Seed is the new Series A for VCs

by Caine Moss

It shouldn't come as a surprise to anyone that VCs have, over the past few quarters, been reluctant to put term sheets down on new investments. Most venture folks have instead been preoccupied with tending to their portfolio companies, either ensuring that their most promising companies have enough capital and resources to weather the downturn, or trying to sell off the others.

The statistics bear this out. U.S. venture-backed companies raised $9.28 billion in the first half of 2009, according to VentureSource. That's 44 percent less than the $16.47 billion raised during the same period in 2008.

It may be too soon to pop the champagne, but the mood in the venture community appears to be slowly improving.

The market is up (the Dow has climbed back to above 9000); cracks are emerging in the tech IPO deep-freeze (with Open Table and Solar Winds having had successful IPOs, and a number of other venture-backed technology companies announcing plans to go public in the near term); and VCs are starting to do deals at an increasing rate (VentureSource cites that the amount of capital invested in the U.S in Q2 2009 rose by 32 percent as compared to Q1 2009).

What is most noteworthy about the recent increase in funding activity is the structural change occurring in the market for early stage investments. In the early part of this decade (after the dotcom boom and subsequent bust), when VCs recommitted to investing in early stage startups, most simply dusted off their Series A term sheets and recommenced investing in the "Series A mold." Series A deals can vary dramatically, but they often look something like this:

1. VCs invest $3-5 million of capital for a 33-50 percent post-money ownership stake in the company.
2. Investors receive a senior liquidation preference on an M&A exit, and will often "participate" with the holders of common stock on the distribution of proceeds beyond their preference, either until all proceeds get distributed or up to some negotiated cap based on a return multiple (e.g., 2x-3x the VC's initial investment).
3. Investors enjoy control features such as special voting "block" rights on important corporate actions such as financings and M&A transactions, as well as on operational activities like hiring executives or entering commercial or strategic transactions.
4. Investors control the Board or at least negotiate for board neutrality (where neither the founders nor the VCs control board voting).
5. Attendant to the investment are a panoply of additional rights including demand registration rights to compel a company IPO after a period of time, first refusal rights on founder stock transfers and "drag-along" rights (which force founders to vote for a sale of the company under certain circumstances).

As investors dip their toes back into the early stage deal pool following the most recent downturn, however, many are opting for "seed" financings instead of the typical Series A described above.

Seed financings are "priced" like Series A deals, meaning a valuation for the company is set and an ownership stake is taken at the time of the investment. However, seed deals tend to involve much smaller amounts of investment capital than Series A financings: usually somewhere between $500,000 and $2 million. These seed deals are also sometimes called "Series 1" or "Series A-1" financings to distinguish them from Series A financings that follow them.

It used to be that seed financings were investment vehicles reserved principally for investors and "seed stage" VCs with small funds that can only deploy small amounts of capital in any given deal. These days, however, we are seeing big-fund VCs seeding early stage deals with a regularity we haven't witnessed before. Based on internal private financing data, my firm (Wilson Sonsini Goodrich & Rosati) alone has closed 14 VC seed deals in the four months from March through June 2009.

So why the recent increase in seed funding? I believe there are three reasons.

First, VCs have to deploy capital and, as noted earlier, they've been reluctant to do so for the past several quarters. Over this time, however, entrepreneurs haven't stopped pitching them great ideas, and with the market showing signs of improvement, they are now starting to fund these ideas.

Second, while the desire to deploy capital has re-emerged, VCs are still skittish. They are reluctant to put large amounts of capital at risk, and figure seed deals to be a suitable "low-risk" investment option for them.They can throw $500k at a founder and tell her to prove out a business model. If she doesn't, then the VC is only out $500k. If she does, then that VC is probably in pole position to lead that founder's Series A financing a few months later.

Third, for software, Internet services and other IT companies, the cost of innovation is a fraction of what it used to be a decade ago, and entrepreneurs starting these companies require less capital for their businesses.

From an entrepreneur's perspective, VC seed investing isn't necessarily a bad thing. After all, some activity is better than no activity. Moreover, investment decisions within the partnerships of these venture firms can be arrived at more quickly and with less friction when only $1 million of investment capital is at stake.

That said, entrepreneurs should be mindful to avoid Series A deal terms when negotiating a Series 1 financing. Many VCs will propose a seed deal using a Series A term sheet (whether by design or mere convenience), and this can end up costing the company much more than it bargained for. Here are some tips for entrepreneurs when negotiating seed deals (with the caveat that each deal is different, and rarely will an entrepreneur get their way in all of these categories):

1. Don't give away too much of the company too early. VCs shouldn't expect more than around 20-40% of a raw start-up when investing seed-stage.
2. Avoid giving investors more than a 1x liquidation preference, and try to ensure that it is "non participating" (i.e., after the investors' preference is taken, all remaining proceeds are allocated only to the holders of common stock).
3. Don't give investors Series-A-type control rights. A VC should expect to receive one board seat, but not to control the board, following a seed financing. Also, while it is customary to give investors voting "block" rights on financings and on a sale of the company, entrepreneurs should avoid granting voting rights that give VCs blocks on operational matters at this stage.
4. Keep other "investor rights" to a minimum. For example, try to avoid granting demand registration rights, ROFRs on founder stock transfers or drag-along rights.
5. Many VCs will want a "super-pro rata" right in seed deals, giving the VC the right to increase its ownership percentage in the next round. This is not necessarily unreasonable, but take care to ensure that in agreeing to super pro-ratas the company is leaving room for a new VC to lead the next round.
6. Beware of the negative market perception that results when the VC that seeded your company declines to participate in the Series A. This happens. Raise this issue with the seed VC early on to assess the risk of this happening, and always keep your communication channels open with other VCs interested in what you are doing.

Seed is the new Series A for many VCs, and this is fine. Just make sure that you, as an entrepreneur looking to raise capital, understand what seed financings are, and also what they are not.

Pitching the VC partnership

by Chris Dixon

The last step to raising venture capital is normally a 1 hour pitch to the whole partnership during their weekly monday meeting.  This is often described to entrepreneurs as a formality, but at least in my experience, for early stage deals, I would say there is probably a 25% chance of you getting a term sheet afterwards and a 75% chance of you getting rejected (although it will rarely come in the form of an actual "no") .

The reason the odds of you getting dinged are that high are:

1) In most VC firms all it takes is one partner to say "This is really stupid - I hate it" to kill a deal.

2) Although by the time you pitch, the lead partner has probably told the other partners about you and probably sent around a memo, the non-lead partners probably didn't pay attention, and only really do when you are presenting.

Good VCs have a much lower post-partnership ding ratio, because they work hard to socialize a deal and really get their partners to focus on it before asking the entrepreneur to present.   For example, I used to work for Rob Stavis at Bessemer and he had a much lower post-meeting ding rate.  This was because he spent a lot of time talking to his partners beforehand ("socializing the deal"), and if they had good objections he got them early on.  (Ps. Hopefully the VC will work extra hard to pre-sell the deal if they ask the entrepreneur to drop everything and fly across the country.)

The very worst thing that can happen in a partnership meeting is what I call the "partner ambush."  Basically this is when the partner who brought you in (the "lead" partner), who you've met with for many hours and fully understands your company and is excited about investing in it, realizes midway through the meeting things are going badly and decides to try to save face by turning on the entrepreneur.

I had this happen to me when I was raising money for my last startup, SiteAdvisor.   Basically what happened is me and my co-founder Tom Pinckney walked into this big, well known VC firm at 4pm to a room of very tired looking guys (yes, they are all male) who had been hearing back-to-back pitches all day (side note:  always try to present in the morning).  No one introduced themselves or said hello, which was a bit unnerving.   The first questions were clearly hostile to the very idea of a consumer security startups (for a bunch of bad reasons, most VCs vastly prefer enterprise to consumer security - especially on the east coast and back in 2005).   One of them literally laughed at the idea of marketing via search engines (this is the east coast - believe it or not many VCs our here still don't know what (white hat) SEO is and how important it can be).   Then the partner who brought me in said "Well, Chris, why not make SiteAdvisor into an enterprise product" basically turning on me and the whole concept of the company.  Things went downward from there.  To add insult and injury, the lead partner never even bothered to call me to ding me afterwards - in fact I haven't heard from him to this day.

In retrospect, that would have actually have been a very good investment for the VC if they had actually given our pitch a fair hearing.  Which gets me to my final point:  I think VCs are making a mistake by putting so much emphasis on the partnership pitch.  There is some positive correlation between presenting to a room full of (sometimes hostile) VCs and building a successful startup, but not a very high one.

Besides missing good investments, the emphasis on the partner pitch leads VCs to invest in bad companies.  An investor friend of mine was recently talking about a failed startup he invested in:

Toward the end of the company, when things were going very badly, I went in and spent a day sitting with the entrepreneur and watching him work.  At that point I realized his one skill in life was pitching investors.  He had no idea how to manage people, build a product, get stuff done, etc.

The current early-stage VC process is optimized to favor people who are good at pitching partnerships, not necessarily people good at creating successful startups.

How NOT to project a SaaS startup's revenues

by Healy Jones

When I was a venture capitalist, I saw a recurring, common mistake made by startup founders who were trying to project their company's revenue for the coming years. Of course, now that I am actually trying to help a startup create their financial projections from the other side of the table I almost made the same mistake! This issue is particularly important when the startup has a SaaS or viral revenue model.

How to NOT project SaaS revenues

Probably the number two or three mistake startup founders (and me, almost) make when estimating their revenues is to assume they acquire their customers in a linear fashion during the year. Many, many CEOs project revenue by the following formula:

(Number of expected customers at year end) X (monthly subscription revenue) X (12 months) X 50% = Anticipated Yearly Revenue

The 50% discount attempts to take into account that you haven't acquired all of the customers on January 1 (Or whatever your fiscal year day one is), but instead get some of them month 1, some month 2, some month 3, etc. However, this creates a major assumption - the assumption is that you get the same number of customers in month 1 as month 12. Usually this is not the case if you are a startup ramping up your marketing and sales programs. Typically you get more of your customers in the final months, and many, many fewer in the first couple. This effect is more pronounced the greater number of marketing programs you are layering on during the year.

To illustrate how this 50% discount will over-estimate your revenues, consider the following example. I am over-simplifying everything to make a point, so please don't make too much fun of this. Although it is so simplified as to be comical.

Assume a startup has 12 different marketing programs that will run for at least 12 months each. The CEO anticipates that these will result in one new customer per month that they are running. The team will have bandwidth to launch one new program per month, so one new program will be launched each month. The company's service is so amazing that no customers will churn; assume the service costs $100 per month. Customer acquisition will be as follows:

1st Month: 1 new marketing program. 1 new customer
2nd Month: 1 new program, one old program. 2 new customers, plus 1 existing customer = 3 total paying customers.
3rd Month: 1 new program, two old programs. 3 new customers, plus 3 existing customer = 6 total paying customers.
......
I think you get the picture. By the end of the year the company will have 78 paying customers.

Running the formula above for expected revenues, we get $46,800.

The problem is that the company won't actually have that high of revenue. Revenues will really be only $36,400. 77.8% of the amount projected. So, even if the company hits their customer acquisition plan they will miss their revenue target. Obviously this could have serious implications to their cash flow, etc. The level of your revenue miss will be even greater if you have a viral product, since your growth will be even more exponential.

It's a much better idea to identify the specific marketing programs that you will be implementing, the months that you'll be rolling them out and the anticipated customer acquisition by month from them. I realize this takes a long time, and you are probably pretty busy trying to actually get your company going. But projecting your cash flow is such an important part of the success in the early life of your startup that I'd suggest you do it and don't fall into the trap of making such simple revenue forecasts that you misjudge your cash needs.

When A Down Round Isn't So Bad (Unless you are a VC)

by Jason Mendelson

All of us in the startup eco-system hear about the "evil" down round or "cramdown" financings that happen.  These days, the noise level around this financing dynamic is increasing, not decreasing.

While most entrepreneurs worry about down rounds, I'd argue that many times the entrepreneurs and employees are the ones that come out ahead.  In most cases, while the valuation is reset, the VCs funding the round don't want to injure the current employee base by wiping out their equity holdings.  So what's the answer?

VCs will look first to wipe out other VCs that are not participating in the round and give additional options to the employees.  Secondly, the VCs may consider wiping out their own previous equity to accomplish the same effect.

What I've seen over the past 10 years is that most (not all) times, the employees end up with roughly the same amount of equity while non-participating VCs are completely taken out and participating VCs being partially diluted.  Of course, ex-employees are wiped out as well.

There are plenty of examples of these types of transaction and there are plenty of examples of ultimate success stories with these companies.  My personal favorite is Stratify, but my friend Lorenzo Carver wrote a blog post about two recent examples: Open Table and SpringSource.  He points out that these are among the best exits of the year.  It's an interesting read.

Bottom line, a down round / cramdown isn't the end of the world for either the company or its employees.  While still stressful and painful, don't get too out of shape.  All could turn out just fine.

The Naked Silicon Valley Emperor And The Blameless VCs

By Tom Foremski

Georges van Hoegaerden, a serial entrepreneur, writes that "The Silicon Valley emperor has no clothes."

...Silicon Valley has become the emperor who wears no clothes. Many Venture Capitalists (VCs) like the emperor will hold their head high and continue their procession for the sake of protecting their management fees.

...the simple fact remains that very little disruptive innovation is born. And without disruptive innovation (and the risks that such innovation incurs) it is just a matter of time before the Limited Partners (LPs) recognize that the emperor's procession is coming to an end.

Mr Hoegaerden says that the fault is with the VCs -- many don't have the entrepreneurial experience to do their job. And they will always look to blame others and never themselves.

He writes that "innovation is not the problem," the problem is ineffective VCs

Entrepreneurs should refuse to work with investors that improperly assess business risk, money from the wrong investor is a dead-end street anyway. But most influential will be the immediate action from LPs who should close their underperforming commitments (instead of flee), reset their fund requirements and require more relevant operating credentials from General Partners (Venture Capital requires more relevant early-stage credentials and vision than other Private Equity sectors).

The naked Emperor procession will continue for a while.

The sheer size of LP commitments outstanding to the VCs will keep the emperors procession going for a while, and the VCs refusal to criticize themselves is a sign that it is incapable of recovery and self regulation. We need new VCs, with a new mindset and a different DNA to get there.

...We are after all at the beginning, not at the end of technology innovation.

Foremski's Take: I agree with much that Georges van Hoegaerden writes, especially with the fact that we are in the early stages of a long period of new innovation -- but I don't see many signs of things changing regarding the VC industry's malaise. Industries only change when there is a considerable amount of pain and there's not that much pain (yet) on the VC side of the innovation equation.

The problem is in funding and guiding the next generations of startups and creating that "seed corn" for the future. There is little of that going on.

And the reason is lack of decent exits, especially the absence of the IPO market. Prospects for the IPO market opening up look very bleak. However, we mustn't project the present into the future because things don't remain the same. The IPO market will return and that will help restore the cycle of capital that powers innovation.

I'm worried that once the IPO market does return there won't be many companies to IPO because we haven't seeded enough startups.

So You Want To Be A VC?

by Jeff Bussgang

Summer is a good time for career reflection. Am I in a job that's personally satisfying as well as financially rewarding? Is my career on a productive, long-term trajectory? Many executives conclude over the summer (often during long walks on the beach with their spouses) that it's time for a change. Some are interested in exploring what it takes to be a VC. Unfortunately, I often find that many of those who aspire to be VCs have a hard time grappling with the stark reality of the industry – only 3000 deals occur each year (almost eerily precisely 3000 from 2002-2005), with an average of 1-2 deals per active partner per year imply there are only 1500-3000 active partners making VC investments spread out over 450 firms (the number of member firms in the National Venture Capital Association). Thus, it remains still very much a cottage industry and therefore not an easy career path for most to pursue.

But for those who remain determined to pursue a career in VC, I can share a few thoughts that I've observed from my years on both sides of the table.

Generally speaking, there are two on-ramps to the VC world. One is what I'll call "The Apprentice" model: go to a top college, get a few years of working experience, go to a top business school, spend a few more years in a start-up (typically in product marketing/management) and then join a firm in your late 20s/early 30s as an associate or principal and hope to be accepted as a junior partner into the partnership after 4-8 years. During that time, you will probably shadow a few of the partners, join one or two boards and try to learn the trade from the experienced, senior partners around you.

The challenge with VCs who follow this path is that the lack of deep operating experience can potentially be viewed negatively by entrepreneurs. Some entrepreneurs ultimately conclude these types of VCs "don't get it" because they've never walked in their shoes. On the other hand, these "Apprentice" VCs are often more successful investors because they are incredibly broad in their range of expertise and analytical in their approaches to selecting new investments.

The second on-ramp is what I'll call the "ex-CEO/Winner" model: work your way up the start-up ladder, become a VC-backed CEO, navigate a successful exit or two and then join one of the VC firms that backed you and with whom you've had a chance to build a relationship (and make money for) over 5-10 years. This on-ramp sometimes begins with a "Venture Partner" title before becoming a full General Partner (i.e., the training wheels come off and you have your own checkbook, subject to partnership approval).

The challenge with VCs who follow this path is that they can be accused of viewing their VC careers as a lifestyle choice – "the back nine" – and never really go through the hard work, long hours and long years to learn the trade.  After all, this is a business where you fund lifecycles are measured in decades. Although these types of VCs may have deep knowledge in the particular domain where they had operating experience, they may not have the breadth or analytical horsepower to productively invest in the fully broad range of opportunities most general partners require to be successful. On the other hand, these "ex-CEO/Winner" VCs have great networks of former employees and business partners and an ability to bond with the next generation of young entrepreneurs for whom they can serve as valuable mentors.

Which path is the more successful one? I have no idea – but I do know that numerous aspiring VCs who can't credibly follow one of these two paths have slim odds to entering the industry; in a world where the odds are slim at any rate.  And I suspect many LPs are looking for partnerships that blend the best of both sides into a single, holistic unit.

Doubling Down

by Fred Wilson

I wrote a post recently called "Double Down, But Only On The Right Hand" that was about Yahoo!'s decision to bail on search and Microsoft's decision to double down on it. It was also about new forms of search, like real time search, that are worth investing in.

Since writing that post, I've been thinking a lot about "doubling down." Conventional investing wisdom is when an investment goes against you, the thing to do is get out and move on to the next one. Most of the great traders I know practice that approach and it works well for them.

But in venture capital and private equity, it is not easy to "get out." These are illiquid investments that you can't simply sell and move on. So when an investment is not working, you are faced with walking away, shutting the company down, or making an additional investment. And these are hard decisions.

Like most VCs, I am guilty of sticking with our investments too long and putting too much money into the ones that are not working. It's an occupational hazard. As I've gotten more experience in the venture business, I've gotten better at this part of the business, but it is still a challenge for me and most VCs I know.

Bliss McCrum, one of the two VCs who taught me the venture business early in my career always said, "if you are going to put more money into a company that is not working, make sure to change the strategy, team, or cost structure, or all three." It's good advice. You will not get a different result doing the same thing.

The important thing to focus on when making a follow-on investment in a company that is not working is to figure out what's wrong with the company and use the financing discussion to fix it. That's when the investors have the most leverage and when change is most easily obtained.

It is also important to recognize that some investments cannot be fixed. And in those cases, painful as it is, the right thing to do is shut the company down or sell it if a buyer can be found. I prefer the latter outcome, even if getting it is more costly to the investors. Finding a "home" for a company and a team has reputation benefits that accrue to the VC investors over a hard shutdown.

The biggest "double down" I ever did in my career was on the Flatiron portfolio in late 2000/early 2001. We had invested $500mm in 60 companies from 1996 to 2000 and had taken out about 3x that number in cash and stock distributions on 24 companies. The remaining 36 companies were all struggling in the wake of the bursting of the Internet bubble and the portfolio was basically worthless on paper.

Our financial partners wanted out, as did we, but there was the little problem of a portfolio of 36 companies. It would have been easier to take our 3x and be done, but that is not what we did.

Our financial partners agreed to invest another $75mm into the portfolio and my partners and I agreed to triage the portfolio and invest the $75mm wisely into the survivors. We shut down roughly a third of the companies and sold off another third over the next year. But on the final third that we thought had real potential, we invested the additional $75mm.

I am not going to get into the full details of that $75mm "double down" but I will say that three of the twelve companies we doubled down on, Bigfoot Interactive, comScore, and Mercado Libre, have produced north of $300mm in combined value for that portfolio. The other nine have produced even more value and we still have four companies left in the portfolio.

I've told this story before on this blog so it may not be new to some of you. But I like to tell it because it was a very formative experience for me. I learned that when times get tough, you can't cut and run. You have to commit yourself to finding a way out. And the way out involves a double down, but it also involves some hard choices, taking some losses, and restructuring the remaining assets so you can go forward.

In times like we are in, most people are living with situations like this. I am as are most of my friends in the VC business and elsewhere. I hope this post helps those of you who are struggling with this process. The ending of the story can be a good one if you do the right thing, are honest with everyone, and double down on both your financial and personal commitment to the investment.

How Should VCs Say No - When It's The Team?

by Jeff Bussgang

One of the things I continue to struggle with as a VC is the unfortunate fact that I am in the business of saying "no" all the time.

Saying "no" in the context of how you invest your time is one thing - fellow VC blogger Brad Feld did a good blog post on this topic in the context of time management a few weeks ago as did Y-Combinator's Paul Graham.  But I really struggle with saying "no" to entrepreneurs.  Entrepreneurs pour their hearts, souls and dreams into their start-up ventures and to summarily dismiss them remains the hardest thing about the job.  One of my entrepreneur buddies asks me whenever I see him:  "So - did you crush any entrepreneurs' dreams today?"  Very funny.  Ha ha.

One of the reasons for this dynamic is that VCs are in the business of trying to see everything (i.e., learn about and meet with all the best deals out there) but do nearly nothing (i.e., invest in only one or two companies a year).  My blog post on this topic a year ago was a bit tongue in cheek (VCs and Deal Flow), but only a bit.

My dilemma becomes more acute when I try to explain why I am saying "no".  In particular, how do you say no when the reason for turning down the investment opportunity is the team?  It's easier to say no when you have concerns about the market, the business model or the price.  The entrepreneurial team is great, you would enjoy working with them, you think they are money-makers, but there's something in the general model that prevents you from pulling the trigger.  Those are the easy ones.

The hard ones are when you are saying no because of the team.  Successful start-ups typically follow Thomas Edison's genius formula:  10% inspiration (in start-up land, the vision or idea), 90% perspiration (in start-up land, the execution).  Whether you like the idea or not is irrelevant if you don't believe the team has the wherewithal to execute it successfully.  Sure, a team can evolve over time and new leaders can be brought in, but very few VCs invest behind teams they don't believe in.

One curmudgeonly VC I know used to say to entrepreneurs:  "I don't think is an opportunity that suits you." At Flybridge Capital, we try our best to be direct and honest in providing feedback to entrepreneurs to help them with their ventures and perhaps we should have the courage to give it to people between the eyes.  I'm just not sure this blunt feedback would pass the decency and respectfulness test.  After all, who am I to project such an unfair judgment based on a 45-60 minute meeting?  VCs need to "Blink" and make snap judgements after those 45-60 minutes in order to filter and prioritize how they spend their time, but why be mean about it?  So in the end, I often settle for a polite "it's just not a fit for us".  Is that the right approach?  Let me know what you think.  What's the meanest turn down you've ever received from a VC?

Beware of Gym Salesman VC

by mark suster

The post is part of a series called "Pitching a VC" – the outlines is here.

You've been trying to raise VC for months.  You've obviously talked with several funds to hedge your bets.  You finally get your first term sheet.  Time to celebrate!

But wait.  What?  They're giving me 48 hours to sign the term sheet or it expires?  WTF?  What about all the other VC's I'm talking with?  I can't get them to close in 48 hours.  But I have a bird in the hand.  Will they really pull the term sheet if I don't sign?

OK.  First, every term sheet has an expiration date in it.  That's normal and no reason for alarm.  A VC isn't going to give you an unlimited offer to stay on the table as you shop the terms around town.  But there is a difference between a term sheet with an expiration date and a VC that puts pressure on you to sign and alludes to pulling if you don't close by the date.

The various excuses they will give you are:

1. I can't leave an offer "hanging out there"
2. I don't want you to shop my deal
3. If I've made you an offer and you don't KNOW you want to work with me maybe there's a problem here
4. Whatever …

You need to make your own mind up regarding an offer and I accept no liability for your basing your decision on my point of view.

So here's my view: it's total bullshit.  Any VC that would try to turn the screws on you to try and pressure a decision is not the kind of VC you want to work with.  If they use these tactics when they "love you" imagine the tactics when you're not performing as well as you would have liked.

It's one thing if this term sheet is the only game in town.  You might NEED to take it.  But I like to say that "VC is more permanent than marriage.  At least in a marriage if you're unhappy you can get divorced."  Not so, VC.  So why should you be pressured to make a quick decision.  It's unlikely that you've even had time to do due diligence calls on this VC – you wouldn't be so presumptuous as to do this pre term sheet.

The only reason some VCs use these tactics is the same reason a gym salesman only offers you a discount if you sign up today.  Once you're out of the gym they're afraid someone else will get a hold of you and you won't sign with them.  And you know damn well that when you come back to the gym tomorrow and ask for the deal that was only valid yesterday they'll still give it to you.

I highly doubt that any VC who submits a term sheet to you would really pull it because you politely ask for a reasonable extension to their deadline.  They've done all the work.  They've had the big debates at the partners' meeting.  You partner sponsor is excited.  And lose it because you need 2 weeks rather than 1?  Really?

Don't mistake eagerness for pressure.  I can understand a VC who tries to close you the way you would try to close a customer deal.  It's OK for them to push for closure but if you politely request more time they should really be understanding.  And if there are threats, implied consequences for taking time to think about it or do due diligence then I'd give that VC a really hard think.

The Dreaded Question of Valuation

by mark suster

This is part of my ongoing series, "Pitching a VC" – the entire outline is here

Whenever I sit on panels and discuss the topic of fund raising the topic of how to handle the discussion of valuation (e.g. how much you're worth) always comes up.

I have very fixed views on this topic although I've learned through these discussions that not everybody agrees with me.  Having sat on both sides of the table on many occasions – I'm pretty sure I'm right about this one ;-)  I know that the line of answering below mostly applies to 2009 (e.g. tough fund raising environment) but I think holds more generally.

VC asks the following line of questioning:

Q: What was your last round post-money valuation?

(translation: how expensive was this deal previously?  Do I think they'll want an up-round, down-round, flat-round?)

Q: When did you raise the money?

(translation: if it was raised in the peak of the market and the price was high then I should be looking for a down round.  If you raised it 1 year ago, what progress have you made that would justify a flat round or an up round)

Q: What are your expectations on valuation? … or … What price are you raising at now?

(translation: based on my views of whether you're over valued at the last round or not, please help me figure out whether it's worth spending any more time with you now.  My scarcest resource is my time.  If you or your investors have unrealistic expectations on valuation I don't want to waste my time trying to talk you down on price.  I'll just move one.  There's plenty of other "fairly priced" deals out there.  See here for an article in the NYT on this tension.

So what do you do?  My advice:

1. Be humble. I prefer the following line, "Listen, we know that it is a tough market out there.  We're realistic about valuations right now.  Obviously we want to get the best valuation we can but we understand the current environment and what the normal valuations are at this time."

(translation: we want a fair price but we're not going to be difficult.  Spend more time with us.  Come on, you know you want to!)

2. Don't name a number. It's up to a VC to price a deal.  He/She knows that.  They don't need you to tell them your asking price – they just need to know that you're not on another planet.  We all had the pre-revenue companies in 2007 trying to get a $40 million pre-money valuation.  It took time for those people to realize that the market had changed so we want to be sure you're not still one of those.

3. Don't say, "we'll let the market determine the price." That's everybodies' favorite line.

(translation to us, "we're going to run a competition and whoever pays the highest price will get the deal."  I know that's not what you mean, it's just how it sounds in VC speak.

4. Don't sound desperate. I know it sounds obvious but you'd be surprised that some people really come across this way at times.  I think some people are so beat up and tired of the fund raising process that they already are like dogs with their heads down expecting to be hit.  The number one rule of VC is to make it seem like you have other options and these are likely to yield results.  You're looking for understated optimism.  Someone else is planning to ask you to the prom.

5. Make it clear that price isn't the only determinant. My recommended line (and I hope you actually mean it!) is, "We obviously want a fair price but price isn't the only consideration for us.  We want an investor who does A,B,C.  Ultimately financial success for us isn't going to come from an additional 5-10% in this round.  It's going to come from a thoughtful and hard working executive team & board.  We're looking for somebody that can contribute to this."

Final note:  Unfortunately many deals from 2005-2008 were overpriced or have investors no longer wishing to invest.  Most teams think the best way to fix all this is by bringing in a new investor.  I know that the easiest way to get concessions out of your existing investors is to have a term sheet so I understand the sentiment.  But I recommend trying your best to clean up your Cap Table before fund raising.  It is hard enough to raise VC in this market with a "clean" deal that is doing reasonably well.  The odds are stacked against you if your deal "has hair on it."  Go to the barber and clean it up.

Winding Down a Co-Founder Equity Relationship

by Jay Parkhill

I have had several questions about this topic recently from different angles, so here are the basic concepts when a co-founder or early employee leaves a company.  Note that there are overlapping employment, noncompetition and other issues here that I am not going to touch in this post.

The Setup

CloudWidget, Inc. has three co-founders.  They own equal 1/3 shares of the company and everything goes along swimmingly until Founder B moves away/gets a new job/has irreconcilable differences with Founders A&C.  Whatever the reason, B decides to exit CloudWidget and move on.

A&C come to me and ask questions that include:

-> Does B own his stock?
-> Can we get some or all of it back?
-> What should we do?

Threshold Questions

We start with the following key points:

1)  Does B own *stock* outright or stock options?  This is a critical point that many first-time entrepreneurs gloss over and that colors everything else that follows.

2)  Is there a vesting period attached to the stock/stock options?  If so, what is it?

Important Concept #1 – Earning into Equity

Every participant in a startup should earn into his/her shares over time so that if/when the person leaves s/he won't get a free ride on the backs of the people still plugging away.  If B's equity was stock options, then almost certainly the options are subject to vesting.  Leaving the company stops the vesting and B must exercise the option and pay the purchase price to get actual shares within 90 days (usually) or the option expires and all right to buy shares vanishes.

It is more common for co-founders to buy stock at the outset than to get stock options, though.  I encourage all my startup clients to put this founder stock on a vesting schedule as well.  This gives the company the right to buy the stock back at the price paid by the founder.  The right expires over time: typically 25% of the shares are owned outright and not subject to repurchase after 1 year, and the repurchase right lapses as to the remainder in monthly increments for another 3 years after that.

For some reason lots of people accept the idea of stock option vesting as a matter of course, but don't put stock on a repurchase schedule.  Again, I highly advise that everyone do this.

Important Concept #2 – Getting the Stock Back

If B holds a stock option CloudWidget needs to do very little.  On termination the option automatically stops vesting.  Good employment practice dictates that CloudWidget give notice that any vested shares must be exercised within [90] days or will lapse, but that's the extent of CloudWidget's affirmative duties.

Let's assume instead that B bought his stock outright, that it was subject to a repurchase right and that some, but not all of the right had lapsed.  CloudWidget needs to find B's stock purchase agreement and read it carefully. Some agreements require that CloudWidget buy back the stock within a set period of time (90 days) and some say that the repurchase is automatic on termination.  It is important to know what B's agreement says so that CloudWidget doesn't blow its opportunity.

If procedures are followed and the agreement is written correctly, B agreed to the repurchase terms when he signed the agreement, so his consent is not required now.  CloudWidget merely needs to exercise the repurchase right, cancel his stock certificate (hopefully in escrow with CloudWidget or its attorneys) and send him a check along with a new certificate for the vested, un-repurchased shares.  If B had vested in 1/3 of his shares he will end up with 1/9th of CloudWidget; A&C each own 4/9ths going forward.

Important Concept #3 – Not Burning Bridges in the Process

This is frequently the hardest part of the whole situation.  Companies need to know what their rights are, and then exercise them judiciously.  Circumstances vary dramatically case by case, and I always let my clients now that the agreement is the baseline for ending a relationship but is not definitive- everyone is free to reach any other agreement that makes sense, and it is often worth trading a little cash or equity in order to maintain a friendly relationship where possible.