3 stages before investment

by Dick Costolo

A reader writes (or I should say "wrote", as this came in almost a month ago):

"My product is almost ready to go, it will make money in the early going as the model is pretty straightforward, but we need to raise money in order to scale the business. There are three of us right now. How much money should we raise in an A round, how long should we expect that to last, how long will investors expect it to last, and so on and so forth?"

Well, the obvious answer is that it all depends, but on the grounds most people would find that unhelpful, I’ll pretend it doesn't all depend and address a few specifics.

First, let's address the hypothesis that the company will make money soon after launch. Irrespective of whether we're talking about profits or just top-line revenue here, I would caution that it almost always takes longer to ramp your top-line than you think it will. Everybody walks into a venture pitch with their three year financial projections that have a lousy first year, a strong second year, and a monster third year. The truth is that even most ultimately successful tech startups have a slow first year, a slow second year, and then you get your spectrum of third year results ranging from really-taking-off to continued-doldrums. It just always takes longer than you think to launch, grow, ramp sales, close deals, etc.

That's a good segue for the rest of the question – how much to raise and how long should you expect the money to last. Everybody has different thoughts on this subject, but I would say there are two helpful guidelines. First, raise enough money to last about a year or a good six months after your next big milestone. Some people like to say "raise just enough to get you to and then you will be able to do a B round at a bigger valuation", etc., but you want to give yourself some reasonable stretch of time to be product and strategy focused after the A round before you have to hit the road again to raise more money. It's no fun having to think about starting to raise money again only a few weeks on the heels of closing the previous round. Second, you always need more money than you think you need, especially if this is your first startup. You can have a nice detailed spreadsheet that accurately reflects market salaries, rent, and more, but you will still require more money than you think.

Those of you reading Marc Andreessen's excellent blog will note that my advice is out of step with his advice to "raise as much as you can". Now, Marc has co-founded a couple of hugely successful public companies and has invested in countless others and his latest post has the words "my company" and "billion dollars" in the title, so if you find yourself wondering whether you should put more credence in his words or mine, I will repeatedly point you in his direction (you start one monster company, maybe you were lucky, maybe you were in the right place at the right time. You found two billion dollar companies? You officially know what the hell you are doing. Nobody is that lucky.) Nonetheless, I'll disagree with him on the funding amount question, especially for first time entrepreneurs, for a couple of reasons. Now, if you're Marc or somebody like him, I don't disagree that you should raise as much as you can on your first institutional round. Marc isn’t getting involved in a new company hoping he can eventually exit for $60 million dollars, that's just not an interesting scale to somebody that's created a couple companies worth well over a billion dollars. I also realize the astute first time entrepreneur in my audience is thinking “but I'm not looking to sell my company for 60 million either! My idea is huge, and I think it’s a home run and I want to go for it!” That’s obviously the right attitude, and it’s an attitude you will need, and it’s the attitude that your investors will want to see from you. Nonetheless, I don’t think it makes sense for most entrepreneurs to raise big A rounds, because you don’t want to price yourself out of interesting opportunities in the first year or two. By raising too much money, you force your hand on the kind of company that you have to build, whether you want to or not. Let’s look at two scenarios for a very promising startup with technology that may be of strategic interest to several profitable public companies (note to self - write a future post about the importance of not planning for or even thinking about exits like this):

Scenario 1: You raise 1 on 3 pre in an A round, so you’ve sold 25 percent of your company for a million bucks and you have a co-founder with whom you’ve evenly split equity, and you have a 15 percent options pool from which you quickly allocate 5 percent that fully accelerates on a change of control.

Scenario 2: You raise 10 on 40 pre in an A round, so you’ve sold 20 percent of your company for 10 million and you have a cofounder with whom you’ve evenly split equity and you have a 15 percent options pool from which you quickly allocate 1 percent that fully accelerates on change of control.

Six months into your post-A round, you are approached by Awesome Corp and they would like to buy your company for $20 million. Company that pursued Scenario 1 is in the following situation: founders each own 35% of the company. Founders each make $7 million dollars, investor takes out $5 million for a speedy 4x, and the options holders pull out the remaining million dollars. Ignoring taxes for the moment (much like ignoring friction in freshman physics, this is impossible and problematic, but humor me), this is a nice outcome for everybody. Your investors, it might surprise you, won’t be particularly thrilled, because it’s important to keep in mind that they are not in this business for IRR, they are in it for multiples, and a 4x on a fantastic new company with only $1 million invested is not that exciting. Still, at a 4x after six months, they’re probably not going to block the deal. It’s nice to make 400% returns in a short period of time. Now let’s look at the same offer if the company pursued Scenario 2. Ruh-roh. Do you think our founders are going to be cashing in any Awesome shares anytime soon? No, they are not.

But wait, don’t the founders actually own MORE of the company? Won’t they actually make MORE money individually? Why yes, they do own more of the company, but that was just a little trick I played on you. It makes no difference, because the investors, who have put up $10 million dollars, stand to take out $4 million dollars, and investors have this thing where their LP’s get very mad at them if they invest 10 and get 4 back after only 6 months. If our founders go look at their Articles of Incorporation and the term sheet they undoubtedly signed from the investors when they raised this round, they will see that the investors have blocking/veto rights, and the investors will veto this deal in a heartbeat. More likely, the company would never even get to this point, because the people at Awesome are going to look at the company cap table and realize that this deal doesn’t get done. The founders have set themselves on a course in which the only two possible outcomes are home run or failure.

I did my math above in 14 seconds and have no time for proofreading these days, so mea culpa if my percentages are off but you get the picture.

I would suggest that there are some very nice middle ground areas for the entrepreneur that hasn’t previously made a bundle of money, and many of these middle ground areas are still large enough to provide venture returns to institutional investors. By overcapitalizing your company, however, you can put yourself in situations where a potentially huge personal outcome is made impossible.

Fine. Let’s say you are only interested in huge home run or failure. The middle ground is for suckers, you say, and you are no sucker. You are an all or nothing hombre. Shouldn’t you now raise as much as you can in an A round? After all, you are in this to rock the world and make a huge difference and build the best damned company you can build.

No, I still don’t think you should raise as much as you can, for several reasons, but I’ll just highlight the most important. You will spend what you raise. If you raise $10 million, you will quickly ramp up to a burn rate of $800k a month, because the investors don’t want their money to sit in a bank account earning interest with 36 months of runway while you hire employees 2 and 3. The amount of money you raise sets you off on a course at a specific pace. Your board will want to know why you aren’t deploying capital. You will hire a marketing team because you can afford to hire a marketing team. You will hire a vp of sales before the product is ready because you can afford to hire a VP of sales. Companies that raise $10 million dollar A rounds don’t raise $5 million dollar B rounds, they raise $30 million dollar B rounds. If you have not accurately predicted how quickly you can grow the top line, you will quickly find that the cap table has gotten away from you, and you will have less flexibility to build the company the way you might like to if the market zigs when you thought it would zag. You want to give yourself the flexibility and room to react to market forces so that you can build the best company possible.

Final notes: It’s possible that by “raise as much as you can”, Marc is implying that the two first time cofounders with an idea that might sell for 20 million in six months will only be able to raise a million bucks. That’s fair enough and probably true. Still, even though I’m putting words in his mouth, I’d just caution that investors will always want to put more capital to work in a great company. Second, I hope that this post isn’t interpreted as “you should raise as little capital as possible” or “make sure you don’t invest too aggressively in your company”. Undercapitalizing your company is just as dangerous as overcapitalizing your company, with the added tragedy that undercapitalized companies sometimes miss out on their opportunities to be the gorilla in a huge market. You want to be capital efficient while making sure you are funding the growth of the business. If customer wins are accelerating and revenue is up 100% quarter to quarter, don’t try to get too cute about finessing growth on the cost side….ramp into growth and hire ahead of demand.  

Here's why we think venture capitalists and other investment professionals should pay income tax rates on "carried" profits, as proposed by legislation in Washington.

The lower capital gains tax rate of 15 percent, which VCs are now paying, is meant to encourage people to take risks, to investment money long-term with a business in hopes of generating superior profits. Encouraging such risks is good for all of us, because it fuels economic expansion and job growth too.

However, the carry doesn't fall into that category of risk-taking. We've come to our conclusion after consulting with Kate Mitchell (see our previous post), a venture capitalist who represents the National Venture Capital Association in Washington hearings, who opposes the tax change. We've also talked at length with the tax attorney Mary Kuusisto, of law-firm Proskauer Rose and who is advising the NVCA.

Mitchell, you'll recall, argued she has invested her own life's savings into her endeavor as a venture capitalist. She placed her hard-gained cash into her venture fund, alongside the cash invested in by other institutional investors (folks like Credit Suisse, Liberty Mutual, Pantheon Ventures), and argued it was tied up for ten years before she saw any returns. That's highly risky.

However, the personal money she invests, it turns out, will still get capital gains treatment. The legislation being considering in Washington wouldn't touch her portion. Rather, it would change the tax treatment on returns from a very different pile of money — that money given to her invest by the other institutional investors (Credit Suisse et al).

Under the contract with these investors, Mitchell and her other general partners at Scale Venture Partners get 20 percent of the profits produced by these dollars. The profits are called "carry." By giving the Mitchell and her other partners at Scale this money to invest, they're asking her to perform a service. They're paying her fees, too, in order to render that service — in the millions of dollars. In other words, this part of the bargain is not a risky activity for Mitchell to engage in, even if she argues differently. In our view, then, it is no different from the job performed by the elevator man, a janitor or cab driver, all of whom must pay income tax.

Let's take an example: Assume, for sake of argument that Mitchell invests $4 million of her own money alongside the money of other investors in a $400 million fund. Assume she is the only general partner. The institutional investors (Credit Suisse, et al.) invest $396 million, and agree she will lay claim to 20 percent of the fund's profits for managing their money.

A. The good scenario.

Let's assume things work out great at the firm. The firm makes makes all its money back, and then an additional 50 percent, or $200 million. First, Mitchell gets her own $4 million back, plus $1.6 million as her portion of rightful profits (as an investor, remember, she gets 80 percent of the $2 million profit on her money). Here, capital gains works as it should. It gave her a tax break to encourage her to take risks, and she walked away with $1.6 million more, and that would be taxed at 15 percent, leaving her with $1.36 million after taxes. Moreover, as general partner, she claims 20 percent of the $200 million in profits that are made on the rest of the $400 million. That's $40 million before taxes. That's the carry that Congress is thinking about taxing. If the bill passes, instead of walking away with $34 million, she'd walk away with only $26.

[Note: She'd have paid income tax on the 2 percent fee she gets in management fees before she realized the carry. However, they'll have been factored out of the profits for determining the carry amount, so this is not an extra tax. The VC lobby does have a quibble, however. The fees are not deductible, resulting in a slightly higher effective tax rate on the carry (yes, this gets complicated). But the legislation won't change any of this, or least that's the assumption, so this is really just a footnote.]

B. The bad scenario

Let's assume the negative scenario. Let's argue that the fund gets an early success from one of the companies it invests in, say $100 million in IPO in returns a year after investing only $10 million on the company. Mitchell would have to pay a 15 federal tax on her 20 percent portion ($18 million) of the profit of $90 million she locks into. So she pays $2.7 million in federal taxes. However, assume that the firm later losses total 90 million on its other investments. Mitchell deserves no profits from carry, because the firm hasn't made any money. So she must give her $18 million back to the firm, setting her back to square one. But she still has paid the $2.7 million, so at the end of it all, she is $2.7 million in the hole. There's may be no tax relief on that loss, she says, because losses can only be offset by gains in the future. Mitchell argues this potential loss means she's taking risk, because of her overall ownership in the firm, justifying she deserves capital gains treatment. However, we disagree with that argument because she didn't need to lock into that profit early on by selling. That's a right afforded her by an agreement with her limited partners.

Final note about the WSJ's math — The WSJ has a piece estimating the total proceeds produced by the tax would be "just" $2 billion, noting it is tiny when compared to the nation's overall budget. However, we'd argue that is a significant amount, and should be taken seriously given that we've got huge budget deficits.

Target Post Money Valuations and Capital Structure

by Will Price

Evaluating an Exit in Today's Capital Markets

VCs and Randomness

by STU PHILLIPS

By Dan M. Mahoney

We are in a hostile economic storm. Business models that were the rage a year ago are now inherently unsound, business plans are being re-evaluated, and valuations have fallen. As venture capital-backed companies navigate this storm, the path to future funding is often blocked by an obstacle known as the "down round."

A financing becomes a down round when an investor places a lower valuation on a company than in a previous round. For example, take Fizzle Out Technologies Inc., a start-up with promising technology that raised capital in its infancy by selling common stock to various friends, colleagues and angel investors. Fizzle also managed to attract the interest of a few venture capital firms. In its first round of institutional financing, the VCs valued Fizzle at $30 million, often referred to as a "pre-money valuation." They invested $10 million in the company, resulting in a post-money valuation of $40 million.

One year later, Fizzle is in need of more money. Unfortunately, the $40 million post-money valuation enjoyed by Fizzle after the first round has eroded. The second-round investors have placed a pre-money valuation of $20 million on the company.

The down round has many consequences, the effect of which can leave an indelible scar on a young company. These consequences involve the exercise of contractual rights held by most VCs and legal concerns imposed at both the federal and state level. While a down round is a disconcerting experience, a defensive position can be created, allowing a company and its board to successfully cope with its effects.

Dilution of a stockholder's ownership is the most debilitating result of a down round. Ideally, as a company progresses and its valuations increase, it will raise money by selling fewer and fewer shares in each successive round. In a down round, however, the company must sell more shares than in a previous round to get the same amount of cash. This erodes the current stockholders' equity stake.

VCs, however, have an advantage over the common stockholders - a price-based anti-dilution provision - that serves as protection against dilution. This protective mechanism is triggered by a down round and increases the amount of common stock the VC will receive on conversion of his or her preferred stock.

To explain further, it is helpful to examine the conversion feature of a typical preferred stock. The classic conversion formula follows:

original share price   conversion price

X

shares of preferred stock to be converted

=

shares of common stock to be received on conversion

At the outset, the "conversion price" will mirror the "original share price." Under this formula, dividing the original share price by the conversion price would produce a quotient of 1, resulting in a 1-for-1 conversion of preferred stock to common stock. Accordingly, as the conversion price is reduced, the number of common shares received on conversion increases.

For example, if Fizzle, whose first-round investors negotiated anti-dilution protection, sold preferred stock in its first round at $2 per share, the conversion price and the original share price would both begin as 2. When Fizzle completes its second round of financing at a lower valuation - say $1 per share - the anti-dilution mechanism is triggered, reducing the conversion price. That increases the number of shares of common stock that the investor will receive on conversion. This in turn increases the dilution already caused by the down round.

The reality of most down rounds involves a concession by the VCs of some or all of their anti-dilution rights. This requires the company to obtain a waiver from each holder of these rights and, in some instances, may even necessitate a formal amendment to the company's charter. Without this concession, the prospects for completing a deal are often bleak. Additionally, as the employees and founders are crammed down, the incentives to produce fade, leading to internal upheaval and diminishing returns on the VC's anti-dilution protection.

Nevertheless, in the venture capital game, forewarned is forearmed. When negotiating its initial financing rounds, a company should be aware of the different types of anti-dilution provisions — the preferable "weighted-average" and the more punitive "full-ratchet." Weighted-average provides a more reasoned approach. It considers the number of shares issued in the dilutive round in proportion to the outstanding capital of the company. A full-ratchet, on the other hand, is less forgiving and is usually an indication that the company had minimal leverage during the negotiating process.

A full-ratchet looks only at the price per share of the dilutive issuance, regardless of the number of shares issued. It then "ratchets" the conversion price down to that price. So, if Fizzle issues shares of its capital stock at $1 per share, under a full-ratchet scenario, the conversion price for the preferred stock issued by Fizzle in its first round at $2 per share would automatically be reduced from 2 to 1. This will be the case regardless of whether Fizzle issues one share or 1 million shares. Accordingly, the first-round investors will receive two shares of common stock for each share of preferred stock they convert, creating significant dilution to the other stockholders:

2  1

(original share price) (conversion price)

= 2 X

shares of preferred stock to be converted

=

shares of common stock to be received on conversion

A weighted-average anti-dilution provision is more forgiving. It reduces the conversion price in proportion to the actual number of shares currently outstanding and issued by the company. If Fizzle, which has 10 million shares of capital stock outstanding, issues 100 shares at $1 per share, this will have an insignificant impact, reducing the conversion price by less than $.01.

If, however, Fizzle issues one million shares at $1, the effect on the conversion and subsequent dilution will be greater. If Fizzle is unable to negotiate a concession on anti-dilution from its current investors, the existence of the weighted-average component will certainly mute the impact relative to a full-ratchet regime.

The upshot is that a company should always try to negotiate a weighted-average anti-dulition provision. However, depending on the circumstances, the VC may push for a full-ratchet. Often, the alternative is a hybrid. For example, Fizzle might try to renegotiate full-ratchet protection down to a specified level and weighted-average thereafter.

Drilling down further, if a company is able to avoid a complete full-ratchet, the weighted-average component should be "broad-based." In a broad-based weighted-average formula, the dilutive issuance is weighted against the fully diluted capital stock of the company (that is, assuming conversion of all preferred stock, options, warrants, etc.), as opposed to a "narrow-based" weighted-average formula, which compares the dilutive issuance against only the common stock then outstanding. Put another way, a broad-based approach compares a dilutive issuance to a larger pie than does a narrow-based approach, making the issuance appear less significant.

Regardless of the type of provision the VC receives, the company should insist on carve-outs (exemptions) from anti-dilution for certain issuances. These carve-outs allow the company to make potentially dilutive issuances, such as options to employees, without triggering the anti-dilution provision. Companies that fail to obtain these exemptions often find themselves explaining away otherwise innocuous issuances, such as a warrant given to a bank in connection with a credit facility. The company's securities lawyer should carefully analyze the capital structure of the client to determine carve-outs appropriate for the company.

Additionally, if a company has any leverage, it can reduce the impact of an anti-dilution provision by negotiating a "pay-to-play" provision and performance adjustments. Under a pay-to-play approach, in order for a VC to initiate its anti-dilution protection, the VC must participate in the dilutive financing at its pro rata allocation. This may also be referred to as the "put-up-or-shut-up" clause since the VC must demonstrate commitment to the company before receiving the benefit of anti-dulition.

A performance adjustment allows the company to recoup its loss of ownership resulting from a down round as the company meets predetermined targets. The different permutations for crafting a performance adjustment are as varied as the imagination of the securities lawyer drafting them. For example, Fizzle might negotiate a staggered increase to the conversion price based on achieving certain sales figures over the next few quarters.

The VC typically wears two hats - stockholder and director - creating fertile ground for a conflict of interest. The role of director involves fiduciary duties that often run counter to the VC's obligations to his or her fund's investors. This conflict of interest is magnified by an inside down round, where the existing VCs/directors, as participants in the financing, establish the share price, as well as other favorable terms. This often leads to accusations of self-dealing on the part of the VC/director. To avoid this volatile issue, the company's board of directors should create a committee of independent and disinterested directors to evaluate the proposed terms of the down round.

Alternatively, the company could obtain majority approval from the disinterested directors or stockholders after full disclosure of all the material facts surrounding the transaction. Further, the company should establish a valuation for the round through an independent source. A valuation established by an independent third party creates an aura of fairness. Ideally, this would be an investment banker who has no financial interest in the company. But, given the financial condition of most start-ups, it will probably be an outside investor.

The use of a third party in a down round, however, is not a panacea for exposure to liability resulting from a breach of fiduciary duty. A cautious, almost paranoid, approach should be taken when faced with a down round, particularly an inside down round.

Toward that end, a company involved in a down round financing should strongly consider making a rights offering to all stockholders, including founders and employees. In the context of a private equity financing, a rights offering is an offer by a company to certain individuals for the right to purchase shares of stock in the company's pending equity financing. This provides stockholders, who would otherwise be precluded from participating in the round and thereby suffer excessive dilution, the opportunity to maintain their equity stake or, at least, minimize the dilutive impact. Many lawyers will not consider a rights offering unless the down round is strictly by insiders. However, in any down round where existing stockholders are likely to be diluted and there is a risk that the directors will be accused of self-dealing, it is an option worth considering.

A rights offering, however, raises concerns of its own. The federal securities laws prohibit the offer or sale of unregistered securities. While the Securities and Exchange Commission has provided certain exemptions from this registration requirement, these exemptions contain very specific guidelines that create logistical difficulties for a company making a rights offering to every stockholder of record.

Regulation D (Rules 501-508) of the Securities Act of 1933, the SEC's safe harbor exemption from registration, requires the company to provide detailed disclosure information (including audited financials) to any offeree who is not an "accredited" investor. An accredited investor is, for simplicity's sake, an officer or director of the company, and/or a person with a net worth of $1 million, and/or a person who makes at least $200,000 per year individually or $300,000 with a spouse.

Additionally, while Regulation D allows sales to an unlimited number of accredited investors, it limits sales to 35 nonaccredited investors. For companies with a significant number of nonaccredited employees, a wholesale rights offering may be impractical.

To fortify its protection against liability, a company and its board should be cautious of what is put in writing. Board minutes should not be a detailed dissertation of what was discussed at the board meeting. Instead, the minutes should contain a brief synopsis of the meeting, documenting that alternatives were considered and creating a record in support of the final valuation. In summary, the outcome should be documented without superfluous detail.

Finally, a company should review the indemnification provisions contained in its bylaws or charter, as well as its D&O insurance coverage, to insure that its officers and directors are adequately covered. While typical corporate law prohibits indemnification where self-dealing is involved, the disinterested directors who are approving the transaction should be confident in the fact that their liability exposure is limited.

It is difficult to predict when the economic storm will dissipate. Until then, we will continue to feel its residual effects. Each company's situation will be unique, requiring forethought and prudence. However, applying the strategies described above will help a company and its advisers create a bulwark against the potential ruin of the down round.