Venture Capital - Thoughts On The Asset Class

by Fred Wilson

I wrote a post a week or so ago thinking outloud about what a good "venture return' is. Yesterday, one of our investors, Lindel Eakman of UTIMCO, stopped by this blog and left a very interesting comment on that post.

Lindel pointed out that UTIMCO's portfolio return on all VC funds over the past 10 years was in the range of 9pcnt and that he thought that wasn't very good. He did point out that VC is well ahead of the public equity markets in their portfolio and so to the extent they have their equity dollars in VC (or other private equity), that is better than public equity right now.

The punch line to Lindel's comment is important. He wonders if VC can't do better than 9pcnt across a diversified portfolio, would UTIMCO simply be better in bonds given the illiquidity and greater risk of the VC asset class?

And sadly, it may well come to that. VC has not proven that it can scale as an asset class since the mid 90s. The vast amount of money that has come into the sector from public pension funds in the past fifteen to twenty years has not been put to work very well and returns for the asset class as a whole have come down. It may well be the case that the public pension money (and other money) may leave the asset class as CIOs and the investment committees ask the hard questions that Lindel is asking.

Peter Parker, a long time VC and entrepreneur, replied to Lindel with the observation that a downsizing of the VC business would be a good thing for the LPs that remain because the best firms in the business are doing very well and are generating returns well above the 9pcnt which may well be the average performance for most investors in the VC asset class over the past 10 years.

I note that the industry returns I posted on this blog a month or two ago show a 10 year average return of 17.3pcnt so UTIMCO's portfolio is in theory below the average, but those 10 year returns are heavily influenced by the late 90s internet bubble and also the phenomenal returns delivered by KP and Sequoia on their Google investment. I would not be surprised to see that 9-10pcnt returns are the average for funds that did not take advantage of either of those big return generators.

Many will argue that this is not good news for entrepreneurs. And that may well be true. But I think entrepreneurs in the web sector have done a great job of figuring out how to build companies on much lower capital needs and we also have a vibrant angel and early stage (pre-VC) market developing. So it may be that the real problem is that there is simply too much money looking to get put to work in the VC asset class (certainly that is true in information technology) and that as money starts to leave the sector, we'll have a smaller and healthier VC business to operate in.

I don't know what this means for biotech and cleantech and it may well be that those sectors can handle larger sums of venture capital and still generate acceptable returns. I'll leave it to those who know something about them to comment.

Investor Pitch: Excite, Engage & Exit with the Ask

by Dan Rua

I've recently been coaching some entrepreneurs presenting at upcoming investor conferences. It's something I've done for years and still enjoy. I remember the first investor pitches I gave and the first I heard, and can appreciate how "blind" many entrepreneurs are flying when doing their first investor presentation.

Although my advice is always tailored to the entrepreneur and company at hand, there is one nugget I try to share with all. Remember the goal of your presentation and don't wander too far from it. In most situations, the goal is to Excite, Engage & Exit with the Ask.

Excite: Focus on what is most exciting about you and your business. Don't get bogged down in re-hashing your business plan. If your technology is truly disruptive, make that point clear. If your team brings significant experienced or unique relationships, hit that. If customers are seeing immediate ROI from your products, put that front and center. Your number 1 job in an investor pitch is to generate excitement, preferably very early in your presentation. Getting audiences to shift forward in their chairs and pay attention is much more important than hitting the "textbook" areas of business analysis.

Engage: If the forum is a conference, then Engage means to deliver your message in a way most people will understand. Ditch the technical jargon and provide real-world examples of creating value for customers. If there is a unique pain point for your customer, share that story because it could evoke immediate understanding/emotion from your audience. If the forum is a partner meeting, then also look for opportunities to bring the audience into a discussion. Ask "how often X has happened" to them, their companies or their families -- something you fix. Ask about the firm's approach to investing so you understand them better and can relate to that in your presentation. Do something to drive two-way discussion -- a partner meeting presentation that goes one-way is almost always deadly.

Exit with the Ask: Always, always, always end with a slide that details what you're asking for or proposing. Don't douse audience excitment with a dead-end close. You need to funnel the audience's interest in your presentation into a decision point. Note, however, that the ask isn't always just an investment amount. To the contrary, the ask at a conference may just be to get audience members to your booth for further questions. The ask at a partner meeting typically involves a dollar amount, but also includes understanding process "next steps" -- driving due diligence or a subsequent meeting. By presenting your Ask to an excited and engaged audience, with your key Ask, you've maximized your chances for success. At the worst, making the Ask will help you avoid wasted time. If you didn't excite the listener and they don't react to your Ask, it's a good sign to improve your pitch and focus your energies on your next prospect.

What comes to your mind when someone says Venture Capital?

by Alexander Muse

When someone says, "Venture Capitalist" what comes to your mind? (throw your first though into the comments)  Early in Brad Feld's career his impression was, "that they were scary people who wanted to take over your company and screw over entrepreneurs." Ironically early in my career I thought they were simply people who would invest in your business and my first encounters with them were very positive - I never really understood all of the fear entrepreneurs expressed when taking about VCs.

Recently I began talking to potential investors about investing around $5MM in our ShopSavvybusiness and ironically I have stayed away from the usual suspects - venture capitalists.  Why, you ask?  Here are a few reasons:

• INDECISION: In times of uncertainty my observation is that they take a VERY long time to say no and even longer to say yes to an investment.
• TIME SUCK: In good times they consume a tremendous amount of your key team members time and energy.
• BUSY WORK: The sort of information  they want entrepreneurs to compile is often very interesting, but building an investment thesis is supposed to be their job not ours.

Of course there are scores of venture capitalists who are great to work with, but in my experience they are located on the coasts and prefer to invest in entrepreneurs who live nearby.  I am not interested in moving.  Brad Feld, a successful venture capitalist in Boulder (and a co-founder of TechStars) has an interesting post in Entrepreneur where he describes the sort of VCs that give VCs a bad name:

• Mr. Know-It-All–the venture capitalist who thinks he knows everything. He's an easy guy to spot because everything he says is a directive about what to do. There's never any dialogue; he says if you listen to him, everything will work out fine–yet, it rarely does.
• Mr. Know-It-All's first cousin is the young venture capitalist trying to show everyone how smart he is. This is especially annoying when he actually hasn’t done much of anything except go to business school and manage to land a job at a VC firm.
• Mr. Know-It-All's second cousin is the experienced entrepreneur who is now a venture capitalist. Though many experienced entrepreneurs think they can comfortably play both roles, the roles of entrepreneur and venture capitalist are totally different.

The point of his post really gets to the heart of my frustration.  Brad realized early on in his career that he could not effectively play the role of entrepreneur and investor so he picked investor (I made the opposite decision for largely the same reasons).  Brad describes the investor's role, "to completely support CEOs or founders. If I lost confidence in them for any reason, my first task was to confront them about it. If we could reconcile this, I'd continue to support them 100 percent and work for them. If not, it was my job as an investor to address my concerns at the board level." I think my reticence or fear of raising money from venture capitalists comes from the fact that my perception of most VCs is completely opposite.

Brad explains, "Arrogance is often a product of the inverse of this approach, where the venture capitalist thinks the CEOs or founders work for him. The great venture capitalists recognize that their existence is dependent on entrepreneurs. Even when the venture capitalists are incredibly experienced and knowledgeable, they know how to walk the line of "you work for me/I work for you" appropriately–and how to check their arrogance at the door."

Beyond the Money: Some VCs Provide Startups With A Competitive Edge

by Jeremiah Owyang

Surprisingly, some of the most important resources from a VC isn't the financial funding.

When I meet with startups I find it helpful to find out who their investor is, secondly, it's important to watch how VCs are funding, as it impacts what type of technologies we'll see in the next few months. I don't know as much as I want to about the VC world, so when I have questions I turn to Jennifer Jones, just this weekend we were engaged in the topic of the overall value that VCs bring. No, not just the money aspect, but the other intangible benefits, as VCs provide several intangible services to their portfolio companies, as I understand it, they include:

VCs Provide Startups With A Competitive Edge by Offering Additional Services:

Thought Leadership
VCs are required to anticipate future trends, and as a result they are highly connected, obtain information from a variety of sources, and have to quickly synthesize what's next. Some of the VCs are more active in public, and are on the speaking circuit, and are sharing their ideas. Take for example David Hornick, who does a great job at this as he discusses why and how he'll invest the $650mm they raised in high tech. Considering the recession this fund will fuel a great deal of innovation –even during a downturn.

Strategic Guidance
Often, VCs sit on the Board of Directors of their portfolio companies and provide guidance, direction, and access to other decision makers. This not only protects the VC to keep an eye on the company, but gives the entrepreneurs a chance to bounce ideas off senior and seasoned investors.

Being Part of The Family
Access is important. When I meet with startups, it's important to know who invested in them, as it indicates their network. If you watch carefully (real carefully) you can see that startups that share the same investor use each others products, exchange executives, and are talking to each other. They often have offsites

Ancillary Services
Some VC firms have education teams and marketing teams that provide a broad range of services to the portfolio companies who don't have the resources to hire full time marketing staff. In fact, I'll be doing a workshop with Giovanni Rodriguez in the near future for a VC group. Recently I held a dinner discussion with Allegis capital andScale Venture Partners, to meet their portfolio and discuss market trends.

Umbrella Branding
Perhaps the most under utilized is the benefit of being part of the brand of a well known firm. There are certain firms that are known for investing in certain verticals, or have a track record of success that lights my eyes up. Companies often tout their investors in briefings, especially if they are a top tier firm.

Parties… eerr um Networking
Ok, that’s my polite way of saying great parties, well networking too. During the height of the economy, some VC firms flew the executives of their portfolio companies out to a one week retreat in Hawaii. Also, some of the best parties in all of Silicon Valley are at August capital –social media networking nirvana.

Recruiting and Fundraising
I added this bullet after the fact, after seeing how David Hornick has added to the conversation it's too important to pass up. VCs offer additional services like recruiting, which I'd be so bold to say is often executive placement of the right folks. Secondly, they help with fundraising, which I would assume would be for additional rounds of investment, I would expect that this would often mean a solid reference from one investor to the next.

Entrepreneurs should weigh all benefits
Of course, with the top tier VC firms, there are certainly considerations, getting backed by a very successful VC firm may mean they have more influence over the terms, may drive the direction of your company, and ultimately, may have more equity of the company. I encourage you to think about the other services, network, and events that your VC will offer you, find out by observing or talking to companies in their portfolio.

VCs offer more than just funding
VC should continue to provide thought leadership in their space, discussing in public why they are raising money, where they anticipate market growth, and how they plan to invest. This not only attracts new investors for their fund, but gives branding cover for their portfolio, and the folks in the industry, like me, visibility on the next trends. What they do beyond the investment makes a different –I can see it.

How much funding do startups Reeaaally need ?

by Kallol Borah

In the last few months, I have had the chance to sit down with a few fellow entrepreneurs and discuss business plans, thanks to me wearing my HeadStart foundation hat. I noticed a few things that were common - entrepreneurs knew their product very well but not really their target customers, most of them had not spoken to more than a handful of prospects and when it came to fund raising, everyone first indicated they need a couple of million dollars. When we jointly ripped the business plans and re-worked them through, the fund requirement came to a few hundred thousand dollars (most of these companies were pre-revenue or have revenues of upto $300-400k per year, thanks to some related project work) except a couple of them.

Intrigued enough, I ran a survey trying to understand how much startups think they need to get to the next stage (pre-revenue->revenues->profits) and the survey results are very revealing (see here).

I asked a lot of entrepreneurs why they chose a 'couple of million dollars' as the figure to ask for and this is what some had to say

1. VCs in India expect a particular % share of a company, no matter what they invest, so better to raise more money than less. Funnily enough, some of them said a couple of VCs (do not want to take names publicly) indicated they will need 25-30% no matter what investment within the $1-2 million range.

2. Some entrepreneurs do not know what to ask for. In the absence of any sales plan and rickety financial models, they go by the million dollars story just because thats what everyone is raising.

I also looked at the E&Y VC Report of 2007 and 2008 and found that Indian startups raise, on an average, similar amounts of money (think it is around $5 million per startup on an avg) compared to Europe and the US; this when, we think India is relatively inexpensive to build products. Is it because VCs in India invest much later in the startup cycle or is that fresh US returned/US mandated VCs have not somehow grasped the Indian ‘value for money’ or is it something else ? Maybe, all of you can throw some light on it ??

Whatever it is, there is a huge hole in the pre-revenue/early stage 'small deal' (Rs 1-2 crore per startup) demand and supply for funding. And I hope this gap is filled very soon so that real innovation is not stifled.

Note: the survey results are taken from the Mint article where I put my thoughts on these numbers. 105 startups responded to the survey.

A VC's Biggest Flaw: Arrogance

By Brad Feld

Early in my entrepreneurial career, I didn't really know what to make of venture capitalists. All I heard was that they were scary people who wanted to take over your company and screw over entrepreneurs. In my first business, I deliberately stayed away from venture capitalists. Never in my wildest dreams did I imagine someday becoming one.

Much to my surprise, being a venture capitalist is a perfect role for me. While a number of the venture capitalists I know and work with are great, many aren't. Their weaknesses vary, but there's typically a common characteristic the not-great venture capitalists share: arrogance.

Arrogance shows up in several ways. The most easily identifiable one is Mr. Know-It-All--the venture capitalist who thinks he knows everything. He's an easy guy to spot because everything he says is a directive about what to do. There's never any dialogue; he says if you listen to him, everything will work out fine--yet, it rarely does.

Mr. Know-It-All's second cousin is the experienced entrepreneur who is now a venture capitalist. Though many experienced entrepreneurs think they can comfortably play both roles, the roles of entrepreneur and venture capitalist are totally different. When I started investing as an angel investor, I often crossed the boundary between investor and entrepreneur. When I became a venture capitalist and started investing larger amounts in more companies, I continued to cross this boundary. It took a few years for this to catch up with me, but it finally smashed me over the head during the internet bubble, when I realized I couldn't effectively play the role of both the investor and the entrepreneur. I had to pick one.

Once I chose the role of investor, I also determined it was my job to completely support CEOs or founders. If I lost confidence in them for any reason, my first task was to confront them about it. If we could reconcile this, I'd continue to support them 100 percent and work for them. If not, it was my job as an investor to address my concerns at the board level.

Arrogance is often a product of the inverse of this approach, where the venture capitalist thinks the CEOs or founders work for him. The great venture capitalists recognize that their existence is dependent on entrepreneurs. Even when the venture capitalists are incredibly experienced and knowledgeable, they know how to walk the line of "you work for me/I work for you" appropriately--and how to check their arrogance at the door.

WHAT VCS SHOULD BE DOING IN A DOWN MARKET

This is a two-parter, since its always instructive to compare the ideal with the actual ...

Every company I've ever started was done in a recession--you know all the reasons: people are available, your competitors are pulling back giving you a great chance to be ahead of them when the market turns positive again, etc. etc. It's very hard to go to market when there isn't one--and in this environment customers are scared of the future and are delaying buying decisions. Time to market has become irrelevant--so called first mover advantage (please don't ever use this in a pitch) never was relevant. So if your company is early, and developing something really revolutionary that may take one or two years to create then ideally VCs should be really interested in this, provided the burn rate is manageable and it doesnt require a massive infrastructure investment.

When the market inhales,large companies cut R&D projects and really high quality people get bored and become available to start or join new tech startups. VCs need to find these teams and embrace them because they create the next round of Googles and Ciscos. Be under no illusion it's harder today to get funded than ever before, because these great teams are out there and if you are competing with deep domain experts you will likely come up short. Also, VCs are human too (well, almost) and are just as scared and uncertain as everyone else, so making the funding decision will take longer and longer, and each time the market takes another big hit they will be reminded just how tightly closed the IPO exit window is, and that they have to have another round of explanations with their LPs as to why the money should stay in the fund. At the same time, their LPs are hammering on their management fee, and wanting to know why they are paying it if the partners are not investing.

I think there are two basic choices in this market, other than the non-choice of do nothing and sit on the money until things get better. VCs first triage their portfolios to see which investments can and should survive, circle the wagons around the portfolio and make sure they have a low enough burn and enough runway to make it. Then they can either go out in a predatory way and force their way into deals they would otherwise be unable to enter, leveraging the fear factor. There is a natural bias towards later stage deals--i.e., doing series B & C deals at A-round pricing--remember many of these firms need to have an exit soon, and given that public markets are closed the only option for many is to be able to sell a later-stage company to demonstrate a return to LPs who have seen nothing but losses for the past year. The problem with this path is it does not leverage the natural skills of a VC--there is a lot less value to add to a later stage company and it looks more like a banking deal. Also there are a lot of bankers and other VCs also looking for that type of deal ;-)

The other path is to forget revenue and look for highly disruptive plays that may take two years to develop their product but when they do it can really cause order of magnitude changes in the business model. These are extremely risky, and often more like science projects than businesses but they also offer venture scale returns--10 to 100x and it only takes one good one to make an entire fund (one of the Google VCs experienced exactly this win in a portfolio that was otherwise abysmal--and who says we are so smart...)

It's a shame to waste a good crisis, in good times companies are struggling to meet orders and focus all their efforts on supporting manufacturing and keeping the engine running. They have no time for revolution. In times like this they need aspirin for the pain, not steroids for performance--it is a time for revolution. And a little revolution now and then is usually a good thing ;-)

Next time: What VCs are actually doing in this market (this one might take a while...)

Time To Reboot The Basic VC Deal Structure

By Edwin L. Miller Jr., Sullivan & Worcester

New York Times columnist Tom Friedman recently suggested that "It's Time to Reboot America," meaning that the financial crisis gives us a chance to fundamentally re-examine the way government and the private sector operate. Perhaps it is also time to re-examine the basic venture capital deal structure that has changed little since the 1970s.

A related issue is bloated legal documents. Simple forms that address only realistic scenarios are desirable. Sensible legal documents do not have to paper to death every one-in-a-thousand scenario. Simple, common-sense documents are easier for all parties to understand and be comfortable with, and they are cheaper and quicker to negotiate and sign. This approach may be a competitive advantage, or if broadly accepted, would promote a better outcome for all parties.

Where do we start?

Registration Rights. The reality of how an IPO works in practice is that the issuer's registration rights agreement is never taken out of the drawer—other than to find the waiver provisions. Forget demand rights to force an IPO. It never happens and is intimidating to entrepreneurs.

Forget piggy-back rights other than in connection with an IPO; the secondary/follow-on offering process for public companies has become so streamlined that the delay that would be needed to implement piggy-back registration provisions could jeopardize a potential offering that is in everyone's interest.

Demand rights after the IPO are obsolete. For one thing, SEC rules relating to resales have been relaxed. Also, the market reality is that secondary offering exits happen only when market conditions make them feasible. When they are feasible, it is in everyone's interest to eliminate the overhang of the VCs' shares and register them for resale.

If it is in everyone's interest, you don't need an agreement. Instead of demand rights, investors should consider doing what PIPE investors have been doing for years: providing for automatic, not demand, shelf registration rights for affiliates to permit unrestricted resales after the IPO lock-up period.

What’s left of the standard registration rights boilerplate? It's probably just indemnification. That could be a simple covenant in the investors' rights agreement to the effect that the investors are entitled to indemnification for '33 Act liability on a resale registration.

Price Anti-Dilution Provisions. It is hard to see how these provisions benefit anyone. Let's first start with fairness. Why should investors be price-protected on the downside? That's the bet they make. If there are new economics at play in a subsequent round, the pricing of that round by the participating investors will take into account the existence or lack of price anti-dilution. Investors that don't participate, along with management, will all be diluted on the same basis.

Representations and Warranties. For a Series A round, 10 to 15 pages of representations and warranties are not necessary. The business and legal affairs of the company at that stage are likely very simple. In a Series B round, the existing investors know enough about the company that they shouldn't need extensive representations. New investors could well make do with less than overly complex representations.

If long or short representations are breached, what is the investors' remedy? The irony is that if they sue the company, they are, in effect, suing themselves for their own money and paying the other side's legal expenses. If they are looking for rescission, it will take years to get their money back, and since the company would not fundable because of the lawsuit, at the end of the process there likely will not be anything left.

What's the alternative? In the Series A round, some basic company representations, plus some simple, fair and non-threatening representations from the founders—like no actual knowledge of IP problems and no undisclosed promises of equity. Most of the "real" representations in later rounds are largely covered by the required legal opinion in any event.

Right of First Refusal/ Co-Sale. Why should the founders ever be permitted to sell shares prior to a liquidity event? They almost never do, anyway. This concept could be effectively implemented by a simple provision that says that any sale by a founder would require the consent of the investors. One of the conditions to granting permission could be offering a co-sale right to the investors.

Redemption Provisions. These provisions actually were omitted in the Internet heyday. They don't work and are almost never used—companies never have the money to pay up. If the company had the money to pay up, the investors likely would not be disgruntled and want out, or the company would be happy to buy them out.

If this provision actually had teeth, like the rare provision that changes the board composition, under any but the most extraordinary circumstances, it would be entirely unfair to founders to require ceding board control without the effective ability to pay up in the first place.

Dividends. Some agreements provide that the company will pay dividends on the preferred as a priority "if declared by the board." What board would vote to declare a dividend on the preferred and not the common? Why not simply provide that no dividends can be paid at all without all constituencies agreeing to it?

Liquidation Preference. This is one area where investors shortchange themselves. Why should the founders get any money out of the deal unless the investors earn an equity rate of return? There should be a minimum IRR recovery as part of the liquidation preference in lieu of an accruing dividend. Participating preferred has always been a thorn in the side of entrepreneurs. If the investor were entitled to a priority equity return, a participating preferred feature would not be necessary.

Employee Pool. The concept of the employee pool never made corporate finance sense. Why not offer the company a “true” pre-money valuation, and price the round by dividing that valuation by shares outstanding and vested shares under option? Unvested options are earned after the investment and are essentially in lieu of other compensation.

Why should the founders pay for that compensation and not the investors? The pool is a fiction. When the pool is exhausted, it always is simply increased. You need to give equity incentives to employees to grow the business. They are the ones who create the value.

Down Rounds/Founder Anti-Dilution Protection. The abusive down round has tarnished the industry. Try explaining to a founder why the investors hate him/her at a $1 per share when only recently they loved him/her at $10 per share. The standard rationale is "market conditions."

The only problem with that rationale is that there is no market. VCs don't do hostile takeovers/investments. The standard "protective" procedure is to have an outside investor "price" the round. But how does an outside investor proposing an unfairly low valuation protect the existing investors when they make the same unfair investment?

A solution to this problem is difficult precisely because of the lack of a real market. I have proposed one solution—a specified minimum share of the ultimate liquidity proceeds for founders that would vest like equity compensation (see my column on this topic in the October 2008 VCJ). Many down rounds could be challenged under Delaware case law imposing an "entire fairness" standard on insider transactions. That doctrine permits a hindsight assessment of the procedures and price. A protective provision that should be considered would be to cut the pre-down round stockholders in on an unexpected and near-term big win.

The Alternative

An alternative deal structure would greatly simplify the standard National Venture Capital Association documentation to look like this:

• Stock purchase agreement with basic company representations and some basic, reasonable and knowledge-qualified founder representations on things they should know about.
• Investors rights agreement with IPO piggy-back and shelf registration rights only, basic indemnification provisions and basic reporting and other covenants.
• No ROFR/Co-Sale agreement—founders are restricted from selling their shares until a liquidity event.
• Charter amendment, with a specified IRR as the liquidation preference, no participating preferred, a prohibition on dividends, no price anti-dilution protection and no redemption provisions.

Valuation and the power of framing

by Julien Wallen

There are some discussions going on about the valuation of web start-up funding rounds. Most people predict that it will go down. But should it really be the case?

A web start-up investment has a particular cash flow profile for investors: very negative today and 4-7 years down the road very positive (hopefully). With this particularity in mind, the current crisis should in theory lead at worst to a small decrease in web start-up valuation levels (for a comprehensive site  on valuation go here):

• DCF tells us that there should be only a small decrease in valuation levels today: the cost of capital for the next few years cash flows is increasing but the remaining elements are not affected (e.g., LT cost of capital)

• Multiple approach, if correctly used, should marginally affect today's valuation levels. (however it is not - during a bubble investors overestimate valuation and during a downturn they underestimate it because they use the current market multiples)

• Option valuation implies that today's valuation levels should increase because volatility has gone through the roof (mind you while it is the best methodology in theory to value start-ups, it's nearly impossible to apply in practice)

But what about reality?

VC funding is a market in which each player (VCs and entrepreneurs) has a framing at any particular point in time. In the past few weeks, a majority of VCs have changed dramatically their framing. They are afraid of having difficulties to raise their next fund. This fear is even stronger for poor perfomers. This leads today to an effective decrease in supply of VC capital and of valuations expectations. Let's call this the "fear framing". I am not saying that it is an organized process by VCs ; it's rather an "unconscious" process for the vast majority of them.

While in theory "fair" valuation levels should not be dramatically affected for web start-ups, I am afraid that some entrepreneurs will get caught in this "fear framing" and accept "unjustified" valuations. Others (if they have enough cash to survive) will only accept "fair" valuations.

VCs investing in other VCs

by Ouriel OHAYON

Yesterday i was compelled and glad to learn that Sequoia is investing in Ycombinator. When the best established VC ( Sequoia) in the world invests in the smartest super early stage VC in the world ( YCombinator), i think it's worth a pause and some thoughts.

Although most VCs claim they do seed deals, most of their real activity is post seed (you can also call it early stage). But very rarely you'll find them working in the way Ycombinator does: a very little amount of money (up to 50k) at the idea stage to support the intial product development and some traction.

We tried with lgilab to learn from the Ycombinator approach. But the expectation and mechanism and legitimately different. Most of the times we decline a project, not because it is not interesting but because of the size of the opportunity. Most VCs who do seed deals still have expectations of big exits. With Ycombinator like models the expectation is not that big. An exit sub 50m USD is considered as a success.

With the exponential growth of the TinyWeb (meaning small companies, solving tiny problems with nice revenues possibly big one) models like Ycombinator totally make sense. Sequoia is aware that they are not adressing those startups and they are aware that more and more exits in the future will happen in that direction. Investing in Ycombinator is a smart move. Sometimes some of the YCombinator babies will grow beyond expectation and Sequoia will probably be happy to have a preferred access to some deals.

I twitted yesterday that it was the first time i thought a VC was investing in another VC. But i was wrong. Actually partly wrong. A few persons rightly pointed me to the fact that this is something that has already happened in the US  and India (problably because of the size of the market).

But i never heard of anything equivalent in Europe and in Israel -at least not something that marked me recently (maybe i missed something because i am new to this country and profession).

I believe like i said many times that the most of the upcoming exits in the Israeli internet market will be small one (sub 50m USD) that are not adressable by VCs. I hope to see the birth of equivalent models like YCombinator here and think that established VCs should be the first investors in those organisations. For that it requires them to negotiate a special mandate with their LPs (own investors) so they can do that. It also requires to do it right (a whole post in itself) meaning investing in extremely low cost structures with proven management and access to deal flow.

I would be happy to hear what other VC colleagues/Investor think about that?

How to be an Angel Investor

by Paul Graham

(This essay is derived from a talk at AngelConf.)

When we sold our startup in 1998 I thought one day I'd do some angel investing. Seven years later I still hadn't started. I put it off because it seemed mysterious and complicated. It turns out to be easier than I expected, and also more interesting.

The part I thought was hard, the mechanics of investing, really isn't. You give a startup money and they give you stock. You'll probably get either preferred stock, which means stock with extra rights like getting your money back first in a sale, or convertible debt, which means (on paper) you're lending the company money, and the debt converts to stock at the next sufficiently big funding round. [1]

There are sometimes minor tactical advantages to using one or the other. The paperwork for convertible debt is simpler. But really it doesn't matter much which you use. Don't spend much time worrying about the details of deal terms, especially when you first start angel investing. That's not how you win at this game. When you hear people talking about a successful angel investor, they're not saying "He got a 4x liquidation preference." They're saying "He invested in Google."

That's how you win: by investing in the right startups. That is so much more important than anything else that I worry I'm misleading you by even talking about other things.

Mechanics
Angel investors often syndicate deals, which means they join together to invest on the same terms. In a syndicate there is usually a "lead" investor who negotiates the terms with the startup. But not always: sometimes the startup cobbles together a syndicate of investors who approach them independently, and the startup's lawyer supplies the paperwork.

The easiest way to get started in angel investing is to find a friend who already does it, and try to get included in his syndicates. Then all you have to do is write checks.

Don't feel like you have to join a syndicate, though. It's not that hard to do it yourself. You can just use the standardseries AA documents Wilson Sonsini and Y Combinator published online. You should of course have your lawyer review everything. Both you and the startup should have lawyers. But the lawyers don't have to create the agreement from scratch. [2]

When you negotiate terms with a startup, there are two numbers you care about: how much money you're putting in, and the valuation of the company. The valuation determines how much stock you get. If you put $50,000 into a company at a pre-money valuation of $1 million, then the post-money valuation is $1.05 million, and you get .05/1.05, or 4.76% of the company's stock.

If the company raises more money later, the new investor will take a chunk of the company away from all the existing shareholders just as you did. If in the next round they sell 10% of the company to a new investor, your 4.76% will be reduced to 4.28%.

That's ok. Dilution is normal. What saves you from being mistreated in future rounds, usually, is that you're in the same boat as the founders. They can't dilute you without diluting themselves just as much. And they won't dilute themselves unless they end up net ahead. So in theory, each further round of investment leaves you with a smaller share of an even more valuable company, till after several more rounds you end up with .5% of the company at the point where it IPOs, and you are very happy because your $50,000 has become $5 million. [3]

The agreement by which you invest should have provisions that let you contribute to future rounds to maintain your percentage. So it's your choice whether you get diluted. [4]If the company does really well, you eventually will, because eventually the valuations will get so high it's not worth it for you.

How much does an angel invest? That varies enormously, from $10,000 to hundreds of thousands or in rare cases even millions. The upper bound is obviously the total amount the founders want to raise. The lower bound is 5-10% of the total or $10,000, whichever is greater. A typical angel round these days might be $150,000 raised from 5 people.

Valuations don't vary as much. For angel rounds it's rare to see a valuation lower than half a million or higher than 4 or 5 million. 4 million is starting to be VC territory.

How do you decide what valuation to offer? If you're part of a round led by someone else, that problem is solved for you. But what if you're investing by yourself? There's no real answer. There is no rational way to value an early stage startup. The valuation reflects nothing more than the strength of the company's bargaining position. If they really want you, either because they desperately need money, or you're someone who can help them a lot, they'll let you invest at a low valuation. If they don't need you, it will be higher. So guess. The startup may not have any more idea what the number should be than you do. [5]

Ultimately it doesn't matter much. When angels make a lot of money from a deal, it's not because they invested at a valuation of $1.5 million instead of $3 million. It's because the company was really successful.

I can't emphasize that too much. Don't get hung up on mechanics or deal terms. What you should spend your time thinking about is whether the company is good.

(Similarly, founders also should not get hung up on deal terms, but should spend their time thinking about how to make the company good.)

There's a second less obvious component of an angel investment: how much you're expected to help the startup. Like the amount you invest, this can vary a lot. You don't have to do anything if you don't want to; you could simply be a source of money. Or you can become a de facto employee of the company. Just make sure that you and the startup agree in advance about roughly how much you'll do for them.

Really hot companies sometimes have high standards for angels. The ones everyone wants to invest in practically audition investors, and only take money from people who are famous and/or will work hard for them. But don't feel like you have to put in a lot of time or you won't get to invest in any good startups. There is a surprising lack of correlation between how hot a deal a startup is and how well it ends up doing. Lots of hot startups will end up failing, and lots of startups no one likes will end up succeeding. And the latter are so desperate for money that they'll take it from anyone at a low valuation. [6]

Picking Winners
It would be nice to be able to pick those out, wouldn't it? The part of angel investing that has most effect on your returns, picking the right companies, is also the hardest. So you should practically ignore (or more precisely, archive, in the Gmail sense) everything I've told you so far. You may need to refer to it at some point, but it is not the central issue.

The central issue is picking the right startups. What "Make something people want" is for startups, "Pick the right startups" is for investors. Combined they yield "Pick the startups that will make something people want."

How do you do that? It's not as simple as picking startups that are already making something wildly popular. By then it's too late for angels. VCs will already be onto them. As an angel, you have to pick startups before they've got a hit—either because they've made something great but users don't realize it yet, like Google early on, or because they're still an iteration or two away from the big hit, like Paypal when they were making software for transferring money between PDAs.

To be a good angel investor, you have to be a good judge of potential. That's what it comes down to. VCs can be fast followers. Most of them don't try to predict what will win. They just try to notice quickly when something already is winning. But angels have to be able to predict. [7]

One interesting consequence of this fact is that there are a lot of people out there who have never even made an angel investment and yet are already better angel investors than they realize. Someone who doesn't know the first thing about the mechanics of venture funding but knows what a successful startup founder looks like is actually far ahead of someone who knows termsheets inside out, but thinks"hacker" means someone who breaks into computers. If you can recognize good startup founders by empathizing with them—if you both resonate at the same frequency—then you may already be a better startup picker than the median professional VC. [8]

Paul Buchheit, for example, started angel investing about a year after me, and he was pretty much immediately as good as me at picking startups. My extra year of experience was rounding error compared to our ability to empathize with founders.

What makes a good founder? If there were a word that meant the opposite of hapless, that would be the one. Bad founders seem hapless. They may be smart, or not, but somehow events overwhelm them and they get discouraged and give up. Good founders make things happen the way they want. Which is not to say they force things to happen in a predefined way. Good founders have a healthy respect for reality. But they are relentlessly resourceful. That's the closest I can get to the opposite of hapless. You want to fund people who are relentlessly resourceful.

Notice we started out talking about things, and now we're talking about people. There is an ongoing debate between investors which is more important, the people, or the idea—or more precisely, the market. Some, like Ron Conway, say it's the people—that the idea will change, but the people are the foundation of the company. Whereas Marc Andreessen says he'd back ok founders in a hot market over great founders in a bad one. [9]

These two positions are not so far apart as they seem, because good people find good markets. Bill Gates would probably have ended up pretty rich even if IBM hadn't happened to drop the PC standard in his lap.
I've thought a lot about the disagreement between the investors who prefer to bet on people and those who prefer to bet on markets. It's kind of surprising that it even exists. You'd expect opinions to have converged more.

But I think I've figured out what's going on. The three most prominent people I know who favor markets are Marc, Jawed Karim, and Joe Kraus. And all three of them, in their own startups, basically flew into a thermal: they hit a market growing so fast that it was all they could do to keep up with it. That kind of experience is hard to ignore. Plus I think they underestimate themselves: they think back to how easy it felt to ride that huge thermal upward, and they think "anyone could have done it." But that isn't true; they are not ordinary people.

So as an angel investor I think you want to go with Ron Conway and bet on people. Thermals happen, yes, but no one can predict them—not even the founders, and certainly not you as an investor. And only good people can ride the thermals if they hit them anyway.

Deal Flow
Of course the question of how to choose startups presumes you have startups to choose between. How do you find them? This is yet another problem that gets solved for you by syndicates. If you tag along on a friend's investments, you don't have to find startups.

The problem is not finding startups, exactly, but finding a stream of reasonably high quality ones. The traditional way to do this is through contacts. If you're friends with a lot of investors and founders, they'll send deals your way. The Valley basically runs on referrals. And once you start to become known as reliable, useful investor, people will refer lots of deals to you. I certainly will.

There's also a newer way to find startups, which is to come to events like Y Combinator's Demo Day, where a batch of newly created startups presents to investors all at once. We have two Demo Days a year, one in March and one in August. These are basically mass referrals.

But events like Demo Day only account for a fraction of matches between startups and investors. The personal referral is still the most common route. So if you want to hear about new startups, the best way to do it is to get lots of referrals.

The best way to get lots of referrals is to invest in startups. No matter how smart and nice you seem, insiders will be reluctant to send you referrals until you've proven yourself by doing a couple investments. Some smart, nice guys turn out to be flaky, high-maintenance investors. But once you prove yourself as a good investor, the deal flow, as they call it, will increase rapidly in both quality and quantity. At the extreme, for someone like Ron Conway, it is basically identical with the deal flow of the whole Valley.

So if you want to invest seriously, the way to get started is to bootstrap yourself off your existing connections, be a good investor in the startups you meet that way, and eventually you'll start a chain reaction. Good investors are rare, even in Silicon Valley. There probably aren't more than a couple hundred serious angels in the whole Valley, and yet they're probably the single most important ingredient in making the Valley what it is. Angels are the limiting reagent in startup formation.

If there are only a couple hundred serious angels in the Valley, then by deciding to become one you could single-handedly make the pipeline for startups in Silicon Valley significantly wider. That is kind of mind-blowing.

Being Good
How do you be a good angel investor? The first thing you need is to be decisive. When we talk to founders about good and bad investors, one of the ways we describe the good ones is to say "he writes checks." That doesn't mean the investor says yes to everyone. Far from it. It means he makes up his mind quickly, and follows through. You may be thinking, how hard could that be? You'll see when you try it. It follows from the nature of angel investing that the decisions are hard. You have to guess early, at the stage when the most promising ideas still seem counterintuitive, because if they were obviously good, VCs would already have funded them.

Suppose it's 1998. You come across a startup founded by a couple grad students. They say they're going to work on Internet search. There are already a bunch of big public companies doing search. How can these grad students possibly compete with them? And does search even matter anyway? All the search engines are trying to get people to start calling them "portals" instead. Why would you want to invest in a startup run by a couple of nobodies who are trying to compete with large, aggressive companies in an area they themselves have declared passe? And yet the grad students seem pretty smart. What do you do?

There's a hack for being decisive when you're inexperienced: ratchet down the size of your investment till it's an amount you wouldn't care too much about losing. For every rich person (you probably shouldn't try angel investing unless you think of yourself as rich) there's some amount that would be painless, though annoying, to lose. Till you feel comfortable investing, don't invest more than that per startup.

For example, if you have $5 million in investable assets, it would probably be painless (though annoying) to lose $15,000. That's less than .3% of your net worth. So start by making 3 or 4 $15,000 investments. Nothing will teach you about angel investing like experience. Treat the first few as an educational expense. $60,000 is less than a lot of graduate programs. Plus you get equity.

What's really uncool is to be strategically indecisive: to string founders along while trying to gather more information about the startup's trajectory. [10] There's always a temptation to do that, because you just have so little to go on, but you have to consciously resist it. In the long term it's to your advantage to be good.

The other component of being a good angel investor is simply to be a good person. Angel investing is not a business where you make money by screwing people over. Startups create wealth, and creating wealth is not a zero sum game. No one has to lose for you to win. In fact, if you mistreat the founders you invest in, they'll just get demoralized and the company will do worse. Plus your referrals will dry up. So I recommend being good.

The most successful angel investors I know are all basically good people. Once they invest in a company, all they want to do is help it. And they'll help people they haven't invested in too. When they do favors they don't seem to keep track of them. It's too much overhead. They just try to help everyone, and assume good things will flow back to them somehow. Empirically that seems to work.

Notes
[1] Convertible debt can be either capped at a particular valuation, or can be done at a discount to whatever the valuation turns out to be when it converts. E.g. convertible debt at a discount of 30% means when it converts you get stock as if you'd invested at a 30% lower valuation. That can be useful in cases where you can't or don't want to figure out what the valuation should be. You leave it to the next investor. On the other hand, a lot of investors want to know exactly what they're getting, so they will only do convertible debt with a cap.

[2] The expensive part of creating an agreement from scratch is not writing the agreement, but bickering at several hundred dollars an hour over the details. That's why the series AA paperwork aims at a middle ground. You can just start from the compromise you'd have reached after lots of back and forth.

When you fund a startup, both your lawyers should be specialists in startups. Do not use ordinary corporate lawyers for this. Their inexperience makes them overbuild: they'll create huge, overcomplicated agreements, and spend hours arguing over irrelevant things.
In the Valley, the top startup law firms are Wilson Sonsini, Orrick, Fenwick & West, Gunderson Dettmer, and Cooley Godward. In Boston the best are Goodwin Procter, Wilmer Hale, and Foley Hoag.

[3] Your mileage may vary.

[4] These anti-dilution provisions also protect you against tricks like a later investor trying to steal the company by doing another round that values the company at $1. If you have a competent startup lawyer handle the deal for you, you should be protected against such tricks initially. But it could become a problem later. If a big VC firm wants to invest in the startup after you, they may try to make you take out your anti-dilution protections. And if they do the startup will be pressuring you to agree. They'll tell you that if you don't, you're going to kill their deal with the VC. I recommend you solve this problem by having a gentlemen's agreement with the founders: agree with them in advance that you're not going to give up your anti-dilution protections. Then it's up to them to tell VCs early on.
The reason you don't want to give them up is the following scenario. The VCs recapitalize the company, meaning they give it additional funding at a pre-money valuation of zero. This wipes out the existing shareholders, including both you and the founders. They then grant the founders lots of options, because they need them to stay around, but you get nothing.

Obviously this is not a nice thing to do. It doesn't happen often. Brand-name VCs wouldn't recapitalize a company just to steal a few percent from an angel. But there's a continuum here. A less upstanding, lower-tier VC might be tempted to do it to steal a big chunk of stock.

I'm not saying you should always absolutely refuse to give up your anti-dilution protections. Everything is a negotiation. If you're part of a powerful syndicate, you might be able to give up legal protections and rely on social ones. If you invest in a deal led by a big angel like Ron Conway, for example, you're pretty well protected against being mistreated, because any VC would think twice before crossing him. This kind of protection is one of the reasons angels like to invest in syndicates.

[5] Don't invest so much, or at such a low valuation, that you end up with an excessively large share of a startup, unless you're sure your money will be the last they ever need. Later stage investors won't invest in a company if the founders don't have enough equity left to motivate them. I talked to a VC recently who said he'd met with a company he really liked, but he turned them down because investors already owned more than half of it. Those investors probably thought they'd been pretty clever by getting such a large chunk of this desirable company, but in fact they were shooting themselves in the foot.

[6] At any given time I know of at least 3 or 4 YC alumni who I believe will be big successes but who are running on vapor, financially, because investors don't yet get what they're doing. (And no, unfortunately, I can't tell you who they are. I can't refer a startup to an investor I don't know.)

[7] There are some VCs who can predict instead of reacting. Not surprisingly, these are the most successful ones.

[8] It's somewhat sneaky of me to put it this way, because the median VC loses money. That's one of the most surprising things I've learned about VC while working on Y Combinator. Only a fraction of VCs even have positive returns. The rest exist to satisfy demand among fund managers for venture capital as an asset class. Learning this explained a lot about some of the VCs I encountered when we were working on Viaweb.

[9] VCs also generally say they prefer great markets to great people. But what they're really saying is they want both. They're so selective that they only even consider great people. So when they say they care above all about big markets, they mean that's how they choose between great people.

[10] Founders rightly dislike the sort of investor who says he's interested in investing but doesn't want to lead. There are circumstances where this is an acceptable excuse, but more often than not what it means is "No, but if you turn out to be a hot deal, I want to be able to claim retroactively I said yes."

If you like a startup enough to invest in it, then invest in it. Just use the standard series AA terms and write them a check.

Thanks to Sam Altman, Paul Buchheit, Jessica Livingston, Robert Morris, and Fred Wilson for reading drafts of this.

The Best Time to Start a Venture Capital Firm

by www.JobSearchDigest.com

Tough times have historically been better for startup companies than most people think says Jim Verdonik in an article in Portland's BizJournal online. Granted, entrepreneurs tend to see the glass "half full" more often than most people. But there are solid business reasons why new ventures flourish in the worst of times.

First, there's necessity. Since many big companies have slashed their work forces, laid-off workers have to focus on starting over. Some of them are naturally going to want to be their own boss, or pursue that entrepreneurial opportunity they've been dreaming about for years. There's less competition in the marketplace. Plus, talented people are easier to find and hire during a downturn.

Current market conditions are irrelevant to many new companies as well, since they often need 1-2 years of market research and product development before they're even ready to launch. Since most downturns last less than two years, a new company starting now would be ready to launch just as the economy starts climbing again.

Then there's ROI. Verdonik says venture capital investment return data over the past few decades shows that ROI is actually higher for investments made during poor economic times, versus boom periods.

That's because ROI depends on valuations when the investment is made to the time of the exit date. Since valuations are usually lower during bad times, downturn investors start off with a substantial advantage which can result in higher exit ROIs. Call them value or vulture venture capitalists. Either way, they often produce higher returns.

One final bonus: during the good times when money is easy to get, companies tend to burn through it faster. Downturn companies tend to be more frugal and get a bigger bang for their buck. And downturn companies raise less money, because they spend less. Another reason they often provide better ROIs.

Raising Capital in a Buyer's Market

by Rosalind Resnick

Ordinarily, New York is a seller's market.

It's the kind of town where you can't get a ticket to a show for less than $100, you can't get a table at a restaurant on Saturday night unless you book a month in advance and, unless you're willing to pony up the full asking price, you can kiss that penthouse goodbye.

These days, of course, it's a different story. With Wall Street shedding jobs and bankers' bonuses being downsized, New York seems to be in the middle of a giant markdown sale. Whether it's shoes, handbags or condos, there's no reason to pay retail when you can buy whatever you want for 50 percent to 75 percent off. And, while the city's bars and restaurants are still packed, you can often get a table if you call the night before.

So what do you do if you're a seller? Well, it isn't pretty. Either you sell your condo, art collection or designer dresses at a deep discount or you pull them off the market and hope for a better day.

What if you're a startup company looking to raise capital? Well, that makes you a seller and the same harsh rules of demand-side economics apply. A couple of weeks ago, I got a call from a friend from my dotcom days. Sales at his e-commerce business were booming, he told me, but the company was running out of cash to finance its rapid growth. And due to the credit crunch, the bank refused to increase the company's line of credit. His options: Raise capital from a VC at a low valuation or borrow money from a private investor at double-digit interest rates.

From talking to our clients at Axxess, I know he's not the only entrepreneur who's found himself between a rock and a hard place.

But even in a market as tough as this one, entrepreneurs do have options–once they learn to conquer their fear. Let's face it: If you didn't have something worth selling, investors wouldn't be interested in talking to you at all. And without you and your product, there wouldn't be anything for that VC to buy.

Back at NetCreations, we encountered many VCs and investors who viewed us as a vulnerable little company they could get into at a discounted valuation. When the market plunged in 1998 during the Russian debt crisis, one VC offered us $2 million for 20 percent of our company. We told him to take a hike. The following year, the market recovered and, after growing our sales from $3.4 million to $20.7 million, we went public at a $300 million market cap.

Today's market is different, of course. Even before the stock market tanked, going IPO was no longer an option for most small companies. And because our company was kicking off cash, we had the luxury of saying "no" to vulture capitalists who wanted to take our equity.

But today's startups have options, too, especially if they're kicking off cash–or, at the very least, showing that people are using or buying the products or services they've created. The rule of "traction" doesn't apply only to tech companies but to fashion labels, restaurants and consumer products companies as well.

Whatever cards you're holding, you need to play them for all they're worth. If the prospective investor sees that he's the only one you're talking to, then your negotiating leverage is going to be zero. And if you're days away from missing payroll, you're going to have to take pretty much anything that's put on the table.

Now, I'm not telling you to walk away from the money. You've got to do what you've got to do to keep your company afloat. I'm just advising you to think strategically about raising capital, reach out to as many investors as you can and present as strong a case as possible that your company has what it takes to be a winner.

Because now is not the time to be holding a "75 percent off" sale.

For the MIT 100K Participants: Executive Summaries

by Simeon Simeonov

I was invited to speak tonight at the MIT 100K Web/IT track mixer but, unfortunately, I'm sick (which wouldn't have necessarily prevented me from going) and have lost my voice (which would have made going to the event pointless). So, in exchange, here are some thoughts on the topic we were going to discuss at the event–the dreaded executive summary. I invite the 100Kers to comment liberally and we'll get a discussion going.

Plenty has been written on how to write good exec summaries. The best article I've found is the one that Garage Ventures did. There is not much I can add about what needs to be in a good exec summary but I can share some "secrets" of how most VCs engage with exec summaries. Keep in mind that this is real world advice, which is not necessarily what you need to win in the BPC but then you are trying to build real startups as opposed to startups that win competitions, right?

VCs have a love/hate relationship with executive summaries. Actually, most VCs either love or hate them. Personally, I hate them. Most, even the ones by good teams, are terribly written so, statistically speaking, it's a waste of my time to read them. If I was making an initial decline or investigate further decision on exec summaries alone, I wouldn't have engaged with some of the great startups I know. Therefore, I prefer to look at a presentation and skip the exec summary.

Exec summaries are rarely read. They are skimmed, typically with the purpose of making a quick decline decision. Choose your words carefully. Don't have extraneous content. Highlight key points. Use a graph or diagram, provided it would be self-explanatory to someone who knows nothing about your business. Use simple analogies that relate your technology or business model to successful companies. Be humble when you do that–VCs don't want to see another startup which thinks its approach is analogous to Microsoft's or Google's or Facebook's.

Be conscious of your goal. It is to get to the next level, ideally a face-to-face meeting. You need to sell enough to get there but no more. Don't over-educate or over-sell. It will lead to a wordy and heavy exec summary. Avoid the common hyperbole such as "this is a $56B market" or "we have no competition." Statements like these only make you look immature.

Be explicit about your team building goals. This advice is especially important for teams with fewer "done it before" execs. I think it would be fair to put MIT $100K team in this broad category. As a judge in previous years, I've been disappointed to see founding teams with too many chiefs (CEO, CFO, CTO, CSO, CMO, CPO, etc.) none of whom would be hired in those positions if the funded company were to do an executive search. VCs want to know that the founding team knows its limitations.

Tune your exec summaries for the investors you are talking to. Who said you should have only one version of the exec summary? Typically, a very early stage startup has a lot of options and its future will in some way be influenced by its investors. How you pitch to an angel group for a $500K seed investment is not how you'd pitch a VC with a $1B fund. The angel group and the large VC have different business models. They want to invest in different companies. In some cases, your company could be a fit for both, as long as you are flexible and open to the options, but your story needs to be different.

Under-promise and over-deliver. Do not make big claims in your exec summary, especially about the near future, unless you are absolutely certain you can deliver on them. For example, don't say you'll have a distribution deal with Large Vendor X negotiated in the next 90 days if the probability is less than 90%. You'll likely be talking to VCs for many weeks or months. Your credibility depends on making promises and keeping them.

Pitching 101: The Competitive Matrix

by Eric Wiesen

In the last installation of Pitching 101 I applauded a company who had applied the best practice of doing research before pitching investors. Today's chapter is about a practice of which I'm less fond.

As background, it goes without saying that we're going to want to talk about competition in your space. We're going to want to have this discussion first because we're going to need to know whom you're dealing with as a competitive set, but equally importantly, we need to get a sense of how you think about competition and about your competitors.

To this point, it has somehow become commonplace to include a "Competitive Matrix" slide that looks like this:

On the one hand, we get what you're trying to say - you're doing something very differentiated and very special. And in a sense, you're trying to make good on the general investor worldview that if you're going to compete with incumbents, your offering needs to be not just incrementally superior to them but a significant step forward.

But … come on. We know and you know that in only very rare cases is this slide even remotely accurate. In very rare cases can you legitimately cluster all your competitors, large and small, into the lower-left corner of the competitive matrix slide.

Most investors essentially ignore this slide except for the names of the competitors, about whom they'll do their own research. At best, it's a non-factor. But it also looks like you are hiding a scary competitive set of threats through chest-beating hyperbole. And at worst, it signals to investors that you don't actually understand your competitive challenges. And that's not something you want to communicate.

My suggestion for best practice is a willingness to have a frank conversation with investors about your competition. Below are some good answers I've heard from companies who do this well, answering the competitive question from different angles:

"Yes, XYZ company has raised a lot of money and was a year ahead of us, but they've executed poorly, their technology led them down a dead end, and we have won 10 out of 12 customer wins from them in the last six months, which is the real proof that even though they're the big name, customers are looking for an excuse to leave them".

"Sure, ABC company is the big name in the space, but they invested tremendous resources in building out a big global platform, and we use cloud services for everything we do. Until and unless they scrap everything they've done, we have a major cost structure advantage".

"It's true that Google could come around and crush us, but that's true about almost every B2C web company. We've looked at what they've done in areas around our space, have talked to people at Google, and we're comfortable this is not a high-priority area for them. But you're right, you can never totally control for this."

Ultimately, if you are really scared to give investors the true answer, and if that true answer is that you're doing something incrementally better than an entrenched incumbent (or incumbents) or something without a lot of differentiation other than "we're smarter and will do a better job", you may be in the wrong business. Investors are going to figure that out whether you tell them upfront or not, but you're much more likely to get constructive feedback and form a good relationship with investors if you play it straight with regard to competition.

Check Your VC's Pulse

By Brad Feld  

With the U.S. economy bouncing around chaotically, VC-backed companies are in a unique position: Until they become cash-flow positive, they're dependent on the support of their investors for additional financing. 

I recently heard some remarkable rumors and innuendos about how software and internet investing was finished as the VC firms stopped investing. I expect these assertions were triggered by the now infamous "RIP: Good Times" presentation from Sequoia Capital in October. A number of people I've talked to concluded that a bunch of VC firms were going to simply go out of business.

I heard this type of talk a mere seven years ago. After the dotcom bubble popped, there were endless predictions of doom for the software/internet industry and the venture capitalists that supported it. The broader predictions of VC extinction didn't happen, and my firm made some of its best investments between 2000 and 2004.

As an entrepreneur, you probably don't care as much about the overall VC industry as you care about your VC investors. So while the noise might be intellectually interesting, you're asking, "How does it affect me?"

To find out, ask your venture capitalists these important questions:

• What year (vintage) is your fund? Almost all VC funds are set up as 10-year partnerships that can be extended several years. They usually spend their first three to five years investing in new companies and the balance of the partnership managing those investments.
• Have you raised a new fund since you invested in our company? The long-term health of a VC firm can be measured by how recently it has raised a new fund. Optimally, a VC firm raises a new fund every three to five years, so it's always actively investing in companies.
• When are you planning to raise a new fund? If the answer to this question is sketchy, pay attention. It usually takes at least a year to raise a new fund unless your VC firm is well-established with a long history.

As a key business partner, your VC firm should be open and direct with you about these questions. If the firm has raised a new fund since 2004, you probably have nothing to worry about. If its last fund was raised between 2001 and 2003, you should press the firm about its fundraising plans. If its last fund was raised before 2001, you should be mildly concerned, as it may have difficulty raising another fund. While there are no right answers, the level of clarity you get from your investors is important. 

If a VC firm can't or won't raise another fund, it will likely still be in business for many years as it manages its existing portfolio, although its level of activity and involvement will decline as time passes. As with many things in life, the cliché applies: VC firms rarely die--they just fade away.

The Trouble with Options

by Dave Broadwin

Everyone wants "incentive stock options" (as such term is defined in the Internal Revenue Code) as opposed to non-qualified options, because of the potential to capture capital gains tax treatment after the exercise of the incentive stock options and the eventual sale of the underlying stock. The option holder hopes to pay capital gains tax (as opposed to income tax) on the difference between the exercise price of the option and the price at which the underlying stock is eventually sold. So, if you have options to purchase 100,000 shares the Mighty Software Corporation with an exercise price of $.20 per share when Mighty is sold to Microsoft for $2.00 per share, your hope is to realize $180,000 of profit. If you are taxed at the current long term capital gains tax rate of 15% you would pay $27,000 in tax and keep $153,000. Compare this result to paying tax at the highest marginal rate of 35%. $180,000 multiplied by .35 is $63,000. In this scenario, you keep $117,000 (or $36,000 less than if you had paid tax at the capital gains rate).

The dirty little secret of incentive stock options is that the holder must comply with a variety of requirements under the Internal Revenue Code to actually get capital gains treatment. Among these requirements, is a holding period requirement the effect of which is to prevent the option holder from getting capital gains treatment in almost all cases. The holding period requirement is that one must hold the stock obtained upon exercise an incentive stock option for a minimum of one year in order to get capital gains treatment. In fact, you have to hold the option and the stock for a combination of two years, but at least one year has to be after exercise. 

What is wrong with this? Nobody exercises stock options until there is a liquidity event or they are ready to sell the underlying stock. So, when Microsoft closes on the acquisition of Mighty, you will exercise your option and get cash, and you will be taxed at ordinary income rates. Ah you say, what if Mighty goes public? Well, if you exercise and hold for one year, you can get capital gains treatment, but you will be taking a risk that the market price of Mighty stock will decline during that period. Furthermore, most people cash in their options when they have a need for a chunk of cash, such as for a down payment on a new house. They do not exercise and hold.

One thing to consider that can mitigate this problem is to ask for restricted stock or to exercise your options (as soon as they have vested) and start the holding period. In the case of option exercises, you will have to pay the exercise price of $.20 per share (in our example). This means you would be out of pocket $20,000 and you would be taking the risk that the company will never have a liquidity event. In addition, the spread at the time of exercise (the difference between the exercise price and the value of the stock received) is a preference item for purposes of the Alternative Minimum Tax, which means that you end up paying AMT tax for the year of exercise.  In the alternative, you might obtain a grant of restricted stock, file an 83(b) election, take the value of the stock into income in the current year, and start your holding period. In our example, if $.20 is the fair market value of a share, you would have income of $20,000 on which you would pay income tax ($7,000 in our example), and absent a liquidity event, you might never recover this amount. Now, these numbers seem small, but if you are looking at stock with a valuation of $1.00 or some other high number, then the cost of exercising options or paying tax on a grant of restricted stock could be prohibitive. Your individual circumstances will have a significant effect on what will work best for you.

We structure our option plans to accommodate incentive stock options, non-qualified options and restricted stock. While everyone may want an incentive stock option, you should recognize that it is very unlikely that you will get the favorable captial gain tax treatement and think about any  different choices that you might have.

The Unsaid Reason VCs May Not Back You: Resource Efficiency

by Mark Peter Davis

When VCs are asked what their investment criteria are they will list off a number of common considerations: big market size, competitive advantage, a specific geography, a target stage, etc. There is, however, another important consideration which is not often mentioned: the resource efficiency of the company.

The Framework
Resource efficiency refers to how much value can be created through the company with a given amount of resources.

Note that this definition refers to “value”, not revenue. While revenue is often a driver of value, there are other types of value: technology assets, customers, etc. YouTube is a prime example of a company that created substantial value without generating revenue.

Also note, that the definition refers to “resources”, not capital. While the most measurable resource on the market is capital – time, knowledge and other resources are also important considerations. Many of the tech-lite companies on the market today are less capital intensive, but that doesn’t mean that the companies don’t consume substantial resources. The most typical resource consumed is time on the part of management and investors.

Resource Efficiency Framework

Using this framework, there are broadly two types of categories that companies fall into: linear or exponential growers. Linear growers increase the value of the company in proportion to the amount of resources invested in the company. Exponential growers realize increased efficiencies over time – for every additional unit of resource invested in the company the value increases more than it did for the prior unit of resource. Simply put, in an exponential growth company the next million dollars of investment or unit of time creates more value than the prior million dollars or unit of time.

In general linear growth companies sell a physical good or a labor dependent service where one more employee generates a proportional increase in revenue. Consumer product, consulting, investment banking, customer service, recruiting and others are some of the obvious types of linear growth companies. It is worth noting, however, that while these linear growth businesses do realize increased efficiency over time, especially as back-office functions are scaled, the effects of their scale is less robust than in other companies.

Exponential growth companies often have a single asset that can be leveraged across an increasing number of customers. The most obvious example is a web-based service. In general the site only has to be built once, but can service an increasing number of customers.

DOWN ROUNDS AND VALUATION

by Dr. Larry Marshall

There is a small company here that has just relocated to be in Silicon Valley and it has a Term Sheet from a VC who effectively underwrote its financing on the presumption that the VCs would be able to secure a co-investor here in the Valley. The VCs now want to renege on the term sheet and change the raise and pre-$. Sounds like another "vulture capital" story doesn't it? Well perhaps ... or perhaps not.

So one of the worst things that can happen to a company and the investors, is a "down round." It's one of the main reasons VCs push back on valuations. If the company cannot create enough value on a funding round to justify a larger pre-$ on the next round, everyone is in serious trouble. The VCs hate down rounds, not because it changes their ownership (this is a common misconception among entrepreneurs)--the VCs are naturally trying to own as much of the company as they reasonably can, but there are simple and reasonable limits to this, which if they are ignored by the VCs will be corrected by the market anyway.

In a down round, what the previous round holders lose they make up for on the next round--net net, they typically end up at the same place--no big deal. But the founders, ouch! The team is usually okay because the new investors boost the ESOP to incentivize the team, taking that boost out of the founders and the previous investors. What VCs hate about down rounds is having to tell their limited partners that they effectively lost money--the value they are carrying the investment at has gone down, and this is never a fun conversation ;-(

Now from the VC side, the company has missed some required accomplishments in order to attract a co-investor, like the new version of its product, which can be sold here vs. the old one which can't, the building of a team, and others--but as in most cases, communication and misunderstanding are largely behind the issues, and the end result is ... do the VCs stick to the original deal which will almost certainly result in a down round, or do they work with the company to restructure? The company on the other hand, does it wheel out the lawyers and try to force the original deal, or does it have conversation(s)?

Back to my recurring theme of team, team, team--once the VCs have funded, even partially, they are in the same boat as the entrepreneurs, generally they don't propose deal changes that don't make sense from a shareholder's perspective. For VCs deal terms get renegotiated by teams frequently--e.g., management carve out in acquisition overtakes liquidation preference, anti-dilution, and earn out rarely finds its way back to the investors but ends up in the pockets of the team, etc….

It will be interesting to revisit this case, and the urban myths it creates over the next several months, because it could go either way. Wheeling out the lawyers rarely works, because (in my experience) the only ones that win are the lawyers and litigation makes you a poor investment risk in the future regardless of whether you are successful or not. Unfortunately, the reality of most situations is that both sides are right, and ironically wrong at the same time. If the entrepreneurs cave, are they opening the door for future renegotiation? Should they argue the case of whether they delivered or not, whether it was miscommunication or not?

At the end of the day its largely irrelevant--it is what it is, deal with it! I suspect the right solution is for everyone to compromise--for the VCs to put up more cash to give the company more runway so it can have the best possible chance of delivering the up round needed (which goes against the post money problem by making it even higher), but at the same time give the VCs a claw back provision or warrants or some other mechanism to turn a Down Round (if there is one) into a flat round, so that everyone wins. For sure, while everyone is arguing the "he said she said," the chances of the company hitting its milestones are getting smaller, and that’s in nobody's interest!

How sub-prime VC stings twice

by Georges van Hoegaerden

Sub-prime Venture Capital is akin to the sub-prime lending market and we predict the bottom will soon fall out of sub-prime VC too, spurred by the fear of economic pressure and the depressing returns of expiring post 911 venture funds.

Just like working for Carnival Cruise looks glamorous but is not the way to explore the world, unsuspecting young entrepreneurs who fall for sub-prime investors will soon find out that building those technologies has all the glamour but few of the rewards associated with innovation. Regardless, many chasing the mighty dollar will fall for it.

Here is how entrepreneurs can recognize a sting from subprime VC:

Step 1: We like the idea, but before we invest please finish the product some more, then come back
Step 2: 6 Months later, you finished the product. Great, now prove it works by getting 100,000 daily users, then come back
Step 3: Fantastic, now we'll take 60% of your company for $1M
Ouch, that hurts.

Here is why sub-prime tactics hurt our innovative ecosystem, just like sub-prime lendings have a negative effect on the housing market as a whole.

ad 1/ Technology development is the investment risk we understand quite well, timely applicability to a market is the real issue. So, proving that the entrepreneur can build a product can easily be derived from the entrepreneur's vision, knowledge and credentials in that space, juiced up with some kitchen-sink prototyping. On top of that a 6-month self-funded development timeframe with 2-3 developers can hardly yield a sustainable competitive advantage anyway, so R&D development proves nothing.

ad 2/ In many cases it is impossible to land 100,000 users before you have a critical mass of product capabilities. That critical mass comes from an R&D investment that generates substantial differentiation, and rarely from tip-toeing into the marketplace. Marketplaces, for example, only grow when a critical mass of both supply and demand are lured in and participate, which often requires a bolstering of technology to support all constituents, rather than minimizing it. Already, too many technology products enter the market unfinished as a result of underfunding and yield false negatives.

ad 3/ Control and valuation of the company are a direct indication of the future success of an early-stage company. The vast majority of technology success stories are derived from retained majority control by its founders and CEO (Facebook, Google, Twitter, eBay etc). Investors are terrible operators (no surprise given their background and experience) and should not want to own a majority stake in their companies, simply out of self-preservation.

Additionally, the danger of these tactics deployed by sub-prime investors (many of the large venture funds deploy fashionable sub-prime tactics too) is that it marginalizes technology innovation and provides a very unstable breeding ground for the fund performance as well:

a/ Venture Capital is meant to stimulate the high-risk / high-yield asset class as defined by its Limited Partners, the sub-prime strategy described here (anecdotally) serves nothing more than low-risk / low-yield segment of the technology asset class.

b/ No fund larger than $100 Million can support the management attention needed to spur these tiny injections along. As a result sub-prime investors just constricted what they thought of interesting innovation with too little time and too little money to provide critical market entry.

c/ Very few low cost entry deals yield the disruption that prices out favorably to makes any dent in the return of the fund as a whole. Venture funds need few big returns to keep LPs coming back for more.

The only early-stage investors who may be able to turn sub-prime deals into prime are the investors who:
- have proven to be successful operators themselves
- support the vision before the product is there
- have great syndicates to support the full runway of a disruptive market entry going forward.

Investors that can turn sub-prime into prime can be counted on one, maybe two hands. People like Marc Andreessen with his new AZ (Andreessen-Horowitz) fund come to mind. But entrepreneurs who are not stung by these visionary investors may just as well hop on that cruise ship and enjoy life some more.

The economics of big technology plays have not suddenly changed, the cost of developing technology may have declined slightly but simultaneously competition has increased exponentially. So, we prefer to focus on plays that are high-risk and high-yield simply because only they create the disruptive innovation that can keep VC firms in business.
The challenge for early-stage entrepreneurs remains the same, to create unbridled and disruptive innovation that finds only one investor that believes in it. If many more do, believe me, the technology is just not disruptive enough. So, be ready for some controversy.

Finding the right investor, amongst 700+ firms in the U.S. requires that entrepreneurs understand and can read the dating game. If they don't, we'll be happy to help. But get to us before you've been stung 217 times.