It's Time for Venture Capital – Now More Than Ever

by Allan Leinwand

Recently two separate posts ran here that argued in favor of technology entrepreneurs who need early-stage money taking it from angels. I, however, believe they should seriously consider taking it from people in my profession: venture capitalists. The current economic meltdown and its effects, which are expected to be felt for at least the next year, require investors with deep pockets and a long-term investment horizon starting from a company's earliest days.

Entrepreneurs seeking funding usually turn to one of two sources: angels and venture capitalists. And given that I fall into the latter category, let me go on record as saying that both sources can provide exceptional outcomes. In fact, in many cases, some of the best deals that we see in venture capital come from angel investors. So angels and venture capitalists are not mutually exclusive sources of funding, as one can lead to the other. However, with the economy as it stands today, entrepreneurs need to think clearly about how to solve their funding needs from now all the way until better economic times.

I have known many entrepreneurs that have worked with angel investors and had great outcomes. Generally, angels are exceptionally smart entrepreneurial individuals who make fast investment decisions, take a smaller ownership percentage than venture capitalists in startups they fund and opt to have minimal involvement in the operational aspects of the business. On the other hand, some entrepreneurs note that angels are not focused enough on their business (anecdotally I have heard of some angels spreading their investments over 30 or more startups) and some have a fairly short expectation on the investment horizon for returning their capital.

For an entrepreneur, working with a venture capitalist is a different experience. Investing our limited partner's money generally requires us to have a more diligent and lengthy investment process than angels, to work with a very limited set of companies (at Panorama Capital we limit our full-time involvement to 5-7 companies for each partner) and thoroughly study a market before investment. As venture capitalists, we would argue that this focus and investment commitment should equate to more ownership in a startup than is typically taken by an angel investor.

After the initial investment, we also give access to syndicates for additional financing, study the market landscape for partners and competitors and help with team building. In other words, while we are more focused on our investments, we are also working on behalf of our limited partners to provide a return on their investment and that, in some instances, can admittedly result in a conflict of interests between us and the entrepreneur. In my experience, this conflict happens less often than one might think, typically when there isn't a strong and productive relationship between the investor (angel or venture capitalist) and the entrepreneur.

While there are objective reasons to take capital from both an angel or venture capitalist, in my mind the current economic downturn means that an entrepreneur needs an investor who will commit to a startup over a much longer time period than a typical angel investor. For example, before we commit, we ask ourselves if this is an investment that we would be excited about being involved with for 10 years.

The technology IPO market is dead and many predict it will stay that way for at least another 18 months. Debt financing for larger firms to use for mergers and acquisitions is practically non-existent. So unless you're an entrepreneur working at a startup that is narrowly focused on getting bought by a company that is flush with cash (and there are a few of these, such as Google, Microsoft and Cisco), you're going to need an investor with a long-term commitment to your business.

While I do know some truly remarkable angels who can help on all of these fronts, overall it seems clear to me that now, more than ever, is the time for venture capital.

(Not so) Scary terms in offer letters.

by Babak Nivi

Offer letters are short and easy to read, as far as legal documents go. But they contain some seemingly scary terms that are (1) ubiquitous in Silicon Valley and (2) usually "no big deal".

We're not saying that no one has ever gotten into a conflict or lawsuit over these terms—just that it isn't common. The offer letters from the major Silicon Valley law firms are very consistent.

Here are the seemingly scary terms from an offer letter I got from Yokum Taku at Wilson Sonsini. As always, this is not legal advice.

Options

"If you decide to join the Company, it will be recommended at the first meeting of the Company's Board of Directors following your start date that the Company grant you an option to purchase X shares of the Company's Common Stock at a price per share equal to the fair market value per share of the Common Stock on the date of grant, as determined by the Company's Board of Directors."

You don't get your options until the board grants them at the next board meeting. But they should start vesting on your start date.

The strike price is equal to the fair market value as of the grant date (sometime after the next board meeting). But that probably won't be higher than the FMV as of your first day of work.

"This option grant shall be subject to the terms and conditions of the Company's Stock Option Plan and Stock Option Agreement."

These are big documents that you're agreeing to without seeing. If you're concerned, request copies before you sign your employment offer.

We've never seen anyone negotiate exceptions to these documents. Just make sure the company doesn't have a right to repurchase your vested stock.

Conflicts

"Moreover, you agree that, during the term of your employment with the Company, you will not engage in any other employment, occupation, consulting or other business activity directly related to the business in which the Company is now involved or becomes involved during the term of your employment, nor will you engage in any other activities that conflict with your obligations to the Company."

The company isn't forbidding you to work on your own business on the side.

Get a lawyer to advise you on what you need to do to own your side business. At a minimum, work on the side business on your own time and don't use anything owned by the company.

IP Assignment

"As a condition of your employment, you are also required to sign and comply with an Invention Assignment Agreement (enclosed) which requires, among other provisions, the assignment of patent rights to any invention made during your employment at the Company."

These Invention Assignment Agreements always seem too far-reaching but they're rarely negotiated, especially if they're coming from one of the major Silicon Valley law firms.

The Invention Assignment Agreement usually asks employees to carve out the IP they developed before joining the company by listing it in an exhibit. If you've developed a lot of IP that is relevant to the business, you might want to ask the company to list its IP instead of, or in addition to, yours.

At-Will Employment and Sundry Items

"You should be aware that your employment with the Company is for no specified period and constitutes at-will employment. As a result, you are free to resign at any time, for any reason or for no reason. Similarly, the Company is free to conclude its employment relationship with you at any time, with or without cause, and with or without notice."

This is an offer letter, not a 5-year contract with the Chicago Bulls.

"You should note that the Company may modify job titles, salaries and benefits from time to time as it deems necessary."

You have no job security.

"This offer of employment will terminate if it is not accepted, signed and returned by such-and-such date."

This offer expires soon.

"This letter, along with any agreements relating to proprietary rights between you and the Company, set forth the terms of your employment with the Company and supersede any prior representations or agreements including, but not limited to, any representations made during your recruitment, interviews or pre-employment negotiations, whether written or oral."

If it isn't in this agreement, it isn't happening, even if we told you it was.

Why aren't VCs freaking out as Wall Street burns?

by Matt McCall

Interesting Piece from PEWeek:

"Why aren't VCs freaking out as Wall Street burns? It's a question that I've been asking for more than a week now. There is, of course, the usual litany of responses: we're long term investors, we invest in fundamentals, our LPs are going to be good for their commitments because they're so big and so various....

Then there's another train of thought: VCs and their portfolio companies have actually gotten smarter about business since the dotcom bust. I've identified a few ways VCs and their companies are doing business differently. Help me out, identify a few more.

1. Better Money Management: Milestones matter to VCs. Ask any entrepreneur, and you'll find it's likely he or she are getting money in tranches based on deliverables. Most tranches go through, even when milestones aren't met, but the process allows VCs a better way of keeping track of the progress of their portfolio companies. VCs are less likely to write mega checks in the early stages, many have raised the bar of proof points needed to get a big round. Money is also more likely to go to things that directly drive valuation increases as a smaller percentage of any round is going to PCs, servers and bandwidth.

2. New Sales Models: It used to be about "Big Game Hunting" and multimillion dollar site licenses. It's a model that was great for vendors: get all the money up front, then worry about delivering the product. But Software as a Service permanently transformed the way IT was sold. Now new installations are cheaper and can be scaled slowly. It's a model that's been adopted by IT appliance and PC companies as well. So when Datamonitor finds that IT budgets aren't going to rise in 2009 Datamonitor Survey , there's less reason to freak out. Most IT buyers have already planned their spend out: it'll be re-upping on the services they're already subscribed to.

3. Decreased Addiction to Advertising: The banner ad was a big part of any dotcom business model. When advertising budgets fell, hundreds of online businesses shriveled on the vine. Now, online businesses look less to online advertising for real revenue. Google Adwords had a big hand in that. Suddenly it was a lot easier to install advertising on your site, but it was also less lucrative. Nobody ever got rich putting up Google Ads, but at least using the service saves companies from having to hire expensive advertising sales people. The addiction to advertising has been broken and many companies are looking for other ways to make real value online.

4. Moderate Exit Expectations: If you're not looking to flip a startup to the public market, what do you care that Wall Street's investment banks are falling like dominos? Had this same crisis had happened 10 years ago, you can bet VCs would be pulling their hair out. But when there are already no IPOs, it's hard for the public market to get worse. When exit expectations are more reasonable, it's easier to keep cash burn in check. Startups are less likely to build out sales teams, for example, planning perhaps to later plug in to an exisiting sales organization via aquisition.

What else have you learned from the dotcom bust that's helping out now?"

A new kind of VC? Bring it on...

by Mark MacLeod

Fred Wilson is the last VC on Earth who needs more press, but I was impressed by an article published about him and his fund Union Square Ventures this week.

Fred is a celebrity VC. His blog gets 25K visitors per week. But that's not what makes him or his fund different. After all, I'd argue that John Doerr and Mike Moritz are celebrities in their own right. The difference lies in the types of companies and investments Fred and his fund make.

The typical VC deal goes like this: Give me 20+ % of your company, put me on the board and give me a bunch of vetoes over key decisions. Fred makes it easier to get going. He puts in less $ upfront, and in return asks for a lower stake.

VC 2.0

Back in June I posted about how web 2.0 could help smaller VC funds drive returns. My thesis was this:

To put smaller amounts into a larger number of companies you need some commonality between these companies so that you can streamline your portfolio management. Web 2.0 gives this to VCs.

All web 2.0 companies have similar key metrics. If your service is free and advertising supported, then the key to your business is the CPM rate you can get by delivering a clear, focused and valuable demographic to advertisers.

Well, turns out this is what Fred and Union Square Ventures are doing. They've put $500K to $1M to work in a number of small web plays including Twitter and Feedburner.

So, what can VCs learn from Fred & company so that they too can become this new breed of VC?

Start a blog: Anyone can start a blog. The tough part is committing to it and keeping it going.

Be genuine: This is an extension of your blog and being social (as in leveraging social media). Be real, be genuine, be open.

Eat your own dog food: If you're going to invest in web 2.0 companies, you'd better be spending a lot of your time using their services and just generally consuming and experiencing the latest and greatest that the web has to offer.

Forget about IP:In the traditional VC model, IP (ie patents) are important. In the web 2.0 World its about design, user experience and efficient and large scale user acquisition. I.e. its an execution play, not an IP one.

Be entrepreneur-friendly:There's a growing backlash against the traditional VC model. As the costs to build a company go down, VC is no longer the only way to go. If you want the best deal flow find ways to make VC more appealing.

Walk the talk: Add real value to your companies. These smaller web companies cannot build out a full executive team and so there is more room for VCs to bring their experience to the mix. And as I posted, if you're spending all your time investing in the web 2.0 space, then you will have serious value to add to the mix.

So, who will the next Fred Wilson be? No idea, but I hope he or she is in Canada!

Amid turmoil and news of $700B federal bailout, is the sky falling for venture capitalists and start-ups?

by Dean Takahashi

We've asked some prominent players in venture capital and start-ups about where the venture capital industry and start-ups are headed over the next year, given the economic turmoil.

The $700 billion federal bailout plan still being negotiated by Congress and the Bush Administration may restore confidence, but it looks like uncertainty will last for months. Many people believe we’ll be in a prolonged recession. In the latest news, Goldman Sachs and Morgan Stanley, the last big independent investment banks on Wall Street, will transform themselves into bank holding companies subject to far greater regulation, the Federal Reserve said Sunday night — one more nail in the coffin of what was once a freewheeling culture on Wall Street. Both banks had also engaged in some private equity and venture capital investing.

The situation is more volatile than the last time we did this, during the Bear Sterns financial crisis this spring. The world markets are hanging in the balance.

Fred Wilson, blogger and partner at Union Square Ventures:

Start-up outlook: Technology driven change is accelerating, not decelerating and one could argue that technology driven change is part of why we are seeing such economic woes on Wall Street and elsewhere. Silicon Valley and the venture capital ecosystem at large is fueled by innovative people working with technology to deliver game changing companies to the market. There's never been a better time to do that. So from that perspective, I don't see much impact. I do think that everyone is feeling more conservative right now with their capital and that will likely impact investors, probably more so individual investors than institutional investors. I also think M&A transactions might take a hiatus for a bit in here. And we might as well forget about the IPO market for now.

Venture capital outlook: Probably less deal making, more focus on portfolio companies. There will be a hard look at under-performing portfolio companies to make sure they deserve more funding. Down cycles, if that is what we are in for, will always force VCs to look hard at their existing portfolio companies. This trend will be reinforced by the fact that it will be harder to raise follow-on rounds for companies that are struggling. A rising market, which is what we've had for the past five or six years, lifts all boats. A falling one works the other way. All that said, I think the venture capital market will be the least impacted of all the major investment asset classes out there.

Steve Perlman, founder and chief executive of Rearden, a research-focused investment company in Palo Alto, Calif.:

Start-up outlook: Compared to other sectors, technology has weathered the storm pretty well, and we're still seeing strong interest in tech startups, both in terms of strategic partnerships and investment although funding from pure financial investors is closed until the storm blows over. We're seeing closer attention to the strength of the business models, and we're seeing particular interest in market segments which benefit when consumers and businesses are forced to cut costs. For example, home media/entertainment (people go out/travel less and consume more media) and green/cleantech (high gas prices combined with social awareness of global warming/political instability issues).

Venture capital outlook: I think VCs are far better positioned for this bear market than they were for the dotcom collapse. This time, there's no tech bubble to burst. Investments I've seen over the last few years have been far more realistic and conservative (arguably too conservative, even in the current market). And, in the case of Internet-based startups, as the Internet has matured, business models that were once pure speculation now can be modeled and valued against actual data, like real CPMs, hosting costs, audience behavior, etc. Of course, no one's expecting an IPO window to open up until the market settles down, but there hasn't been much of an IPO window over the last few years, so that has been factored in already. The next year will likely be slow because consumer/business spending is slowing down and people will be cautious, but in my view the Silicon Valley ecosystem (startups, VCs and big tech) is in much better shape for this storm than the last one.

Mike Kwatinetz, founder and partner, Azure Capital Partners:

Start-up outlook: It's important for startups to be more cautious on burn levels as time to liquidity has lengthened. Also they need to try to raise new rounds earlier as they can take longer. There probably will be more recaps as older funds run out of "dry powder" and may not be able to cross-invest from a new fund (in an old deal).

Venture capital outlook: Should not impact top tier funds. But for less successful funds it gets complicated. Many investors use distributions from existing funds to help make new commitments so there could be less capital available for private equity. However, LBO funds may have more difficulty getting loans to use to leverage deals and therefore may have slowed their pace. Since this delays their raising capital could offset other issue and mean venture funds will be ok. The magnitude of how much these 2 trends offset each other will determine how well second tier VCs do in raising new funds.

Gordon Ritter, founder and general partner at Emergence Capital Partners:

The outlook for start-ups: The higher your ASP (average selling price) for your product or service, the more your revenue growth will be slowing in 2009. If you don’t have an ASP because you rely on advertising revenue, your "company's ASP" will be lower in 2009.

Venture capital outlook: Fear is overtaking greed at this time. I suspect greed will return to the venture market after the New Year and early stage venture investments will be back to early 2008 pace. Real business models will replace unique visitors as the metric of success.

Mike Cassidy, former CEO of Xfire and serial entrepreneur:

On start-up outlook: I think there will be increased polarization: Strong start-ups will get stronger and weaker ones will struggle. Strong ones will benefit because:
- It will be easier to hire. (Less competition from other startups because there will be fewer of them. Less competition from weaker startups because prospective hires will be seeking stronger management teams and stronger investors.)
- It will be easier to rent office space. (Fewer startups will be competing for space.)
- It will be easier to get press/media attention. (Again due to fewer startups competing for attention.)
- It will be easier to raise follow-up rounds of financing. (Investors, too, will "flee to quality" even more than previously.) Weaker startups will find it even harder to hire and raise money due to "flight to quality" by employees and investors.

Venture capital outlook: It's already been a challenging time in venture capital recently, so I don't think things will be dramatically worse over the next 12 months. As above, I think the strong VC's will get even stronger and the weaker ones will struggle. The strong VC's may benefit from reduced competition from alternative funding sources (hedge funds, angels, etc.). And I think the wiser (stronger) startups will migrate even more towards raising money from the stronger VC's. It sure doesn't look like there will be a lot of IPO's over the next 12 months. And acquisitions are still way down too. But stronger VC's have a deeper pipeline that will eventually pay off. There are still a reasonable number of good startups out there that are making progress and will be wins for their investors.

Guy Kawasaki, angel investor and serial entrepreneur, head of Garage.com:

Start-up/venture outlook: The collapse of greedy banks that loaned money to people who should not have bought homes should be unrelated to venture capital investing. In fact, it should make venture capital a more attractive investment class. But it won't because it's all a mental game. When Wall Street goes into a funk, it affects the mood of the venture capital industry. Truly, entrepreneurs and venture capitalists should be worried about what may happen in five years, not five days, but short-term emotions will rule. With regard to entrepreneurs specifically, if the Lehman debacle scares them from starting a company, they were going to fail anyway.

Lise Buyer, principal, Class V Group:

Startup/venture outlook: The good news is there's still a lot of money looking to be invested. The bad news is the public markets have very little tolerance for incremental risk these days and that condition will likely remain for quite some time. Why invest in an unseasoned, unproven start-up when the stocks of so many financially viable companies are "on sale"? Start-ups planning a quick exit should re-think that game plan. Companies committed to producing a stand-alone new product or service, should focus on raising and spending money assuming no exit for five to seven years. History suggests that companies that built solid, self-sustaining businesses before tapping the public markets perform dramatically better post the IPO. Public investors seeking to outperform the averages, are always on the lookout for emerging companies that solve a real problem, fill a real need, appeal to paying customers and can build a profitable business around those products or services. If you built it, they really will come; these days its a matter of proof and patience.

Stewart Alsop, partner at Alsop Louie Partners:

Start-up/venture outlook: No impact unless the whole economy goes into the tank and takes the startups with it. We operate on the belief that we're investing in companies that make a big enough difference that they should not be affected by the state of the economy.

Anatomy of a Series A Deal: Part II - Assessment

by David Aronoff

In part one of this monologue I discussed how VC's source deals. The second step in the venture capital investment process comprises assessing (I chose this word instead of evaluating, because that frequently gets confused with valuing, which is completely different) a potential investment.

There are two stages to assessing an investment - (1) a preliminary assessment, to determine if some new project (VC speak for deal) is interesting enough to warrant digging in, and (2) a comprehensive assessment, also known as due diligence.

Preliminary Assessment

In general, active VC firms see several thousand business proposals each year and have to winnow this number down to a very small number (in our case 8-10) of new investments. Therefore, a preliminary assessment - a SAT test for startup ideas - is crucial. I mentioned in the previous post that I review each and every business proposal I receive. If I didn't have a reasonably quick method for first level fit assessment, I might not have sufficient time to make a single investment.

What criteria do we use for this preliminary assessment? I first look for relevant experience and point of view for the problem/solution - "fit." For example, an enterprise software veteran pitching an HDTV tuner semiconductor idea is likely a poor experience fit and unless there were extenuating circumstances, I would pass on the opportunity.

Other attractive aspects include novelty of the idea, early customer feedback and engagement, and of course advanced development work on the product or service. While none of these are pre-requisites for us to make an investment and conversely, having them (all or part) does not ensure we'll engage, they do help.

Often, VCs make snap judgments about prospects and turn them down immediately - really a "blink" reaction. It may be because we didn't really care for the entrepreneurs (based on negative visceral reaction, or credible reference checking), the space, the business model, the level of competition, or any/all of the above. While I would like to think that substance prevails over form, the reality is that a good first impression matters a lot.

What doesn't help? Here are a few of my pet peeves:

A phalanx of advisory board members. Unless they are REALLY contributing to the company in a meaningful way, which usually only happens with bio/med tech companies, the long long list of advisors seems silly to me. I am sure he's a great guy, but the identity of your accountant doesn't make me what to invest in your company.

Powerpoint animations & reveals when presenting. These waste everyone's time and slow down getting to the meaningful aspects of one's business.

Chewing gum while pitching. Really. In this day and age I have observed on 3 occasions in the last 2 weeks, people pitching to me while chewing on some Wrigleys or Bubblicious. At least it's better than Skoal I guess.

I view this preliminary assessment as culminating in a declaration of seriousness to entrepreneurs - or not. In the affirmative, we are saying that we are inclined positively to make an investment and need to dig in deeper.

How long does this take? Usually measured in days or a couple of weeks on the outside, but really depends on immediate reaction (+/-), competitiveness of the deal, geography, and workload. As a rule of thumb, if after a first meeting you haven't heard from a VC for four weeks, forget about them ...

Due Diligence (Comprehensive Assessment)

IMO, a comprehensive due diligence program is a requirement for VCs making a new investment and I believe it should be a requirement of the entrepreneurs as well. There is no better predictor of how engaged a VC will be on your board of directors post an investment than how seriously they take learning about your business in the first place.

This doesn't have to mean a slow and painful odyssey; but unfortunately it often is. We strive to be very straightforward in our approach, sharing the high level plan with entrepreneurs - to get their input and feedback and also to be as transparent as possible on the issues that we are considering. That way a team knows how to calibrate progress in a more quantifiable way. A typical diligence program usually comprises many of the following elements:

• Team:resumes for founders, key execs and employees, references both supplied by company and "back channel," spend as much time as possible getting to know the team and vice-versa.
• Technology Assessment: architectural evaluation, review of development schedule and status, resource plan, intellectual property review
• Market Opportunity Analysis: current state of landscape (if appropriate), customers, partners, suppliers, competitors, sizing of opportunity, go-to-market strategy, exogenous factors that may impact the business in the future, exit analysis
• Operational Review: develop perspective on overall company financial plan, capital and resource needs
  This type of diligence process involves face to face meetings, phone calls, email, etc.

Some usual questions we hear, include the following.

How long does it take?

It really depends - on the state of the startup, prior relationship with the founders/executives, state of the market, etc. In our experience, from time of "declaration of seriousness" to a commitment (term sheet negotiated and diligence done) typically spans about 4-6 weeks; sometimes shorter, sometime longer.

When does a term sheet appear?

Ideally, we like to submit a formal term sheet when we are done with all our diligence and ready to close a deal. We start discussing terms (including valuation, equity, option pool, key issues) as soon as we get into comprehensive diligence. Sometimes, however, term sheets are submitted prior to the completion of diligence, but this is not a preferred scheme - and shouldn't be by entrepreneurs, as it ties them up while the VC firm finishes their work.

Anatomy of a Series A Deal: Part I - Sourcing

by David Aronoff

I have to give credit to "Dave" the anonymous commenter on my partner Jeff Bussgang's Sept 23 Blog Post, who complained that venture capitalists' blogs "seems like a buncha crap happening inside an echo chamber, circular praise, recycled insights and so on..." He wrote that he hoped "somebody will be inspired to write about the anatomy of a deal, the mechanics of evaluation and all of that." Dave - not sure I'll hit all you have asked for, but am happy to give some glimpses of what can often be a very opaque process from the entrepreneur's side.

Let me start with the disclaimer: what I am about to write is my own opinion and does not necessarily reflect that of my firm and certainly may not reflect the opinions of the greater venture capital community.

This is going to be a long post, so I will split into multiple entries.

A venture capital investment process comprises the following steps: sourcing, preliminary assessment, due diligence, negotiation of the deal and finally, a formal closing of the investment signaling the deal is completed.

Sourcing - is the lifeblood of a VC firm; without a steady stream of high quality deal flow, firms won't be able to make great investments and will become irrelevant to the best entrepreneurs who want to see a pattern of good investment judgment in their VCs. While each firm and each partner have their own proprietary strategies for finding deals, it's still more art than science.

Sourcing strategies are both proactive and reactive. VCs track forward-looking trends and often put like-minded entrepreneurs together to evaluate ideas and form new companies. But by far most of the investments I have seen made have been in reaction to great ideas by innovators. I suspect there is an inverse relationship between VC-originated ideas and new company success rates, but I'll leave that alone for now.

I reckon that VCs who proactively chase leading edge concepts, put themselves in position to meet the next crop of great entrepreneurs. And by showing (hopefully sincere) interest in their domain specialties, such innovators are more likely to want to work with those VCs. Make sense?

So, how do VCs find deals? In my experience, the predominant method is via personal recommendations directly to the VCs; the entrepreneur or someone close to them has worked the firm or VC before, or knows the VCs, professionally or socially (Another VC partner, lawyer, accountant, fellow board member, etc). Led by the MIT 50K, the business plan competition, has brought an American-Idolesque tenor to direct approaches and many VC firms participate in various annual contests. (we do!). The final categories of deals include over-the-transom submissions (email, snail mail) and broker-introductions. We have made investments that came "blindly" via email or post, from folks we didn't know before - but to be honest, the numbers are very small.

And while I look at each and every proposal I receive, I have to admit that I have never funded (nor my firm to the best of my knowledge) a Series A deal referred by a banker who was being paid to market the deal. While some of my best friends are i-bankers, I bristle at the notion of (a) being part of an auction to get the highest price for a first round and (b) don't think they add any value at that stage. The excuse I have heard is that the bankers have the connections to the VCs that first time entrepreneurs lack; i say that's baloney - especially because those bankers are basically cold calling a group of VCs they don't know in order to cast a wide net - and that act of spraying and praying fundamentally tarnishes the reputation of the company. If you don't know VCs - try email, phone, US mail, fax - exhaust all other methods before resorting to a banker.

How To Pitch To VCs

by Furqan Nazeeri

David Rose (who I confess I did not know of before watching this video) gives a presentation on how to pitch to VCs.  Rose is the founder of New York Angels and also CEO of Angelsoft, the software platform used by most angel investment groups (and about which I previously blogged). 

Rose starts by listing the 10 characteristics of an entrepreneur that the investor is attempting to assess in the pitch:

1. Integrity
2. Passion
3. Experience
4. Knowledge
5. Skill
6. Leadership
7. Commitment
8. Vision
9. Realism
10. Coachable

He gives some tips on how you might help the VC favorably assess these qualities.  Then he talks about a few things you should be sure to do during your presentation:

• Make sure your presentation has a logical presentation
• Talk about things the investor knows / understands
• Validate what you say with evidence
• Establish believable upside in your business

Followed by some things you should NOT do:

• Talk about things the investor does not know about or understand
• Say things the investor "knows" not to be true
• Have internal inconsistencies in your pitch
• Include typos, errors or other mistakes

In terms of what the presentation should look like he says your slides should ideally be:

• Short titles with short bullet points
• Even better, just headlines
• Or best of all, just images

He then promptly breaks that rule by putting up a slide of the slides you should have in *your* presentation (basically a modified Kawasaki-10, which I'd argue is a better framework):

1. Logo (first page)
2. Business overview
3. Management team
4. Market
5. Product
6. Business model
7. Strategic relationships
8. Barriers to entry
9. Financial overview
10. Use of proceeds
11. Capital and valuation

And then to close he has a few tips on how to run the actual presentation:

• Use "presenter mode" in PowerPoint or Keynote
• Use a remote control
• Your handouts should not be your presentation
• Don't read a script
• Never look at the screen

Well, if that summary wasn't enough for you, you can watch the video with Rose's tips on pitching VCs (it's about 15 minutes long) here:

VCs Want Key Team Members To Have Significant Equity

by Mark Davis

When a VC decides to invest, he focuses on structuring both his relationship with the company and the relationship of others within the company in a manner that will increase the odds of success. 

To be clear, by success I mean two things:

• First, that the VC's position will be protected, and
• Second, that the company is poised to generate at large exit. 

VCs protect their positions through the use of preferred stock structures and other rights that I elaborate on in other posts.  At the end of the day, though, a VC maximizes his chances of top-tier returns not through legal structures but by ensuring that a company's management shares the same goals for the business as a VC.

In my post, Why Liquidity Preference Exists, I address one way in which incentives are aligned through liquidity preference.  However, another more basic incentive is typically considered during the structuring of the deal: the equity stake of key team members. 

At the end of the day, do not run portfolio companies.  As a result, the best VCs want to make sure that the key members of each management team have a good bit of equity, ensuring that they have significant upside and real incentives to build their company to a scale that generates returns for everyone.  It's worth repeating:  good VCs want current and future team to own a significant share of the company. 

This premise also holds true when the company is more mature - board members often issue key operators additional options to keep incentives aligned.

This reality doesn't imply that entrepreneurs are sometimes challenged by the ownership requirements of VCs.  Entrepreneurs that are less experienced with the venture process may have valuation expectations that are unrealistic given the risk profile and the return requirements of an early stage investment.  As a result, VC ownership requirements can surprise newcomers.

However, industry veterans are usually aware of VC ownership requirements, why they exist and the fact that founders can do very well despite despite not owning the vast majority of a venture-backed company.  When a company lives up to its potential, the model typically works - VCs get their returns and entrepreneurs become very wealthy.

In sum, VCs also want entrepreneurs to have a significant stake in the company.  However, it's worthwhile to be familiar with the venture capital model, as understanding the typical ownership stakes after a VC investment can ensure that expectations are aligned before term sheets are issued.

I Don't Know...

by Josh Kopelman

I don't know.

Why is it so hard for people (including both entrepreneurs and VCs) to say these three words?

This past week I had two distinctly different meetings with entrepreneurs.  They both were successful serial entrepreneurs.  Both were exceptionally smart.  Both had good ideas.

The first entrepreneur, however, thought that they were expected to know the answer to every question.  There wasn't a question I asked that he didn't have a definitive answer to.  He knew what their pricing model would be.  He knew why Google would never compete with them.  He knew what their consumer churn would be three years out (despite the fact that they hadn't launched yet).  Whenever I tried to discuss the different risks in the business, he told me why they didn't exist. 

The second entrepreneur, had a different approach.  He definitively stated answers when he had them, but when he didn't know he said so.  When asked about his pricing model, he said "well, we're considering a few different options depending on the outcome of some tests we're running..."  When asked about cost of customer acquisition, he said "well we don't know what our numbers will be...but here's our model based on other comparable companies."  When asked about risks, he identified several -- and then we discussed how to reduce/eliminate them.

I've come to believe that a key investment criteria is founder credibility.  And, I think the second entrepreneur was far more credible.  No one expects a pre-launch company to have all the answers.  (In fact, we get scared if you think you have them).  As I've previously discussed, rather than have an entrepreneur sell me on why they are 100% correct, I'd much rather understand how they are attacking the different risks facing the business.

And, by the way, the same applies for venture capitalists.  I often feel that during company pitches -- and board of directors meetings -- we're expected to have an immediate opinion.  Should we double our marketing budget? Should I hire this person?  Will this strategy work?  While it's OK to offer opinions and thoughts, I think it is also appropriate to acknowledge uncertainty.   

Why do people feel pressure to have an answer for every answer?

I don't know...

The "No" Dialog and Some Observations

by Rick Segal

Here's some dialog with respect to a company I turned down recently. I'm pointing this out because this kind of back and forth can turn into that dangerous (and endless) "Let's continue the dialog" insanity.  I've cleaned this up a bit for readability and changed some stuff so as to avoid compromising the company or founders.

Me:

Mike, thanks for letting me take a look at []. It's a pass for me.  I've three issues here. First, I talked to 10 kids in the teenage range over at the local high school and this app was 0 for 10. None of them would even come close to giving me a scenario where they would pay for it while also thinking the sponsored games part was weird based on what I showed them.  Second, this is too hit or miss and requires mass numbers before there is scale to interest an advertiser.  Finally, the dollars you are asking will not, in my opinion, achieve the milestones required to get a later round done in the up direction. You simply won't get far enough to prove it out.  I appreciate you letting me take a look and hope the fast no, while not what you wanted to hear, gets you onto the next person.  Now, go prove me wrong, make a ton of money; my feelings wont be hurt.

Mike:

Rick, I appreciate the fast turn around and candid feedback.  If we can get a trial going and show some trending toward mass adoption and some advertisers, could we get you to revisit?  Again, thank you for the fast turnaround, it really is appreciated.

Me:

Generally speaking if you prove me wrong, get great traction, etc, etc, and de-risk the opportunity, you won't need me and/or you will have a zillion guys throwing money at you. I don't want you on a treadmill which has me constantly giving you the next hurdle to jump over.  I would take another look, but it would have to blow me and my partners away and, as I said, I'm guessing somebody smarter than me will scoop you up.

Mike:

Thanks, we will keep plugging away.

Saying no is always tricky. I struggle with this issue at least 10 times every single day. I think it is super important to give feedback but, as you can see, this feedback is a bit of problem.  In the example above, some people could argue 10 people wasn't enough. Some could argue it was the wrong 10, etc.  So there is the possibility that the entrepreneur dives into a rat hole trying to deal with my feedback.  The endless set of hurdles is always a problem and I try, hard, to avoid this.

Typically, you'll get the sorry, not a fit for us answer without much else. The translation of that 'no' can be anything from they were in a bad mood when they read it all the way to they don't get it.   Many VCs/Angels will tell you they don't want to make enemies or close doors, etc.

So what does all this mean to you? How can you get a fast pass but some actual feedback?  Here are some thoughts for you.

Ask For the Fast No:

As weird as it sounds, you telling them (me), your feelings aren't going to get hurt, you recognize the deal flow to close ratio is not in your favor, and a fast no with the three things you didn't like would be sincerely appreciated, can get you some feedback.  This type of approach can help lower the formality of the process.

Accept Email Dialog for What it is:

Email is a wimpy cop out for not having a phone call to explain the no. Guilty as charged and if most people would be honest, they would say the same. All of us, you included, believe email is way more efficient and we can be productive on our BlackBerry devices, etc. It's true but it is impersonal and is a crappy way to interact with somebody you don't know very well.  Again, I'm guilty of this. 

On this flight to San Francisco, for example, I've read 24 executive summary plans/Power Point Presentations.  Of those, 6 are getting a request for more information. The rest would never make it through process for all the standard reasons. So, I've cranked out 18 pieces of email which have tried to layout the reasons why.  Some are easy. We don't do chicken franchises so the plan for new competition to KFC (I'm serious) is getting an immediate pass with a very easy, we don't do chicken.  We don't do wet lab/medical stuff, again, easy pass.  The new search company that is 100% better than Google gets a pass with we would not invest in a direct, overt competitor to Google commentary. It's as straight up as possible. 

The point here is that you are likely to have your communications via email and should plan accordingly. Try to preface your stuff with the request for feedback and, hopefully, you will get some.

Make Your Business Points Clear:

This is linked to the fast no.  Most of the plans/presentations I've been getting have the basic business thesis points and from that I can comment directly on. Typically, you can do the "Here's what believe" or the "In order to invest you have to believe" slide(s) so my feedback can directly respond to these points.  For me, the crisper this part is, the more likely I'm able to give that feedback you might want.

Balance Speed for Details:

Lots of times you will get pass quickly. In this crazy world, it is way better to at least get the no then the silent treatment or (in my view) worse the "let's continue the dialog" stuff. If you have given some opening that says you really are receptive to the feedback, the fast no with some feedback later is a good outcome for you. I will tell you that while there are stories about jerks everywhere in every business, most people in the VC business try to do the right thing. The simple law of averages should work in your favor. (He says, hopefully.)

Don't Expect Names:

It simply is not going to happen. No VC will say, we pass, here is an intro to somebody else based on a plan sent into the firm.  It just won't happen.  The absolute best you could ever, ever, hope for would be for the VC to say something to another VC that they know was hot on a particular thing.  Then that VC would contact you.  Asking for the names of other VCs is a silly request which will not get honored.  Just so you are aware, sorry.

No sucks.  In my view, the best 'no' outcome is a no with some feedback. Hopefully, you will be successful an never need to worry about a 'no'!

What entrepreneurs need to know about Founders' Stock

by John Bautista

When entrepreneurs start a company, there are four things they need to know about their stock in the company:

• Vesting schedule
• Acceleration of Vesting
• Tax traps
• Potential for future liquidity

VESTING SCHEDULE

The typical vesting schedule for startup employees occurs monthly over 4 years, with the first 25% of such shares not vesting until the employee has remained with the company for at least 12 months (i.e. a one year "cliff"). Vesting stops when an employee leaves the company.

Even Founders' stock vests. This is to overcome the "free rider" problem. Imagine if you start a company with a co-founder, but your co-founder leaves after six months, and you slog it out over the next four years before the company is sold. Most people would agree that your absentee co-founder should not be equally rewarded since he was not there for much of the hard work. Founder vesting takes care of this issue.

Even if you're the sole founder, investors will want to see your founder's stock vest. Your ability and experience is one of the key assets of the company. Therefore, venture capital firms, especially in the early stages of a company's development and funding process, want to make sure that you are committed to the company long term. If you leave, the VCs also want to know that there is sufficient equity to hire the person or people who will assume your responsibilities.

However, many times vesting of founders' shares will follow a different schedule to that of typical startup employees. First, most founder vesting is not subject to the one year cliff because founders usually have a history working with each other, and know and trust each other. In addition, most founders will start vesting of their shares from the date they actually started providing services to the company. This is possible even if you started working on the company prior to the issuance of founders' stock or even prior to the date of incorporation of the company. As a result, at the time of company incorporation, a portion of the shares held by the founders will usually be fully vested.

This vesting is balanced by investors' desire to keep the founders committed to the company over the long term. In Orrick's experience, venture capitalists require that at least 75% of founders' stock remain subject to vesting over the three or four years following the date of a Series A investment.

ACCELERATION OF VESTING

Founders often worry about what happens to the vesting of their stock in two key circumstances:

1. They are fired "without cause" (i.e. they didn't do anything to deserve it)
2. The company gets bought.

There may be provisions for acceleration of vesting if either of these things occur (single trigger acceleration), or if they both occur (double trigger acceleration).

"Single Trigger"  Acceleration is rare. VC's do not like single trigger acceleration provisions in founders' stock that are linked to termination of employment. They argue that equity in a startup should be earned, and if a founder’s services are terminated then the founders' stock should not continue to vest. This is the "free rider" problem again.

In some cases founders can negotiate having a portion of their stock accelerate (usually 6-12 months of vesting) if the founder is involuntarily terminated, or leaves the company for good reason (i.e., the founder is demoted or the company's headquarters are moved). However, under most agreements, there is no acceleration if the founder voluntarily quits or is terminated for "cause". A 6-12 month acceleration is also usual in the event of the death or disability of a founder.

VC's similarly do not like single trigger acceleration on company sale. They argue that it reduces the value of the company to a buyer. Acquirors typically want to retain the founders, and if the founders are already fully vested, it will be harder for them to do that. If founders and VC's agree upon single trigger acceleration in these cases, it is usually 25-50% of the unvested shares.

"Double Trigger" Acceleration is more common. While single trigger acceleration is often contentious, most VC's will accept some double trigger acceleration. The reason is that such acceleration does not diminish the value of the enterprise from the acquiring company's perspective. It is arguably in the acquiring company's control to retain the founders for a period of at least 12 months post acquisition. Therefore, it is only fair to protect the founders in the event of involuntary termination by the acquiring company. In Orrick's experience, it is typical to see double trigger acceleration covering 50-100% of the unvested shares.

TAX TRAPS

If things go well for your company, you'll find that its value increases over time. This would ordinarily be good news. But if you are not careful you may find that you owe taxes on the increase in value as your Founder's stock vests, and before you have the cash to pay those taxes.

There is a way to avoid this risk by filing an "83(b) election" with the IRS within 30 days of the purchase of your Founder's shares and paying your tax early on those shares. One of the most common mistakes I've encountered with founders is their failure to properly file the 83(b) election. This can have very serious effects for you, including creating future tax obligations and/or delaying a venture financing of the company.

Fortunately, over the years, I've developed a number of work-arounds (depending on the circumstances) and we can many times find a solution that puts the founder back in the same position had the 83(b) election been properly filed. Nevertheless, this is one of the first things that your lawyer should check for you.

Of course, you'll still owe tax at the time of sale of the shares if you make money on the sale. But by then, I'm sure you'll be able and happy to pay!

POTENTIAL FOR FUTURE LIQUIDITY

Founders' stock is almost always common stock because VC's purchase preferred stock with rights and preferences superior to the common stock. However, recently my law firm (Orrick, Herrington & Sutcliffe LLP) has created a new security for founders which we call "Founders' Preferred" which enables founders to hold some of their shares in the form of preferred stock. This allows them to sell some of their stock prior to an IPO or company sale.

The "Founders' Preferred" is a special class of stock that founders can convert into any series of preferred stock sold by the company to VC's in a future round of financing. The founders would only choose to convert these shares when they plan to sell those shares to VC's or other investors in that round of financing. This special class of stock is convertible into the future series of preferred stock on a share for share basis. Except for this conversion feature, this class of stock is identical to common stock.

The benefit to you is that you are able to sell your shares at the price of the future preferred round. This avoids multiple problems associated with founders attempting to sell common stock to preferred investors at the preferred stock price.

Furthermore, the benefit to the preferred investors is that they can purchase preferred stock from the founder as opposed to common stock.

"Founders' Preferred" can usually only be implemented at the time of the first issuance of shares to founders. Therefore, it is important to address the advantages and disadvantages of issuing "Founders' Preferred" at the time of company formation. I normally recommend for founders who want to implement "Founders' Preferred" that such shares cover between 10-25% of their total holdings, the remainder being in the form of common stock. The issuance of "Founders' Preferred" remains a new development in company formation structures. Therefore, it's important to consult legal counsel before putting this special class of stock into effect.

Many VCs do not like to see Founders' Preferred in a capital structure.

CONCLUSIONS

As discussed above, there are a number of issues to address when issuing founders' stock. In addition to business terms associated with the appropriate vesting schedule and acceleration of vesting provisions, founders need to be navigate important legal and tax considerations. My advice to founders is to make sure to "get it right" the first time. Although here are many companies on the web that specialize in helping founders by offering forms for setting up companies, it is important that founders get the right business and legal advice, and not just use pre-packaged forms.

This advice should begin at the time of company formation. A little bit of advice can go a long way!

For VCs, One More Storm Cloud

by Ken Schachter

Venture capitalists may not be exposed to toxic mortgage securities, but they, and the startups that they fund, will feel the pain, nonetheless.

A Yale University professor and a think tank analyst said the turmoil on Wall Street will extend the current deep freeze in the initial public offering market, curb merger and acquisition activity, and make it harder to raise money from limited partners.

The financial markets were in turmoil Monday as iconic investment bank Lehman Brothers said it was filing for bankruptcy protections and Bank of America bought troubled investment firm Merrill Lynch & Co. for $50 billion. Meanwhile, insurance giant American International Group was struggling to shore up its balance sheet. That turmoil was triggered by the firms’ exposure to billions of dollars in subprime mortgages whose value was difficult to determine.

Though VCs and their portfolio companies are far-removed from mortgage-backed securities, they will not be immune to the forces buffeting the financial markets, said Andrew Metrick, professor of finance at Yale University's School of Management.

"The main problem is the industry has been kicked in the face for the last seven years," he said. "The latest turmoil on Wall Street is not a direct threat, but the exit markets have been closed down already."

Since the beginning of 2001, roughly 300 venture-backed companies have staged IPOs, he said, compared to a healthier rate of 150 IPOs per year in the 1990s.

The climate for mergers and acquisitions—an alternative exit path for venture-backed companies—also is likely to take a hit.

"Everyone's just trying to scramble to survive," he said.

Ross DeVol, director, regional economics at the Milken Institute, an economic think tank based in Santa Monica, California, said VCs also will face a challenge in raising funds from the institutional investors and wealthy individuals who provide their capital.

"It's going to be more difficult to raise new funds in the next year," he said.

Startups also will be feeling the pinch as VCs keep a tight rein on the purse strings.

VC firms are "going to be much more diligent about where they invest," Mr. DeVol said. "I think it will make it harder for startups to get money."

Said professor Metrick: "It's too early to write the obit, but the patient is in a lot of trouble … It's a real crisis."

5 Hacks For Closing an Angel Round

Killer VC Pitch Deck Appendix

by Furqan Nazeeri

Most appendices are weak. Typically they are the result of a 30-page presentation being pared down to 12.  They're just extra slides randomly ordered in your PowerPoint file starting at slide 12 or so.

Here are some tips how to avoid that and to create a killer appendix.

First, my advice is to start building your deck by creating your presentation on one slide. Yes, that's right. Just one slide. 30-point font with 4-5 bullets total (hopefully fewer). 

Next, expand to 3 slides. Now that you have your pitch deck (okay, it's 3 slides so it's more like a "pitch patio") you should practice giving your presentation. It should be 3-5 minute long. 

Finally, expand the presentation to the standard Kawasaki-10. Then do some more practice giving this pitch. Video tape yourself. In front of an audience. Critique your pitch.

Note that this whole process is the reverse of what normally happens (creating a 30 page deck and then start the process of paring it down).

Now you should go find a few people who know a lot about your industry/business...entrepreneurs who have "done it before." Maybe even a venture capitalist (tell them you don't want their money...you just want them to tell you everything that is wrong with your business).  Ask them to take 30 minutes and tell you how much your idea/plan/business sucks. Set the ground rules that they can't say anything positive.  (I'd like to see the look on the VC's face when you say that!).  Kick the crap out of your business...or as we used to call it: "8-Mile-ing" (if you haven't seen the movie, go see it and the scene at the end will answer your question). After you have 8-Miled your business, give a 3-6 word title to each objection you heard.  For example, "Team too inexperienced" or "CPM forecast 10x too big?"  Then prioritize them in decending order by your estimate of the probability of it happening and size of its adverse impact.  Keep the top 20.

Finally we're at the appendix.  You now have the titles of each of 20 pages of your appendix (i.e. the objections).  The contents of the slide for each are your retort.  I would put each slide in a separate file in a folder called "appendix" (or Mr. Wallace if you want to run with the joke).  In the body of the slide, hyperlink key points to webpages, data files, spreadsheets, whatever helps you make your retort.  Sometime during your VC pitch, you're going to get asked a question or two (probably one of the top 10 VC objections) that will be phrased eerily similar to the title of one of your appendix slides.  That's when you fire it up and start drilling down.

Do that, and you've got a killer appendix.

Plan B for Fund Raising

by Guy Kawasaki

Here's how most entrepreneurs approach venture capital funding raising. I call it Plan A. It's a plan and an outcome that no one talks about but happens all the time. I've been on both sides, so I should know.

• Step 1: the entrepreneur cogitates: "Let's raise $1-2 million so we can focus on programming and marketing and not worry about raising money. We'll hit all our milestones and then go out for another $5 million in two years and get acquired or go public soon after that." Believe it or not, many companies raise the $1-2 million and sometimes more because venture capitalists compete for the deal.

• Step 2: the entreprenur fantasizes: "Our most conservative forecast is one million users in the first six months. We need to scale to prepare for this, and the reason why VCs gave us money is that they want us to scale and win the land grab."

• Step 3: the product is late, and the dogs don't eat the food. After six months, there are 10,000 users, not one million. The company has scaled up its expenses but for no reason. Money is tight, but the VCs are still clueless and accustomed to initial projections being off by orders of magnitude.

• Step 4: Unbelievably, the company is still able to raise a second round of $5 million. Life is good. The entrepreneur "knows" that things are going to pick up so she scales up some more to prepare for the "hockey-stick" growth curve that coming soon.

• Step 5: Another six months go by, and there's still no viral explosion. (To continue the hockey analogy, the handle, not the blade, is touching the ice.) The venture capitalists that the entrepreneur thought were true believers and BFFs (best friends for life) go to Demo and see three products that do the same thing that appear to be further along.

• Step 6: Out of the blue, the lead-dog venture capitalist calls up the day after a partners meeting and says, "We just don't see how you're going to make it. We want to give your company a 'soft landing' by merging it with our online dogfood company. And we'll call some executives we know at Yahoo!, Google, and Fox Interactive to see if they're interested. We want our money back before you burn through it because my partners think this has gone on too long."

• Step 7: The entrepreneur hangs up the phone in a state of shock. A week ago in a board meeting, no one said anything about shutting down the company. She thought that her investors were getting a little antsy but were fundamentally still behind her. She calls the investors "stupid, arrogant bastards who don't get it" in her staff meeting–conveniently forgetting that she's missed three years of forecasts by 90% and has burned through $3 million.

• Step 8: The company rapidly implodes. No one wants to merge it with another dog in the venture capitalist's portfolio, and no one at Google, Yahoo!, or Fox Interactive is interested. This is a fundamental fact of companies: they are bought not sold. That is, an entrepreneur or investor can seldom call up logical buyers and get a deal done. All an entrepreneur can do is create a good company and pick up the phone when a buyer is calling.

  The company is sold for pennies on the dollar for what little assets (intellectual or physical) that it has. Some money is returned to the investors. The management team toys with two ideas: first, buying the company from the investors, but it quickly realizes that it created a dog that's not worth buying. Second, suing the investors for not fulfilling their fiduciary responsibility to the company, but when the lawyers laugh at this idea, the team gives it up too.

As readers of this Open Forum blog, I want you to be open to another way. I call this Plan B. In this plan, you take very little if any venture capital until you need capital to expand, not create, your product. Here's how it works:

• Step 1: You dig, scratch, and claw yourself to $100,000 of funds from your friends and family. Maybe you work as a YCombinator company. You take no salary. You live with your parents, and you keep your day job at Microsoft. You hope your spouse doesn't get laid off. You have no office, but work virtually and meet your co-founders at Starbucks if you have to. Everything you use is Open Source or shareware.

• Step 2: Rather than trying to boil the ocean ("the mobile sector"), you boil a tea kettle. Rather than paying to attend high-end conferences, you hang out in the lobbies of the hotels where the events are and meet the same people for free. Rather than hiring a PR firm, you suck up to bloggers and hope they cover your product. Rather than buying booth space, you get on Twitter and use it to gain a reputation for your product.

• Step 3: You're late with your product too (because everyone is late), but you're not burning $250,000/month, and you don't have to tell increasingly greater lies at monthly board meetings. Finally, you release your prototype. TechCrunch covers your release because you wrote Mike Arrington a compelling one-paragraph message that you sent on a Friday afternoon because you know he reads email on weekends.

• Step 4: This is where the miracle occurs–lo and behold, people like your product. (Truly, miracles have to occur whether you're bootstrapping or venture-capital funded. It's just that if you're bootstrapping, there's more time for the miracle to happen, and a smaller miracle suffices.) Month to month, you're showing 10-15% growth, and monetization, praise God, has started.

• Step 5: Now you have options. First, you can contact venture capitalists with a company that's already shipping to raise capital to expand your business. This is a very different discussion than raising capital to build a product. Second, you can continue to bootstrap and grow by using your cash flow. Three, you can pick up the phone and agree to meet with Google, Yahoo!, Fox Interactive, or any other company that has noticed you.

Many readers of this blog are not tech entrepreneurs, but the merits of Plan B are the same for almost any type of business. You can try Plan A as long as you realize that the hard work begins after you raise venture capital, and you will need a bigger, faster miracle to make everyone happy. Or, you can just believe me: "Plan B, don't leave home without it."

Why Deferred Salaries Don't Work for Startup Founders

by Jay Parkhill

One of the toughest conversations I have with many startup founders is about salaries.  Founders may come from larger companies that pay them an annual salary and the idea of getting *no* cash for a significant period of time is really hard to wrap one's mind around.  The argument goes something like this:

"I make $X currently, I know I am worth that much and I really need to get the cash.  I can defer collecting it for a little while, but I need to catch up at some point."

My humble suggestion is always the same- don't think about it that way.  You are building equity in a new business.  The equity is your return.  You are unlikely to see your "deferred" salary repaid in that way, so make sure you have enough stock in the business to give the upside you need and work toward making that worth something.

There are really two alternatives to this, neither of which is feasible: accruing a hypothetical salary to be repaid when some large bundle of cash hits the company's accounts through financing or sales efforts, and taking stock in lieu of cash.

The Extra Cash Theory

The repayment on filling the coffers approach is based on the false premise that at some point there will be "extra cash" available.  This never happens.  Investors put money into a business in order to build structures that will take the business down the road.  Seeing their cash go straight through a company's bank account is anathema- except when a founder has actually put in cash without getting stock for it.

The revenue argument is probably even worse.  Revenue is hard to come by and most businesses don't see enough of it to justify paying back salaries on top of current ones and other business expenses.  The idea of generating enough revenue to cover accrued/deferred salaries is a fantasy in almost all cases.

Stock for Salaries

The stock-for-salary proposal is actually much worse than the extra cash idea.  What many founders don't realize is that the IRS treats stock in that case exactly the same as cash and taxes it at the same rate.  If a founder accrues $100k in salary and collects it in stock she still has $100k in income to report.

The problem is that she has $100k worth of illiquid stock, a tax bill of $35k or so and no cash to pay the taxes.  This is not a happy situation for anyone.

No Deferral, No Salary, Just Stock

The way out of the dilemma is to give up on the idea of taking much cash out of the business in the early going.  Buy your founder stock (for cash!) at a very low price when you start the business.  That is what you get instead of a salary, so be mindful of unnecessary dilution (no "advisory" options to friends and relatives) and work on making that stock as valuable as you possibly can.  You may not see much cash for a couple of years or more, but if you are lucky the stock will more than compensate for the sacrifices made in the early days.

How Do I Do Multiple Closings for an Angel Round?

by Brad Feld

Q: How do I do multiple closings on a single round work? In our case, we have an investor wishing to give us  headstart, certainly I imagine not an uncommon case in friend and family scenarios, though here we’d have multiple rounds of angels, without kicking up the gears to flush out a full seed round with other investors before that money changes hands.

A (Brad): There are several ways to do this.  Let's break it into two cases: #1: You are doing a convertible debt round.  #2: You are doing an equity round.

#1: Convertible Debt: This is the easiest case.  For a convertible debt round, you can keep it as simple as issuing a promissory note for each investor.  This promissory note can contain any special conversion terms, including what happens on a qualified financing (including the definition of the qualified financing), what happens on a sale of the company, and what happens if the company fails.  You can do as many closings as you want by simply issuing a separate promissory note for each investor.

#2: Equity Round: The best way to do multiple closings on an angel equity round is to raise the early money using the convertible debt approach above with an automatic conversion into a pre-negotiated equity financing once a certain amount of money is raised.  Let's say you are planning to raise $500k and your early investor is willing to do $100k of it at a $1.5m pre-money valuation.  You can negotiate the equity terms with this investor, issue a promissory note for $100k to get that money into the company, and then agree (contractually or not) to do the full round once you've lined up the $500k.  You do run the risk that either (a) you can't raise the full $500k or (b) some of your later investors will want different terms.  If you have a good relationship with the first investor(s) you can usually manage this by including them in the process.  You can also put a "most favored nation" clause in the promissory note to adjust their conversion features to match whatever the financing ends up if it is more favorable to them than the terms the negotiated. 

An alternative approach to #2 is to negotiate all the equity terms with the expectation that you'll have multiple closings on the equity round.  Then, do a first closing with whatever investors are lined up and have a fixed length of time (typically 60 - 120 days) to raise more money on the same terms.  Again, you should be conscious of the idea that you might have a new investor want better terms - since this is your early angel round, you should consider including a most favored nation clause so the investors that committed to you early get the same deal as later investors in the same round if the terms happen to change.

How The Best VCs Interact With Entrepreneurs

by Mark Davis

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

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

Top Ten Ways In Which The Best VCs Interact With Entrepreneurs

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

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

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

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

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

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