems to me that the greatest entrepreneurs are capable of getting past the business side of the relationship with a VC, engaging them on a more personal level. Developing a personal relationship with a VC can make the fundraising process both significantly easier and more enjoyable.
    Related Post: Build Rapport

Top Ten List: How The Best VCs Interact With Entrepreneurs

by Mark Peter Davis

Since entering the venture capital field, I have observed how other VCs approach the business. Tactics and practices vary greatly and some are better than others.

I have tried to identify venture capital best practices. There is more to the business than picking winners; the nuances of interacting with and supporting entrepreneurs are potentially more important. While I have found that there are dozens of small processes that are exemplary, the principles that make a VC effective and poised for long-term success can be boiled down to a top ten list. Although exceptions always exist, these ten guidelines appear to be the guiding light for how the best VCs interact with entrepreneurs. I believe that these rules are worthwhile for entrepreneurs to be aware of, as it is my hope that they will set the bar for their expectations.

Top Ten Ways In Which The Best VCs Interact With Entrepreneurs

1. Be respectful of entrepreneurs and their efforts – remember that they are changing the world.
2. Handle sensitive information carefully.
3. Be forthcoming if you are evaluating competitive opportunities.
4. Be honest about your intentions.
5. Respond as promptly as possible.
6. Help entrepreneurs when possible regardless of whether or not you intend to invest.
7. Ensure that entrepreneurs share in the upside.
8. Be an active board member.
9. Pursue the exits that are best for everyone around the table.
10. Support the entrepreneurial community.

More broadly, these guidelines address three potential VC short-comings that are commonly cited by entrepreneurs: arrogance, inconsiderate behavior and selfishness. The best VCs avoid these behaviors like the plague, and they do it for good reason; in the long run, it makes them more successful.

The all-stars of VC understand that the entrepreneurs are the stars of the startup show. This perspective keeps actions that could be perceived as arrogant in check. With this mindset, these VCs know that egos are unjustified and, very often, destructive. Simply being respectful can make life for entrepreneurs easier and can enable a type of board room collaboration that yields the most productive outcome.

As I mention in my post, The Venture Police: Reputation, VCs needs to be considerate in order to develop the kind of reputation that attracts the best entrepreneurs. Being considerate means a few things. First, it means stating intentions up front. For example, VCs who are looking at multiple opportunities in an industry need to inform entrepreneurs of that fact. Second, responding to entrepreneur emails in a timely fashion is also important. Responsiveness is part of being a team player – fundraising is a stressful process that does not need to be complicated for no reason. Furthermore, responding to emails is the same courtesy afforded to nearly everyone in business – entrepreneurs deserve the same respect. I have found that a quick "no" is always appreciated – like everybody else, entrepreneurs want to know where they stand. While promptly responding isn't always easy for VCs when their email inboxes are being bombarded, efforts to be responsive appear to be appreciated.

Lastly, even when VCs don't plan to invest, trying to selflessly help entrepreneurs is a noble pursuit – this goodwill gesture not only helps a VC's reputation, it is the right thing to do. Helping an entrepreneur can increase the odds that a new service makes it to market, that new jobs are created and one person gets a little bit closer to realizing a dream.

The best VCs appear to understand that being perceived as arrogant, inconsiderate and selfish can damage their reputation and future deal flow. As a result, they go to great lengths to avoid these perceptions. Ultimately this unique alignment is one of my favorite aspects of the VC role – it's in a VC's best interest to be a good guy.

The most important skill

by John Gannon

I've been wondering lately what is the most important skill or trait that a venture capitalist must have in order to be successful.

We spend our days hearing pitches, analyzing business models, crunching numbers, helping portfolio companies, networking, and talking to people in the industries in which we're thinking of investing.

You can slice a market 16 ways from Sunday and project 5 years of revenues for a startup company but ultimately you are trying to find the best people building businesses around the best ideas.  And then you are doing everything you can to help these people and businesses succeed once you invest.

If that's the case, what's the most important skill or trait for a VC?

I'm going to go out on a limb here and suggest two:

- operating experience:  If you've been there and done that (that being started a company) before, you're apt to have seen similar challenges to those that your portfolio companies are facing.  And consequently, you may be able to provide some relevant thoughts on how to overcome those challenges.

- personal network: If you believe venture capital is all about backing the best entrepreneurs with the best ideas then you need to make sure you know those entrepreneurs and are a part of their personal network.  This is a cliche in the VC business but its a good time to mention it: "An A team with a B idea is better than a B team with an A idea."  I think that says it all (but I'm going to keep blogging anyways…)

Second, as a VC you often have to dive into new markets and sectors and get up to speed very quickly.  Certainly you can read blogs and websites to learn about new areas but in my opinion nothing beats talking to experts working in the sectors in which you're interested.  The problem is that you need to find those people, and in some sectors its not easy to identify them and its even harder to get some of their time once you find them.

The other way personal network comes into play is when you're able to help line up sales or partnership prospects for your portfolio companies.  If you do not have the relevant connectivity into certain sectors, your effectiveness is going to be limited.

What do you think?

Market size and venture capital

by Healy Jones

Not all technology entrepreneurs should raise venture capital, as I've mentioned before in my post "don't raise venture capital." An important component into figuring out if you startup should search for those elusive VC dollars is to size your market. Venture capitalists typically like to invest in startups that have the potential to be the number one or number two in a large industry.

Startups raising VC should be in industries over $1 billion in market size

By "large" I mean an industry that can pretty easily have $1 billion plus in revenues. The rational behind this is pretty simple - in order to generate 10x returns on their investment the VC's startups need to have a real chance to hit several hundred million in size. Larger industries also have more outcomes that can be generated by trade sales to larger companies within that industry or in adjacent industries. Note that the market can be growing to be this size in the next couple of years.

VCs will sometimes find niche industry spaces attractive, ones where a particular startup has a highly likely and defensible chance of becoming number one, but this is much more difficult - and your startup still needs to be able to potentially grow to be $200 million or more in revenues in this niche case. I'd recommend that if your industry is less than $500 million in total size you seriously consider a less capital intensive growth plan, one that can be financed with a few million in angel investments.

When you are thinking of raising venture capital, do the market sizing analysis from the top down and the bottom up. That means do more than just read some analyst reports that suggest that a market is a particular size - actually talk to a number of potential customers. Choose representative customers that are similar to the average potential customer for your startup. Get a feel for their potential desire to purchase and their willingness to pay. With that information, you can then multiply their projected price point against the number of potential customers who look like the ones you have spoken with. Viola, your market size!

The difference between FREE and 1 cent?

by Don Dodge

Walter Isaacson, former editor of Time Magazine, wrote "How To Save Your Newspaper" where he suggests a new system of micropayments to pay for any type of digital content on the web. Newspapers are dying, suffering from rising costs, reduced advertising budgets, and free content on the Internet. Micropayments (less than a dollar) have been tried many times in the past by companies like CyberCash, PepperCoin, DigiCash, and others. None have gained much traction, and making money from such systems is challenging at best. PayPal is useful for larger transactions but the overhead costs make it impractical for micropayments.

So what is the difference between free and a penny? Friction…inertia…hassles. Most people would be happy to pay five cents or even 50 cents to read an article in Time Magazine or the New York Times, or to get access to other useful content like pictures, video, audio recordings, etc. The problem is not the cost, it is the friction in getting it done. For micropayments to work they must be simple, fast, and universally accepted, with the click of a button. Oh, and if everyone paid just a penny to view content it would translate to a $10 CPM rate, which is double or triple what most web content commands. Think about that for a minute.

Mr. Isaacson explains how newspapers and magazines got into this mess;

The easy Internet ad dollars of the late 1990s enticed newspapers and magazines to put all of their content, plus a whole lot of blogs and whistles, onto their websites for free. But the bulk of the ad dollars has ended up flowing to groups that did not actually create much content but instead piggybacked on it: search engines, portals and some aggregators.

Another group that benefits from free journalism is Internet service providers. They get to charge customers $20 to $30 a month for access to the Web's trove of free content and services. As a result, it is not in their interest to facilitate easy ways for media creators to charge for their content. Thus we have a world in which phone companies have accustomed kids to paying up to 20 cents when they send a text message but it seems technologically and psychologically impossible to get people to pay 10 cents for a magazine, newspaper or newscast.

Unwittingly, Mr. Isaacson also illustrates why micropayments have not worked, and why the web advertising model is a challenge in many cases. There are too many players looking to take a piece of the transaction. In the web advertising world that $3 CPM (1,000 impressions) gets split between the host web site, the ad serving network, an ad targeting service, the ad agency, and sometimes other intermediaries. At the end of the day the overhead costs associated with managing all the players percentages translates to fractions of a cent per impression.

Micropayment systems would also have many parties looking to take a fraction of each transaction. The host web site, the content provider, the micropayment technology provider, the bank clearing house, the company that signed up the end user, etc. When the transaction is only pennies to begin with, the “supply chain” can’t sustain itself.

Another quote from Mr. Isaacson; "The key for attracting online revenue, I think, is coming up with an iTunes-easy, quick micropayment method. We need something like digital coins or an E-Z Pass digital wallet – a one-click system that will permit impulse purchases of a newspaper, magazine, article, blog, application, or video for a penny, nickel, dime, or whatever the creator chooses to charge."

Freemium model – Many companies use the Freemium model, meaning the base service is free, but you pay premiums for added services, capacity, or convenience. This model works because people value the free service, make it a part of their routine, and are willing to pay a premium for added services. Usually just 3% to 5% of all users upgrade to paid services but the scale is such that it can be a profitable business.

Consumers are willing to pay for content. But, the price must be reasonable, and the payment system must be simple and frictionless. The technology is available to do it. The problem is the players in the "value chain" need to adjust their expectations on their percentage of the revenue. Micropayments may be a perfect opportunity for an open source solution funded and supported by the largest players in the web community. The world would be a better place for everyone on the web if we had a universal micropayment system.

Common Pitfalls of Market Sizing

by Peter Frisella

Rick Segal published a post last week titled The Great Myth of Market Size. The topic of market size has been on my to do list for a while so I thought it would be a good time to share my experiences. First, I'll start with some words of wisdom from Rick:

Your market size is a reflection of the people who are likely to actually buy/use your product/service and not the entire installed base of whatever

That's pretty much it. We want to know what the Total Addressable Market (TAM) is and as indicated in the quote above, this should only include people that one would reasonably expect to be interested in your product/service.

Sounds pretty straightforward but more often than not, market sizing is a muted effort. The problems I see over and over tend to be of two varieties: (1) failing to segment the market and (2) using peripheral numbers.

Segmentation
Depending on the market, segmentation isn't always an easy task. To start, you should define who the target customer is and from there you can make some reasonable assumptions (make sure you state them) or find some relevant stats to come up with a TAM. I can't count how many times I've seen a slide that details the target customer in a very narrow fashion and then later on the Market Size slide has a number approaching the GDP of Canada. It just doesn't add up.

Example: An entrepreneur has shown some great stats on the overall market but doesn't do the math to determine the TAM for the product/service. Instead, the entrepreneur opts to take path of "everybody in this age group needs this service" – usually any primary research would show this statement to be untrue – So the overall market size sounds great at the outset but once you start to crunch the numbers the size dwindles rather quickly.

I've seen many presentations where all the ingredients for determining a reasonable market size are present but the entrepreneur refuses to do the math and instead focuses on the biggest number.

Peripheral Numbers
This is when the market size number presented actually has little or no relation to the Total Addressable Market (TAM).

Example: There are 100m people in North America that spend $8000/yr on widgets which means there is an $800B widget market.

It sounds great until you realize the company doesn't sell widgets, they provide a service to help people find widgets and the business model is not based on referrals with a revenue share but a subscription model. A dollar increase in the widget market does not correlate to an increase in potential revenue for the business. Sure, the widget market size is related to their business but think about it this way, if you were to capture 100% of the market would that be $800B in revenue? The obvious answer is no since you aren't selling widgets. So if that is the case then why use that number for market sizing purposes when you will never actually capture any of that potential revenue. Instead, the entrepreneur should use the stats that are known about the target customer (i.e. 30% of people are interested in using widget finding services and are willing to pay anywhere from $10 to $30 a month for this service). So 100m people * 30% * $10 = $300m is a good place to start for the TAM on the low side and $900m on the high side.

But people like big numbers
Sure, big numbers turn heads but at some point the numbers are going to have to hold. Having a realistic and well thought out market size speaks volumes about the knowledge and understanding you have about your customers and the market.

There is one final thing that should be mentioned and that is the use of the word 'Conservative'. However harsh it sounds, in most cases when you use the word conservative while talking about the size of your market, your numbers almost instantly become suspect, especially when the number is extremely large to begin with. Almost everybody at some point in their presentation says their numbers are conservative. I'm not saying you can't use the word, because in some cases the numbers are actually conservative estimates. What you need to realize is that it is a relative term and if you're going to use it then back it up with a clear and concise explanation.

Exits

by Tim Jackson

In very general terms, exits usually fall under one of the following categories:

Bankruptcy
Obviously not a good result. A bankruptcy occurs when a company does not have assets available to settle its liabilities. A company can elect voluntarily to declare bankruptcy or a creditor can apply to the courts to have bankruptcy proceedings start. In either case, a third party (called "a receiver") is hired to liquidate the assets and distribute any proceeds to the creditors.  Whether or not a VC will realize any proceeds in a bankruptcy depends on the nature of the investment and the extent to which there are other creditors. In broad terms, the receiver get their fees paid first followed by the  government for things like payroll withholdings and sales tax. Next come the secured creditors - a VC may get some proceeds here if they hold secured debt or preferred shares. Last to be paid are the common shareholders and it is very unlikely in a bankruptcy that there will be anything to distribute to this group. So in summary, not a good result for anyone.

Orderly wind-up
This is similar to a bankruptcy but in this case the decision to close the business is made while there is enough cash to settle with the creditors. The liabilities are paid out and then, like in a bankruptcy, any remaining assets are distributed to shareholders in order of priority (i.e. preferred shareholders before common shareholders).  Again, not usually a very good result for the VC or the founders.

Public Offering
This is what many founders aspire to and in fact, like many VC firms, we expect our companies to act like they will be public companies one day. The process to go public is not easy and we are big believers in making things as easy as possible from day one. For example, securities regulators and stock exchanges have rules regarding stock options and stock option plans. Why not make your plan and option grants comply with public company requirements from day one so that there is one less thing to worry about in the event you eventually take the company public?

I believe there is a misconception about how people make money on an Initial Public Offering (IPO). Lets say you are the founder of a business and own one million shares, the company goes public at a price of $30 per share. You get $30 million right? Not so easy. On paper you are "worth" $30 million but you won't be able to liquidate those shares. On the public offering, the underwriters (the brokerage firm that sells the stock) will require that all shareholders agree not to liquidate their shares for a certain period of time (say six months). For a VC, this is not ideal but it is understood it is part of the deal. What often happens is right before the lock-up period expires, the underwriters will try to arrange a sale for any investors who want to sell to avoid having a large block of shares hit the open market. Unfortunately, management will not usually be able to participate in this share sale. The markets don't like to see founders selling large blocks of stock as it sends the "wrong message" (i.e. why don't the founders believe in the upside potential of the stock?). If the stock is very sought after, the underwriters may agree to allow the founders to sell a small piece of their shareholdings but the reality is that as a public company it will be very difficult to realize all of your "paper wealth". This is the catch 22 for founders –  most aspire to be public companies but the reality is it becomes tough to actually liquidate their shares. Once the company has a track record as a public entity founders should be able to sell shares using a predetermined formula (e.g. 1% of your holdings on the 10th of each month). From a VC perspective the IPO is usually a good result as it provides liquidity.

Financial sale
The sale to a financial buyer, usually a private equity firm, is unusual for early stage technology businesses because financial purchasers are looking for companies that are cash flow positive - a rarity in the tech world :). Usually a financial acquirer will fund the purchase through a combination of debt and equity. The debt lenders will base the amount they are prepared to lend on historical results and future cash flow projections, making positive cash flow a must. I sit on the board of Q9 Networks which recently announced it has agreed to be acquired by a private equity firm. I chaired the special committee of the board that dealt with the sale. After the transaction closes I will share some more thoughts about private equity acquisitions. From a VC perspective a financial sale usually provides immediate liquidity.

Strategic sale
In our experience, this is the most likely exit for VC backed technology companies. Strategic sales occur when another company buys your company for strategic reasons. The reasons can be any of the following:

• The purchaser needs to enhance their product offering and does not have time to develop internally so buys a company that has already completed development (buy vs build).
• The purchaser wants to make sure their competitors do not have access to your products or technology.
• Your technology is so proprietary it is unlikely the purchaser would have been able to develop the solution internally.
• Your technology/product will allow the purchaser to generate significant "pull through" revenue. i.e. the purchaser believes that by combining your product with their existing product they will now have a competitive advantage that will allow them to win significant new business and/or differentiate themselves from competitors.

Assuming the acquirer is paying in cash or is publicly traded, a strategic sale is usually a very good result for the VC because we are able to liquidate our investment immediately. For founders the liquidity will vary. Sometimes an acquirer will require the founders/senior management to put their proceeds in escrow with the amounts being released over time. This escrow ensures the founders remain with the business during a transition period. In other cases, the founders are able to fully liquidate and they are retained through new employment contracts and/or equity in the acquirer.

So which of the above should you aspire to? Ultimately I think you want to make sure you have options and never be in a position where you are forced in a specific direction. The overall advice we give to our founders is: "build the company on the assumption it will go public but recognize that a strategic sale is more likely so don't do anything that will make a sale difficult."

VC Investing Not Dead, Just Different

By Alan Patricof

When we conceived of the idea to start Greycroft Partners, we specifically took into consideration that the paradigm had changed since I first entered the venture capital business in 1969. At that time, and continuing for the next 30 years, the ultimate "win" for a venture capital investment was "going public." It was tantamount to winning the Triple Crown or being awarded an Oscar for best performance.

At one point, the measurement for going public was merely an exciting technical achievement or a modest amount of revenue. This ultimately transmogrified in the late 1990s to an "idea," the word Internet attached to the name or description, or some sexy romanticizing of a multiple of future projected revenues.

Clearly, West Coast manifestations with brand-name venture capital firms attached to an initial public offering helped to exacerbate the phenomenon of a "hot issue." Legitimate efforts were made by regulators to control the allocations of these new issues to prevent unfair treatment of the average investor who was shut out of the process and to dampen speculative excesses.

Nevertheless, "going public" remained the ultimate goal for most start-ups in spite of the fact that more than one-third of the actual exits for venture capitalists were through mergers and acquisitions. Today, that percentage has shifted even further to 80-20 in favor of M.&A. exits.

The underlying support for all of this "irrational exuberance" was the myriad small and mid-sized investment banking firms that thrived across the country in the 1970s and 1980s, primarily in New York City and San Francisco, but also in hometown America. They included names like C.E. Unterberg Towbin; Marron, Eden & Sloss; Carter Berlind;Potoma & Weill; Fahnestock; Wessels, Arnold; Adams Harkness & Hill; Robertson Stephens; Montgomery Securities (the old firm with that name);Laird & Company; D.H. Blair; Raymond James; Black & Company; Robinson Humphrey; Loeb Rhoades & Company;G.H. Walker and, of course, Hambrecht & Quist.

These names filled the map with a whole slew of firms willing to take you public with a good story, raising $10 million, $5 million or even $2 million, with a total market value of $10 million to $50 million. It was a great time to be in the venture business and young companies had access to angels, A rounds, B rounds and I.P.O.s at a relatively young age of development. The biotechnology, semiconductor, disc drive and personal computer industries were nurtured on a system of raising capital that supported young companies with access to capital. It was the time of Data General, DEC,Intel, Genentech and Seagate, to mention just a few.

Small investment firms were the lifeblood of the new-issue business. They not only took these companies public, but also made aftermarkets in the shares, at often-times egregious spreads, which created a viable aftermarket and generated sufficient profits to make up for the small floats. This trading "over the counter," as it was referred to, was done over the phone. When markets went down, one would often hear "1,000 shares offered — no bids." It was in many respects the Wild West.

Electronic trading and the development of Nasdaq gradually served to reduce these spreads on net trades and lowered commission rates for the others. This made for a somewhat more orderly market, but also reduced profitability on individual transactions for the underwriting firms and market makers.

I remember specifically taking a medical electronics company, Datascope, public in 1971 through C.E. Unterberg Towbin with an initial offering of 100,000 shares at $19 a share. The total market capitalization was $10 million. The same firm had brought Intel public the year before with a not much greater offering and market value.

It wasn't until the 1980s and 1990s, when offering sizes began to increase, that big investment firms like Morgan Stanley, Goldman Sachs and First Boston started to recognize the potential in the market for young venture-backed companies. Such names as Diasonics, Cordis, Cisco and Network Appliance, along with Apple, AOL and Microsoft, made for a robust marketplace.

In the late 1990s, the market for high-tech I.P.O.s reached a series of crescendos with valuations based on multiples of projected revenues in the hereafter. It was a heady time and reached such levels that new issues were often oversubscribed by multiples of 5 to 10 times, and there was no easier way to get rich quick than by getting an allocation of an I.P.O.

During this period, the game gradually changed as many of the aforementioned smaller investment firms either went out of business or merged with one of the "four horsemen" as they were commonly known, or a handful of other survivors.

The character of the Nasdaq market also changed. The big players began to assume a more significant role towards the latter half of the 1990s as the size of offerings increased to $25 million, $50 million or even $100 million, with valuations of $200 million, $500 million or even $1 billion, partly because there was so much demand for the new flavor of the day — the Internet — with all its hyperbole of promise of growth and riches.

But the larger the deal, the greater the capital requirements for underwriting and making aftermarkets. The economics of the business had changed and it was no longer possible to do small deals, so small firms could not compete. The bubble finally burst in 2001 and virtually overnight the I.P.O. market dried up as the public realized that in many cases "the emperor had no clothes."

This situation was exacerbated by a gradual reduction in the pool of analysts who covered small companies with small market capitalizations, as the costs just were not justified by the volume of trading. In addition, the regulators put up Chinese walls between the bankers and the analysts, making it much more difficult to follow small companies. Many companies that had managed to go public found they had no coverage and few market makers. Their shares gradually became part of the living dead: a public company with all the attendant regulatory requirements and no interest from investors.

The collapse of the Internet bubble only served to compound the problem as public interest in I.P.O.s dwindled to a trickle as their losses increased. Then, in 2002, in the wake of the Enron, WorldCom and Tyco debacles, the government intervened with the passage of the Sarbanes-Oxley Act, which imposed tougher rules on corporations. This only added further to the cost of an I.P.O. in terms of legal and accounting requirements for both the issuer and underwriter.

The sum and substance of all of these developments is that the minimum economic level to bring a company public today is at least a $50 million offering at a $250 million market value. With realism back in the market and a return to rational metrics, like multiples of revenues and, better yet, profits, venture capitalists have had to face the hard reality that it is highly unlikely that taking a company from start-up to a point where it can justify this type of market capitalization in a three-, five- and even seven-year time frame is realistic, except in a limited number of situations.

For these reasons, I believe that the paradigm has changed for the venture business. We can no longer realistically expect the same kinds of absolute returns that were achieved in the past through a quick turnaround from start-up to liquidity through an I.P.O. Rather, I believe that most of the companies that venture capitalists are funding today will find an exit through merger or acquisition. And if we expect to achieve a return in a reasonable time frame of three to five years, we are probably looking at a sale price of $20 million to $100 million. This is the valuation range where most young companies are being acquired.

To compensate for these lower gross return expectations, we must establish initial valuations, usually in the single digits, that can provide an adequate multiple return and internal rate of return. Inevitably, this suggests that a true venture capital firm should be reverting to smaller-scale funds and restricting individual investments in early-stage companies to accommodate the realities of the exit opportunity. Larger funds can focus on later-stage growth opportunities that can absorb greater amounts of capital where there still exists the possibility of taking companies public in a timely manner.

This, in turn, requires a more disciplined approach to investing. Entrepreneurs must be guided to use capital more efficiently and we must avoid falling into the trap of C, D and even E and F rounds of funding, with successive layers of participating preferred, in order to prove an ill-conceived concept is viable. Equally concerning are the myriad projects that should not appropriately be financed in the first place by a venture capitalist. (I worry about the myriad alternative energy companies that seem to be the next wave of capital-consuming enterprises that may just be beyond our capabilities in view of the limited exit opportunities.)

Entrepreneurs themselves seem to be catching onto the new risk/reward equation and seem far more willing, at an early stage, to opt for a sale at a lower valuation and lock in their gains, figuring that they are young and can repeat the process later with another start-up.

If the scenario I have described strikes a chord of reality, then until someone solves the cost of going public and increases the liquidity in aftermarket trading, we as an industry have to downsize our expectation for exits as well as downsize the size of our funds. We still can produce significant returns for investors, but we cannot accommodate the size to which funds have grown in the past decade.

Venture capital is definitely not dead or even ill; rather it has just taken on a new set of dynamics. Entrepreneurs in this country are stronger than ever, and venture capitalists are the ones to nurture them!

Fundraising Order: Revenues-Grants-Beg-Borrow-Steal-VC

by Mohanjit Jolly

Revenues-grants-beg-borrow-steal-VC may be the ideal fund raising ladder, says Mohanjit Jolly.

In my career as a VC, investment banker and advisor, I have heard thousands of pitches from entrepreneurs, some good but most not so good. The key issue that keeps popping up (and it doesn't matter if this is a Silicon Valley entrepreneur or one here in India) is where the entrepreneur is constantly faced with the circular dilmma, most often referred to as the Catch-22 (I don't think Kurt Vonnegut knew how much that phrase was going to be used in the entrepreneurial lingo).

More specifically, this has to do with the fact that during the fundraising process, a startup often is expected to have achieved certain milestones (especially when the environment where VCs tend to become slightly more risk averse), but the entrepreneur needs capital in order to achieve those very milestones. What is an entrepreneur to do? Well, let me lay out some specific concerns and practical solutions:

--First and foremost, realise that you are asking a VC or an angel investor to part with either their own or their Limited Partners' (LP) money. And although the above request may seem unreasonable to you, it is one that is completely justifiable since the VC will have to answer to their LPs when asked "why in the world did you invest in a raw startup?"

--Also realise that you are competing with other startups for the VC's time and capital. Even though you may think your idea is superb, there may be another scrappy startup that has more traction, a clearer message and has a more believable trajectory to growth and profitability. So, believe it or not, timing may have something to do with how excited a VC gets about your business.

The level of excitement is a combination of both relative and absolute metrics. In absolute terms, a VC may get excited about the idea/vision but he/she has to also evaluate a startup relative to others on his/her desk at that given moment. Since the key resource that a VC has is time (i.e. bandwidth to manage the portfolio), he/she may choose for a potentially less risky smaller play rather than a very risky big play depending on the number and quality of ventures that he/she is evaluating at any given time.

What's worse from a startup's standpoint is that the risk profile for a particular VC continues to shift around over time. As an example, a fund may be more prone to doing early stage risky deals towards the beginning of its fund's investment cycle, and less risky later stage deals towards the end of the fund's lifetime.

With the above as backdrop, let's address the catch-22 scenario directly:

--Take comfort in the fact that this is not a dilemma unique to you alone. This is a fact of startup life that is faced by most, if not all, at some point as they launch their initial venture. But there are specific steps that you can take to address the risk (either perceived or real) that a VC may indicate. I call this series of steps, the "credibility continuum"(CC). 

The credibility continuum is a spectrum of risk reduction parameters. On one end,  there are high margin, high value paying customers (low risk) and on the other end is a raw core team of first time entrepreneurs with nothing but an idea and a small font 40 slide powerpoint presentation (high risk). The VCs would ideally like the startup to be on the "paying customer" end while reality is usually closer to the other side of the spectrum.

--There are key risk reducing techniques that don't cost a lot and also enable the entrepreneur to slide in the right direction on the CC scale. The key risk often hinges around two key areas – can the team execute on the potentially grand vision and will the "dogs eat the dogfood" (i.e. will the customers be willing to pay for a product or service).

A highly successful approach that a seed startup can deploy is "credibility through association". What that means simply is that since you as a raw startup don't have paying customers to truly validate the idea, you can gain credibility (and therefore reduce risk) by getting certain calibre of people associated with the startup, who bring a high level of brand equity and credibility with them.

Ideally, if you can get people to join as early employees or senior executives, it sends a very strong signal to the potential investor on two fronts – that you can sell your vision to get seasoned executives to come on board even though there may not be anything tangible in terms of a product or service currently available, and the fact that people are willing to give up their well-paying  jobs to join your startup means that the idea is potentially very interesting and valuable.

In some cases, the individuals may decide to invest in addition to joining a company. Rule of thumb – cash, by any legal means is usually a positive indication to a VC (cash from customers, from investors, from lenders).

--Further down the credibility continuum are Directors and Advisors. Again, getting seasoned people from the industry to lend their brand and time to the startups gives a level of comfort to investors. Recently I was looking at a seed stage startup where the single biggest plus in my mind was addition of a 35 year veteran from a specific industry as an Advisor, who indicated to me that over the decades she had been approached by many companies for advisory roles, but this one company's value proposition was the most compelling that she had come across in her years in the field, and that's the reason she came on board.

--Getting friendly companies to try the product or service for a fee as Beta customers or conduct a product or service pilot can help. Again, the preference should be to get some cash rather than give the product or service away for free. Obviously, if there is a marquee name, and the only way to get them to lend their logo to your slide 5 of "key customer engagements" is by giving away your product, then do it. Having Tata as a free pilot is better than not having Tata.

--I often tell entrepreneurs that VC money is the most expensive capital they can get. My fundraising ladder goes something like this – Revenues-grants-beg-borrow-steal-VC (some may choose to put stealing after VC). Do not take VC money unless you have to. And often at the earliest stage, small amount of angel investment might be a good starting point.

Angels are a big part of the overall entrepreneurial supply and demand chain that has made Silicon Valley buzz. The angel community is, along with so many other aspects of the startup ecosystem, in its formative stages in India. The Mumbai angels and the Indian Angel Network are a couple of groups that have gotten somewhat institutionalised.

Development of seed stage investing ecosystem will take time, but I am very encouraged by the progress by Angels and VC firms in doing their part to catalyse the process. It's not a question of "if" but a question of "when" the system will become self sustaining.

Bottom line: The catch-22 exists. And the entire life of an entrepreneur is filled with them. But complaining about it doesn't help. My advice is "to suck it up", or in other words, deal with it. Worry about things that you can control and forget about what you cannot control. Be creative, be passionate, be viral. That virus fuelled by passion, commitment, persistence and conviction will ultimately infect others somewhere along the Credibility Continuum and they will join as employees, advisors, directors, and investors.

The job of the entrepreneur is to be a prolific salesperson, since he/she will spend majority of the time convincing others of the "better, faster, cheaper mousetrap", whether it's investors, customers, potential employees, channel partners etc. etc. And quite honestly, that passion combined with a grand vision that is clearly articulated, can make an investor forget the risks and write a check on the spot to a couple of bright eyed, bushy tailed, first time techno-geek entrepreneurs.

Optimum Share and Option Vesting

by Basil Peters

I believe vesting is the most important element of corporate structure. It is essential to ensuring that both entrepreneurs and investors are treated fairly and equitably. Vesting has incredibly powerful effects on the group psychology, culture and corporate performance. I have seen many companies literally fail due to flaws in their vesting.

Widespread employee ownership is still a relatively new concept. Even as recently as the 1980s, there was still debate on the degree to which employee equity ownership affected corporate performance.

Today, it is widely accepted in North America that companies with broad employee ownership create larger increases in shareholder value.

After a couple of decades of experience and a few good analytical studies, there is now a broad consensus on the range of equity that is reasonable for a new CEO, or other senior employee, to expect when joining a company.

Agreement on Magnitudes But Not Vesting Formula

Even though there is now reasonable agreement on the ideal magnitudes of equity ownership, there is still discussion on the optimum vesting formula.

In the mid-1980s, ten year linear vesting was common. As the technology industry matured during the later 1980s, vesting periods shortened.

As tech gathered momentum through the 1990s, it became more difficult to hire and retain. Vesting periods got shorter and shorter. In Silicon Valley, in the mid and later 1990s, vesting periods were often as short as 18 months.

Anyone who has built a company knows this doesn't make sense. It takes much longer than 18 months to get a return on the cost of recruiting and training a new employee. Many employees have not even reached their maximum level of productivity in a new job for the better part of a year.

Interestingly, even though those short vesting periods did not make fundamental sense, they were widespread because the market for human resources is so efficient. Companies quickly realized if they did not offer short vesting periods, they would not be successful in recruiting new employees.

Along with the equity markets, the pendulum swung back in the 2000s. As an example, recent vesting at Microsoft was over 4.5 years. Common ranges for vesting periods today are 4 to 6 years.

Psychological Vesting

One of the challenges in discovering the optimum vesting formula is 'psychological vesting'. Veteran serial entrepreneurs and investors usually agree that when someone is two-thirds vested, they reach a psychological turning point where the vesting of the balance of their equity is much less meaningful to them.

This means that six year vesting is really only effective as a retention mechanism for about four years.

New Appreciation of the 'Contract' with Investors

Experienced early-stage investors have also come to believe that one term in the fundamental 'contract' between the entrepreneurs and investors is that the employees willboth increase the value of the investors' shares and ensure that at some point they also execute an exit.

Investors in companies with large founders positions have often found themselves in situations where the founders have successfully increased the value of the shares but have either no motivation to create an exit or have left the company to pursue some new venture, leaving who ever comes next with the responsibility to create liquidity. Investors familiar with this phenomenon often describe themselves as 'stuckholders'.

Up to Half the Value Can Be Created During The Exit

There is also increasing agreement that up to half the value that an investor or entrepreneur realizes on an investment can be created during the last few months -- during the exit transaction. If an employee leaves before the exit, it does not seem fair that they participate in that final increase in value.

The Optimum Vesting Formula

The optimum vesting formula is the one that is most fair and equitable to both the entrepreneurs and the investors. I believe the best formula has to incorporate the implicit contract to execute an exit and realize on the 50% value increase that is often created at the exit.

This means that the most fair and equitable structure, and the one that maximizes thealignment between the founders and the investors, is to vest:

• 50% of the shares daily over a three year period; and
• the other 50% when there is a sale of the Company.
• All vesting for senior employees accelerates on a sale of the Company.

A sale of the company is an event where everyone in the company has an opportunity to exchange their shares for cash or shares with effectively immediate liquidity (for example, a stock with enough liquidity so everyone who wanted to could sell their shares). In this context an IPO is not a sale of the company. Neither is a conversion into restricted stock.

In these situations, the board should develop a new formula to recognize the incremental or delayed liquidity created by this type of transaction.

This vesting formula is built into the "one page term sheet". I've used this formula in virtually all of my angel investments for over 20 years. During that period, I've had a chance to watch how this vesting formula has affected the group psychology and increased the probabilities of success in over thirty companies. I am convinced this is as close as we can get to optimum.

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.

The Public Company Discount

by Mike Feinstein

Don Dodge wrote recently about public company valuations vs. private company valuations.  This is a subject that is near and dear to my heart.

You can find many examples of public companies that have solid businesses and very low valuations.  Most public tech companies that are financially stable and have enough revenue to be sure to be around for a while are valued at less than 1x revenue these days, plus cash.  Think about that in terms of a start-up:

What's a start-up worth that has $15M of revenue, runs at break-even, and has $5M in cash?  In more typical times, you might expect this company to raise money at $40-70M pre-money, depending on what the long-term upside is.  Currently, a public company with this financial profile is probably valued at less than $20M, including the cash.

This class of public companies are really forgotten.  They are too small to be tracked by most analysts.  They don't trade at very high volumes.  They sound a lot like private companies, but they have the transparency, and costs, of being public.  Investors can probably get a venture-type multiple on these types of companies, with less risk than that start-up.

I think that these types of opportunities will definitely compete with private companies for capital.  In fact, I'm betting on it...Limited Partners of venture capital and private equity funds are starting to see that this is an interesting complement to their usual investing.  They do have the asset allocation issue that Don mentioned since their alternatives are a higher percentage of their portfolio than they would like.  But, as that returns to normal, I expect some capital to flow toward more VC-like investing in the public market.

And, what happens to that start-up that has the attractive financials?  They'll get financed, but they may not get the valuation that they would like.  If they are really cash-flow break even, they'd be better off tapping some debt until better valuation times return.