Murphy's Law and the Convertible Note

From Venture Capital Brazil

In the US, we often quote something called Murphy's Law, which states, "That which can go wrong, will go wrong." I believe that the more VC investing someone has done, the more they come to believe in the universal applicability of Mr. Murphy's code. Just because things will go wrong, however, doesn't mean a startup won't succeed, it just means its going to be a lot harder than anyone can anticipate.

That's why entrepreneurs that have track records of success are so valuable to investors. They have proven that they can overcome the dozens of unexpected challenges that inevitably arise when starting a business.

It also points out why it's so important to invest in an industry in which the tide is rising. Often times, just being in an industry at a time of high growth can itself overcome many of the setbacks startups face.

Entrepreneurs, on the other hand, tend to flip Murphy's law on its head. That which can go right, will go right. It's not a bad outlook and, in fact, unrelenting (but not delusional) optimism is required to be a successful entrepreneur.

These two different outlooks, however, lead to one of the most common and difficult issues investors and entrepreneurs face: what is the valuation of an early-stage company?

Entrepreneurs focus on the potential upside to their business (otherwise they wouldn't bother starting it). They tend to approach the question of valuation from the point of view of, "We could be the next Google/eBay/Facebook/Twitter (etc.). Given that possibility, we should AT LEAST be valued at $10mm/$20mm/$30mm (etc.)."

Investors, on the other hand, tend to approach the valuation issue with Murphy's Law.

One of the ways to avoid the valuation issue is to use a convertible note for the seed investment. A convertible note is essentially a debt instrument that converts to equity at a discount to the valuation of the NEXT investment round. The theory is that, by the next round of investment, the company will have more of a track record and thus the valuation can be more easily and fairly determined.

For example, assume a seed investor provides $1,000,000 in convertible debt to a startup, with the agreement that the $1mm in debt will convert to equity at a 20% discount to the valuation of the next round.

One year later, the company completes a Series A round at a $10,000,000 pre-money valuation. Concurrent with the transaction, the seed investors convert their $1,000,000 into equity at an $8,000,000 valuation (a 20% discount to the $10,000,000 valuation). So, the seed investors own 12.5% of the company "pre-money", i.e., before the Series A investors put their in their investment.

The convertible note is a common and important tool in angel/seed stage investing in the US; I haven't seen it used yet in Brazil but it could be a useful adaption for use in Brazilian angel groups and seed investing.

Some early-stage VCs dislike convertible notes. Others, like many angel investing groups in the US, use them for every deal that they do.

On the good side, a convertible note avoids the problem of valuation: the newer the company, the less data available to do a meaningful valuation, i.e, the more subjective a valuation becomes and the more room for disagreement between investors and entrepreneurs. A convertible note solves the problem by acting as debt until the next round of institutional capital, whereby it "converts" into equity at a preset discount to the valuation of that round. (The assumption is that, by the time of that institutional round, the company has enough of a track record to enable a relatively accurate valuation.)

The primary case against the convertible note is that it limits the upside of the seed investor. Theoretically, since the seed investor is providing capital at the highest risk, his upside should also have unlimited potential. Yet, when the seed investor uses a convertible note, he necessarily caps his upside by agreeing to convert at a pre-determined discount to the next round.

Let's do some math. (I worry about posts that have a lot of math but, let's face it, the investment business is about return on investment, and calculating return on investment is about math.)

Scenario 1:

The seed investors put in $1MM into Startup X using a convertible note, which will convert to equity at a 20% discount to the valuation at the next round of investment.

A year later, a large VC firm makes a Series A investment in Startup X; they give X a $10MM pre-money valuation and prepare to invest $5MM.

Prior to completion of the Series A investment (as part of the Series A process, really), the seed investors convert their $1MM in debt into equity at an $8MM valuation (20% discount to $10MM). Thus, they own 12.5% of the company before the $5MM Series A investment.

12.5% of $10MM = $1.25MM, so, on paper, the $1MM seed investment has appreciated 25% in one year. Not bad.

After the $5MM Series A comes in, the seed investors still have an investment worth $1.25MM but they have been diluted down to 8.3% of the company.

As I said, not bad.

Scenario 2:

In this case, assume the seed investors decide to negotiate a valuation with the startup and get 33% of the company in exchange for their $1MM investment (i.e., the negotiated a $2MM pre-money valuation for Startup X, $3MM post-money).

A year later, the exact same Series A as in Scenario 1 takes place.

Since the Series A investors value the company at $10MM pre-money and the seed investors own 33% of the company, the seedf investors' stake is worth $3.33MM.

After the $5MM Series A investment, the seed investors own 22% of the company, (almost 3x what they own in the convertible note example).

In sum, by negotiating a valuation for their investment, rather than deferring it to the next round, the seed investors increased the value of their investment (on paper) and their ownership percentage by 300%.

Scenario 3:

Let's take another example, which is more interesting because it shows that, the more successful the startup up is, the more crushed the convertible note investors can be.

Assume the same scenario as example #1 – the seed investors use a convertible note – but this time startup does extremely well after the investment.

Instead of a $10MM pre-money valuation, the Series A investors give the company a $50MM pre-money valuation and decide to invest $15MM. Great! The seed investors scored a grand slam!!

Not really – let's do the math:

The convertible notes converts at $40MM, a 20% discount to $50mm. Their investment is still worth $1.25MM – a good paper return – but they only own 2.5% of the company. After the $15MM investment, they only own 1.9% of the company.

Is it really fair that the seed investors provided $1MM of high-risk capital to get the company to a $65mm valuation and yet they only have stock worth $1.25MM?

If they had negotiated for a third of the company upon investment, Scenario 2, they would now own 25% of the company after the Series A investment and their stake would be worth $16.5MM!!!

There are some other critical things to consider in the debate over convertible notes – whether the seed investors receive preferred or common shares upon conversion, what happens if the Series A is a "down round", what happens if there is no Series A, etc. — but this is already a long post so we'll get to it in a later post.

Does Startup Location Matter?

by todd vernon

Location with a capital L matters. Anyone who has started a tech company in Colorado will likely tell you that in some ways you will be handicapped a bit by your location. Of course there are advantages to starting something in Colorado, Boulder specifically, but I think anyone who would say it's no different is kidding themselves. Sometimes it's just better to be where the action is and the action is in the Valley.

I had a meeting a few weeks back that got me thinking about location with a small L however. I was visiting a startup whose office was in a neighboring community in a light industrial park. I have several friends who match that description so if you're reading this, you have a startup in a remote industrial park, and you know me - I'm probably NOT talking about you, so don't get bent out of shape.

When I walked into the startups office it was like a morgue. No energy, no light, no excitement, no phone calls, no screaming, no coffee shops, nothing, nothing outside, 90 degree pavement in every direction, someone welding in the "office" next door. I had a nice meeting and when I left I had that shiver you get when you drive through an intersection in your car – look in the rear view mirror and see the horrible twisted carnage of a 3 car collision that you "almost "participated in. The smell of death was in the air and I hated it. The company is dying, they are all alone, and they are on the virtual moon by themselves.

All this got me thinking. Where should your startup be located? I used to be a huge advocate of the cheap office space off in the middle of nowhere. I mean it made sense, you have to be scrappy, don't spend money on the location spend money on the people –right?

When Lijit moved to Boulder over a year ago, it was hard to rationalize (for me). The office space was more expensive, a lot more distractions in town, the parking is expensive. Why would you do that? Now after another year of Lijit under my belt and exposure to Boulder I get it and would never go back to remote model. What changed?

Moving to Boulder has been the best cultural thing we ever did. We are constantly surrounded by smart successful people, with smart successful business that we can and do leverage everyday. These relationships depend on our ability to "capture" these moments a little at a time. Meetings where interactions become scheduled events destroy the entire effect. Today alone I talked with a Lijit board member in the coffee shop, ate lunch with a successful entrepreneur from the Foundry Group offices, talked with one of my investors in the street by the office, and met with the founder of an interactive ad agency and never got in my car. In fact, none of those were planned meetings.

My conclusion is that the closer you can get to smart people, the more likely some of it will rub off on your company, your staff, and yourself.

Who Should Attend Your VC Pitch?

by mark suster

This post is part of my series called, "Pitching a VC" (link here) that covers what to do before, during and after your VC presentations.

In this post I want to cover the topic of which members on your team should attend the first VC meeting.

Let's call this the "screening" meeting since it will almost always have at most 1 partner and sometimes won't even have a partner but instead an associate or principal.

Option 1.  CEO attends on his / her own.  For a first meeting I think you can get away with just the CEO attending.  The argument for just the CEO is that this is a chance for the CEO to build rapport with the partner and 1-on-1 is often the best way to do so.  Obviously the other arguments for just 1 person attending are that the other staff can stay focused on the business and it may be a case where travel is involved so you want to keep costs to a minimum.  Note that if your company has two founders the non-CEO founder could attend provided that this person is commercial and is good with people (as opposed to the deeply technical guy).

Option 2. CEO attends with 1 or more staff. My preferred option is that multiple people attend even the first VC meeting.  VC's invest in teams not individuals.  Even the most talented individuals in the world need great teams surrounding them.  It is rare that you a single person who is excellent commercially, technically, product wise, is a "people person" / great leader, runs good internal admin AND knows how to make money.  So if you have a great team then getting them all involved in the meeting is a great way to show that you have "a deep bench."  If the VC is fielding a  partner then I believe this even more so but if the VC is fielding an associate then you can use your own judgment.

If you bring the full team make sure that you construct the entire storyline in advance so everybody knows how you plan to have the meeting flow.  Who is going to cover which slides, who is going to field which questions, how are you going to answer difficult questions (which you should write down in advance and practice).  Definitely don't "wing it" – have practice sessions to see how each member performs.  Honestly I would say a good 50% of team presentations that I see seem like they really haven't practiced the flow very well amongst team members.

Here are some pointers from things that sometimes don't go well.  Try to avoid the following:

1. Big disagreements in front of the VC – Believe it or not it is not that uncommon where I'll ask a controversial question to see how the team responds and you'll see team members disagreeing on a topic.  I know that it is important within your 4 walls to allow dissent but the VC pitch isn't the time for it.  If somebody answers a question in a way that you think didn't put your best foot forward find a constructive way of adding to the point rather than disagreeing with your team member.  It never looks good if it seems like you're discussing the topic for the first time or you disagree on the answher.  You wouldn't do it in a customer meeting – don't do it in our meeting.  My rule for VC meetings was the same that I had for sales meetings that I would attend with the sales staff – if a tough question comes up and the point person assigned to the topic doesn't answer leave a moment of silence.  This is a queue for the most senior member in the room to pick up the question.  Or the point person can simply say, "why don't I let Mike handle that question."
2. CEO talks over staff – Even more common than an argument is the domineering CEO that talks over his / her staff.  As the CEO you need to pre-agree which questions your team is going to answer and which slides they'll cover.  Practice the questiosn / answers amongst your team members before you get to the VC but when you're at the meeting consider it a "live performance" and live with the results.  Far better that somebody says something in the wrong way than to have a CEO who talks over his staff.
3. Company sends the junior staff – I recently had a very interesting company approach me.  I met with a guy at a conference and he told me about his company.  I loved the idea.  He didn't immediately tell me that he was head of biz dev and not the CEO.  No big deal.  But when it came time for a web conference call (he was from NorCal) and he walked me through the Powerpoint deck I saw the CEO title in his org chart slide and it wasn't him.  Then I was annoyed.  Why wasn't the CEO on the call?  If I'm willing to take my time out of my busy schedule to hear about the company why wasn't the CEO taking the time out of his schedule?  My perception was that they clearly didn't see me as the most important VC they were pitching or how could the CEO not be on the phone?  I said so.  The guy did his best to respond by saying, "I'm leading the fund raising.  It isn't the CEO's forte and he's asked me to handle it."  Wrong.  A large part of being a CEO is the skills to persuade.  Persuade investors to give you money, people to quit their jobs for  company that isn't well funded, business partners to do deals with a company that has a limited track record, journalists to write about the company and customers to pay for products.  If that's not you and you're the CEO ...... think twice about whether you really need a business partner so you can assume the role that you are good at in the company.
4. Bag carriers attend – Another very common mistake is what I call "the bag carrier."  Last year I sat in a meeting with 3 guys who were building an early stage start-up.  Product was completed but no customers yet.  They point to one guy at the start of the meeting and say he's our lead technical guy.  He didn't say a word the entire meeting.  Cheeky guy that I am I finally asked the guy, "why did you come today?"  His response wasn't that polished, which answered my question of why he did no speaking.  My rule: either practice something for this person to cover and accept that they don't present well or leave them at home.
5. Part time staff attends -Last tip.  I have been at several meetings where a guy is running biz dev, finance, sales or whatever and during the meeting I ask him whether he's full time and he responds that he is either: part time, consulting the company or planning to quit his job when the company is funded.  My view is that this person should stay home and not attend the meeting.  If he's the finance guy and you're worried about financial questions – don't.  Study the numbers yourself.  If you can't master the details of the financial projections ask yourself whether you're really supposed to be the CEO.  If for some reason you're convinced that this person must attend for credibility (again, I think it hurts credibility) then please make sure that you proactively point out to the VC that the person isn't full time.  It hurts your credibility immensely if we only find out because we asked the question.

作者: ReachVC 桂曙光

一般说来，即便是最老练的创业者，在其创业生涯中，很难有超过10次的VC融资经验。相反，一个普通的VC，每年都会直接或间接做5-10个项目的投资。所以，在企业融资谈判的时候，VC是有压倒性的优势的，因为他们有更多经验。这种不平等的地位，最常见的结果就是创业者往往错误地只关注估值的问题，而VC却会对一系列条款全盘综合考虑。

几个术语

在VC融资中，最重要也是最受关注的条款，是所谓的投资前估值（Pre-money Valuation），也就是企业在VC投资之前，值多少钱。“投资前估值”通常被简称为“pre-money”或“pre”，老练的创业者和VC讨论的时候，通常是这个样子的：“我给你pre 6个million怎么样？”“我的产品不错、有客户，我想至少应该是pre 8个million!”跟pre对应的是投资后估值（post-money valuation），简称为“post-money”或“post”。post等于pre加上融资额。即：如果一家企业融资400万，pre-money为600万，post-money就是1000万，VC投400万就可以占40%的股份，创始人团队占60%。

还有一个对价格影响很大的条款是期权池（Option Pool）的大小。大部分企业在VC投资之后，都需要为新招募的、或者是以前的管理团队预留一部分期权，这些人通常需要分配期权，发放期权就会稀释其他股东的股份。尽管是预期要招聘这些人，但很多VC会要求在投资之前，企业就把这些期权预留出来，这样，投资之后，VC的股份就不会被预留的期权稀释了。在上面融资400万，pre-money估值600万的例子中（VC简称为“Pre 6投4”），如果VC要求期权池大小为20%，那么企业的股权结构为：VC的股份比例仍然为40%，20%的未分配期权，管理团队及创始人持有40%。换句话说，管理团队及创始人拿出自己20%的股份，未来分配给要将要招聘的和一些以前的团队。

投资后股权价值

前几天，看到Flybridge Partner的合伙人Jeff Bussgang介绍他们搞了一个术语，叫做“promote”，来帮助创业者了解一个项目背后的真实价值，而不是仅仅关注投资前估值或投资后股权比例。Jeff给“promote”的定义是“VC投资后创始人团队的股份比例乘上公司的投资后估值”，Foundry Group的合伙人Feld Brad将之称之为“创始人投资后股权价值（Founders Post-Deal Ownership Value，即FPDOV）”。Jeff和Feld都认为创始人在与VC谈判的时候，要用“Promote”而不是“pre”作为判断的依据。

Jeff举了一个例子，他跟另外一家VC竞争一个项目，他提出的投资方案是“Pre 7投6、20%的期权池”。也就是说，Jeff会给企业700万的pre估值，投600万，占46%的股份。创始人拿出20%股份作为期权池之后，还剩下34%的股份。而他的竞争对手的方案是“Pre 9投6、30%的期权池”，即pre估值为900万，投600万占40%的股份，创始人还剩余30%的股份。最后，创业者选择了Jeff的竞争对手，他给出的理由是：“Jeff，他们的价格更好，我认为公司的价值不止700万美元。”

这个创业者仅仅对比pre-money的大小，就将Jeff给淘汰了，让他很是郁闷。Jeff用“promote”简单分析了他们两家VC的报价：他的“pre 7投6、20%期权池”的方案下，创始人团队将会持有一个post估值1300万公司的34%的股份，换句话说，他们的创业成果是440万的“promote”。在“pre 9投6、30%期权池”的方案下，创始人团队的“Promote”几乎相同：1500万投资后估值的30%，即450万。也就是说，Jeff的方案跟竞争者的没什么差别，只不过pre和期权池小些，而VC投资后创业者手中的股权价值基本相同。

对于这个创始人来说，有一个更好的做法，他可以跟给出pre估值900万的VC说，30%的期权池太多了，我们不需要招聘那么多管理团队。如果能够将期权池降低到15%就很棒了，这样创始人团队的股份比例就增加到45%，“promote”变为675万美元。那么，当然放弃Jeff就是更好的选择了。

退出时的股权价值

Jeff的看法是对的，创业者不应该只关注公司的pre估值，因为pre估值中还包含了期权池，而期权是由董事会控制，发给其他员工的。所以，他建议创业者应该关注“promote”，即VC投资后创始人自己手中的股权价值。

但是把“promote”作为对比不同VC的Term Sheet的一个重要财务指标，是值得商榷的。Polaris Venture Partners的技术顾问Simeon Simeonov提出了一个很重要、但又常常会被忽视的一个原因：公司在做VC融资的时后，谁都没有赚到钱，因为对于早期的VC融资，创始人想套现基本是不可能的。创始人的“promote”不管是大是小，都是空头支票，是对不了现的。所以，他认为真正重要的是在公司实现退出（exit）的时候，创始人的股权价值，而不是Jeff和Feld所说的“投资后股权价值”。

如果一切顺利的话，公司退出时，创始人的股权价值就是“创始人当时的股份比例乘上公司的退出价值”。无论是以IPO还是被并购（M&A）的方式退出，公司的退出价值会受到很多不可预计的因素影响，变动范围很大。但是，退出时的创始人的股权比例却可以在一定程度上进行预测，比如公司在退出前还需要几轮融资、每轮融资稀释多少股份、等。对于一个典型的技术性公司，平均来说创始人在退出前会稀释掉45%-65%的股份。创始人要做的，就是尽量让自己的股权少被稀释一些。

期权池对创始人价值的影响

Simeon还给创始人提出了几条减少股份稀释的手段，其中一条是让创始人从一开始就留出一个大大的期权池，比如Jeff的案例中，他认为30%的期权池更好，创业者放弃Jeff是对的。他认为一个大大的期权池，就可以防止以后期权不够用，还要创始人继续拿出股份，再次被稀释。

仔细想想，这个逻辑好像不对。如果期权都是从创始人这一个锅里往外拿，早拿晚拿有什么区别呢？我的看法刚好相反，我认为期权池越小越好，最好为零，也就是说pre估值里不包含期权池，创始人不要单独为期权池买单。因为既然VC投资进来，跟创始人一起做股东，就没有理由只让创始人自己拿一部分股份做期权池，要拿大家一起拿，期权池在VC投资之后设立。比如前面融资400万，pre-money估值600万（“Pre 6投4”）的例子中，如果期权池大小为20%，那么在设立期权池之前，VC的股份比例为40%，创始人为60%。然后VC和创始人按比例分别拿出8%和12%的股份，凑成20%的期权池，这样，投资后，公司的股权结构是：创始人占48%、VC占32%、期权池20%。

这种期权池的做法对创业者是最有利的，但基本上没有VC会答应，VC的逻辑是要让原始股东出期权。那如果这个逻辑成立的话，对于后续B融资（假定现在是A轮，后续是B轮）的VC来说，A轮的VC和创始人都算原始股东，B轮时的期权池应该由A轮VC和创始人一起出。所以，A轮的VC没有理由把公司直到上市退出期间的所有期权都让创始人来扛。对于创业者来说，最好制定一个A轮到B轮融资期间的管理团队招募和期权激励计划，争取设立一个尽量小的期权池。B轮的时候再设新的期权池，这个时候，A轮VC总该为期权池掏股份了吧。

设立尽量小的期权池还有一个道理，因为对于期权池里没有分配完的期权，是不会还给创始人的，通常是注销掉，这样相当于所有的股东（当然包括VC了）按比例增加了股份比例，换句话说，VC白白捡了便宜。

总结

我建议创始人最好能做一个Excel表格，将公司每轮融资及退出时的股份变化模拟一下，一旦落实到数字，就很容理解VC在价格上的动机了。

创业者在跟VC谈判的时候，应该花点时间搞清楚Term Sheet条款的方方面面。在挑选对比Term Sheet的时候，要通盘考虑，不仅仅是跟价格相关的，比如pre、post、期权池、promote，还有其他一些会影响价格的条款（参与清算权、股利、等）和影响对公司控制的条款（董事会构成、保护条款、等）。（ReachVC 桂曙光）

NINAs and Egg Breakers (Pitching a VC)

by mark suster

VC's keep different titles but the most common that I've come across that are investment professionals are (in ascending order of seniority): analyst, associate, principal and partner.  These are the permanent members of a VC.  Then there is the EIR (entrepreneur in residence) who is usually at a VC for a temporary period of time and other individuals such as venture partners or operating partners.

The process for raising money from a VC is a sales process and as such much of what is taught in enterprise sales can be applied.  My initial career was as a software developer, database designer, product manager and then project manager.  So running a sales process wasn't originally in my professional toolkit.  Some of the best advice came from a senior sales coach in Germany named Kai Krickel who ran a consultancy with the appropriately name of TEDIC (the excuse department is closed).  He had formerly run country operations for a very prominent enterprise sales company called PTC.  I'll cover more sales lessons in a separate section of the blog, but for now some thoughts about people you’ll meet in the VC process:

1. Some people have authority (A)

Somebody with authority is a decision maker.  That's obviously a good starting point in any sales process.  I've always subscribed to the "call high" philosophy of sales where you hope that your initial entry into any organization is the highest level at which you can usefully be introduced.  In a VC firm the people with authority are clearly partners, although some firms have principals that also have authority.  But don't confuse authority with "sole" authority.  Often times in a VC firm, as with enterprise sales, getting to yes requires multiple partners to agree.  And don't assume that because a person's title is "managing partner" or "founding partner" that this necessarily means that person has more authority than other partners.  In every firm, VC or otherwise, there are people who get deals done.  They are people who are persuasive (see point 3 below), who compile relevant facts and who are willing to put their reputations on the line to get a deal done.  You've likely dealt with this if you've done sales or biz dev in your job.  You've likely met SVP's in companies that never seem comfortable with pushing though decisions without a large number of other people validating the decision.  The same can be true with VC partners – some push deals through and some seek broad consensus or air cover. But anybody that has authority (read: a vote) must be treated seriously.  You need to understand and get to know the interests, issues and concerns of every person who has authority over the decision that your firm wants.  Every person with authority has a vote.  And don't assume that just because you have a partner as your "champion" that it means that you don't need to spend time with the other partners so that they also feel bought in.

2. Some people have influence (I)

I've made it clear that my preference when I'm selling is to always "call high" but let's face it – you can't always start at the top.  In VC you might get an introduction to a partner through a colleague of yours who is a lawyer or an entrepreneur but the partner may ask for the deal to initially be screened by somebody more junior in their firm.  Don't view this as a slight.  When you think about a typical VC who sits on 5-7 boards, has to raise money for his/her firm so that they can invest, has to help run the operations of their fun, is swamped with inbound emails or requests for meetings and gets involved with industry events like speaking at conference, there is always going to be a need to get some leverage by having trusted resources help evaluate your company.

When you spend time with analysts, associates, principals and even EIR's realize that many of them have "influence"  (e.g. they can recommend whether or not your team gets more time and attention).  But just remember that they are  not check writers.  Kai taught me in sales to be careful not to make assumptions that because somebody's job title is high that they have influence or because a person's job title is lower means that they don't have influence.  And each analyst or associate may have different levels of influence with different partners.  So how could you find all this out?

I have heard some people in VC round table debates say not to bother spending too much time researching the individuals of a VC firm – you have more important stuff to focus on.  I disagree.  I think if you're running a sales campaign to raise money and you've identified a firm that you think will be a good fit for you that you should put in the time.  And frankly if you do get a term sheet one day these are the people you'll be working with so the more you know them (and their reputation) the better.  The most obvious way to know about your contact's influence is to network with portfolio companies or other entrepreneurs that have pitched this VC before and get their insights.

If you build good rapport with the non-partner resources then you might be able to get clues from them about how to get deals approved by the partners.  See if they will help you figure out which partner is likely to be most interested in your company's space.  And get advice from them on how to best manage the approval process.  Importantly, ask for their support in getting the partner meeting set up.  These are all things that an enterprise sales person would do in their sales process.

3. Some people have influence & authority (IA … aka Egg Breakers)

Obviously the people that you REALLY want to get access to are the people with both influence and authority.  These are the people I call "egg breakers" because they're willing to get rough to get things done.  These are the people that will metaphorically (or sometimes literally) slam the table and say "we need to do this deal and here's why ...".  They not only have a vote at the table but the skill & will to get decisions made.  Very few investment decisions are unanimous "no brainers" – just imagine having been pitched Google in a world where you had previous search engines like Alta Vista or given the success of Yahoo!  Imagine having been pitched Facebook in a world where MySpace seemed to be running away with market share or more recently having been pitched Twitter when Facebook seemed unstoppable.  Your goal in any sales process is to find and nurture egg breakers.  VC is no exception.

4. Some people have No Influence & No Authority (NINA)

But of course the people you need to be the most careful about spending too much time with are people with No Influence & No Authority (so called NINAs).  In enterprise sales these are the people that worry me the most because they are often the easiest to meet and spend the most time with you.  I've worked with many sales reps over the years who spend time with time-wasting NINAs because they're easy and make you feel good.  NINAs will tell you that your products are great and that your competitors stink.  It's hard to go into the lion's den and see the people who are most cynical or give you a rough time.  So many people naturally gravitate towards NINAs.  Remember that not only can they not make decisions but the I is key – they have no influence.  People tend not to listen to them very much or they don't have good political support to get initiatives approved.

How do you know when you have a NINA?  Aside from the obvious point I always harp on about (asking portfolio companies and other entrepreneurs that have pitched to them before), the best way to tell is when you ask them to help you with the next step (e.g. getting to a partner meeting) and they're either not able to do it or they keep requesting 3 more meetings before getting there.

NINA's take on another form in VC, though, which are the "VC Zombies".  These are the funds that are at the end of the life on their investments and do not seem to be able to raise a new fund.  They continue to take meetings with entrepreneurs but they never fund anything (because they can't).  These are very easy to flush out with some basic research: how many deals has the fund done in the past 3 years and when was their current fund raised (many funds are 10 years in length).  No new money, no new deals = NINA.

The only way to deal with NINAs in enterprise sales or in VC is to go directly to somebody else in the firm who has either influence or authority.  Or talk with a different VC.

7 Great Reasons Not To Take VC Money

By Greg Gianforte

Raising venture capital for early stage start-ups seems to be the prevailing path for most entrepreneurs; however, most would-be founders should reconsider.

Here are some reasons why:

- If you start by selling your concept to potential prospects (rather than stock to VCs), you will either end up with initial customers or a conviction that your idea won't work. Why raise money and then find out which one it will be?

- Raising money takes time away from understanding your market and potential customers. Often more time than it would take to just go sell something to a customer. Let your customers fund your business through product orders.

- Adding VCs to the mix early gives you an additional set of masters you must serve in addition to your customers. It is always hard to serve two masters, especially in a startup.

- With no money you can't make a fatal mistake. This is a blessing. Without VC money, you are forced to figure out how to extract funds from your customers for value you deliver. Ultimately that is the only thing that really matters.

- Money removes spending discipline. If you have the money you will spend it - whether you have figured out your business model and market or not.

-Raising VC money determines your exit strategy. You will either sell the business or take it public. What if you end up with a very profitable, modest sized business that you want to just run? That is no longer an option once you raise VC money.

- You sell your precious equity very dearly before you have a proven business model. This is the worst time to raise money from a valuation perspective. I know this is a contrarian view. And some of you are saying that might be fine for a small company.

Don't forget Dell, HP, Microsoft all originally started without VC funding; you can build a big business with bootstrapping and without VC money. At RightNow, we doubled our revenue and employees every 90 days for two years before we took any outside money, and even then the employees retained more than 75% ownership after raising $32m.

Do You Really Even Need VC?

by Mark Suster

I recently spoke on a panel in Santa Monica organized by my friend Jason Nazar, CEO of DocStoc, titled Startups Uncensored, Pitching Venture Capitalists.  There were about 200 people in the audience.

Jason started by asking the audience how many of them were start-ups – 90% of the hands went up.  He then asked for a show of hands of people who had already raised a round of Venture Capital – no hands.  I guess you're thinking, "duh, that's why they came to the panel discussion." ;-)

He next asked me specifically how many of these companies were likely to get VC funding (thanks, Jason) and I responded, "less than 5%," to which I heard a big gasp.  I responded that I thought this was a good thing – not something nasty.  I contend that the vast majority of companies should never raise venture capital.

Raising venture capital is like adding rocket fuel to your business and for most businesses this a) isn't warranted b) creates the wrong incentives and c) even if it is successful means that the founders don't make enough personal money when the ultimate business is sold.

I repeat this advice on a very frequent basis to most entrepreneurs I meet and I find it usually surprises people.  "You're a VC – aren't you supposed to want to give us money?"  No.  I want you to create a successful company that will be fulfilling to you and your employees and will make life better, faster and easier for your customers.

I also want you to make a great deal of money when you sell the company one day (or pay yourself great annual dividends to be paid out at a lower tax rate than you pay for your salary).  A banker once told me that he was surprised how many $50+ million exits where the founders made very little money.

For most tech entrepreneurs my advice is:

1. Raise a very small round of capital – usually from the three F's (friends, family & fools): $100-200k

2. Use this to get a product built, sign up pilot customers and get your initial team in place

3. Raise a round of angel money / seed capital: $250k-$750k.

4. Keep your burn rate REALLY low for the first year.  Your goal if to prove to your investors and to yourself whether you have a scalable business here

5. Assess the situation in 1 year. For many businesses you will find that within 15 months into your operations you will know whether you can carve out a meaningful position in the market to build a small company.  I see so many companies that get to $1-2 million run rate and are break-even somewhere within their first three years.  This is fine.  It creates options for you.

6a. VC Route - If you arrive at this point and you believe this can be a really big business ($50-100+ million in sales) then it's time to start thinking seriously about VC.  Awesome.  I know that some people know from day 1 that they're building businesses that will require VC – they have a huge idea and want to "go for it."  I accept that this is sometimes the case.  But it is rare.

6b. Angel Route - If you're in the more likely situation that you can see how to get your business from $1 million this year to $3 million within 3 years and maybe $8 million within 5 years then VC may not be for you.  VC's aren't looking for companies that are doing $15 million in sales in 8 years from their investment.  In this scenario I advocate a combination of bank debt, venture debt, small equity raise ($1-2 million) from high net-worth individuals.  These people would be thrilled with a company that could potentially double or triple their money.  VC's would not be happy with this outcome.

Shouldn't most businesses at least TRY to go out and raise VC if they could?  No.

1. Adding VC is like adding rocket fuel to your company.  VC's want to get your business into orbit (e.g. to scale) quickly and reach huge levels of revenue.  At times this may be at odds with your economic interests (and/or not within your capabilities).  If you try to go t0o quickly and don't gain quick adoption you're left with either an un-financeable company that could go bankrupt or be sold in a firesale or more likely the VC puts in a bridge loan to "rescue" you.  If you're fortunate enough to eventually raise another round you may find out that you own a much smaller percentage of the company that you had initially wanted.

2. VCs want big outcomes.  When you raise money from a VC they will demand a veto right over the sale of the company.  You might be very happy selling your business for $9 million and owning 50% of the company.  Your VC is not necessarily going to be happy getting $3 million for his 33% stake for which he invested $1 million.

Wait, but isn't that a 3x return?  Yes, but in aggregate it's still just $3 million and if the VC has a $300 million it is just 1% of the money that he needs to get to reach his "hurdle rate" of when he's entitled to earn carry (e.g. big bucks).  It's just too much time to spend with a company for such a small total return.  Many VC's would still let you sell the business at this price if you really wanted to.  They would likely think either that it's senseless to go on with a company where the CEO is set on selling or maybe on the basis that you'd be interested in raising money from this VC for your next company and really make that company a home run for all involved.  Be aware that some VC's have been known to actually block sales.

3. Preserve your options.  My final advice that I give to entrepreneurs is, "if you ARE going to raise VC, raise a small amount initially.  If you raise $2 million from a VC and along the way you get the feeling that this is going to be an interesting company but maybe the market won't be as big as you expected or suddenly Google decided to compete so it may be harder to become the 800 pound gorilla then it iwill be easier to have a medium outcome while still retaining value for yourself.  Maybe you can run it for 3-4 years and find a way for Microsoft to buy it for $12 million to compete with Google.  If you raised $5 million it is unlikely that the VCs would settle for this outcome and would likely rather push you for a much bigger outcome.

So why not preserve your options.  If the business is really "taking off" and you see the white space in front of you to become a huge company then you can always raise a larger round to accelerate.  Think about Ning or Meebo.  Once they each raised their huge rounds at large valuations … could they really ever try to do anything but going into outer space?

One last comment on the subject of optionality.  There are certain mega funds that are institutions in Silicon Valley that maybe of backed Google or Facebook and have regularly churned out multi-billion companies over the past 20-30 years.  While it might be nice to be an investor in one of these funds you also need to be aware that some (not all) of them are much less interested in the "double" and at least one firm is known for either stopping to attend board meetings of companies that won't be rockets or even worse blowing out the CEO's who can't get into outer space and finding ones they think can.  I'm not saying that I blame them – they obviously have a success formula.  But if you want to preserve your options for a double make sure that you don't raise money from the Barry Bonds of VC … who only swings for the fences.  Obviously talking to other entrepreneurs will help you determine how your potential VC might act in this situation.

So why on Earth do you work in VC if you feel this way?

I said that most businesses shouldn't raise VC.  But there are still many businesses that are capable of becoming very large ($50-100+ million revenue) businesses.  These businesses need cash to grow.  When a business has this kind of high potential I always counsel in the same way, "if you really believe that this is going to be a big market and you can be a market share leader then I guarantee there are 3 Phd's in San Jose who think the same thing.  They'll have access to venture capital and will be filing patents to kick your ass."

"If this market is big then by the time you start announcing your first customer wins it will perk up the ears of a third-time, serial entrepreneur who sold his last business for $80 million.  He is going to sniff out the opportunity and put money and energy behind grabbing this market.  So if you're not prepared to grab the market opportunity while it's here somebody else will."

In the right circumstances and in the right amounts … VC's is the best way to scale mega businesses.  And it is those businesses that I'm looking to fund.

Tips for bright & not blurry eyed business plans

by David PASIEKA

I finally broke down over the weekend and attacked the stack of five business plans that I promised to read and comment on. They ranged in length from 15 to 80 pages and covered multiple industries and segments. My mind was whirling as I completed the last "...in conclusion" section. As I compared and contrasted the individual documents I was inspired to write a couple tips to help those entrepreneurs with their next versions.

a) Capture my attention quickly - Perhaps its starts with your overarching vision, but find a clever way establishing and leading our interest in your product or service quickly.

b) Make it easy to read and compelling to turn the pages - Think about that spy novel that drives you absorb the content and turn the pages as the plot unfolds.

c) Follow business plan protocol - There are many protocols & templates out there and they all lead the reader through a time tested process. All of the headings and topics will need to be addressed so there are no shortcuts to be taken. One client suggested that since their product was so unique they had no competitors and “never would’ - therefore they left the section completely out!

d) Cadence your content with appropriate emphasis - A colleague of mine at MaRS, Andy Haigh, has developed a 25-page format for the business plan. His rationale is simple: create something that the reader can digest in a single sitting - lean towards 25 pages rather then 60. The flow goes something like:

• Executive Summary (2-3 pages) - Company description, value proposition, key highlights
• Introduction (2-3 pages) - What is the problem that the company is trying to solve?
• Product & Technology (2-4 pages) - How does your technology solve the problem?
• Market Size (2-4 pages) - Start with the big numbers and narrow it down to your market.
• Go to Market Strategy (2-3 pages) - How do you plan on attacking the marketplace?
• Competition (2-3 pages) - How are you “better, faster, cheaper” ?
• Management (2 pages) - Do you have the team to make it all come together?
• Financial Summary (2-3 pages) - Financial model, investment opportunity, cash flows.
• Strong Summary (1 page) - Re-iterate key points

e) Visualize at every opportunity - 25 pages of solid text will not work for your reader. Since a picture says a 1000 words, photographers and graphics designer are the world's most effective writers. Use charts, graphs, pictures, white space and section headings to help illustrate the points and focus the reader.

f) Proof points - Do you have the customers, beta trials, strategic partnerships and trending financials to clearly demonstrate that you have it right?

g) Strong finish - Having lead the reader through a compelling 25 page journey, re-iterate the key points to leave them with a lasting impression.

I have tried to capture in a few words what is clearly a significant art form. Have Andy and I missed anything? We look forward to your feedback.

by ReachVC 桂曙光

关于VC的10个真相（上）

6、VC也需要企业的增值服务

分众传媒的上市及上市后收购框架传媒、聚众传媒、好耶、玺诚传媒等公司，让众多VC收益颇丰。不仅如此，由于分众传媒可能是国内涉及VC最多的创业企业，也是让最多VC赚到钱的企业，因此，分众传媒也是被VC用来作为品牌宣传用得最频繁的案例。

都说一个成功的男人背后一定有一个好女人，其实好VC的背后也一定要有一些拿得出手的好案例。这些成功案例，不仅仅给予VC必要的资金回报，同时，按照VC的话来说，也给VC带来了增值服务——品牌影响力。这一方面有利于VC去募集资金，说服出资人投资，另外，也有利于VC树立行业地位，在争夺好项目的时候，有些竞争优势。

VC通常会在自己公司的网站上，列出投资项目清单，当然，最重要的是那些已经成功退出的，行业知名度高的公司。至于哪些已经死掉的项目，通常是一概不提的。也有些VC会为每一个投资案例做一个精致的牌子，统一挂在公司“业绩墙”上，这样初来乍到的创业者就很容易被唬住了。就连最近出事的红鼎创投，也把子虚乌有的投资项目放在网上，作为忽悠的资本。

除了VC圈之外，那些成功的企业，知名度通常要比VC要高很多，所以，在很多行业会议、资本论坛、电视节目等场合，VC在介绍自己的时候，通常会这么说：“我是某某VC公司的某某，我们的基金有N亿美元，我们投资过百度、盛大、分众、等公司，…...”。

不仅仅是VC公司需要借助成功公司的影响力，VC的投资经理和合伙人也需要。很多VC合伙人就是靠着在一、二个成功案例的投资过程中起到主导作用，从而树立在VC界的影响力，要么跳槽到更大牌的VC公司，要么另立门户。但也有很多VC投资人还躺在5年、8年前的案例上吃老本，却再也投不到一个好项目，他也就慢慢淡出了创业者和VC圈的视野了。

说到底，VC公司和VC投资人的立身之本还是投资到好的项目。

7、VC的社会贡献没有想象中那么大

目前，工商部门注册的中小企业数量有500万户左右，他们贡献了GDP的60%左右，上交的税收超过总额的一半，还提供了全国80%左右的城镇就业岗位。但VC每年投资的企业数量是多少呢？据统计，最近几年国内VC的投资案例数量最多也就每年400、500家左右，这还要算上一半左右的投资是针对同一家公司的后续追加投资，每年的投资总额也就30、40亿美元左右，换算成人民币不到300亿。这样的蜻蜓点水般的投资，只是让VC挑中那些鹤立鸡群的优质企业，并给他们锦上添花一下。

通常的看法是VC可以促进科技创新，这也是无稽之谈，基本上国内的VC没有几家会投资研发型的公司，相反，对于抄袭国外现成商业模式的项目、拿钱可以快速复制的项目，他们却是一窝蜂扑上去。所以，我们看不到几家VC投资的公司研发出了什么芯片、新药、精密仪器、等等，却看到他们把几十亿美元投进一大堆这样的公司：盗版猖獗的视频网站、大打擦边球的交友网站、无处不在并造成视觉污染的广告牌、等等，VC的这些投资已经造成了某些行业的虚假繁荣。

对VC来说，他的唯一目的是获得投资回报，所以，为了到达目的，有时会投资一个卑鄙无耻的混蛋或者是一家没有社会公德的公司，只要这个混蛋或公司能为他挣钱。于是我们就可以看到这样的一些公司得到VC的投资：做流氓软件的互联网公司、有环境污染的化工企业、用医疗垃圾加工化妆品的公司、可以提炼出毒品的医药中间公司、．．．．．．．。

有时候天使投资人倒是愿意通过支持和帮助创业者的方式，来回馈社会。所以，他们经常愿意投资那些初创的、风险更大一些的、有一定社会意义的项目。我也认识很多优秀的VC，但是还没有任何VC有回馈社会的动机。

8、VC也差钱

VC的基金通常是10年左右的生命期，VC公司可能在前面的4-5年要把钱全部投出去，后面几年把投资的项目退出，实现投资回报。通常，GP会把1半左右的资金用于新公司的初次投资，另外一般用户后续追加投资。比如，一个1亿美元的VC基金，5000万左右会用于对新项目进行初次投资，如果这些项目中的一些发展不错，另外5000万左右就用于追加投资。从这个角度看，对于初次向VC融资的创业者而言，VC基金的规模比实际数字要小一半左右。

另外，对于占国内主流（有限合伙制）的VC基金，其资金主要有两个来源：机构和非常富有的个人，机构包括公共养老基金、公司养老基金、保险公司、富裕个人、捐赠基金/基金会等。根据全美风险投资协会（NVCA）的报告，机构投资者（VC出资人）自身的资产配置中，有50-60%是投资于上市公司的股票，20-30%是投资于债券，投资给PE和VC这类私募股权的比例都很小，通常是5%左右。这些出资人并不是在VC基金设立之初就投入全部资金，而是采取承诺制，就是说按照基金的投资进度（4-5年），分期分批出资。在2008-2009这次金融危机中，全世界股市跳水，很多VC出资人的上市公司股票资产严重缩水，相对而言，他们承诺给VC基金的资金就占据了更多的比例，这就违反了他们自身的资产配置原则。于是，很多VC出资人被迫违约，放弃对VC基金继续出资，导致很多VC基金实际可以投资的资金，要小于号称的基金规模。比如声称1亿美金规模的VC基金，可能最后只分期到账8000万美元。

还有一点，VC公司管理VC基金是要收取管理费的，通常管理费是基金总额的一个比例，每年2%左右，管理费在基金存续期内每年收取。由于有一部分钱VC公司以管理费的形式花掉了，所以能够用于投资的资金是会小于VC基金总额的。比如1亿美元的VC基金，每年的管理费是200万美元，10年生命期就是2000万美元，所以，真正能够用于投资就只有8000万美元。

所以，实际上VC公司可用于投资的资金是比看起来要小很多，他们是差钱的。对于VC公司的合伙人，他们拿着丰厚的管理费，似乎不差钱。但这也有例外，比如国内人民币的合伙制基金，有些出资人是按实际出资额给管理费，1亿规模的基金，如果第一年出资人只给VC基金出资1000万，VC公司的管理费就只有1000万的2%——20万，那VC公司的合伙人就差钱了。更有甚者，有些出资人是按实际投资额给管理费，如果哪一年VC公司没有投资一个项目，那就没有管理费，VC公司更是差钱了。

9、VC不会控制公司

很多创业者在找VC之前最为顾忌的，是担心VC投资之后会控股公司，以后创业者就无法对公司做主了。

但这种担心是多余的，VC之所以投资某个公司，并不是想去控制公司的运营，而是看到这家公司、这个创业者能够把公司做大，他们希望能搭搭顺风车，跟着创业者一起赚钱。所以，他们也担心创业者无法控制公司，无法对公司的发展做主，或者是没有前进的动力。VC要降低这种顾虑，通常在第一轮投资的时候，只要求30%左右的股份，保证创业者还是大股东，即便经过后续1、2轮的融资稀释，创业者还会持有可能超过50%的股份，这种他就有足够经济利益和公司的话语权，有理由埋头拼命做好公司，否则他随时都想着去找个高薪的工作，做个甩手掌柜。

当然，如果创业者在公司做大之后，发现自己能力的不足，愿意把公司管理权让贤给VC认可的职业经理人，自己只做股东，VC也是可以接受的。

说VC不会控制公司，并不表示VC不监管公司。为了保证投资的安全，VC会通过签署投资协议、进入董事会、派财务总监等管理人员的方式，对公司的运营进行监管。

投资协议可以看作是创业者和VC之间的“君子约定”，但创业者可以选择不做君子，而做小人。中国的现状就是人的法律意识淡薄，缺乏契约精神，同时违法成本非常低。另外更重要的是，国内的法律体系和政策并不支持美国VC那些常规的、对投资者进行保护的协议条款。比如，优先股的权利、投资人董事的否决权、动用大笔资金银行需查看“董事会决议”、等等，这是造成大量创业者“出轨”事件的外因。即使这样，VC也只能打掉牙往肚子里咽，谁叫他识人不善呢。曾听到一个融资的创业者说过：“就怕他不投资进来！”后话不言而喻，“进来”就不怕你了！

10、VC不看商业计划书

创业者在找VC融资之前，通常会辛辛苦苦地拼凑出了一份几十页、甚至100多页的商业计划书，有些人还会花钱找中介公司帮忙写。但是，最近美国马里兰大学斯密斯商学院的2位教授和1为博士生做的一项研究，他们发现商业计划书的好坏跟融资成功与否没有关系，根据商业计划书的内容，无法预知哪家公司能获得VC的青睐。当然，这并不表示写一份商业计划书完全是浪费时间、没有意义，因为它还可以作为公司日常运营的指导文件。但是，它并不能带来钱。

如果商业计划没有用，什么才有用呢？VC不看商业计划书，怎么了解项目呢？其实，创业者找VC融资，“关系”网络才是关键。那些融到资的创业者要么在之前就认识VC，要么有朋友将他们推荐给VC，当然如果是VC找上门当然更好。创业者只需要先给VC看一份1、2页纸的项目简介，并在VC有兴趣继续沟通的时候，做一个PPT融资演示就行了，项目简介和融资PPT文件都最好简短些，VC太忙，不会看80页、100多页的长篇大论。如果VC被你打动了，那你需要准备的材料就不仅仅是100页那么点儿了。

当然，有人会持怀疑态度：如果你找人要几百万、几千万的资金，他怎么能不花时间好好看看你的商业计划呢？但是你想一想，如果要让你在决定跟一个人会面之前，需要仔细看完100页的商业计划，你会怎么做？而且这个人你以前从来就没有见过，或者是从哪里听说过？再想一下，如果每天有5-20个这样的人想见你，你要看这么多计划，那又是个什么概念！这非常没有效率，知名的VC每天会被各种各样要钱的项目包围，无数只要钱的手在眼前挥舞。所以，你要想得到VC的会面机会，就需要尽量简短一些，而50页的商业计划显然是背道而驰的。

你通常需要一个融资演示PPT，也可以叫做商业计划书吧，大约20页即可，这是VC的基本规矩。VC需要确信，与创业者的会面不会耽误双方的时间。

当然，对于很多成熟的、非常抢手的项目，创业者更是不用准备什么商业计划书了，相反，倒是VC需要准备一份材料，说服创业者为什么要让你投资进来。(ReachVC 桂曙光)

Raising Angel Money

by Mark Suster

A friend of mine who lives in Silicon Valley called me lastt week to talk about his new company.  He's been a very prominent member of the technology community for 15+ years and is deeply respected by both junior and senior members who have worked closely with him.  This is the exact kind of guy who as a VC you would love to invest in provided he can deliver on a well rounded team (getting there) and a great idea (done).

We had a lengthy conversation about whether he should take angel money, which has been offered to him.  The investment money he's been offered has been "priced" (meaning the value of his company at which the angels would buy stock has been set at the recommendation of the angel investors) and he was wondering whether he should take the money.

His alternative is to hold out for "convertible debt" that would not immediately be priced.  The purchase price for investors in this type of investment is set in the future when he would raise his first round of venture capital money.  (Quick side note for explanation: when you raise money as convertible debt it means that the money you raise is in the form of a loan and not given as equity.  It is called convertible because it usually automatically converts to equity when you raise your professional round of venture capital.  It typically gets a discount to the price that the VC pays.  The discount can be any % number but in my experience is usually between 15-30%).

The conversation about angel money is one I have all the time with entrepreneurs so I thought it would make for a good post on understanding angel investing – how they think, how you should think and how the first round venture capital firm will think by the time the deal gets to them.

How Angels Think – OK, let me start by saying that I rarely do angel investing since I mostly think it's a sucker's bet unless you have very deep pockets or unless you're in a tech bull market ('97-00, '05-'08) where exits can happen without a lot of follow-on rounds of funding.  If you want to know more about why I feel this way feel free to ask in the comments section and I'll elaborate.  I have had the discussion about whether angels should pricing their investments or offer convertible dent with many professional angel investors in the past and 2 in particular that I'll use in this discussion.

One side of the argument – angels should price:  18 months ago I sat on a panel with Ron Conway, the legendary angel investor from Silicon Valley who invested in Google, Twitter, Digg and many other early-stage Silicon Valley success stories.  The topic of angel pricing came up.  Ron said he never likes to do convertible debt deals and always insists on pricing his investments.  His rationale was clear, "If I invest in a company I open my Rolodex for them.  I help them with business development introductions.  I introduce employees.  I give them credibility in the fund raising process.  Let's say the company was worth $1 million when I met them and I've helped them with both my Rolodex and my cash and they can now raise a round of venture capital at a valuation of $6 million.  I would be hurting my own interests.  A $500,000 investment at a 30% discount to a $6 million round is still priced and more than $4 million and is certainly worth much less than my investing at a $1 million pre-money where I could own 33% of the company."

This is how I believe angel investors should think.  You're money helps the entrepreneur get through a very difficult period and your money has a lot more risk since you don't know whether VCs will really want to back this idea or team.  Your biggest risk is what we call in the industry, "funding risk" and it is especially prevalent in tough economic times like now where VC money is harder to come by.  Now more than ever I think angels should be pricing rounds.

The other side of the argument – angels should not price if the deal is "hot":  I had breakfast in Palo Alto recently with a friend of mine who is a very well known angel investor.  He actually invests angel sized rounds on behalf of a larger VC fund.  He told me the following in private (versus Ron's comments on a public panel) so I'd prefer not to reveal his name since I didn't ask for authorization.

His argument was simple, "The best deals in Silicon Valley are very competitive and I only want to invest in the best deals.  If I have to spend weeks debating valuation with entrepreneurs then my probability of getting into the best deals is decreased.  I'd much rather be in the deal at a 30% discount to the VC round then to out of the deal altogether and miss investing in the best deals.  If the market conditions worsen then I'll ask for a larger discount.  Maybe 40%?  Maybe 50%?"

He has a point.  This individual really does have access to the best deals in Silicon Valley at formation stage based on his solid reputation for working with entrepreneurs in a hands-on way to help them with their business strategy before raising money.  People like working with him and feel he gives credibility.  His view is that if he gives the entrepreneurs more time to get around to meet all the angel stars in Silicon Valley (Ron Conway, Mike Maples, Jeff Clavier or any of the other host of angel investors who have sterling reputations and once under their spell it may be harder for my friend to close the deal.

In my estimation he has done good investments in the past 2 years but obviously we'll need to judge that later when we see whether these investments make money.  My bet is they will.  Two observations here: 1) he has very unique access to the some of the most proprietary deals in the world and 2) he has only been a VC for 2 years and therefore might see a side benefit of increasing reputation by being in "hot" deals.

For everybody else I believe angels should price.  So why do many angels agree to fund with convertible debt?  Maybe there are more sophisticated reasons than I am aware of so feel free to weigh in with comments if you think I'm missing something.

I believe most convertible debt deals by angels are done by people who are not professionally investors.  There are many groups of angels who like to pool their money together to invest in technology.  Sometimes they are ex Tech execs who have made a bit of cash and sometimes they are groups of wealthy doctors, lawyers, real estate professionals – whatever.  But I believe they don't price either because they don't know better or they want proprietary access to deals they think they otherwise wouldn't have been able to invest in without agreeing this structure.

How entrepreneurs should think – So now that you know how angels think about pricing early-stage deals, how should this affect your decisions in the fund raising process?

As an entrepreneur you should raise money from the most experienced people possible – period.  If you have the opportunity to raise a small amount of money from a group of experienced investors who have a track record of helping companies get from that tricky idea stage to being a well-formed company with a good product and solid market-entry strategy I would take the money – even if it were priced.  Worrying about giving up an extra 10% of your company at this stage can be meaningless if the ultimate outcome is either success or failure.  Even VC's think this way, which is why Fred Wilson when describing his decision to syndicate a portion of his invesment in GeoCities to another investor says, "I learned that good partners are worth every penny of returns you give up to get them." (whole article here if you're interested)

Don't worry about getting "screwed" by sage angel investors.  If they really are well regarded and serial investors they won't likely screw you.  Why?  Because if they try to take 50% of your company for $500,000 then they know it will be very hard to raise VC because we'll know that too much of the value has been taken away from the founders before our investment.

People like John Greathouse and  Klaus Schauser in Santa Barbara have a great track record both in building companies themselves and also in helping the companies that they angel fund pull together  great management teams, launch great technology products and importantly raise VC from top-notch VC's.

If you're the kind of person that Ron Conway, Klaus Schauser or John Greathouse would be willing to fund then you're probably the kind of person who could string together a group of wealthy real estate professionals to give you a convertible debt financing and avoid taking as much dilution at this early stage of your company.  Should you take the "cheap" and easy money?

I've obviously laid out my case in the argument.  Most companies have binary outcomes: you're either really successful as a company or you're not.  Unfortunately the overwhelming majority of companies end up in the latter category.  You know the old saying, "a larger percentage of zero is still zero."  So my advice is to stack the odds as much in your favor as possible by taking the experienced money from people who have a reputation for really helping entrepreneurs.

If you're struggling to raise money at all then you should obviously take the money from wherever you can get it and many times that is reality.  If you believe you have a great idea and are passionate about trying to build a company around it then the only thing worse than raising money from inexperienced people is raising no money at all.  Go for it.

If you can raise money from prominent angel investors AND get the investment done as convertible debt – knock your socks off!  Take the money. (note: this advice does not include taking convertible debt from VC investors, which I generally advise against.  (Again, if you want me to elaborate I'm happy to do so in the comments section).

How do VC's think about your angel money structure? – First, let me state that many VC's have done many earlier-stage, angel-like deals in the past few years.  It takes less money to start companies than it did 10 years ago and these VC's had seen the best deals get done by über-wealthy angels.  As a result many VC's were getting into the game of writing $500,000 – $1 million checks.

Will this continue?  I don't know for sure.  On the one hand I believe many VC's have realized that this early-stage investing is riskier than they had perceived and they'll just end up doing the $3 million rounds down the line when the business has more proof points.  So I think many VC's may pull back to their traditional roles of letting angel investors take the early stage risk.

On the other hand, it is true that it takes significantly less capital to get companies off the ground these days and given Cloud Computing I believe this trend will continue (see my experiences and views here).  It is also true that many VC fund sizes going forward will likely be smaller as LP's come to realize that smaller fund sizes for VC funds (as opposed to growth equity funds) better aligns the interests of the VC and the LP.  So I suspect some VC's will continue doing deals that are on the border between what an angel would do and what a VC would do.  I am personally in this camp.  And Andreessen Horowitz certainly is as well, announcing their willingness to deals as low as even $50,000.

But to the question of how a VC thinks about your angel money if you do raise it, here are my thoughts:

• Your chances of raising money from a VC are significantly greater if you have raised money from prominent people.
• In most cases we probably don't care whether the deal was priced or convertible debt.  We would, however, look to make sure that you didn't take too much dilution, which would be a negative.
• If you did convertible debt at a large discount (say 30%) and it was done only 2 months before you're talking to a VC they will probably grumble about the discount that the previous investor is getting.  But ultimately I believe most VCs will get over this because the dilution taken from the discounted convertible debt will likely come from the founders and not the VC
• If you have many angels (say a group of 10-15 people) and if these people are not sophisticated serial angel investors it could cause problems.  VC's will be a bit wary of having small investors who try to hold the company hostage during future financing rounds.  Anyone who has been around the industry long enough would have seen this happen at least once.  If you do round up money from a load of small unsophisticated investors please make sure to get a great corporate lawyer with experience in doing VC deals to structure the deal to minimize the amount of signatures you need to get for approvals and to ensure that every angel has signed an accredited investor statement.

If you ever see me in person ask me to tell you the story about the pig farmer who seed-funded my first company.  I have all the scars from F'ing up the formation of my first company to write blog posts like this.

by ReachVC 桂曙光

1、VC会错过好项目

Bessemer Venture Partners（BVP）是美国一家创办有近100年历史的著名VC，他们已经成功帮助100多家企业在纳斯达克等全球各地的证券交易所成功上市，Forbes 2006年排出的100名高科技投资人当中，BVP占有4个席位。即便如此成功，他们却错了Google、Intel、苹果电脑、Lotus、Compaq等一大批知名公司，而这些公司间接成就了红杉资本（Sequoia Capital）、KPCB等全球VC标杆的地位。BVP的合作人在苹果电脑上市前的Pre-IPO融资中，认为价格“太贵了”；说eBay是“只有没脑子的人才会看上它”；对于联邦快递，有7次投资机会都没有投；对于Google，他们当时租了BVP一个合伙人的朋友家车库办公，BVP的合伙人听了这个朋友的推荐后，说：“除了从车库走，我还能怎么离开你们家？”

国内最知名的本土VC——联想投资也有错过好项目的经历。腾讯QQ的团队曾找到刚刚成立的联想投资，结果，投资经理看不太懂，就把他们给打发走了。再后来，因为种种原因，他们又错过了百度、盛大、药明康德等项目。

事实上，VC界这样看走眼好项目的事情并不罕见，不过却很少有VC敢于像BVP、联想投资一样公开出来，有少量VC至多也只是在公司内部讨论或者检讨自己的过失，“成功的案例才是赚钱和炫耀的资本”。历史上很多成立比BVP晚好多年的VC早就没了踪影。为什么BVP能够一直活下来，还活得不错？其实，优秀的VC并不是永远都不错过好项目、不投资坏项目，而是犯的错误比别人少一点，抓住的机会比别人多一点。

既然连成功的VC都会看走眼、放过好项目，下一次创业者在被VC拒绝的时候，就没有必要妄自菲薄，丧失继续寻找VC的信心了。

2、VC竞争激烈

VC，表面上看起来是一个光鲜亮丽的行业，很多刚走出校门的学生想加入VC公司，一大批成功的企业家和创业者转变成了VC，大量创业者的目标是“公司上市了，转头做VC”，很多大型企业设立了专门的VC投资部门及子公司，一批券商已经和正在投身VC，甚至连很多江浙富商、山西煤老板也拿钱做VC。

但光鲜的背后，VC行业的竞争其实非常激烈，甚至用“惨烈”来形容也不为过。

VC之间的竞争，其实主要是项目的竞争，毕竟只有把钱投资到好项目中去，才能获得好的投资收益，才能给基金的出资人好的回报。这有这样，他们才能继续募集更多的自己，继续从事这个行业。所以，做得好的VC，不断在募集新的基金；而很多做得不好的VC，默默地消失掉了。

VC竞争项目，或者叫“抢”项目，主要有这么几种方式：第一种是价格，对企业的估值高，别人投500万，你投1000万，其他条件相同的情况下，基本可以胜出；第二种是品牌，有些VC投过很多知名公司，在资本市场有很大的名气，他们通常可以在相同，甚至略低的价格条件下胜出；第三种是速度，有些VC从第一次接触项目，到最后签署投资协议，中间需要6个月，甚至1年的时间，他们这样花时间做详细的项目调研是可以降低风险，但有些胆子大、动作快的VC，他们可能3个月就抢先投进去了；第四种是关系，通常VC喜欢广交朋友，通过朋友的网络，拓宽项目来源。有些地方性的VC，对于当地的项目，会有很多信息来源和人脉资源。有些政府背景的VC，通过项目所在地的政府施压，可以抢在其他VC的前面。还有些VC，通过跟大牌VC搞好关系，跟着他们玩。

所以，当你的公司那一天做到几亿销售额、几千万利润、并且还在高速成长的时候，你就会发现，公司门口排队要求跟你见面的VC打起来了。

3、VC的傲慢与无知

我有很多认识的或合作过的VC，他们大多很出色，对待创业者也很友善。当然也有许多并不怎么样，无论是做人还是做投资。他们有各种各样的缺点，但基本都有一个傲慢自大的共性。这些傲慢的VC认为自己无所不知，通常在各种会议、论坛里高谈阔论、指点江山。他们在跟创业者见面的时候，还没有听明白创业者说的是什么，就开始对创业者进行批判，“指导”他们应该怎么做。见过最离谱的VC是半躺在椅子上，斜着眼，扬着下巴跟创业者“交流”，期间还要拿着“黑莓”手机收发邮件、打打电话什么的。

这些VC多数是那种想要显示自己有多聪明的年轻VC，他们其实没干过什么，只是读过MBA、在国外投行干过，然后想办法混进VC公司，对行业没有多深的了解，对企业的运营可能一窍不通。

另外一种VC也很讨厌，他们以前是成功的创业者。因为他们通常有丰富的创业经验，觉得自己可能给创业者很多帮助，于是就忽视自己作为VC和创业者之间的界限，不是去全力支持创业者，通过董事会来解决企业出现的问题，而是参与到企业的日常运营中去，干预创业者对企业的掌控，他们可能认为创业者是为VC打工的。而真正优秀的VC，他们知道不管自己曾经多么成功、经验多么丰富，投资之后，他们就需要信任和依赖创业者。

还有一类比较初级的VC，他们把创业者当作免费的老师。想要了解哪个行业和领域，就以VC的身份、投资的名义，找一批这方面的创业者过来聊，创业者通常会受宠若惊，知无不言，言无不尽，一圈聊下来，VC成了半个“专家”，创业者们做了免费的培训。如果创业者能够提供详细的商业计划书，并且在商业计划书中进行详细的行业分析、竞争对手分析的话，VC就更喜欢了，这样他们不但了解的行业，还扫描了一遍这个行业的项目，还跟创业者交上朋友（以后持续学习、帮忙评估项目、推荐项目等都用得着），一举多得。

4、VC不会投资有风险的公司

VC被称为风险投资是不太合适的，更好的叫法是“创业投资”，是针对初创和成长期的创业企业进行投资。在美国，VC主要投的是商业模式有比较大的爆发力和扩展性、比较轻资产、跟新经济相关联的初创公司，比如TMT领域、替代能源、环保和生物科技。

中国的VC也确实投资过一些TMT领域的项目，比如最早的新浪、百度等，2003年Web2.0之后，更是有一批拷贝美国的互联网商业模式的公司拿到大把的美金，这个过程一直持续到2006年底，好像哪家VC没有投资1、2个web2.0的项目就丧失了一个巨大金矿一样。可是美国模式在中国不好使，中国终究没有出现Youtube、Myspace、Facebook一样级别的公司。

于是中国的VC开始寻找新的投资去向，从2006、2007年开始一大批在成熟的VC市场无人问津、已经过气的行业，在中国突然成了香饽饽，比如种茶种菜的、养鸡养猪的、剪头洗脚的、制衣制鞋的、卖水饺卖火锅的，等等企业成为VC追逐的一个趋势。这些被投资的企业的共同特点是：传统生产服务行业、企业规模很大、企业处于成熟期、短期内（2－3年）有上市的可能。VC的单笔投资额度也越来越大，很多外资VC对于二、三百万美元一下的项目根本不看，有些VC甚至只投1000万美元以上的项目、甚至Pre-IPO的项目。

VC被称作风险投资，并不是他们愿意承担风险，恰恰相反，他们的最根本原则是通过前期的尽职调查，以及投资后的协议控制，要尽量规避和降低投资风险。投资更为成熟的项目，也是一种规避投资风险的方式。说实话，中国的VC称为Very Conservative（非常保守）可能更为恰当，因为他们的大部分都在做PE的工作，而不太愿意投资偏早期的项目。这种情况可能是因为国内的成熟好项目实在是太多了，不投白不投；另外，这种风险小的投资，容易让VC获得成功案例，扬名立万，这对于他们在VC圈生存是很有帮助的。

只有发明专利、创意想法的创业者们，就不要劳神费力去找VC了，你们离VC的距离还有十万八千里呢！

5、VC不会提供什么增值服务

国外的VC大部分都是四、五十岁的人在运营，有很多做得极为出色的VC都超过六十岁了。合伙人级别的VC、甚至是投资经理大部分都是在某个行业浸淫了很多年，已经对一些对行业非常熟悉、理解非常深厚。与此不同的，中国的VC机构大多是由一些30、40岁左右的人在管控，甚至出现了很多80后的VC合伙人。

优秀的VC公司由于其合伙人有广泛的行业关系和丰富的企业管理经验，确实能够为被投资企业提供很多增值服务，但是也有很多VC公司的增值服务流于口头上的空谈。

VC常常宣称的增值服务有这么几种：

“帮助企业进行市场拓展。”要提供这项增值服务，VC必须对市场营销有很深的体验，可事实上绝大多数VC合伙人并没有市场营销的工作经验和背景，他们更多的是财务、投行、技术等背景，真正做市场营销出身的VC非常少。

“提升公司品牌。”媒体对VC的关注跟普通老百姓对VC关注还有巨大的差异，VC投资了公司，可能对于公司在资本市场上有一定的“被认可”的效应，但对于消费公司产品或服务的老百姓来说，还不如在电视或报纸上做个广告来的有效。

“物色高级管理团队。”VC通常有非常广泛的人脉资源，但事实上他们找来的职业经理人未必称职，他们可能对VC更忠诚，他们可能有大企业的经营管理经验，但未必适应创业企业，他们空降到公司之后可能导致无法服众，他们进入公司很可能引入新的矛盾而且会增加经营成本。

“规范公司的财务管理。”的确，在VC投资之前，绝大多数公司的财务管理是比较混乱的，但这基本上不会影响公司赚钱，否则VC也不会投资。VC声称可以协助企业规范财务管理，可实际上绝大多数VC合伙人并不熟悉财务管理工作，他们最多也是帮企业聘请一位CFO。如果公司真的需要规范化财务管理，他们完全可以自己请一个有经验的会计师或者请财务咨询公司帮忙。

当然，VC还可以很多其他增值服务，比如“战略”、“上市”等等。有些VC公司只有那么3、5个合伙人，一年要投资10多个项目，平均每个合伙人需要在10多家公司做董事，他是如何给公司提供增值服务的，估计连他自己都不知道。实话实说，大部分VC只是在被投资的公司做得非常好或者非常糟糕的时候，才会出来掺和一下。（ReachVC 桂曙光）

How not to communicate with us.

by Tom Hedrick

Following are a few disguised excerpts of an email exchange with a representative of a company looking for capital. As context, the company had been in existence for roughly 10 years and had current revenue of less than $1.5 million per year.  They had a nice patent portfolio but did not have what would be considered commercial or business model success. It still had quite a bit of venture risk. This discussion centered on the company's valuation expectations that were (at least) triple the value we thought was reasonable.

Excerpt 1:  "There is no limit to the upside in future revenue and earnings"

Hmmm…no limit, really? Be excited, but don't over do it.

Excerpt 2: "Employing a worst case scenario they (the company) are estimating a five year revenue target of about X million" (around 25x current revenue)

Let's see, it took 10 years to reach about $1.5 million and the "worst case" is around 25x the current situation.  Be careful about use of the worst case…worst case in venture is no revenue. If you make such strident comments be able to back them up with comments such as the size of the sales pipeline or the value of an existing contract with a customer.  Both the pipeline and contracts can be easily tested in diligence.

Excerpt 3: "That would accord the company an exit value of more than $YYY million."

The company expectation on valuation would have made the exit equal to a 5X return for investors. That might be a good 5-year returns target for a larger, profitable or even breakeven business. But, this company was still burning over $100k per month.  We cannot speak for other VC's but we do not like portfolio companies doing our return math for us. That kind of exercise is one that we complete at the end of diligence when we thoroughly understand risk, markets, exits, etc.

The YYY valuation exceeded the top quartile value for all venture exits. When communicating exit values, do your research and gain some context, if you are presenting a case that we will make a 5x return on what has to be a top quartile exit valuation back that up with great facts. Our immediate reaction was 1) median venture exits are about 40% of that so, 2) our expected return is about 2x….and it still has a lot of venture risk.

Comparing term sheets

by Simeon Simeonov

Jeff Bussgang did a guest post on the topic of how entrepreneurs should look at and compare competing term sheets.

Jeff correctly points out that the pre-money valuation of the company is not what entrepreneurs should focus on exclusively because the pre-money includes an option pool, which is under board control. Instead, he suggests that entrepreneurs should look at "the promote" which is the ownership of the founders * the post money as an indication of how good a deal they got. In his example he compares a 6 on 7 offer with a 20% pool with a 6 on 9 offer with a 30% pool. The promote in the first case is $4.4M (34% of 13M post) and in the second it is $4.5M (30% of $15M post).

This all makes sense–focusing on ownership as opposed to pre-money valuation is important but I disagree that "the promote" is the key financial metric to focus on when comparing term sheets. The main reason for this is the obvoious but often forgotten point that nobody makes money on a financing (in early stage financings it is extremely rare for founders to be able to take some cash out). Therefore, what really matters is the value of the stake that founders are going to have at exit.

Typically, if things go OK, that's ownership-at-exit * exit-value. Exit value depends on too many things to be predictable. However, the ownership at exit can be predicted to an extent. In a typical technology startup, on average, founders will experience 45-65% dilution before exit. That's quite a range. Here are some rules of thumb related to financings for how to end up on the lower end of the dilution scale:

• Have large option pools–they protect everyone from dilution. If you take a term sheet with an artificially small option pool, it will have to be increased in the future and your ownership will be diluted. To take Jeff's specific example, the second deal 6 on 9 with 30% pool is noticeably better than the 6 on 7 deal with the 20% pool even though the promotes are nearly identical because the extra 10% in the pool are insurance against another 10% dilution. In short, don't get into deals because you feel you'll own more of the company only to find out that you get further diluted in the future through option pool increases.
• Raise more capital and don't spend it faster. In well-managed companies, there is a correlation between the amount of capital that is raised and the amount of progress that's made, which, hopefully, results in an increase in pre-money valuation for the next financing round and hence less founder dilution. Even if they put just a little bit of money into your company, VCs will own rights that essentially give them substantial control over future financings. Don't accept a deal just because you'll own a lot after this round. You have to think about follow-on financings also.
• Pick the VCs carefully. Some firms and partners have much better brands and, other things being equal, are more likely to help you get great terms on a follow-on financing. However, there are circumstances where the VCs on your board don't really have a great incentive to help you get a great price. The reasons are too complex to summarize here.

I advise every founder and startup CEO to have a good spreadsheet showing how every major shareholder is impacted in various financing and exit scenarios. When you put things down to numbers, it becomes much easier to understand why it is rational for certain parties to behave in certain ways.

As for comparing across competing term sheets, there is no single financial metric to focus on. You have to think about the overall financing model for getting to exit.

In VC deals, Price Doesn't Matter - But The "Promote" Does

by Jeff Bussgang

VCs have an unfair advantage when it comes to financings.  They simply have more experience doing deals.

A typical start-up company will do 2-4 venture capital financings before a successful exit (or, conversely, an ignomious ending).  A typical serial entreprenur may lead 2-3 companies in their career before calling it quits (or checking themselves in to an insane asylum).  Thus, the universe of financings that even the most experienced entrepreneurs get directly exposed to is typically 5-10 financings over a 15-20 year career.  In contrast, the typical venture capitalist, either individually or across their partnership, will do 5-10 financings in any given year.  Year in, year out,

Thus, VCs and entrepreneurs are not operating on an equal playing field when it comes to negotiating financings and interpreting the impact of the terms involved.

One area that has always struck me where this assymetrical relationship comes into sharp focus is when there's a discussion around the price of the deal.  Entrepreneurs often mistakenly focus solely on the pre-money valuation while VCs look at multiple knobs in the negotiation to drive to a set of terms that, in total, they find acceptable.  And if they don't focus on the pre-money, they focus on their ownership position after the financing, irrespecive of the amount of capital that was raised.

In my partnership, we've come up with a new term (I think it's new - I don't see it written or talked about much) called the "promote" to help communicate with entrepreneurs the real value behind a particular deal so get them to step back from concentrating only on the pre-money valuation or post-money ownership.

What is the promote?  First, let me take a step back and define a few terms.  In the world of VC-backed financings, there are multiple terms that impact the ultimate price of the deal.  The first, and most focused on, is something called the pre-money valuation. That is, what is the company worth prior to the money being invested? This pre-money valuation is own known in shorthand as “the pre” and you will hear entrepreneurs and VCs discussing other company finances using this term (“You were able to raise money at a $9 pre?  I had to struggle to get to $6 pre and I have a prototype and real customers!  Life isn’t fair.”)

But the pre-money isn’t the only term that defines price, the amount of capital raised and the post-money plays a part as well.  The post-money is the pre-money plus the invested capital.  That is, if a company raises $4 million at a pre-money valuation of $6 million, then the post-money is $10 million.  The investors who provided the $4 million own 40% of the company and the management team owns 60%.

Another term that impacts the price is the size of the option pool.  Most VCs invest in companies that need to hire additional management team members and sales and marketing and technical talent to build the business.  These new hires typically receive stock options, and the issuance of those stock options dilute the other investors.  In anticipation of those hiring needs, many VCs will require that an option pool with unallocated stock options be created prior to the money coming in, thereby forming a stock option budget for new hires that will not require further dilution after the investment.  In our $4 million invested in a $6 million pre-money valuation example above (known in VC-speak shorthand as “4 on 6”), if the VCs insist on an unallocated stock option pool of 20%, then the investors still own 40%, there is a 20% unallocated stock option pool at the discretion of the board, and a 40% stake is owned by the management team.  In other words, the existing management team/founders have given up 20% points of their ownership in order to go towards future hires.

This relationship between option pool size and price isn’t always understood by entrepreneurs, but is well-understood by VCs.  I learned it the hard way in the first term sheet that I put forward to an entrepreneur.  I was competing with another firm.  We put forward a “6 on 7” deal with a 20% option pool.  In other words, we would invest (alongside another VC) $6 million at a $7 million pre-money valuation to own 46% of the company.  The founders would own 34% and we would set aside a stock option pool of 20% for future hires.  One of my competitors put forward a “6 on 9” deal, in other words $6 million invested at a $9 million pre-money valuation to own 40% of the company.  But my competitor inserted a larger option pool than I did – 30% – so the founders would only receive 30% of the company as compared to my deal that gave them 34%.  The entrepreneur chose the competing deal.  When I asked why he looked me in the eye and said, “Jeff – their price was better.  My company is worth more than $7 million”. 

At the time, I wasn’t facile enough with the nuances myself to argue against his faulty logic.  That's why we instituted a policy at Flybridge to talk about the “promote” for the founding team more than the “pre”.  The “promote”, as we have called it, is the founding team’s ownership percentage multiplied by the post-money valuation.  It represents the $ value in the ownership that the founding team is carrying forward after the financing is done.

In my example of the “6 on 7” deal with the 20% option pool, the founding team owns 34% of a company with a $13 million post-money valuation.  In other words, they have a $4.4 million “promote” in exchange for their founding contributions.  Note that in the “6 on 9” deal, the founding team had a nearly identical promote:  30% of a $15 million post-money valuation, or $4.5 million.  In other words, my offer wasn’t different than the competing offer, it just had a smaller pre and a smaller option pool.

Entrepreneurs negotiating with VCs should spend time making sure they understand all of the aspects of the deal, but particularly the elements of price - the pre-money, the post-money, the option pool - and do the simple math to calculate the "promote".  There are many other elements of the deal that affect price (participation, dividends) and control (board composition, protective provisions), but make sure you think hard about the value you're carrying forward, not just the price tag you think the VC is giving your company in the "pre".

Top 10 Attributes of Successful Southern California VC Investments

by Jeff Cohn

Contrary to the common belief that Southern California "should be an easy place to raise money" with all of its' entertainment and real estate wealth, it is a very difficult place to raise Venture Capital for technology start-ups. The bulk of all professional Venture Capital is managed out of offices based in Silicon Valley and most of these fund managers like to invest close to home (except MHS Capital). To make matters even more difficult almost 90% of VCs based inSoCal in 1999 are now gone while our beachhead entertainmentcompanies have a terrible track record at making early stage investments and now typically wait to invest in later rounds.

So how does an entrepreneur based in SoCal get the attention of VCfunds today? Over the last ten years I have seen hundreds ofentrepreneurs raise VC funding and I have compiled a top ten list of attributes for companies raising Venture Capital in Southern California.

1. The team is articulate, polished and focused in their delivery of their value proposition
2. Frugality reigns supreme and founders have bootstrapped the product development
3. Founders are thought leaders with relevant engineering and marketing domain expertise
4. Founders have chemistry and have established culture with their investors and employees
5. Company has paying customer references with high gross margins
6. Word of mouth marketing and industry references are working
7. The market is still somewhat undefined and growing rapidly
8. Pain relief creates incremental revenue or cost savingopportunities for customers
9. Founding team is raising money through their own personal networks or referrals
10. Company has a clean capital structure and the founders have personally invested
    

The right size VC fund

by Lee Hower

As the VC industry goes through a certain level of upheaval, one of the frequently cited issues is the growth in fund size over the last 5-10 years. All other factors aside, VCs themselves have an incentive to grow the size of funds (or raise add'l funds focused on other strategies) because of the potential for the partners to "get rich on management fees". People like Fred Wilsonand Chris Duovos have highlighted the challenges associated with generating strong returns with an industry composed of many large funds, the "VC math problem" so to speak.

Many people in the VC ecosystem (including me) believe the industry as a whole will contract in the coming years. After years of seeing $20-30B committed annually to VC as an asset class, in the first half of 2009 LP commitments were half that much. But an open debate remains as to what size funds will compose a VC industry that's materially smaller than the recent past. There are a couple schools of thought regarding this issue.

1) The VC "Index" Fund --> These folks suggest that $1B+ funds may be large in absolute terms, but in reality these funds are often pursuing mutiple sectors, geographies, and/or stages of investment. So in essence, these funds often describe themselves to LPs not as one huge fund but as an "index" of reasonably-sized VC funds or a "basket" of different strategies. Invest in our billion (or multi-billion) dollar fund, and in reality it's like buying a $200-400M life sciences fund, a $200-400M IT fund, and a $200-400M cleantech fund all rolled in one. Or a US fund plus a China fund plus an Europe fund all in one. Or an early-stage plus late-stage or growth equity fund. You get the idea. Firms like NEA, Oak, and others which have organized themselves in this fashion and are investing out of $1B+ funds tend to advance this perspective.

2) "Back to Basics" Small Funds --> This group believes that virtually all VC funds have grown too large. The capital requirements for launching and operating a startup (at least in IT / digital media) have dropped precipitously. Similarly most of the recent exits for VC-backed companies have been through M&A rather than IPO, and on average they are $100M or less. Therefore, the future of VC will look a lot like the early days of VC (starting in the late '60s running thru much of the '80s), with small partnerships managing small funds (<$250M or so). These will often be focused early-stage VC investing and often with a specific sector or perhaps geographic focus. Long-time, highly successful VC Alan Patricof (who launched Greycroft, a small $75M fund, a few yrs ago) is firmly in this camp as well as many others.

3) "Big" Funds Still Where It's At --> This group believes that the reasonably big VC fund (say $400-600M) still makes a lot of sense. Launching a startup may have become a lot more capital efficient, but building a big company (exit value of hundreds of millions or billion+) still requires significant capital prior to exit (tens of millions). To those who say the days of $1B+ exits are behind us, look no further than recent examples like Data Domain (IPO then >$2B acquisition), Equalogic (>$1B acquisition), athenahealth (IPO), or YouTube (>$1B acquisition). Unsurprisingly VCs who have "big" funds currently and want to continue to raise "big" funds in the future typically advocate this view. Not to pick on him, but David Hornik (GP at August Capital, which just raised a $650M fund) is just one example.

Having reflected on this issue quite a bit recently, I've come to the conclusion that they're all right to some extent and the future of VC will involve at least some firms of all three types. I think there's a great opportunity for smaller funds managed by smaller partnerships (including my own firm). These firms can capitalize on the fact that many startups don't need a great deal of capital, and at inception may be unclear whether they can (or want to) become a $1B+ company someday or are more likely to be a $100M company. Modestly sized VC-funds can generate attractive returns in whichever of these outcomes might ultimately occur. We're also seeing some firms that grew to have fairly large funds in the recent past revert back to investing with smaller funds (CRV, Atlas, et al).

But by the same token, I think several "big" funds in the VC ecosystem will continue to be very sucessful. I tend to agree most that few startups can become very big companies without requiring tens of millions of capital (and I don't see this changing anytime soon). The future Google's, Skype's, eBay's, and Genentech's of the world will still be created in the coming years. The VCs that can source, select, and win these investments will generate many multiples of invested capital and hundreds of millions if not billions of proceeds. I don't think the $500M VC fund in and of itself is a problem... I think the proliferation of many $500M VC funds is what's unsustainable. Presumably if LPs truly do pursue a "flight to quality", the industry won't see 30+ firms with funds of this scale but perhaps a dozen or thereabouts.

So while the VC industry may contract by as much as 50% in the near future, there's probably a place for us all... the small funds, the big funds, the index funds. Every VC just wants to be sure they end up in the "right" 50% when it's all said and done.

Why VCs Take Dividends

by Mark Peter Davis

In my post, Dividends:  Common Structures, I talk about the three commonly used structures by which VCs accrue dividends.  The motivation behind each dividend structure varies. 

When Declared
The when declared structure is designed to ensure that the VCs aren't excluded from dividend payments.  This prevents the board from declaring dividends that only pay other share classes and leave the VCs out.

Cumulative
Cumulative dividends enable VCs to be compensated for investments that take longer to liquidate.  From an investor perspective this makes sense as the longer it takes to realize an investment (have the company exit) the worse their returns looks to the investors in the venture capital fund.  As a result, by accruing dividends a VC's return can be enhanced partially offsetting the effect of having a longer duration to liquidation.

Compounding
Compounding dividends can substantially increase investor returns over time.  While some VCs will use this structure simply to enhance returns, this approach may also be used to create incentive alignment.  In unique situations where there is either 1) additional risk to holding onto an investment for an extended period (e.g., a patent expiring) or 2) where the is concern that the entrepreneur will not be seeking an appropriately timed exit. 

In the situation of the patent expiration, the value of the exit may decline over time.  Having compounding dividends enables an investor to increase their liquidity preference thereby increasing the percentage of the exit value that they will have rights to as the company's value declines.  This may have the effect of stabilizing a return.  Conversely, in this scenario the operators will receive a smaller percentage of the payout as time passes creating an incentive from them to sell the company early.

In the second situation, where the investors are concerned about the entrepreneur's intent to pursue an exit, the compounding dividends does create an incentive for the entrepreneur to consider the timing of the sale (in addition to the size of the exit).

It's worth noting that it's most common to see the when declared or cumulative dividend structures in term sheets.

Is VC too Fat and Happy?

by Mark Suster

Much criticism has come of our industry in the past few months and in my opinion much of it is deserved (but I'm definitely a believer in the meme that VC isn't broken but some of the participants are (see here, here and here)). But the VC industry is too fat – a thoughtful piece by Paul Kedrosky on shrinking the industry by half is here.

The latest to weigh in was the NY Times with this well written piece in yesterday's paper.  I think it propely captures the moment and questions whether the structure of the industry for the past 10 years is the the right one for the next 10.  In my opinion it also makes Tim Draper truly seem out of touch ...... we need more VC money to "spread the wealth to the seven billion creative minds out there." Really? WTF?  I'm prefer to assume he was quoted out of context since I'm told Tim isn't a bad guy.  (UPDATE: Great response from Bill Bryant of DFJ is here.  As I said, I had hoped it was out of context).

My own views echo those in the NY Times article and come from my experience of raising VC as a entrepreneur over 2 companies and 8 years and working with 9 firms that invested and many VC's that issued term sheets that we never closed on.  Here are my conclusions:

1. There is way too much money in VC – Lowering the amount of money will be healthy for VC's and  start-up companies.  When I was a start-up CEO I always believed in charging a fair price for the products that I created.  But in 1999-2001 so much money went into our competitors that people were willing to low-ball on price to win deals because they (we all) had too much VC money that would fund our losses.  In today's world this is worse – people are willing to offer products for free funded by 2 years worth of VC money (and I'm not even talking about ad supported businesses).

2. Fund sizes have been way too large – I remember pitching on Sand Hill Road in 2005 for my second company, Koral, and I told VC's that I only wanted $2 million.  A number of investors told me that their minimum was $5-8 million and they encouraged me to take more money, "because I'd need it."  Luckily I was on company number two and I had already painfully learned the lesson of raising too much capital so I didn't follow this advice. At the time I couldn't understand this mentality until it was explained to me this way, "look, I have a $600 million fund.  I can't invest $2 million in companies and stay actively involved."

Actually, I get this.  But then I think this fund ought to be a later stage growth equity firm and not a VC or they ought to have more partners in the firm investing smaller amounts. I believe passionately in capital efficient businesses that prove out their model before trying to scale.  This suits the interest of the VC but I believe it suits the interest of the start-up founders even more so.  Some VC firms like Accel, Index and others have created separate "growth" funds with larger dollar sizes for later stage deals – that makes sense to me.

The incentives for many VC's has been wrong.  They've been too happy to have multiple "stacked" funds of large sizes so that their management fees (which are typically 2% of the fund size) can be large.  I don't believe that VC's who maximize their fees by having large funds are in the interests of their Limited Partners and I actually believe it encourages the wrong people to want to work in VC. (as I side note I wonder how LP's can justify this size of management fees for the "mega" funds that have billions of dollars.  Do they think it creates aligned interests to make partners so wealthy on just deploying capital?)

Dana Settle said it well in the NY Times piece.  Start-ups need less money to get going these days and you can get a good return at a $100 million exit provided you didn't put in too much money and you can get in at an early stage.  Venture exits last quarter on average were just $22 million last quarter (vs. $41 million a year before $60 million over the last 8 years).  I know we're all looking for the home run that "returns the fund" but to be successful I believe the industry needs more Greycrofts.

3. There are way too many non-operators - I won't go as far as to say that every VC needs to have been an operator because I've worked with tons who I really respect who don't come from an operator background.  I certainly believe operating experience helps a lot, though, and believe that every firm needs to have a few entrepreneur partners in their stable.  I experienced way too many ex i-banker and consultants who never had any operating experience and had a better grasp on whether my operating margin in year 5 was appropriate vs. an intuitive feel on whether my product would be adopted by customers.

No doubt they can do the deep analysis and really help at financing time to analyze the pro's / con's of venture debt.  And I'm sure they really earn their money at exit time in the sale.  But some of them lack the depth of understanding in the key decisions that each entrepreneur faces.  They have no idea what it feels like to be 3 weeks away from missing payroll with an employee asking you whether it is a good idea to buy a house (should you actually tell them there is a 10% chance you'll be out of work in 3 weeks?) or customers are entrusting you with orders that you're not 100% sure you'll be able to fulfill.  What advice can they give you about dealing with customers in this scenario?  If VC's truly understood the angst and emotional drain this puts their founders under they wouldn't bleed you until the 11th hour waiting for your internal financing term sheet so that they get more information or negotiate a better deal with you.  A great VC wouldn't do this.

I recently debated with some founders the best way to go about laying off one of their employees.  They were telling him they were letting him go for cost control reasons when it was really for performance reasons.  I'll cover the topic some other day but I believed the right thing to do was to fire him for performance and tell him this.  I gave them 30 minutes of rationale from my experience on why I thought that would help and not hurt with morale.  (btw, they didn't take my advice ;-) I have been through more downsizing (can you say 2001?) then I care to think about and have had many years of firing based on performance.  It's never fun.  Many VC's have never had to deal with this "dirty" work and never will.  Sure, they've let an analyst or associate go but in the VC world this is very different than cutting a developer on a tight team of 6 developers when each of the remaining 5 could go out and get another great start-up job without a sweat.  Not true in VC.

I like to say that you can't run a burger chain unless you've flipped burgers.  I think we could use more burger-flipping VCs.  I think that’s why so many people are excited to hear about the Andreessen Horowitz fund.

4. In a strong wind even turkeys can fly – I believe that there are way too many VC's that believe their own hype from the successes that they had in the late 90's (or frankly from 05-08).  It reminds me of the real estate investors who were telling me what a fool I was not to be buying condos in Florida in 2006.  The difference in VC is that many of the senior people in industry who had past successes don't have real down side when markets become more difficult.  They are simply able to stay in their funds and milk it.  Obviously the industry luminaries like Sequoia, Kleiner Perkins and Accel have continued to prove they can pick the best winners but there are also many who had hits by sheerly being in the market.

Years ago a sage mentor of mine told me in 1997, "don't assess our company relative to competition now.  In a strong wind even turkeys can fly.  In a down market the best companies separate themselves from the pack.  The weak disappear."  So it goes with VC.  Eventually those with no leadership will dwindle and help realize Paul Kedrosky's prediction.

5. Some VC's lack empathy. Some VC's simply can't understand the world of the start-up founders or they're too far removed from the daily grind to really empathize.  Being a CEO is much lonelier than anyone who's never done it can imagine.  I know that there are the breakout successes like Google, Twitter and YouTube.  But  the rest of companies go through through cycles.  Even the best companies go through it.  I'm sure that LinkedIn, Facebook, Mint and others have been through tough times.

You don't have many people to share your problems with because you try to keep it together for all your staff.  You need to come in every day to the office and motivate people even when you have your own self doubt and worries.  You need to hire, sell, talk positively to the press, etc. while blindly having faith that your next round of capital is going to come.  You have co-founder issues.   Your clients grind you.  Your employees need more money to get by.  Your product is shipping late and with some of your key features postponed.  Your crack developer quit to move to NY.  Your spouse or girl/boyfriend is irritated because s/he hasn't seen you enough.  Or worse you don't have one and you're getting too fat.  This is an unbelievably honest piece from an entrepreneur coving this topic.  Have you been there?  That's when I think you can offer real advice.  That's where a VC needs empathy.

6. Are some VC's too old?.  The NY Times article alludes to this.  As for me, I'm not ageist.  I see fantastic VCs in their 50's/60's that blog, use Facebook, use Twitter, IM people and use Salesforce.com, Google Docs, RSS Readers, etc. (no, using a Kindle and a Blackberry doesn't count).  The NY Times piece profiles one of our industry veterans, Alan Patricoff.  He still works incredibly hard.  I don't know how old Howard Morgan at First Round Capital is but I know he's not 35.  He travels more than most 35 year olds I know and knows more about what's going on in early-stage tech than many of these same people.

I think it's more about mentality and willingness to accept the creative destruction of the new without being jaded by your past.  I remember a conversation I had with a prominent older VC from Sand Hill Road 6 months ago who decided to call it quits.  I asked him why and he said, "I just realized that it's all changing so fast and I don't have it in my to want to learn all the new technologies that everybody in their 20's are playing with."

Blogs are reshaping the publising indutry.  Companies like TopSpin Media are finding new distribution channels for musicians.  Twitter is chaning our communication landscape.  Cloud computing is coming and will change the IT industry.  Young people do place real value on virtual goods and define their self worth through online brands the way we do in our offline lives.  People will spend hours translating movies, adding restaurant reviews and updating Wikipedia for nothing more than to be part of a community and be "Internet famous" to that community. Virtual reality and augmented reality are real phenomena and not this year's fad.

As one senior VC partner lamented to me "kids these days don't read physical newspapers any more" and I showed him how much news I could consume from so many more sources than he could through RSS feeds and after showing him he still didn't get it.  Some people never will.

My advice to entrepreneurs – find a VC you feel can really relate to you and your company on a personal level.  Find people that are in it for the passion of building great products and love the rush of the start-up.  Find "egg breakers" willing to take risks.  And be careful of VC's that have a gleam of easy money in their eyes.

Update: several people asked me for VC's that do "get it."  There are many and I don't want my post to be seen as damning of the whole industry – just several players in it (not to mention that many hedge funds did venture investing in the past 3 years who had no previous VC experience).  Here just a quick, non comprehensive list of some obvious VC's who do get it:  I think there's a host of VCs who do get it.   True Ventures, Foundry Group,Union Square Ventures, First Round Capital, Founders Fund, and I obviously I feel GRP Partners in LA (who funded 2 of my companies and I worked with for 7 years before I chose to join).  There are obviously many, many more.

Where Do Venture Capitalists Find Their Companies?

by Jason Mendelson

I've received a few emails recently asking me where VCs find their investment companies.  I can't speak for all firms, but if I look over the past 10 years of my career and add in results from other VCs that I'm close to, I will conclude the following:

VCs get their deal flow from the following sources (in no particular order):

1. Personal Networks;

2. Repeat Entrepreneurs;

3. Other VCs;

4. Email / Blog / Cold Calls;

5. Professional Service Providers; and

6. Venture Shows / Trade Shows.

It's hard to put a particular percentage on each category.  In general, I think that good VCs with healthy deal flow invest in 1% or less in the aggregate of their deal flow.  I know that sounds like a small number, but the great majority of companies presented to us to invest in are easy rejects.

As for division between sources, I think a healthy VC might see the following division:

1. Personal Networks; 30-50%

2. Repeat Entrepreneurs; 30-50%

3. Other VCs; 10-20%

4. Email / Blog / Cold Calls; 5-10%

5. Professional Service Providers; 5-10% and

6. Venture Shows / Trade Shows. 0%

So what does this mean?  The low hanging fruit is VC / Trade shows.  If you are presenting at a show, you've already struck out the normal routes of VC investment and you are pitching to "everyone."  I think that most VCs who have healthy and proprietary deal flow don't go / care about these types of events.

Clearly personal networks / repeat entrepreneurs (what I call "proprietary deal flow") are the major sources of companies.  This is why investors should chose one VC over another. 

As for the cold call / email / blog category - yes it does happen.  In our newest fund, we have one deal already in this category and we are working on another that fits this bill. A VC with a strong web presence can attract good deals.

The professional service providers can also be a source of deals.  While I've spent plenty of time making fun of lawyers and accountants, occasionally they have good clients to fund. 

So bottom line - you have a much greater chance of getting a deal done if you are already in a VC's network or if you get a warm intro from someone in our network.  Your other avenues are much less likely, but not impossible.

The "capital invested" trap

by Lee Hower

A lot of startup pitches I see or hear often include a point something along the lines of:

"Over $X million has been invested to date in building our technology/product"

Whether X is $2M or $20M or more, this conclusion is largely a fallacy. It's a derivative of the "sunk costs" issue we learn from economics text books. The amount of capital invested in developing a product isn't necessarily correlated with it's commercial success or potential. eBay was built on a few hundred thousand in capital and was already breakeven when Benchmark invested. Google has obviously continued to invest heavily in search, but reportedly they never fully exhausted their one and only round of venture funding from Sequoia and Kleiner before reaching profitability. Similarly, just because one startup spent $X million building a product doesn't mean a smart team of motivated engineers couldn't build a better version for far less.

Whenever I hear the "capital invested" point about a product, I tend to see it as a red flag. My anecdotal evidence suggests that entrepreneurs who highlight this in their pitches do so to justify company progress which isn't commensurate with the amount of capital raised to date. Or it's to suggest a barrier to entry when the company has few other strong competitive advantages.

My suggestion? Focus a pitch on the true metrics of progress and future success of your product or technology. Show potential invesetors why your startup will win over the competitors, whether through product superiority or more cost effective customer acquisition or what have you. Smart investors rarely fall into the "capital invested" trap so it's not worth emphasizing in a pitch.